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Liz Truss’s premiership marked a low point for the UK stock market. And during this period, already beaten-down Rolls-Royce (LSE:RR) shares plunged to deeper lows. I remember it well as my investments slumped just as I was getting married. What’s more, I also remember the pound collapsing against the euro. That made my Sicilian honeymoon negronis a lot more expensive.
However, Rolls-Royce recovered. In fact, it was highlighted as the most clearly mis-valued stock on the index shortly after Truss’s resignation. What followed was a series of earnings beats from the company that alerted investors to the mammoth potential of this British engineering giant.
The stock is up a phenomenal 1,285% from its Truss era lows. That means that £10,000 invested then would be worth around £138,500 today. If anything, hopefully this alerts potential investors to the possible outcomes when successfully finding and investing in undervalued stocks.
How did it get so high?
Rolls-Royce has momentum. Momentum is a really important factor to consider when investing. Because the problem with investing in undervalued stocks with no momentum is that they may never realise their fair value.
But that’s not a problem here anymore. In addition to beating earnings expectations over and over again, the company is a leader in industrial technology. It’s an important cog in the UK’s defence future, it continues to innovate in aerospace, and it also offers an exciting future in nuclear energy.
Coupled with extremely high barriers to entry in its core businesses operations, this is the reason the stock has been re-rated so many times. In the context of the stock market, re-rating refers to a change in how investors perceive the value of a company’s stock, leading to a higher or lower valuation multiple (like the price-to-earnings (P/E) ratio) without a corresponding change in the company’s actual earnings.
Today, Rolls is trading around 38 times forward earnings. That puts it in line with American peer GE. And it’s quite unusual to see UK firms trading in line with American peers.
Pushing higher still?
I see no reason why Rolls-Royce shares couldn’t trade higher if it continues to beat expectations and deliver positive updates. However, a re-rating seems unlikely given its current premium to the UK norm.
There are still risks too. A slowdown in the global economy could weigh on air travel. In turn, this wouldn’t be good for Rolls-Royce, which receives income from flying hours contracts.
It’s also no longer my top pick in the sector. I prefer Melrose Industries. Beaten down but with tonnes of potential, it resembles Rolls three years ago. The company trades at 15 times forward earnings but hopes to deliver 20% earnings growth throughout the medium term. Its P/E-to-growth (PEG) ratio of 0.75 is a fraction of Rolls’ at nearly 2.5.
So, is Rolls-Royce worth considering? Absolutely, but my preference is Melrose.
