I look to utilise the Stocks and Shares ISA whenever I can. In fact, 95% of my non-pension investments are made within the ISA wrapper.
And within my ISA, I have a relatively diverse portfolio, with around 20-30 stocks and bonds. But the stock I’m least likely to sell is Rolls-Royce (LSE:RR). So, why is that?
Formidable moat
An economic moat is a competitive advantage that a company has in its sector, allowing it to protect its market share and profitability.
In the case of Rolls-Royce, it primarily operates in three sectors: civil aerospace, power systems, and defence. There’s one thing all of these sectors have in common, and that’s they have extremely high barriers to entry.
There’s a reason so few companies make aircraft engines, and that the defence industry is far less diverse than it used to be. The standards and development costs are so high.
In other words, I don’t think there are any or many companies with a stronger economic moat than Rolls-Royce.
Tailwinds
Appropriately, some of the strongest forces pushing Rolls ahead come from the civil aviation sector. According to Airbus, the aviation industry will need over 40,000 new aircraft in the next two decades. That’s at least 80,000 new engines.
The only issue is that Rolls-Royce left the narrow-body jet market in 2011, and the vast majority of demand is expected to come from exactly that part of the market. Airbus predicts that the industry will require 8,000 wide-body aircraft.
CEO Tufan Erginbilgiç has expressed plans to rejoin the narrow-body market, but that might not happen until the 2030s given the lag of developing planes and engines accordingly.
However, we can also note support in power systems and perhaps most evidently defence. Rolls stands to benefit over the long run as European nations increase their defence spending, but also from programmes like AUKUS, for which the London-headquartered company is building nuclear-powered submarine engines.
Valuation
Business momentum is great, but for an investment to make sense, the stock has got to represent value for money. Despite surging 500% from its lows, Rolls-Royce has all the hallmarks of a strong investment.
The engineering giant is currently trading at 22.4 times forward earnings, making it expensive for a FTSE 100 stock, but broadly in line with the industry average.
But the really attractive metric is the price-to-earnings-to-growth (PEG) ratio, which stands at just 0.67 times. The PEG ratio, which is earnings adjusted for growth, indicates a company is trading at fair value if the ratio is around one. A result of 0.67 suggests that the stock is significantly undervalued.
Discounted cash flow calculations broadly come to a similar outcome. The metric infers that Rolls-Royce’s fair value could be around £6.70. That means the stock could go 71% higher than it is today.
Forecasts can be wrong. But it’s hard to argue that there isn’t a very strong investment case for Rolls-Royce at this moment in time. As such, it’s the last stock I’d sell in my portfolio.
