Throw a dart at a calendar in the past few years and where would buying Rolls-Royce (LSE: RR) shares have got you?
Over the past year, a 46% gain. Not spectacular, but still well over double the 18% gain in the wider FTSE 100 index (of which the aeronautical engineer is a constituent member) during the same period.
Five years? Rolls-Royce shares are up 1,045% during that period.
That is a remarkable performance in itself. It also means that while the current dividend yield of 0.8% may seem insipid, a buyer back then (when there was no dividend) would now be getting a yield in the high single digits.
Has the opportunity now passed forever? Or might the share’s mixed performance so far this year potentially offer me an opportunity to buy a dip?
Share prices: business performance, momentum, or both?
To answer that question, it may help to step back and consider why Rolls-Royce shares have put in such a strong performance over the past few years.
In the short- to medium-term, a share price can rise because of what is known as momentum. Investors buy, pushing up the share price, leading other investors to buy, further pushing the share price up and so on.
A different reason a share price might rise is because of strong underlying business performance That can push it up in the short or medium-term, but also in the long term.
As Warren Buffett’s mentor Ben Graham said, in the short term the market is a voting machine, but in the long term it is a weighing machine. In other words, business performance ultimately trumps momentum.
I reckon the past few years have definitely seen momentum help Rolls-Royce shares.
But – crucially – that momentum has not come from nowhere. It has been based at least in part on business numbers. Rolls-Royce’s commercial performance has been transformed in recent years.
That has been helped by external factors like the post-pandemic demand recovery in civil aviation.
But it also reflects internal shifts, such as a more focused set of financial growth targets and an aggressive cost-cutting programme.
Rolls-Royce has the wind in its sails – but for how long?
Civil aviation demand recovery is not the only external factor that has worked in Rolls’ favour.
Its two other main businesses are defence and power systems. Both have benefitted from increased geopolitical risks and conflict.
I expect that to last for the foreseeable future, as far as defence is concerned.
Power systems seems less clear to me. If oil prices remain elevated that could increase interest in Rolls’ small nuclear reactors, already gathering significant attention.
But there is a risk that what happens is closer to the 1970s oil crisis: high prices drive customers to look at alternative energy sources, but when oil tumbles in price again, that interest largely evaporates.
For now, though, the bigger risk I see is civil aviation. High jet fuel prices and geopolitical uncertainty could hurt passenger demand, pushing airlines to cut back on engine purchases.
Priced at over 40 times earnings, I do not think that risk is adequately reflected by Rolls-Royce shares today.
Given the strength of the business, there could yet be another big opportunity here for small investors like me, at the right price. But I do not see it today and have no plans to buy.
Should you invest £5,000 in Rolls-Royce Plc right now?
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Christopher Ruane has no position in any of the shares mentioned.
