Investors may be jittery over Rolls-Royce (RR.) as earlier this year the Serious Fraud Office widened its investigation into the company, but Dan Brocklebank, equity analyst at Orbis Investments, says it is a stock worth holding over the long term due to high demand and barriers to entry for its jet engine business.
"In our experience, mispricings can often arise when stocks rotate from being perceived as growth to value," he says. "That has certainly been the case with Rolls-Royce, which has fallen out of favour with many investors after being a stock market darling from 2011 to early 2014. The company issued a string of profit warnings between February 2014 and last November. At that point its shares had fallen about 60 per cent from their peak and we decided to make Rolls-Royce a large position in the Orbis Funds.
"Many such contrarian shares are out of favour for good reason, but in the case of Rolls-Royce we believe it has hit a temporary speed bump in what is otherwise a fundamentally strong business. For example, its core wide-body jet engine markets are a rational duopoly with nearly impenetrable barriers to entry until the mid-2020s and possibly much longer. The aircraft engine business produces steady revenue, in part because of long-term service contracts, and is analogous to selling razors but making much more money selling blades.
"We also believe Warren East, who became chief executive officer last July, has both the skillset and sense of urgency needed to help Rolls-Royce emerge from its current weakness with much greater focus, improved profitability and better growth prospects.
"Turnarounds can have a way of getting worse before they get better and we would not be surprised if Rolls-Royce continues to be a volatile stock. But we much prefer to invest in attractively priced shares such as Rolls-Royce, rather than paying an excessively high premium for the safety that other areas of the market appear to offer.
"Earnings are depressed today, but we estimate that Rolls-Royce will be able to generate more than 70p per share in net profit annually by the end of our three to five-year investment horizon."
