Everyone loves a bargain. And based on Thursday’s surge, many in the market believe Rolls-Royce (LSE: RR) shares are priced too low. Are they right?
Rolls-Royce shares: unfairly valued?
It’s not hard to see the appeal. Rolls-Royce shares still languish far below where they were a few years ago. With Covid-19 infection rates falling in the UK and demand for international travel roaring back, I think there’s a lot to be optimistic about. Put simply, more planes in the sky mean greater demand for the company’s engines (and the need for those engines to be maintained) going forward.
Yesterday’s news that the Rolls would be looking to turn cash-flow positive in the second half of this year was also encouraging. That said, it’s clear a full business rebound is still some way off. As indicated yesterday, the slow recovery in travel means its target of £750m in cash flow might not be reached in 2022 as hoped. A lot can happen before then. This is where things get problematic.
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Based on past performance, Rolls still qualifies as a high-beta stock. In other words, its share price is more sensitive to setbacks than the market as a whole. That’s concerning if I think a correction is imminent.
As an aside, ‘anchoring’ myself to historical prices that Rolls-Royce shares have hit should also be avoided. In reality, stocks don’t know how valuable they once, were or whether they’re regarded as ‘bargains’ or not. Shares also don’t care who owns them.
Speaking of bargain hunting, I wonder if I might be able to make a better return from Pershing Square (LSE: PSH)?
Better buy?
I reckon this top-tier fund has stayed off many radars due to its manager — US billionaire Bill Ackman — not being particularly well known in the UK. Lacking exposure to tech stocks, PSH definitely doesn’t generate as many headlines as fellow FTSE 100 member Scottish Mortgage Investment Trust either.
Ackman is a value-focused investor and Pershing Square has just 10 ‘bargain’ holdings. Some names will probably ring a bell. Hilton and Chipotle, for example. Others like Lowe’s (the home improvement retailer) and Agilent Technologies (analytical instrument developer) may be less familiar. Universal Music Group will also enter the portfolio soon.
What I find really interesting about Pershing Square is that it trades on a big discount to its underlying holdings (net asset value). That’s despite PSH outperforming the S&P 500 index over the last five years — no mean feat considering the latter’s huge dependence on only a few tech titans.
Then again, like Rolls-Royce shares, the portfolio has definitely benefited from the huge bounce seen in stocks as a whole over the last year or so. So, if I were to invest in PSN now, I’d still expect some volatility. I’d also need to be comfortable with Ackman’s occasional desire to short stocks (which hasn’t always paid off).
Risk vs reward
All things considered, I’d be more inclined to buy a stake in Pershing Square over Rolls-Royce shares today. I don’t expect an easy ride for either. Nevertheless, the former focuses on companies that offer Buffett-style ‘economic moats’, high returns on capital and robust balance sheets. This leads me to think PSH offers a better risk/reward trade-off compared to RR.
