I always keep a list of shares I would like to own if I could buy them at an attractive price. During the market turbulence in recent weeks, I have bought some of those shares, such as JD Sports and Filtronic. Rolls-Royce (LSE: RR) is also on my list. But the Rolls-Royce share price has not yet fallen to a point where I think it is attractively enough priced to add to my portfolio.
Why not?
Thinking about risks and rewards
All shares offer (or appear to offer) some potential for reward, otherwise investors would not buy them.
But all shares also involve risk. In some cases that is far, far higher than in others. But it is important to remember that even the most stable of shares involves risks.
Rolls-Royce faces risks of external demand shocks
If you do not know what an external demand shock is, the past couple of weeks have provided a very helpful practical demonstration.
A demand shock is when a market for a product or service suddenly encounters less collective demand from would-be customers. That can be because of things it has done itself, such as raising prices or reducing its distribution.
But it can also be because of an external factor. Tariffs are one and they are certainly a risk for Rolls-Royce, given its global footprint.
But there are other potential external demand shocks that I see as risks for both revenues and profits at Rolls-Royce.
Pandemic-era travel restrictions illustrates this perfectly. Demand for civil aviation cratered, driving down demand for aircraft sales and servicing. Rolls-Royce lost lots of money — and its share price was in pennies.
A fundamentally attractive business model
How times change!
The Rolls-Royce share price has soared 471% in the past five years, even when allowing for a 16% correction since the middle of last month.
Fundamentally, I think there is a lot to like about the aircraft engine business. High technical and capital requirements act as barriers to entry, giving manufacturers pricing power. Rolls has a large installed base of engines, helping provide substantial servicing revenues.
It has a strong reputation and is also benefiting from increased defence spending by many governments.
I’m still not ready to buy…
But while those factors make the business attractive to me, I would only want to invest at a price I feel offers me sufficient margin of safety when considering the risks Rolls faces.
The current price-to-earnings ratio of 23 looks high to me, although it partly reflects City expectations of earnings growth.
At a couple of pounds a share, I would be happy with the margin of safety on offer – and quite possibly also at £3 a share if business performance stayed as strong as it has lately.
Currently, though, the Rolls-Royce share price is closer to £7. For now, it will remain on my watchlist but I will not be investing.
