‘Investment success doesn’t come from buying good things, but rather from buying things well.’ (Howard Marks, Chairman Oaktree Capital)
This is a quote I have often referred to and it occupies a permanent position on the wall in our offices. While it may sound like common sense, it is very difficult to stick to a price conscious investment approach in practice. Good prices are only present if there is some form of bad news attached to a particular asset, thus investor attention is usually focused on questioning the quality of the asset. This in turn leads to the attractive price which creates a low risk entry point for long-term investors.
At the moment companies that are of obvious quality (consumer staple companies etc.) are not well priced, thus you may be buying a good thing, but in most cases you are not buying it well. As a result, to find bargains today, investors need to look for less obvious quality. We have recently purchased a few companies that we think offer varying degrees of quality, but where we are very confident that the price we are paying is a good one. This note highlights one of those companies which is a core holding in our Global Portfolios.
Rolls Royce designs, develops, manufactures and services integrated power systems for use in the air, on land and at sea. Its defence aerospace, marine and power systems divisions are reasonable businesses, but it is the civil aerospace division that we are attracted to. This part of the business designs and manufactures efficient engines for large aircraft, something not many are equipped to do.
Demand for new aircraft can be lumpy in nature, but the growing demand for more efficient engines is structural in nature. This fact is supported by the order books of engine suppliers like Rolls Royce and the backlog of aircraft manufacturers like Airbus which are at all-time highs. Given this backdrop Rolls Royce has a very long runway to increase its installed base of jet engines, as it currently has the most efficient large engine in the world. As a result, the company has been able to secure exclusive positions on most of Airbus’s wide body planes, which are also the most efficient planes in the world. This run way is well captured by the following paragraph out of the latest Rolls Royce annual report.
‘The future growth of air travel is widely understood and reflected in our GBP 63 billion civil aerospace order book. To give this some perspective, in the past decade we have delivered 1,600 Trent engines. In the decade ahead we expect to deliver 4,000. All of the engines in this expanding fleet will produce service revenues that will extend for decades to come.’
Barriers to entry in the industry are extremely high for obvious reasons and the partnership with the likes of Airbus provide an extremely wide moat around the civil aerospace division. Rolls Royce and General Electric form a duopoly in the wide body jet engine market and it is difficult to see this competitive position changing. As long as people continue to fly, Rolls Royce will produce efficient engines for the global aircraft pool, and collect service revenues for decades into the future on those aircraft. The business model produces most of the profits and cash flows from the service and maintenance of the aircraft, as opposed to the initial sale. As a result once their new, more efficient engines gain traction, the ensuing profitability will be of a very high quality.
Some cyclical headwinds have led to a 40% fall in the share price, providing an opportunity to buy a world class business at a compelling price. Our investment thesis is further supported by a new CEO with a strong track record, who we are confident will allocate capital according to the competitive positioning of the underlying businesses, and drive profitability and shareholder returns to significantly higher levels in the years ahead.
In Rolls Royce we believe we are buying a good thing, and also buying it well. profitability, we are buying a company that has excellent long-term fundamentals:
- Near-insurmountable barriers to entry
- A strong recurring service and maintenance revenue stream
- Accelerating growth profile in the coming decade
- Highly regarded new CEO at the helm
Despite near term pressure on these solid fundamentals, coupled with low investor expectations, provide a very solid long-term return profile. We are delighted to be an owner of this global leader in its field.