November 2015 – Baobab Investment Management

Rolls Royce Revisited

A few months ago we outlined our investment thesis on Rolls Royce. Last week the company provided a poor operational update and outlook and the share price fell sharply on the news. This note is a review of our thesis on Rolls Royce where we have continued to accumulate shares into market weakness.

Rolls Royce provides sophisticated power systems (engines) and services for use in the air, land and at sea. It is important to note that the company no longer has any link to the well-known auto-manufacturer. The aerospace division represents roughly two-thirds of company revenue and is the key to our thesis.

Our investment thesis can be summarised as follows:

Air travel is a structural growth market
Within the industry, demand for more efficient engines will continue to grow
Rolls Royce has a strong competitive advantage within its core market (engines for large aircraft)
As their installed fleet of engines grows, recurring service revenue will follow
A new CEO will be able to simplify the business and improve group margins and cash flows

The two charts below show the expected growth in their core market as well as the expected engines to be delivered by Rolls Royce over the next 10 years.

Given the nature of the industry, the timing of this large backlog of engine demand converting to sales and cash flow is uncertain. It is this uncertainty that is allowing us to buy shares in the company at very depressed levels, even though we acknowledge that we have probably been early in our staggered purchases.

Despite the negative update, we remain comfortable with the long-term industry dynamics as well as the competitive positioning of Rolls Royce who operate in a duopoly in the wide-body aircraft engine market. This is supported by the fact that they are the exclusive engine provider for most of the Airbus wide-body fleet. We look forward to the new CEO providing a strategic review later in the month as to how he plans to capitalize on this strong competitive position to grow cash flows for shareholders in the years ahead.

Sporting analogies are often used to explain the complex world of investing. There have been recent articles highlighting how the Springboks might have fared were they listed on the stock market. With the World Cup over, I do think that there are a few key characteristics of the winning All Blacks that are also required to achieve success in the investment management industry.

Consistency in approach

A key strength of the All Blacks has been the consistency in the style of rugby that they play. While it may be easy on the eye, the fact that they have adopted the same approach over a lengthy period of time is what is important and hasbeenakeyingredientoftheirsuccess. Investmentmanagementisnodifferent. Whilethereisscopefordifferent approaches or philosophies, the important thing is to be consistent and not make changes at inopportune times.

Process versus results

It is a natural tendency to be too focused on short term results and many view this as a key weakness of the Springbok team. Good sports and investment teams, like the All Blacks, are focused on the process, confident in the fact that following a sound process will lead to the desired results. Games will be lost and investment mistakes will be made, but the key is to learn from these and try to improve the process going forward.

Temperament

The All Blacks players and coaching staff displayed a calmness of true champions during the latter stages of the tournament, making sound decisions under intense pressure. Strong temperament is one of the key ingredients for long term investment success as well. The ability to think clearly and independently, remain calm and be decisive in times of market turbulence is a key differentiator in the investment industry.

The bench

The All Blacks substitute bench was also a major factor in their success. We think of the Special Value Situations portion of our portfolio as our bench. While the contribution (position size) may not be as significant as the starting fifteen (Core Blue Chip Holdings), during the full course of the game they can make a large contribution to the end result. Like Steve Hansen, it is our job to utilise them wisely in accordance with our long term objective.

Value versus growth

Were the All Blacks and the Springboks listed at the moment, it is likely that the All Blacks would be a popular, high flying growth stock trading on a PE of 50. They would be very difficult not to own. The Springboks, on the other hand, would be trading on a single digit multiple and feature in the portfolios of value managers only. We would be attracted to the Springboks as an out of favour Blue Chip operating below potential, but we might have some concerns around the strategic direction of management.

Humility

Despite their dominance in the tournament the All Blacks remained grounded and humble at all times. The lack of arrogance after such a lengthy period of outperformance can only be admired. Humility is another key attribute of most good investors. If one does not have it, the market is likely to teach one sooner or later.

Summary

Despite all the similarities between sport and investing, there is one key difference. In sport one knows when the World Cup is going to take place and can prepare accordingly. In investing the real test comes in times of market panic, but investors are not forewarned and the big games usually arrive unexpectedly. We remain focused, looking at different combinations, whilst patiently selecting a squad of businesses that we think will enable us to win most games in the years that lie ahead.