Is it too late to buy Rolls-Royce shares?

Anyone who decided to buy Rolls-Royce (LSE:RR) shares five years ago has done very well. The share price is up 677% since June 2020 and it isn’t really showing any signs of slowing down. 

The good news keeps coming with the announcement this week that the company has been selected to build the UK’s first small modular nuclear reactors. So is it too late to buy Rolls-Royce shares?

How much higher can it go?

According to Peter Lynch, one of the biggest mistakes an investor can make is assuming shares that have gone up can’t go higher. A good illustration is the stock now known as Altria.

Shares in the tobacco company went up 400% between 1951 and 1961. But adjusting for splits, it’s gone from around 42 cents per share to just under $60 since then – an increase of almost 15,000%.

That’s not including the dividends, which have been significant. But investors in 1961 who thought the stock couldn’t keep going because it was already up 400%, made an expensive mistake.

Over the long term, the important thing was the company’s scope for international expansion and the strength of its brands. So the question for investors is whether Rolls-Royce is in a similar position.

Growth prospects

Aside from incremental increases in travel demand, there are three major sources of potential growth for investors to pay attention to. The first is a possible expansion into narrow-body aircraft.

The firm’s looking to use its Ultrafan technology to produce a more efficient engine for narrow-body aircraft. And if it succeeds, it could significantly increase the company’s addressable market.

Another is the industry-wide shift to Sustainable Aviation Fuel (SAF). While most manufacturers are on the case with this, Rolls-Royce is arguably further ahead than most of its competitors. 

The third is the potential expansion of small modular nuclear reactors. Again, this is still in its early stages, but the company has a very strong competitive position in this industry.

Risks

Making aircraft engines requires a lot of technical knowledge and this makes Rolls-Royce difficult to disrupt. As a result, I think the major risks are on the side of demand. 

Whether it’s an Icelandic ash cloud or a pandemic, air travel can be subject to major external shocks. They’re usually one-off in nature, but another one always seems to show up from time to time.

When these come around, the impact on Rolls-Royce’s balance sheet can be significant. Sizeable operational leverage means a downturn in flying hours can hit profitability hard.

This is worth considering. But investors should be careful to try and distinguish between the kind of threat that makes a stock unattractive over the long term and one that makes it unusually volatile.

Still an opportunity?

Unless the stock goes to zero, buying Rolls-Royce shares at 88p (where it was three years ago) is better than buying it at £8.80 (where it is now). But that doesn’t mean the opportunity’s passed.

The stock’s expensive, but the firm has some clear competitive strengths that should serve it well over the long term. It’s not top of my list to buy right now, but I do think it’s worth keeping in mind.