The best way to invest in one of Britain's top industries
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David Stevenson Sep 16, 2010
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BAE: world class business going cheap
As the old adage goes, it takes two views to make a market. In other words, it's just as well that we don't all agree investment-wise. Otherwise there wouldn't be anyone to buy shares from, or indeed to sell them to. We'd all be on the same side of the trade.
But when two of the City's top fund managers take differing views about a stock, it's worth taking notice.
Rolls Royce is the company in question. On the one hand, managers at Threadneedle have been buying in. But on the other, top fund manager Neil Woodford is cutting his stake.
So who's likely to be right? And should you be investing in Rolls – or is there a cheaper alternative?
If only every British company were as successful as Rolls Royce
Let's get one thing clear straight away. Rolls Royce plc is the business. It's the world's second largest maker of aircraft engines. It's also big in marine and energy (the car company was split out in 1973 and is now part of BMW).
If every British company were as successful as Rolls Royce has been, and still is, the UK wouldn't be well down the table in the global manufacturing league. We'd be near the top.
In 1999 the company had a £13bn order book. During the next decade, Rolls Royce managed to grow its overall orders at 16% a year. The backlog at the end of last year was a hugely impressive £58bn. To put that figure into perspective, it's the equivalent of around 20% of the UK's entire industrial annual output.
What's more, over that period both sales and profits have grown by around 10% compound. At the same time the firm, which employs almost 40,000 people worldwide, has actually reduced its workforce. No wonder, you might think, the fund managers at Threadneedle have been buying into Rolls Royce.
So why is Woodford selling?
Yet Neil Woodford at Invesco Perpetual has been selling the stock. Why?
To make it clear, Woodford isn't selling his entire stake in Rolls. Indeed, he's still its largest shareholder, "with a 5.56% stake at the end of July", points out Matthew Goodburn at Citywire. "But the position has been gradually trimmed over the last year".
And when you look at the stock's fundamentals, you can see why the Invesco Perpetual star manager is now cutting back his holding.
Rolls Royce has done very nicely in 2010. It's gained over 20% while the overall market has risen just 3%. And the shares now stand on a forecast p/e ratio of 15 for the current year. That's back up at its valuation level at the 2007 market peak, according to Bloomberg.
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Meanwhile, the prospective yield has dropped right to the bottom end of the long-term historic range, at just 2.7%. For an income fund manager like Woodford, that's unlikely to be a high enough return.
There's also been some recent trouble with the Trent 1000 engine being built for Boeing's 787 Dreamliner aircraft. Problems happen in engine testing, and no doubt these will be sorted sooner or later, but they could hang over Rolls Royce shares for a while yet.
In other words, great company though Rolls Royce is, much of the good news is already factored into the price.
Yet it operates in one of the few areas where our country actually excels on the world stage. Britain has the biggest aerospace industry in Europe, and is second only to the US worldwide.
Another stock looks a better buy
It's a good industry to have exposure to. So is there a stock in the sector that looks a better bet?
Well, yes – as long as you're prepared to look beyond the immediate headlines. Right now, as we'll all soon be very painfully aware, our government is about to slash its costs. This means state suppliers are bound to suffer as orders are cancelled. And one area earmarked for the machete is defence.
So on the face of it, BAE Systems (LSE: BA/) isn't an obvious investment choice right now.
I'm not going to speculate here as to what will and won't be cut. But there's little doubt BAE will lose some business. Further, buying shares in a weapons business isn't everyone's cup of tea.
But, that said, from a pure investment angle, BAE certainly offers good value. It's the second-largest defence firm on the planet, and sells to more than 100 countries. Just 20% of its business comes from the UK. Some 50% is derived from the US, while great strides are being made in the likes of India. What's more, defence is one area unlikely to be cut globally. Indeed, spending here is forecast to grow 50% by 2014 to nearly $1.3 trillion.
BAE's share price is down 6% in 2010. Yet the total order book is £44bn. And the expected current year p/e is about half that of Rolls Royce, according to Bloomberg. In turn, that's just half the valuation level of three years ago. That must be pricing in almost all the worries about UK defence cutbacks. Meanwhile the prospective yield is almost double RR's at 5%.
Sure, BAE shares have flipped up a bit within the last week. But this bounce was from their lowest level for more than five years. There's no doubt this is a very cheap stock. And any further weakness prompted by those "defence cuts" headlines would provide an even better buying opportunity.
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