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Stephen Lamacraft 22 October 2014 Est. reading: 3 min read

Edit (23/10/14 08.50am): The word “revenue” was removed from the phrase “medium term revenue guidance”.

To have been invested in Rolls-Royce shares this year has been a painful experience. The shares were particularly weak on Friday last week following an unexpected and disappointing trading update from the company in advance of its Marine Capital Markets day, which I have just attended in Ålesund, Norway. This update was, in effect, a warning that revenue and profit expectations for 2014 and 2015 were too high, with deteriorating economic conditions and Russian trade sanctions to blame.

The Norwegians have a phrase which translates to “it’s no shame to look into the warm spring sun and regret a lost limb”. Bruised by the falling share price but with all four limbs still intact, the trip to Norway represented an opportunity to reflect on the investment case and ultimately reassure myself and the rest of the investment team that it remains valid and compelling.

It shouldn’t be a surprise to anyone that Rolls-Royce is, in part, exposed to the slings and arrows of the global economy – it is still a cyclical business, albeit much less so than it used to be thanks to its aftermarket business (revenues from maintaining its existing base of installed engines). But the extent of the recent deterioration in trading has clearly alarmed the market, as illustrated by the chart below.

Chart showing the Rolls-Royce share price and forecast PE (current year) over time

Unfortunately though, this isn’t the first time that Rolls-Royce has disappointed this year, and the magnitude of the latest sell-off appears to reflect the market’s growing frustration with the company’s ability to manage expectations effectively. We have some sympathy with this view. Rolls-Royce is a complex business, but some of its communications this year have posed more questions than they have answered.

However, although the market has clearly focused on the short-term disappointment of last week’s statement, we believe that in so doing, it is ignoring some meaningful long-term positives.

For example, the shares are now more attractively valued than they have been in some time – in PE terms, it hasn’t traded at these levels since 2009. It remains a quality business with superb technology, operating in an industry with very high barriers to entry. It has a substantial long-term forward order book which is the product of a well-executed long-term strategy, years of meticulous product development and a proven business model. In increasing capacity to fulfil the order book it has experienced some growing pains but we remain confident that the business can deliver to the long-term order book successfully and profitably.

In the same statement which caused the shares to slide last week, Rolls-Royce has for the first time provided medium term guidance which comfortably beat market expectations. If it achieves its stated targets for 2018, current earnings forecasts will be way too low. As long-term investors, this is exactly the sort of market inefficiency that we aim to exploit – the market is focusing on the short-term disappointment, whereas we look beyond this to assess the long-term opportunity.

“Don’t sell the skin, until you have shot the bear” is another Norwegian saying, which suggests that premature activity can be a mistake but patience is often rewarded. We do take heed of the market’s reaction last week but, based on what I heard and saw in Ålesund, I am reassured.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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