Rolls-Royce Holding (LSE: RR), Meggitt (LSE: MGGT) and GKN (LSE: GKN) have all underperformed the FTSE 100 by a large margin so far this year:
|
|
2014 YTD performance |
|
FTSE 100 |
-4% |
|
Meggitt |
-18% |
|
GKN |
-21% |
|
Rolls-Royce |
-26% |
However, such a short-term view disguises the fact that over the last five years, all three of these firms have significantly outperformed the wider index — Rolls-Royce, for example, has gained 108% since 2009, compared to just 30% for the FTSE 100.
Given this, I’ve been wondering whether this year’s weakness could be a good opportunity to buy into these quality businesses, rather than a cause for concern.
A rare opportunity?
Let’s start with a look at the forecast valuations of each of these firms:
|
2014 |
Rolls-Royce |
Meggitt |
GKN |
|
Forecast P/E |
14.5 |
13.3 |
10.5 |
|
Prospective yield |
2.5% |
3.1% |
2.9% |
|
2015 |
|
|
|
|
Forecast P/E |
13.4 |
12.1 |
9.8 |
|
Prospective yield |
2.7% |
3.4% |
3.1% |
All three of these firms offers a below-average yield, but all three are expected to increase their dividends by around 6% in 2014 and 8% in 2015 — faster than the market average.
Is the outlook rosy?
Of course, it’s possible that this year’s underperformance is the start of a longer-running slump, which will bring their long-term gains closer to those of the FTSE 100, a process investors refer to as mean reversion.
Is this likely? I believe all three of these companies are high quality businesses with competitive advantages that should protect them from a protracted slump, but there have been a few warning flags so far this year.
Rolls-Royce: In its interim results, Rolls reported a 7% fall in underlying revenue and a 20% fall in underlying profits. The firm’s order book shrunk by 2% and chief executive John Rishton said that Rolls “will experience growing pains”.
Meggitt: First-half revenue fell by 3%, with underlying operating profit down by 17%. It did, however, manage to grow its order book by 9%, and like Rolls-Royce, expects to have a stronger second half.
GKN: GKN’s exposure to the automobile sector gives it a slightly different outlook to the other two firms, and this helped drive 6% growth in pre-tax profits during the first half of this year, underpinning strong free cash flow.
Three to buy?
Although all three face headwinds from declining military spending, I think that much of this risk has already been factored into current valuations. Currency headwinds are now starting to reverse, and this should help offset weaker military sales.
Overall, I think that all three of these firms look attractive long-term buys, although further research would be required to make a final selection.