Image source: The Motley Fool
Few investors have a stellar track record as impressive as billionaire Warren Buffett. The ‘Oracle of Omaha’ has vastly outperformed the S&P 500 since the 1960s using a relatively simple investing strategy: buy and hold shares of wonderful companies trading at a fair price.
Throughout his career, he’s handed out a lot of advice about his stock market approach to the wider investing community. And that includes: “The time to get interested is when no one else is. You can’t buy what is popular and do well.”
Anyone who followed this lesson with Rolls-Royce (LSE:RR.) shares back in 2023 has been immensely rewarded. The once-struggling engineering giant delivered a remarkable turnaround under new leadership. And anyone who invested at the beginning of this journey when Rolls-Royce shares were exceptionally unpopular has gone on to earn an almost 1,100% return!
But today, Rolls-Royce has become exceptionally popular, repeatedly appearing on the top 10 buy lists of investing platforms like AJ Bell.
So following Buffett’s advice, does that mean now’s the time to sell?
The popularity of Rolls-Royce
Even after delivering a monstrous explosion of growth, it’s not difficult to see why investors continue to be bullish for the future.
- The current geopolitical background is driving a secular increase in defence spending across the UK and Europe.
- Management has proven to be outstanding stewards, raising guidance for 14 consecutive quarters.
- Free cash flow generation within its civil aerospace business has become exceptional.
- Ongoing efficiency programmes suggest that operating margins will continue to expand for the next couple of years.
- The company’s small modular reactor (SMR) segment is expected to drive significant growth and turn profitable by 2030, securing the group’s long-term trajectory.
Combining all this with near-perfect execution, Rolls-Royce certainly seems to fit into Buffett’s ‘wonderful’ category. Even more so, given its innovation investment is digging out a wider competitive moat.
What’s Buffett’s concern?
The billionaire’s stance on avoiding popular stocks is rooted in the fact that investors almost always embed increasingly lofty expectations that will eventually result in disappointment. Don’t forget, paying too high a price for even a wonderful company can lead to painful losses.
Looking at Rolls-Royce today, its valuation leaves little room for error.
The upcoming rollout of its SMR technology and other large-scale programmes may not be as flawless as expected. And with significant upfront costs involved, profit margins could actually come under pressure in the near term.
Bullish investors may also be placing too much weight on geopolitical tailwinds. Even CEO Tufan Erginbilgiç has warned that a resolution to the war in Ukraine would adversely impact the current outstanding performance of its defence segment.
What now?
Looking at the risk-to-reward ratio, Rolls-Royce shares don’t appear very attractive right now. And even other institutional analysts have begun advising their clients not to fall into the trap of chasing higher returns with this FTSE stock.
So for investors seeking Rolls-Royce-like returns in 2026, I think it’s prudent to listen to Buffett once again and maybe look for another unpopular business with the potential to surprise and amaze. Luckily, there are quite a few to explore.
