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The Investment Case For Diageo plc

It’s hard to fault Diageo (LSE: DGE) (NYSE: DEO.US) as an investment — but for one crucial factor: its qualities are no secret, and so its shares are expensive. But in the words of Warren Buffett, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” So let’s look in more detail at the investment case.

Defensive moat

Diageo is the world’s largest vertically integrated producer of premium spirits and beer, with distribution in 180 countries. It’s a classic defensive share because demand for alcohol is relatively economically insensitive. But what is most attractive to investors is its wide economic moat. That comes from a combination of:

  • Brands. Diageo forensically analyses its markets by category and price-point, targeting brands accordingly. Thirteen strategic brands contribute two thirds of sales globally, supported by three quarters of total marketing spend;
  • Global scope. Diageo has grown by acquiring local drinks producers, taking their products into its international distribution network whilst simultaneously opening up the newly-acquired distribution network to its existing brands;
  • Market power. The scale of its sales and marketing spend give it clout with merchandisers (and the third-party distributors required by law in the US).

Growth

Growth in sales and profits should come from:

  • Emerging markets. Sales are growing fast in Latin America, Africa, Asia and Eastern Europe/Turkey which together are expected to account for half of all sales within two years. Diageo is benefiting from increasing numbers, wealth and sophistication of emerging market consumers;
  • ‘Premiumisation’. It’s an ugly word, but Diageo likes it. By clever marketing it drives consumers up the price curve, whether it’s a rural African switching from local brew to branded beer, or a Middle Englander trading up from Johnnie Walker Red Label to Black Label and beyond;
  • Acquisitions, with more of the distribution synergies I described above.

At a price

Diageo is trading on a fairly pricey forward P/E of 18.3. More significantly, its yield has been driven down to 2.6% by the ‘great rotation’ out of bonds. That’s the lowest yield the company has traded at since its creation in 1997.

There’s a danger that when interest rates finally rise money will switch back into bonds, and bond-like equities such as Diageo will suffer. But Diageo’s shares have been trading sideways since last spring, and new investors could find themselves waiting a very long time for a better entry point.

Dividends

Diageo’s yield may be below the market average, but it has a superlative dividend track record. The payout has increased every year since 1997.

An ever-rising dividend, together with reinvestment, can be a great wealth-booster. Over the past 25 years, about 60% of the total return from the FTSE All share Index has come from reinvested dividends.

You can learn more about how you can use dividends to grow your wealth in 'My Five Golden Rules for Building a Dividend Portfolio'.  It's an exclusive report published by the Motley Fool. You can get it by clicking here -- it's free.

 > Tony owns shares in Diageo.