How Long Can Diageo plc And Unilever plc Continue To Beat The Market?

Diageo (LSE: DGE) and Unilever (LSE: ULVR) have beaten the FTSE 100 consistently over the last ten years. For shareholders in both companies, like me, this has been good news:

  2016 to date 1 year 5 years 10 years
FTSE 100 +1.4% -10.0% +5.2% +3.2%
Diageo +2.6% +2.1% +58.3% +107.9%
Unilever +10.3% +8.1% +63.8% +151.5%

These figures show the benefits of investing in high quality companies with strong management. Investors in Diageo and Unilever have enjoyed a decade of strong growth, unlike investors whose money has been tied up in a FTSE 100 tracker.

I’ve no intention of selling my Diageo and Unilever shares, which form part of a long-term income portfolio. But I am unsure about whether I should buy any more at current prices.

Unilever and Diageo have enjoyed premium valuations for so long that they have become widely accepted. Very few investors seem to question whether it makes sense to pay around 22 times 2016 forecast earnings for both companies.

One reason for this is that the stable earnings produced by Unilever’s consumer goods and Diageo’s big drinks brands are very attractive. They don’t crash when the market crashes and they aren’t linked to commodity prices.

Since the financial crisis, investors have flocked into assets which are able to provide reliable returns. In the case of both these stocks, dividend yields have been pushed down to around 3%. This desire for safety is understandable but it’s unlikely to last forever. At some point this trend will probably change.

Earnings momentum is revealing

I’m struggling to decide whether I should buy more shares in Diageo and Unilever, or wait until they start to look cheaper. This could mean a long wait, during which both companies could become even more expensive! On the other hand, my patience may be rewarded with the chance to grab a real bargain.

Of the two stocks, I think I’d favour buying Unilever in today’s market. Although the shares currently trade on a 2016 forecast P/E of 22 and offer a yield of just 2.9%, I think Unilever has stronger earnings momentum than Diageo.

Diageo’s adjusted earnings per share were lower last year than in any year since 2011. In contrast, Unilever’s adjusted earnings have risen from €1.53 per share in 2012 to €1.82 in 2015 — a 19% increase.

Broker forecasts for both firms reflect these trends. Forecasts for Unilever’s 2016 earnings per share have risen by 2.2% over the last year. That’s not a big increase, but it’s certainly preferable to the 10% cut brokers have made to their 2016 predictions for Diageo.

Broker forecasts aren’t always reliable, but the consensus figures, which I’ve used above, are usually a good guide for big companies.

Is either stock really a buy?

I don’t think I’m going to invest further in Diageo or Unilever at the moment. My concern is that shares in both companies are already priced for success. I don’t think their shares are likely to rise any faster than their earnings, which is likely to limit gains to a few per cent each year.

I prefer to invest in long-term income stocks like Diageo and Unilever when they offer above-average yields and the opportunity to profit from an upwards re-rating of their share prices.

As a result, I’m not going to be buying any more shares in Diageo or Unilever until they look a little cheaper.

I’ll let you know if my position changes.

However, you may be interested to know that the Motley Fool's top dividend experts don't agree with my view.

They recently selected Diageo and Unilever for their ultimate lifetime income portfolio, 5 Shares To Retire On.

The Fool's experts believe that the quality and long-term growth potential offered by Diageo and Unilever make them good value in today's market.

If you'd like full details of all five stocks chosen by the Fool's experts, then download this FREE, no-obligation report today.

To get started, just click here now.

Roland Head owns shares of Diageo and Unilever. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Diageo. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.