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Questor: Diageo produces prodigious amounts of cash – but does it invest them wisely?
A “quality” company – from the point of view of a long-term shareholder – has several attributes. First, it is reliably profitable and, importantly, able to translate profits into cash. The complexity of modern accounting practices makes it possible for businesses to report profits without actually making money in cash terms.
Profits are easily manipulated, whereas cash balances are not. So when a firm consistently reports cashflows that are broadly similar to profits, investors are reassured that nothing funny is going on and profits are not illusory.
Second, a quality company makes high returns on its own investments. Some firms that appear to be growing strongly turn out to be doing so simply by deploying more capital, often borrowed, with little to show in due course. Unless that capital produces returns comfortably above cost, investors are not benefiting.
Third, the business should be able to reinvest the cash produced from its existing operations in new assets that are able to produce the same high returns.
If a company can do all these things, it will grow its profits reliably and in a way that compounds every year. In these circumstances a rising share price is almost inevitable (unless the shares were heavily overvalued in the first place).
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One fund manager who likes to invest in quality companies is Nick Train of Lindsell Train. The second-largest holding in his Global Equity fund is one that exemplifies the quality concept: Diageo.
“Most companies do not generate operating margins of about 30pc on a regular basis, nor do they turn nearly all of their operating income into cash. Diageo is one such company that does so often – blessed by its exceptional brand portfolio and global distribution,” Train said in a recent update to investors.
But he also drew attention to the third requirement of a quality company, namely the ability to reinvest the surplus cash at similarly high rates of return.
“When a company has intrinsic advantages such as [Diageo’s], shareholders’ expectations ratchet up,” he said. “In particular they expect the board of the company in question to allocate its ample cashflows in a disciplined and value-creating way. There’s no point in generating above-average cash returns on capital if the excess cash is then misallocated.
“We do not say this is the case with Diageo, but even the company admits that some of its investments of the last few years could have been better timed.”
He said several deals that Diageo undertook to increase its exposure to emerging economies between 2011 and 2013 had been made “at a time of high optimism and high prices”, and that since then these acquired businesses had gone through “a variety of hard times”.
“Then there’s the $700m (£538m) Diageo has just announced it is paying for George Clooney’s tequila start-up, Casamigos,” Train said. “We support the transaction and acknowledge the success the company has had in building up smaller, newer brands. Even so, Diageo bought another tequila, Don Julio, in 2015 and it’ll be interesting to see how the company develops and differentiates the pair.
“What’s more, part of the consideration to pay for Don Julio was the sale/swap of Diageo’s then Irish whiskey brand, Bushmills, the world’s oldest distillery. We were sorry to see Bushmills go and then somewhat surprised to see Diageo announce this year that it is investing in the creation of a new Irish whiskey brand. It’ll take some doing to match the 409-year heritage of Bushmills. [This] does not appear consistent.”
Train added: “We’ve bought a lot of Diageo shares in 2017 and think them undervalued. None the less there are questions that we have about the execution of its strategy – questions that don’t necessarily ring alarm bells, but are definitely the kind to keep an eye on.
"We are watching very closely the capital allocation decisions taken by the boards of the companies we hold – knowing that over time it is the calibre of those decisions that will determine the long-term success, or otherwise, of our own investment decisions.”
We trust Train’s judgment on this and will in turn keep a close eye on his actions with regard to Diageo. For now the shares are a “hold”.
Questor says: hold
Ticker: DGE
Share price at close: £25.77½