12% Annual Returns Through 2021

Diageo (DEO) is fast becoming my best idea for risk-adjusted returns over the medium term. Among non-cyclical business sectors, it seems that almost everywhere you look, you either have to pay towards the high end of fair value for a stock, overpay a little bit, or take on a corporation that is trading at a favorable valuation because it is working through some problems. There is absolutely a place in a portfolio for that third category, but there is also a place in a portfolio for those corporations that roll along nicely, growing earnings, selling products that drown the shareholders in cash, and create dividend streams that are almost certain to rise over every rolling five year period.

That’s why I like Diageo so much right now. The stock price of $107 per share seems like a very good deal for shareholders that have a generational holding mindset (I classify it as a “very good deal” on a relative basis compared to other large-cap opportunities that are available today.)

When you are looking for a stock that you can hold for the rest of your lifetime, you will look for the following characteristics as strong signals of a suitable investment candidate:

-High returns on equity throughout the business cycle
-High profits at the bottom of the business cycle
-A solid commitment to paying out meaningful shareholder dividends
-The ability to grow those dividends
-An excellent track record dating back decades
-Long-run earnings per share growth in the 8-12% range
-Operations in an industry that has a historical track record of creating shareholder wealth
-individual success within that industry with a favorable history
-a strong moat that gives it a pricing power advantage over competitors so that it can naturally grow earnings without the need to retain a significant amount of profits to ward off competition
-fair valuation or better at the time of purchase

Diageo checks off all of those boxes.

-The return on equity frequently hovers in the very high 30% to 41% range
-the profits only declined from $4.64 to $4.24 during the unfavorable business conditions of 2008 and 2009
-the dividend payout ratio has historically vacillated between 43% and 64% of earnings
-the dividends grow by 7.5% per year
-the firm was originally incorporated as Arthur Guinness & Son in 1886
-the core economic engine that grows earnings over the long term by 8% per year
-it operates in the beverage sector which includes Pepsi, Dr. Pepper, Coca-Cola, Brown Forman, and Anheuser-Busch, which are five of the fifty best investments you could have made since 1956
-It has a post-WWII half-century record of 13.5% annual returns from 1947 through 1997 (when Guinness merged to become Diageo)
-strong brands that include Captain Morgan, Jose Cuervo, Smirnoff, Guinness, and Johnnie Walker.
-These brands create strong moats that enable Diageo to earn net profit margins of 16.9% during recessions and nearly 24% during strong global economic conditions.

In my view, Diageo is one of the most reliable ways to earn double-digit returns in a very high quality way over the medium term. I agree with the analyst forecasts that signal 8% earnings per share growth over the next five years. You get a 3.23% starting dividend. And you ought to get a little bit of P/E expansion from the stock, which currently trades at 17.98x earnings and has a fair valuation of somewhere in the 19-21x earnings range.

The way I see it, the total returns from Diageo over the next five years will be: 8.00% from earnings per share growth, 3.23% from the dividend, and 1.00% tacked on resulting from P/E expansion. That puts current investors on a trajectory for 12.23% annual returns over the next few years. That’s about as good as you can find in the arena of low-risk, high-quality blue chip stocks.

I also like the outside probabilities of receiving a 50% or greater buyout premium if Diageo becomes the next target for 3G Capital. Once SABMiller gets fully absorbed into the 3G machine, Diageo seems like it will be on the next logical target. While I would not want this to happen from a competitive perspective, and I would hate to see Diageo become the next in line to dilute brand quality at the expense of short-term profits that would surely arise if controlled by 3G, I cannot also ignore the possibility that Diageo shareholders might get a very rich one-off payout if it is the next asset consumed in Anheuser-Busch Inbev’s efforts to be the beer industry consolidator.

As an aside, it’s interesting to me that Anheuser-Busch CEO Carlos Brito mentioned that he entered the beer industry because he was studying for an MBA at Stanford and started studying the richest people across the various. He noticed that the beer baron families were either the wealthiest people in the country, or near the top of the list, and thought it would be a way to go through life with an industry tailwind at his back that would make it easier to amass wealth (in my own notes, I call this the “It’s easier to run Nike than a steel mill” principle.)

With large companies, it sometimes becomes necessary to result to financial engineering to propel earnings forward rather than just selling more product. Diageo doesn’t do this–they have had 688 million shares outstanding every year since 2010 and it’s been organic earnings growth rather than cost-cutting that have advanced earnings per share. The revenue growth figure stands at 5.5% which makes it easy to facilitate high single digit earnings per share growth. It’s a very strong business which naturally grows, returns cash to owners, and trades at a slightly favorable valuation. Those are the kinds of factors that combine very well to create wealth over the both the medium and long run.