As you may have noticed, many of my ‘turkeys of the week’ have been large-cap stocks whose share prices were too high. I typically sell when a company has become overvalued, but before doing so, I need to understand why it has done so. The reason for selling is just as important as the rationale for buying. There has recently been a noticeable shift in investor sentiment towards ‘defensive’ plays. A policy of battening down the hatches has meant risk is out and safety is in. This rotation into large caps has been further fuelled by mergers and acquisition activity and fears of the potential damage to small caps of rising interest rates. For example, over the past 12 months, the Aim index is down 4%, while the FTSE 100 and the FTSE 250 are both up 11% and 24% respectively (as at 18 August).
Turkey of the week: Diageo (DGE, 949p) tipped as a BUY by Dresdner Kleinwort
However, what’s de rigueur one moment can quite easily become unfashionable the next, especially if price and value become out of synch. All that’s usually needed is a trigger to switch sentiment. The catalyst that sends investors back into ‘higher beta’ (or riskier) assets could occur when the City thinks that interest rates and oil prices have peaked.
In addition, with many small caps trading on single digit p/e multiples, while large caps remain on ratings sometimes double this, then I can see all the ingredients for an overdue correction.
Take Diageo as an example of a classic defensive play. It is the world’s largest premium drinks business, with a market capitalisation of £26.5bn. Its brands, including Smirnoff Vodka, Johnnie Walker, Guinness, Baileys and Captain Morgan, enjoy an estimated 27% share of the global spirits market. However, due to this fund rotation into safer waters, I believe its shares are now over-bought. Let me explain why.
The stock, at 949p, trades on 2006 and 2007 p/e ratios of 18.0 and 16.5 respectively. For this top-whack valuation, I would expect earnings per share growth rates of at least 10%-15%. However, analysts are forecasting more pedestrian increases of only 7%-9%.
Additionally, although Diageo’s brands are robust, there are still some strong headwinds on the horizon that will need to be carefully negotiated. These include tougher consumer markets, continual pressure from supermarkets to lower prices, higher energy costs, increasing regulation (measures to tackle binge drinking, smoking bans in pubs, and so on) and an ongoing trend towards less profitable home consumption.
Consequently, once a greater appetite for risk returns, then I could easily see Diageo’s shares falling back down to a p/e multiple of 14, which, given the City’s June 2007 earnings per share expectations of 57.4p, would generate a target price of 804p.
Although consumers are prepared to pay extra for Baileys or Smirnoff Blue, I believe that for a premium of roughly 18%, investors shouldn’t fork out simply to gain the benefits of greater predictability. If you’re looking purely
for safety, then choose a high-interest bank account.
Recommendation: Take profits at 949p
Paul Hill’s personal portfolio has gone up by 483% over the last five years. To find out more about his own specialist share-tipping service, ‘Precision Guided Investments’, click on the link below: