What makes for a good business? It can be hard to tell. Past success might help boost a company’s market capitalisation, meaning it gets promoted to the FTSE 100 index of leading shares. But not all FTSE 100 shares keep doing well in the long run.
How many investors now recall former members such as Dalgety and MFI Furniture?
Even when buying blue-chip shares for my portfolio, I do not just look at past performance but also consider future prospects. For example, does a company operate in a business area with a competitive advantage that could help it do well for a decade or more? That fits with my approach as a long-term investor.
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Here is a pair of FTSE 100 shares I think could still be reporting sizeable profits a decade from now.
Diageo
As the owner of brands such as Johnnie Walker, Diageo (LSE: DGE) has quite a lot going for it. I expect demand for alcoholic beverages to remain high over time. Owning unique brands means Diageo can retain customers by offering something unique. The premium nature of many Diageo brands gives the producer pricing power, which can help its profitability.
Indeed, in the first half of its financial year, the company reported a 17% year-on-year increase in profits to £2.3bn. It has raised its dividend annually for more than three decades.
There are possible risks. Younger consumers are buying less alcohol than previous generations. That could hurt sales and profits. But I think the business model is excellent and will hopefully continue to work well for the long term.
Tesco
Perhaps even more than Diageo, I see Tesco (LSE: TSCO) as operating in a market set to stay large. People need to eat, so the UK’s fundamental grocery market is resilient.
But while grocery retailing is a high-volume (“pile ‘em high”) business, price competition can mean it offers low (“sell ‘em cheap”) profit margins. Diageo turned over £22.4bn last year and made a post-tax profit of £4.4bn, but at Tesco, the equivalent numbers were £61.3bn and £1.5bn. In other words, Tesco’s net margin of 2.5% was just over a sixth of Diageo’s 14.8%.
Given the low margins in grocery, scale helps. As the UK’s largest retailer, Tesco is well-positioned to benefit from its size. But it also risks too. Inflation can eat into those already thin margins. Digital competition could pull shoppers away from stores.
Tesco’s large customer base, well-established digital operation and famous brand may help it turn some such threats into opportunities. I do not see it as an exciting business, but a solid one I expect can do well in the coming decade.
Should I buy?
However, just because a business could do well in the long term does not on its own make me want to invest in it. I also need to consider the share price. Overpaying even for a great business can be unrewarding.
Diageo shares trade on a price-to-earnings (P/E) ratio of 22. That makes them too costly for my tastes. Tesco is not much cheaper, with a P/E ratio of 21.
I like both of these FTSE 100 shares. But their current valuations are unattractive to me. So I would not buy either for my portfolio at the moment.
