What’s going on with Diageo (LSE DGE) shares right now?
We’re in a bull market and stocks have been going up. But the premium alcoholic drinks supplier is trending down, and it has been since the end of 2021.
That’s not ‘supposed’ to happen to a quality business. And the company is certainly that. It scores well against the traditional quality indicators.
Quality at a price to match?
For example, the operating margin is almost 27%. That compares to an arguably lower-quality business, such as Tesco, at just over 4%.
Diageo’s return on capital is about 15%. Meanwhile, Tesco can only manage a little over 8%.
Nevertheless, even Tesco has participated in this bull run:
One of the problems is Diageo has had a rich-looking valuation for years.
Remember all the hype about so-called bond-proxy trades?
When interest rates were on the floor for years following the credit-crunch and great recession of the noughties, investors earnt little on their cash deposits. instead, they turned to companies with defensive operations and labelled them bond-proxies.
Because operations were considered resistant to the ups and downs of the wider economy, the defensives were almost as reliable as putting money into a bond, went the argument.
Was it all just another bubble?
Investors were all over these types of shares. Why? Because they believed the underlying businesses could offer predictable returns and sometimes have higher yields than bond market offerings.
Other stocks caught up in the craze included fast-moving consumer goods outfit Unilever, smoking products supplier British American Tobacco and others.
The outcome over about a decade from around 2009 was a massive bull market for these defensive, bond-proxy stocks — and valuation expansion. So, price-to-earnings ratios increased as the share prices rose.
Most good things end though. Now it looks like those stocks were in another bubble. In hindsight, they look as if they had become overvalued compared to their rates of earnings growth.
Because of that, it looks like Investors have likely been selling the shares. Events conspired to push the valuations lower as well. For example, interest rates have been improving, making actual bonds and cash accounts more appealing. So, there’s less need to invest in defensives as a bond-proxy anymore.
On top of that, the pandemic crash caused cyclical stocks to look better value, so some investors likely rotated out of the defensives and into them.
That scenario repeated itself at the beginning of the bull run starting last Autumn in 2023.
There’s also been war, supply-chain problems, inflation and other things. The common theme is that all those events put pressure on overvalued stocks like Diageo and the other one-time bond-proxy darlings. And that’s on top of any company/business-specific issues they may have endured.
What I’d do now
Nevertheless, Diageo is still a great company and may make a decent long-term investment – at some point.
So, should I buy or go nowhere near?
Well, I’d never buy while a downtrend remains in place, despite an improving valuation.
So, for now, I’d dig in with deeper research and watch Diageo while keeping a safe distance from the shares. But that position may change quickly!
