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“Buying on the dip” is a popular strategy that entails buying a stock after a sharp fall in its price. It seeks to exploit a short-term decline in a company’s value to benefit from a subsequent recovery.
In Questor’s view the 10pc decline in Diageo’s share price since the start of the year represents such an opportunity. Its shares have been hit by sterling’s recent strength; the firm reports in sterling but sells its diverse range of alcoholic drinks all over the world.
Crucially, it focuses on higher-priced spirits in an era when they are delivering strong growth thanks to changing industry trends. Consumers are drinking less but trading up to premium spirits.
The value growth of spirits outpaced that of the wider alcoholic drinks market between 2010 and 2020. In turn, higher-priced spirits volumes grew nine times faster than the broader spirits market over the same period. And, as spirits account for just 4pc of the global alcoholic beverage market, they offer significant potential for long-term growth.
Their prospects are further enhanced by a growing global middle class. According to the World Bank’s forecasts, an additional 550m consumers will join the world’s “middle class and above” income bracket by 2031. Diageo is well placed to benefit from increasing consumer spending since it grew or held onto its off-trade market share across 85pc of its global markets in the 2021 financial year.
In addition, the company’s acquisition strategy should further improve its range of premium spirits. And, thanks to new products in the zero-alcohol and ready-to-drink segments, the firm is in a strong position to react to evolving consumer trends.
Meanwhile, it is well placed to benefit from economic reopening following the pandemic. It has suffered from the effects of travel restrictions and lockdown measures on travel sales and on-trade revenue over the past two years. Now that both areas are likely to have reached their lowest ebb, and in view of forecasts of world economic growth of 4.9pc this year, the firm’s operating environment looks promising.
The company’s latest trading update highlighted a solid performance across all regions and a further update is due on Thursday when it releases interim results.
That trading update also reported that it was managing rising inflationary pressures. In Questor’s view, the company’s capacity to pass rising input costs on to its customers is relatively strong. It benefits from exceptional customer loyalty that makes its products relatively “price inelastic”.
As a result, Diageo could provide a degree of protection in an era when inflation in Britain has reached a 30-year high and global inflationary forces have been building over recent months. The stock is included in this column’s Wealth Preserver portfolio for that very reason.
Rising inflation has already prompted the Bank of England to raise interest rates and more of the same seems likely. This could ultimately inhibit Diageo’s profit growth because of its significant net debt, which amounts to 142pc of equity or net assets.
Moreover, rising interest rates may further strengthen sterling, which would act as a drag to the firm’s earnings.
However, net interest cover of 10 suggests that the firm has sufficient financial headroom to overcome a modest likely rise in interest rates. And, following that share price fall in recent weeks, investors appear to have factored in the prospect of an increasingly hawkish stance from the Bank of England.
Therefore, buying Diageo “on the dip” gives investors access to a high-quality business that is well placed to overcome near-term economic uncertainty. More importantly, it is positioned for growth as the pandemic recedes and global demand for premium spirits continues to rise.
Questor says: buy
Share price at close: £37.58
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