Sprucegrove’s inventory of investable candidates, our Working List, is comprised of roughly 400 companies fully vetted by our investment research team as high-quality names we would be pleased to own, provided valuations are attractive. Projected Return on Equity is one of the most important calculations each Analyst makes when completing their research and making a recommendation on a company. Our goal is to only buy high-quality names (those with attractive Projected ROEs and strong balance sheets) versus buying companies just because they are statistically cheap, but we will not buy quality at any price. In our continuous efforts to enhance quality and value of each portfolio, our proprietary valuation measure (i.e. Normalized Price/Earnings, or “NP/E”) is a critical metric.
Our decades-long history with Diageo (and one of its predecessors, Guinness plc) provides insight into our process. We began covering Guinness in the mid-1990s and, with a history of superior profit margins and ROEs combined with a healthy balance sheet, we initiated a position in 1996 at an NP/E in the mid-teens. In May 1997, Guinness merged with Grand Metropolitan to create Diageo, forming a global powerhouse in spirits and beers with an impressive roster of brands including (not the full list): Johnnie Walker, Bell’s, VAT 69, and J&B Rare Scotch whiskies; Cragganmore, Dalwhinnie and Lagavulin malts; Smirnoff vodka; Baileys Irish Cream liqueur; Gordon’s and Tanqueray gins; and in beers Guinness stout, Kilkenny Irish beer and Smithwick’s ale. While Diageo’s quality remained high, by early 1999, valuations became lofty and once NP/E crossed into the mid-20s, we began trimming our position.
In 2000, Diageo introduced a strategy of premiumization, focusing on the exclusivity of each brand and pricing accordingly, replacing the former volume-driven strategy. In 2001, the company, alongside Allied-Domecq, purchased Seagram’s and added Crown Royal Canadian whiskey, Captain Morgan’s rum (amongst other products) and in 2005 acquired Bushmill’s Irish whiskey. The early 2000s saw a revival in the “cocktail culture” as well as a trend towards more brown spirits consumption, and this benefited Diageo. By 2006, in their largest and most profitable market, the U.S., 85% of Diageo’s sales came from dedicated distributors across 39 states, the result of a five-year undertaking when Diageo started restructuring distribution agreements to have a dedicated Diageo sales force. By 2007 Diageo held nine of the Top-20 global premium brands in spirits. Diageo’s leadership position in the premium drinks segment of the industry drove higher profits compared to other players and, with valuations reasonable relative to quality, we held our position.
By 2008, while Diageo generated standout profitability over the prior 10 years, we were keeping a close eye on the balance sheet as we monitored the preceding couple of years’ upward trajectory of Diageo’s net debt to equity (2008 was 186% from less than 100% in 2004-2006). This was uncomfortable for us, particularly as management staunchly adhered to share repurchases every year, even during periods of increased borrowing. So, with valuations returning to the mid-20s and concern with the balance sheet, we eliminated the holding in 2008.
From 2009 – 2014, Diageo maintained its market leadership in the spirits industry across whisky, tequila, vodka, and gin and their pole position in the beer market with Guinness. They capitalized well on organic and inorganic growth in key markets, including multiple acquisitions in China, Brazil and India. All of this resulted in impressive profitability and, while ROEs were well above 30% during this timeframe, we maintained an “avoid” due to a still leveraged balance sheet and relatively high valuations.
2015 saw Diageo’s quality becoming ever more attractive given first and foremost an improving balance sheet (net debt/equity declined to 121% compared to 238% in 2009) and an enhanced product portfolio with the exchanging of its Bushmill’s Irish Whiskey for the remaining 50% of Don Julio tequila it did not already own. Roughly seven years after Sprucegrove eliminated Diageo from the portfolio, in the latter half of 2015 the market provided us an opportunity to reinitiate a position at an average NP/E in the mid-teens and we continued to add incrementally through 2017.
Subsequent to Diageo adding another premium brand to its portfolio in 2017 by acquiring Casamigos tequila, by 2018 they held leading market shares in spirits of 20% in North America, 12% in Europe, 36% in India and 23% across Latin America. The more profitable Premium and Super-Premium product segments grew from 35% of total sales in 2012 to 50% by 2018, contributing to margin growth. There was also a revival in the growth of white spirits which was heavily tilted in favor of gin and tequila, playing to Diageo’s portfolio strengths. Impressively, Diageo’s Super-Premium portfolio comprised 15% of industry sales in 2019 and grew twice the global industry rate during the prior five years. While we believed Diageo was very well positioned to benefit from attractive long-term global spirits consumption growth, especially in emerging countries, and confident they would continue to generate impressive profitability and cash-flows, with shares close to fully valued, we maintained our existing position leading into 2020.
In March 2020, with COVID’s impact on economies and lifestyles, Diageo shared that they were expecting some operating margin impact, mostly from China, but anticipated a return to normal in the latter half of the year. To “plan for the best but prepare for the worse” they issued debt, suspended their stock buybacks, and reduced various marketing initiatives and discretionary capital expenditures. As the year progressed, while there were short-term shifts (unsurprisingly, a significant increase in at-home consumption and decrease in restaurant and travel-related purchases), Diageo’s brands demonstrated good resiliency. Given a significant increase in Diageo’s net debt/equity to 182%, the weakening of the balance sheet (driven largely by the resumption in share buybacks) combined with valuations increasing into the upper 20s, led us to begin trimming our position end of 2020 and further reducing our position into 2021.
Today, Diageo continues to benefit from their more than 20-year focus on “Premiumization” as premium spirits have demonstrated faster-growth and higher profitability than lower-end price categories. The company has a diverse portfolio of premium spirits brands with #1 or #2 position in each of its categories, and the breadth and depth of their offering allows Diageo to capitalize on market trends as spirits rotate into and out of favor as consumer preferences evolve. Unfortunately, while we appreciate many of Diageo’s competitive strengths, with an increasingly leveraged balance sheet and higher relative valuations, we would expect our current course of action of trimming exposure to continue in the foreseeable future.
This information is intended to provide insight into our disciplined investment process, consistently applied across all portfolios. Holdings examples may not apply across all accounts. Data is “as of” the date indicated and should not be relied upon as a complete or current listing of holdings (or top holdings) of the Representative Account. Holdings are subject to change without notice, and may not represent current or future portfolio composition.
The opinions, estimates and views expressed are on behalf of Sprucegrove, constitute Sprucegrove’s best judgement as of the date of this document and are subject to change at any time based on market or other conditions. Sprucegrove does not guarantee the accuracy, adequacy or completeness of any third party data. Any predictions, opinions, and other information contained in this report are subject to change and without notice of any kind and may no longer be true and accurate after the date this report was first completed and disseminated. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. In addition, any forecasts are based upon subjective estimates and assumptions about circumstances and events that may not yet have taken place or may never do so. While the information set out in this document has been prepared in good faith, no representation or warranty is given, and no responsibility is accepted, by Sprucegrove in relation to its accuracy or completeness.
The information provided herein should not be considered a recommendation to purchase or sell any particular security. The securities discussed herein are examples of Sprucegrove’s investment approach but do not represent an entire portfolio or the performance of a fund or strategy and in the aggregate may represent only a small percentage of portfolio holdings. It should not be assumed that any of the securities discussed herein were or will prove to be profitable, or that the investment recommendations or decisions made by Sprucegrove in the future will be profitable.
Any index information provided is for illustrative purposes only and is not intended to imply past or future performance. Please note an investor cannot invest directly in an index. Unless otherwise noted, index returns reflect the reinvestment of income and dividends, if any, but do not reflect fees, brokerage commissions or other expenses of investing.
The MSCI data is comprised of a custom index calculated by MSCI for, and as requested by, Sprucegrove. The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering and securities, financial products or indices. Neither MSCI nor any other third party involved in or related to compiling, computing or creating the MSCI data (the “MSCI Parties”) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data. Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. [www.msci.com)
This material is for informational purposes only to provide general information and is not meant to be legal or tax advice for any particular investor, which can only be provided by qualified tax and legal counsel. Please read the constating documents carefully prior to investing. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal, and tax professionals before making any investments.
All data is in U.S. dollars, unless otherwise noted. Past performance is no guarantee of future results.
Source: Sprucegrove, Diageo, MSCI