Diageo Up 3% On Week, Down 8% On Year – What Next?

Trade Diageo Shares Your Capital Is At Risk
Tim Worstall
Updated: 3 Feb 2022

Key points:

Diageo (LON: DGE) shares should, according to the standard theory, benefit from rising inflation. There’s also a possibility that any compression of disposable income should benefit the company’s sales and thus profits. While such theory is all very well it does in fact require that the market itself believe the theory. Which isn’t something wholly in evidence as yet.

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As background Diageo has a substantial portfolio of premium liquor brands. They’re able to sell these at premium prices largely through the perception – and possibly the reality – that they’re better stuff than the competition. Diageo does this rather well, they’ve got opportunities to expand what they do and so on. There’s no particular reason not to like the stock.

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The problem though is that Diageo just looks to be rather out of fashion. Solid, dependable, long-term business just isn’t what investors have been looking for of late. Far more exciting is all that big bang stuff over in the tech sector. But this might be about to change. Objectively, it should be about to change but objectively isn’t necessarily how stock markets work.

The macroeconomic background is changing that is. For the first time in a generation, we now expect substantial inflation plus the strongly rising interest rates which accompany such. Which means re-learning the investment tactics of that generation ago.

Rising interest rates means people making money now rise in value relative to those swallowing capital to build a future cashflow. Rising inflation means that those able to exercise some pricing power can keep up with inflation, those who are necessarily price takers tend not to be able to.

So, a company like Diageo, with a solid and long-running business, with some pricing power (this is what “premium brand” really means) should rise in value compared to those big bang tech stocks. The important word there though is “should”. We could even upgrade that to “will” if we like as long as we don’t get fixated upon the “when”.

Mature companies in fast-moving consumer goods markets with pricing power are the solution to the question “What to invest in when inflation and interest rates rise?”.

But that then brings us to two different levels of uncertainty. The first is well, is that inflation going to be a long-running feature? Those insistences that it would all be “transitory” are looking a little thin now but how long term will it be? This can also be combined with worries about interest rates. The inflation might require significant rises, but the economy may be too weak to take them.

So, the two beneficial effects upon the Diageo share price might be weaker than the classic theory would suggest.

The other uncertainty is that even if this is all true then when is the market as a whole going to recognise this and a rerating of Diageo shares take place?

There are those good arguments that Diageo should be higher than it is. But what will really determine whether Diageo shares do undergo a rerating is how many other people believe those arguments?

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