Woodford cautious on high expectations for Nick Train favourite

Woodford Investment Management has warned on Diageo’s valuation in its latest fund update, raising concerns about high expectations for the stock’s outlook, while Nick Train has recently argued the stock is undervalued.

Neither of Woodford’s UK equity income funds have any allocation to Diageo, while the Lindsell Train Global Equity fund has been adding to the stock all year making it the second-largest holding at 7.4 per cent of the portfolio.

In the Lindsell Train UK Equity Income fund is the largest holding at 10 per cent.

The drinks giant’s price to earnings have increased from 17.1x to 22.1x over the space of 15 months, bolstered by earnings forecasts increasing 15 per cent for the current financial year, partially due to currency fluctuations.

Woodford head of investment communications Mitchell Fraser-Jones says Diageo’s share price has risen much more than the 15 per cent earnings increase and the market’s behaviour has introduced more risk.

According to Bloomberg, Diageo’s anticipated earnings growth rate has improved from about 4 per cent per annum in mid 2016, to about 10 per cent now, but Fraser-Jones warns it could continue at its current growth rate of 3 per cent to 4 per cent.

“Either way, we have a situation here in which the starting valuation is high and expectations are high. In our view, that is not an attractive combination,” Fraser-Jones says.

“We would rather invest in stocks where valuations are low and expectations are low – which is one of the reasons we remain attracted to the healthcare industry, and have grown increasingly attracted to UK domestic cyclicals in recent months.”

1m 3m 6m 1yr 3yr
Woodford Equity Income -2.6 -6.1 -3.7 -0.1 23.6
Woodford Income Focus -0.03 -2.7  n/a n/a  n/a
Lindsell Train UK Equity -1.7 -0.1 5.8 15.9 48.1
Lindsell Train
Global Equity
-3.7 -1.3 8.6 19.0 77.1
Source: FE

In contrast, Nick Train argued in the Lindsell Train Global Equity fund update last month that Diageo is undervalued and that he has bought “a lot” of shares in the year to date. Unilever is the only fund in which the fund holds a larger position at 7.8 per cent of the portfolio.

Train says the team, which includes Michael Lindsell and James Bullock, pays close attention to companies’ capital allocation decisions and that they’ve been impressed with the chief executive Ivan Menezes and CFO Kathryn Mikells; however, he does raise some questions over acquisition strategy.

“Most companies do not generate circa 30 per cent operating margins on a regular basis nor do they turn nearly or all of their operating income into cash. Diageo is one such company that does so often – blessed by its exceptional brand portfolio and global distribution. But when a company has intrinsic advantages such as these shareholders’ expectations ratchet up.”

Train says emerging market acquisitions between 2011 and 2013 came at a time of high optimism about those regions and came at a high price, but notes that Menezes and Mikells were not at the helm at the time and that they are now happy Diageo owns those assets, especially in India.

Train adds that they support the $700m purchase of George Clooney’s tequila start-up – Casamigos, which he describes as a “hot brand in a fashionable category”, although he notes it will be interesting to see how Diageo differentiates it from Don Julio.

On a £1.5bn share buyback, Train says the team would have liked better timing even if they are not opposed to it, noting July’s final results sent shares up 7 per cent, up over 40 per cent from 2015 lows.