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Diageo: A Top Beer Stock to Hold During Recessions

The beer industry has strong economics, which makes it attractive for investors. Companies that manufacture and distribute beer hold competitive advantages, economies of scale and the ability to raise prices over time. Even better, beer sales hold up extremely well during economic downturns, which makes these stocks especially valuable during a recession.

Beer stocks also widely offer high dividend yields and regular dividend increases. Diageo PLC (NYSE:DEO) holds all of these qualities. The stock has performed extremely well and is up 15% year to date. While beer is a large part of its business, Diageo has a diversified portfolio.

Diageo is highly profitable with a long growth trajectory thanks largely to its strong brands and exposure to emerging markets. It is an attractive dividend growth stock.

Business overview

Diageo is one largest alcoholic beverages companies in the world. It has a market capitalization of $96 billion. It is a diversified manufacturer with a large portfolio of leading brands, including Johnnie Walker, Smirnoff, Captain Morgan and Ketel One, among others. Beer is a centerpiece in its portfolio, led by the Guinness brand.

These strong brands provide Diageo with a number of critical advantages. The company sees steady demand each year thanks to its highly popular brands and also the recession-resistant nature of alcoholic beverages. Sales of beer tend to remain flat (or even increase) during difficult economic times, which provides global manufacturers like Diageo with consistent profits. The company remained highly profitable during the Great Recession. Earnings declined slightly in 2010, but more than recovered in 2011. The dividend is highly secure, with a recession-resilient business model and a dividend payout ratio just over 50%.

Diageo scores highly in terms of safety and quality. The company has a long-term credit rating of A- from Standard & Poor's and A3 from Moody's, which indicates a healthy balance sheet. The brewer's numerous competitive advantages support its high-quality business model.

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In addition, Diageo's industry-leading brands provide the company with pricing power. It can boost its revenue growth each year, in part, by raising prices. It also helps boost earnings per share growth as well. Lastly, Diageo is a global company with a huge supply chain. Because of economies of scale, it can effectively lower costs to expand profit margins.

Growth Prospects

Diageo has excellent growth prospects thanks to its strong business model, top-tier brand portfolio and exposure to several emerging markets. The company released strong financial results for the fourth quarter in July. Net sales grew 5.8% $16.1 billion. Excluding currency fluctuations, organic revenue increased 6.1% on the back of price increases and volume growth. Organic revenue growth of beer came in at 1% thanks to price increases.

Separately, Diageo is seeing a big boost from the emerging markets, which refer to nations showing high rates of economic growth. For example, sales grew 9% in Asia Pacific, Latin America and the Caribbean. These growth rates were significantly higher than in the U.S., where organic sales were up 5%.

These results show the value of an emerging market presence, which widely offers higher growth rates for global beer and alcoholic beverage companies like Diageo. The primary catalyst for earnings growth is emerging markets. Latin America, China and India have huge growth potential for the company as these regions have large populations and rapidly expanding middle classes.

Share repurchases will also fuel earnings per share growth. Diageo repurchased $3.5 billion worth of stock in 2019. The company approved a buyback of up to $5.6 billion from fiscal 2020 through fiscal 2022. With a market cap of slightly less than $100 billion, investors should expect Diageo's stock buybacks to add 2% to 3% to its annual earnings per share growth through 2022.

Diageo is a very shareholder-friendly company as it returns lots of cash to investors through share buybacks and dividends. The company pays a semi-annual dividend. Diageo's current annualized dividend totals $3.55 per American depositary receipt (four ordinary Diageo shares represent one Diageo ADS). Over the next five years, we expect dividends to grow at a 5% annual rate. The current approximate dividend yield of 2.2% beats the average S&P 500 yield, with room for future increases.

Final thoughts

Through earnings growth and dividends, Diageo's stock could offer total annual returns in the mid-single-digits. The stock appears slightly overvalued with a price-earnings ratio above 20. A contracting valuation multiple would represent a headwind for future returns, but earnings growth and dividends can still provide shareholders with a satisfactory rate of return.

Diageo is a high-quality company with several strong brands and durable competitive advantages. The company has shown growth in every region that it sells its products. It also has growth potential for the future. The only negative aspect of is the stock's current valuation, which has expanded considerably in recent years. This was undoubtedly due to the high-quality earnings growth the company has enjoyed.

Disclosure: No positions in any stocks mentioned.

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This article first appeared on GuruFocus.