Terry Smith vs Nick Train: who is right on Diageo?

Britain’s two best-known fund managers – Terry Smith and Nick Train – invest in a similar style – seeking out “quality” companies that have stood the test of time and can keep growing steadily.

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Smith runs a global fund (Fundsmith Equity) and Train manages both UK and international strategies: Lindsell Trian Global Equity and Lindsell Train UK Equity.

The two star managers sometimes agree on companies. For example, consumer goods giants Unilever and PepsiCo are held by both investors. 

However, they have now diverged on a large consumer stock: alcoholic drinks company Diageo (LSE:DGE).

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In August, Smith sold his position. Meanwhile, it is a 10% position in Lindsell Train UK Equity and a 7% position in Lindsell Train Global Equity.

The shares have been under pressure, falling 10% this year and 37% since the beginning of 2022. A lower share price means its dividend yield has risen, to more than 3%, and its valuation has dropped to 19 times earnings compared with an average of 26 over the past five years, according to data group Morningstar.

The share price weakness is linked to slowing sales, which dropped 1.3% in the last financial year, while profits dropped 3.3%. Diageo owns brands including Guinness, Gordon’s, Baileys, Tanqueray and Captain Morgan.

But who is right about the £55 billion drinks company, Terry Smith or Nick Train?

Why Terry Smith sold Diageo

Speaking on our On The Money podcast this month, Smith said that Diageo has been the only company he’s sold this year.

Reasons for the sale include problems in Latin America, where Smith says the company has too much stock in a down period for spirits consumption.

“And I’ve got to say, we’re very puzzled about it, mainly because it’s not the only drinks company that we follow. We follow them, Brown Forman, Davide Campari, Pernod Ricard and Rémy Cointreau, and none of the others can tell us what they’re talking about, basically. A bit worrying,” Smith said.

The other reasons for the sale are that there is a general downturn in spirits consumptions in America after a spike during Covid, and weight-loss drugs from the likes of Novo Nordisk and Eli Lilly may lead to reduced consumption of alcohol.

“I think we might be in the early stages of seeing that starting to take effect, basically. But if we are and it is going to be an effect, it’s going to be an interesting headwind, because Ozempic and Wegovy are only labelled in eight countries at the moment. So, when this really does become widely available, it could have a very interesting effect,” Smith said.

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Finally, Smith has questioned the management of the company. He said that he does not understand the leadership team’s reasons for the issues in Latin America.

“Is the management good? I mean, are they going to react well to this or not? And we’ve had a recent change in management there, and we worry about that. Because we thought Sir Ivan Menezes – who retired and then sadly died very shortly afterwards – was a top guy.

“He understood the marketing of the spirits world, I thought, intimately, and I just don’t know whether the current incumbent does quite so well. So, we’ve [had] a kind-of untested pilot appear when we’re going through more than a bit of turbulence here,” Smith said.

Why Nick Train still likes it

Despite the headwinds for Diageo, Nick Train has been topping up his position and it is still a top stock for the fund manager.

In fact, he’s said before that Diageo is the company that every investor should own. He’s called it the “world’s best alcoholic beverages business” and prizes it for its strong brands that often customers are willing to pay a premium for.

However, responding to the recent poor performance of the stock and the underlying company business, he’s said that as long -term investors in the company, he’s “left looking for bright spots in a disappointing phase of Diageo’s history”.

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But Train does find some reasons for cheer. For example, he says that 75% of its brands gained or is holding market share in the past financial year.

Plus, two of its big long-term growth drivers – Guinness and Tequila outside the United States – grew their revenues at a double-digit pace.

Train adds: “The company generated $2.6 billion (£1.95 billion) of free cash flow, up $400 million on the previous year. New earnings forecasts are now emerging for Diageo’s financial year end June 2025. Those we monitor show a wide divergence, between £1.60 and £1.20 per share, reflecting the uncertain timing of an improvement in sales trends.”

Train puts a share price target of £40 on Diageo, which is 53% higher than the £26 they trade at today. The shares are around a 20 times price-to-earnings ratio based on forecast earnings of £1.20 a share next year, but Train thinks they should trade at up to 33 times, hence his optimistic price outlook.

“We would not even consider selling out of an asset as advantaged as Diageo at anything less than a 30 time or more multiple. That gives a possible target price of around £40, which will be higher when Diageo’s earnings grow again. We have added to our holding when we can,” he said.

What do analysts say?

Investment analysts also have a positive view on the company. One of the most bullish is Bank of America, which says the shares are worth £28 and the “worst is behind” the drinks giant.

The analyst said: “After two years of earnings downgrades and share price underperformance, we believe the worst is behind. With a reasonable valuation, improving momentum of the business and a relative scarcity of compelling investment alternatives in staples, we expect the stock to rerate a little and to outperform.”

It believes sales will grow 3% next year and profits about 2%.

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Another optimist is Morningstar, which rates the stock “significantly undervalued”. It says that its sales reach is impressive, with its US distributors employing more than 2,800 dedicated salespeople focused solely on the company’s products, which contributes to above-average operating margins in this profitable region.

Morningstar adds that premium distilled spirits are an affordable luxury category that should benefit from long-term demand growth from aspirational and high-income consumers.