Why Britain's Warren Buffett is keeping a watchful eye on Diageo plc

There are a number of FTSE 100 companies with characteristics that mark them as Warren Buffett-type stocks. Big profit margins, prodigious cash flows and high returns on equity, reflecting some sort of competitive advantage (barriers to entry, powerful brands and so on), are qualities Buffett looks for.

The likes of Diageo(LSE: DGE), Unilever, London Stock Exchange and Burberry have such qualities. It's therefore no surprise that these stocks feature prominently in the Lindsell Train UK Equity Fund and Finsbury Growth & Income Trust, both of which are managed by Nick Train (a.k.a. Britain's Warren Buffett).

Alarm bells?

Train has held drinks giant Diageo for years and it has a weighting of over 10% in his portfolios. However, unlike many investors who consider it a stock to "buy and forget", Train -- like Buffett -- reviews all the businesses he's invested in on an ongoing basis.

In his latest monthly fund update, he has expressed concerns about Diageo "that don't necessarily ring alarm bells, but are definitely of the kind that need having an eye kept on."

Capital allocation

It's the quality of capital allocation decisions taken in boardrooms that ultimately determines the long-term success of a business. As Train observes: "There's no point in generating above-average cash returns on capital if the excess cash is then misallocated."

There's no shortage of examples of companies that made bad decisions on capital allocation. Royal Bank of Scotland's takeover of ABN Amro is one. The massive expansion-at-any-cost investment of a few years ago pursued by big miners, such as Rio Tinto and BHP Billiton, is another.

Train is concerned about Diageo's capital allocation decisions of recent years.

Price, timing and consistency

He notes that, in hindsight: "The several deals Diageo did to increase its exposure to Emerging Economies between 2011 and 2013... were made at a time of high optimism about Emerging Markets and high prices for Emerging Market assets."

While acknowledging that both the CEO and CFO of the company have changed since the deals were done, he's also concerned about the subsequent capital allocation decisions by the Diageo board. These include the recently announced £1.5bn share buyback when the shares are trading at an all-time high and the $700m acquisition of George Clooney's tequila start-up, Casamigos. Train points out that Diageo is paying "up to 20 times sales for a hot brand in a fashionable category."

Then there's Diageo's 2015 disposal of Irish Whiskey brand Bushmills, the world's oldest distillery. Train was "sorry to see Bushmills go and then somewhat surprised to see Diageo announce this year it is investing in the creation of a brand new Irish Whiskey brand. It'll take some doing to match the 409-year heritage of Bushmills. And, ostensibly, it does not appear consistent."

Object lesson

Train is a huge admirer of Diageo's "exceptional brand portfolio and global distribution" and I believe he'd be a most reluctant seller of the shares if it were to come to that. However, his analysis is an object lesson for all investors on how we should monitor our holdings on an ongoing basis.

Decisions on capital allocation are among the most important taken in any boardroom and, as Train says, "cumulatively and over time it is the calibre of those decisions that will determine the long-term success, or otherwise, of our own investment decisions."

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G A Chester has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Burberry and Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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