Why I'd sell Diageo plc and buy Next plc

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Next NXT shop window display

The market likes this morning's interim results announcement from clothing retailer Next (LSE: NXT) and the shares are up around 11.5% as I write.

At first glance, there's nothing to get excited about in the figures. Total sales declined by 2.2% compared to a year ago and earnings per share dropped 6.2%. The directors kept the dividend at last year's level suggesting a neutral stance, so why have the shares rocketed?

Looking for recovery?

I think the market is looking for a recovery with Next because even after today's rise the share price is still more than 36% down from the highs it reached at the end of 2016 -- the well-flagged softening of the retail sector left its mark on the firm for sure. I think we are seeing the move up today because of what the directors had to say in this interim report about the outlook.

While acknowledging that the first half of the year had been difficult as they expected, they said the trading outcome over the last three months has been "encouraging on a number of fronts."  Although they are expecting the retail environment to remain difficult they think the firm's forward prospects "appear somewhat less challenging than they did six months ago."   

After upgrading revenue and profit guidance a little, the firm thinks full-year sales will be between 2% down and 1.5% up on last year, and profit before tax will decline between 13.1% and 5.5% compared to last year's outcome. Those figures may seem a little grim but they aren't quite as bad as before this announcement, and I think this faint whiff of recovery may be the catalyst for today's rise in the shares.

Valuation matters

The big attraction, of course, is that on standard valuation indicators the stock looks cheaper than it has for several years. At 4,835p, the stock trades on a price-to-earnings (P/E) ratio for the current year near 11, and the dividend yield runs close to 3.7%. Maybe one day the P/E rating will return to high double-digits and we'll be measuring the dividend yield in the two's again, suggesting significant share-price appreciation from here.

I think there's a good chance Next will re-rate again and I'd rather take my chances with the firm than with premium drinks company Diageo(LSE: DGE) right now. Although I'm a big fan of defensive firms such as Diageo, I think the valuation is ahead of itself and the dividend yield is poor. I fear that defensives could go out of fashion causing a valuation rerating downwards.

Rotation imminent?

At today's 2,553p share price, Diageo trades on a forward P/E rating of almost 22 for the year to June 2018, yet City analysts following the firm expect earnings to grow just 8% that year. To me, that looks like a growth rating for workmanlike expectations and the forward yield of around 2.6% is not enough to compensate for the over-pricing.

The stock has had a good run but the valuation-trade making cyclicals such as Next appealing could see the large-scale rotation out of the defensives driving the rating of firms such as Diageo down.

Protecting the downside

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended 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.