SLXX and Diageo

I have a large pot of cash to be invested. It amounts to a little over 20% of my existing portfolio. The investments I'm considering are:

• SLXX. A sterling corporate bond ETF.
• DGE. Diageo, an international beer wine and spirits company.

I will probably invest the money next week. I want to make sure I've done my homework and know what I'm investing in.

SLXX

The majority of the corporate bonds in this ETF are financial. At a price of £95.24, it has a flat yield of 8.08%, and a gross yield to redemption of 9.67%. The expense ratio is 0.2%. The interesting thing is how those numbers will be affected by some defaults.

I plugged in the entire list of holdings into Excel, and postulated what the effect would be if every bond trading at below 50% of its face value defaulted. That's 11 defaults out of 49 holdings, or 22.92% default rate. The net asset value would fall to £86.94. The flat yield would fall to 6.04%. The gross yield to redemption would only be slightly higher. But what if the other 38 bonds returned to par value? That would mean the net asset value increased slightly, to £95.96.

I think that's a pretty pessimistic scenario, but it still gives an acceptable return. I don't actually believe governments will let large banks default, even on their subordinated debt. In the rosiest possible scenario, no defaults at all, the par value of the fund is £121.51.

My concerns over SLXX are not just over defaults. I'm also concerned about the erosive effects of inflation. But I am funding the investment from a £mortgage, so my debts will be eroded along with my assets in SLXX.

In conclusion, I think SLXX warrants a place in my portfolio.

Diageo

Diageo is a great example of the sort of company that Warren Buffett likes to invest in. It has an excellent Return on Capital Employed and a moat (premium brands) to sustain it indefinitely. It has excellent free cash flow. It spends a substantial amount of money investing in its brands through advertising, widening its moat all the time. This sort of investment genuinely adds value, but is accounted as an expense, in much the same way as R&D at a pharmaceuticals firm.

The problem is that shareholder equity is only £4.6bn, vs a market cap of £18.4bn. Investors are paying a high price for that RoCE. They have £8.4bn of debt. But Diageo's really valuable assets are its brands. Many of these don't appear as assets in the books, and those that do will be accounted for at purchase price rather than current value. I cannot put a value on those brands except by looking at their earning power.

If Diageo had no debt it could borrow money, return it to shareholders, and get to its current position - so theoretically its current fair value should be no more than its debt-free value minus the level of debt.

Debt-free Diageo has shareholder equity of £13bn. It makes something like £2.7bn per year pre-tax, so let's assume £2bn post-tax. It would be an almost totally risk-free investment, and would be in a position to pay all of its earnings to shareholders or reinvest in the business. A P/E ratio of 20 would seem reasonable for such a stupendous company, so £40bn. Subtracting £8.4bn of debt, that puts a cap on its present value of £31.6bn (1264p per share).

But Diageo has taken on a lot of debt. Has it weakened its financial position far enough to affect its value? I don't think so. It has a good credit rating (A-, A3, A). It has reached a point where it is unwise to borrow further, but I don't think there is any real risk of it defaulting on its debt. It claims to have no financial covenants on its debt, and only a 2x interest cover requirement on its committed banking facilities.

One issue is that it has spent a number of years purchasing its own shares at high prices, and has now decided to stop, in order to avoid piling on more debt. I suspect this has a lot to do with the current slide in the share price.

What other potential problems does Diageo face? It has a negative tangible book value - it has negligible value except as a going concern. It has a £5bn+ pension fund, with a large portfolio of equities - that will certainly be suffering at the moment. It is certainly not recession-proof, although I expect it to be reasonably resilient.

In conclusion, I think Diageo is a good buy at its current price. It's on a P/E ratio of about 12, and I think a fair valuation is closer to 20.

Conclusion

I plan to invest on Monday, splitting my cash between SLXX and DGE, probably 50:50.

Update 23/03/09

Bought SLXX at 96.76p, DGE at 741.44p. My portfolio now looks like this:

BRK-B: 16.7%
SLXX: 9.1%
NXT: 8.9%
DGE: 8.7%
GNK: 8.2%
IEEM: 7.6%
TSCO: 7.5%
IAPD: 5.9%
IDVY: 5.6%
RBS: 5.0%
BDI: 3.2%
ZRX: 2.9%
BARC: 2.2%
HSBA: 2.2%
QDG: 2.1%
LLOY: 1.6%
MXM: 1.4%
TW: 1.2%