Investment Column: Drinkers ready to trade up so buy Diageo

Smith & Nephew; Catlin

Our view: Buy

Share price: 1017.5p (-7p)

Global consumers have cut back on quaffing Diageo's premium brand booze during the downturn in favour of the cheaper alternatives. Stateside, for example, customers switched from Johnnie Walker Blue Label to Black Label – and this sort of thing was partly behind Diageo's pre-tax profits slipping by 1 per cent to £1.4bn for the six months to 31 December 2009, a wee dram below analyst expectations. Total sales over the "challenging" period also fell 2 per cent to £5.2bn at constant currency rates.

But there was still plenty to toast in the interims, notably an improvement in the second quarter and a resilient performance by "standard priced brands", together with a 2 per cent rise in global sales of Guinness, driven by strong performances in Africa, South-east Asia and the UK, where the black stuff registered its highest ever share of the on-trade market. Overall, the company maintained its guidance for "low single-digit organic operating profit growth" for the full year. Diageo also wet the tastebuds of investors with a 5 per cent rise in its interim dividend to 14.6p and a mouth-watering increase in its free cash flow, which soared by more than £500m to stand at £904m by 31 December, boosted by tight cost controls.

Diageo was cautious when asked about the cash pile being used to fund further acquisitions. However, the chief executive, Paul Walsh, was cautiously upbeat about the outlook for the company, which is seeing encouraging signs as the world's economy begins to recover.

While Diageo's shares are not cheap, trading on 15 times forecast 2010 earnings, we tend to believe they still have a few more rounds in them, and it's not yet time to call last orders, particularly if customers start to trade up again. Buy.

Smith & Nephew

Our view: Strong buy

Share price: 659.75p (+27p)

If anyone doubted just how bad the recession has been, consider yesterday's full-year results from the knee and hip replacement group Smith & Nephew.

The company actually issued impressive numbers, beating expectations with a 22 per cent hike in fourth-quarter earnings. That was a significant improvement on this time last year, but what's worth noting is what has been happening in S&N's market. People needing operations to replace dodgy joints have been putting them off during the downturn. Analysts at Morgan Stanley pointed out that the market for hip and knee replacements in 2009 was very weak – posting an overall fall of 4 per cent – the worst for more than 15 years. That will not last in 2010. Growth rates in the hip and knee market should begin to accelerate again as people who have put off operations start beating a path to their surgeons' doors.

A host of analysts are now lining up to back the group. They have taken note of this, and the group's valuation. Despite yesterday's 4.27 per cent rise, the stock is still pretty cheap. The shares currently trade on 20 times this year's forecast numbers – which is inexpensive when you consider peers globally sit on 22 to 24 times.

Although the dividend yield of 1.49 per cent is nothing to get too excited about, we expect the share price to make progress from here and would strike while the iron's hot. With long-term demographics in its favour and the slowdown in the company's market of last year likely to turn around soon, we make this company a strong buy.

Catlin

Our view: Avoid for now

Share price: 335.75p (+10.8p)

A jaunty enough set of numbers from Catlin, the Lloyds insurer which is rapidly expanding outside of Lime Street. With little in the way of really nasty claims, Catlin made a strong profit on its underwriting, while the returns from investing the premiums it took in were very healthy.

We're disappointed that Catlin has removed staff bonuses from its combined ratio, which measures the profits made on each £1 of premium after claims and costs are taken into consideration. Others might do the same thing (as Catlin argues) but that doesn't make it right and does slightly flatter this year's figure.

We also wonder whether Catlin can keep up the pace. Premiums are still rising but the pace of growth has slowed markedly. The benign claims environment of last year probably can't go on forever, and investment returns are unlikely to be as stellar as this year's for two years running. So the company will be doing really well if it is to improve much its 2009 pre-tax profits of $603m.

The shares are not expensive, trading at just under 90 per cent of the company's book value, and Catlin is financially strong, with a good capital cushion. However, right now the case against Catlin is strong enough that we would avoid for the moment.