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An investor’s quiz and a stock you can drink to

This U.S. advisory has some surprising answers to a true or false quiz and recommends that you put some alcohol in your portfolio.

It is our observation that the farther away you are from your school days, the more you enjoy a quiz. Unless you’re a contestant on Jeopardy, it doesn’t really matter whether you come up with the right answers or not. And however you come by the answers, you can turn around and use them to impress people at your next social gathering.

It’s a no-lose situation. Today we have a simple investment quiz with just three questions — to which many investors would give three wrong answers.

On the other hand, the answers aren’t just black and white. But then neither is investing.

The true-or-false questions come to us from Louis Rukeyser’s Wall Street. The quiz is set by Mr. Nikolas Lanyi, successor to the late Mr. Rukeyser as editor of the publication. Later, we’ll hear why booze is a good investment, in moderation.

Don’t keep moving money around

Here’s the first question: “True or False: I should make asset-allocation decisions based on the short-term direction of the economy.”

Actually, in this case we suspect many would say one thing and do another. The correct answer, according to Mr. Lanyi, is:

“False. Smart investors choose their portfolios based on their long-term investment goals and their sensitivity to volatility. Then they stick with them, as long as those two factors don’t change. Moving money in and out of assets based on predictions about what will happen over the six months makes little sense — as those predictions are as likely to be wrong as right.”

One adjustment that’s worth making now, says the editor, is to increase your exposure to foreign economies. It needn’t be foreign stocks, he adds. It could be U.S. multinationals who do a lot of business in fast-growing countries.

As we implied above, we suspect that some investors would pay lip service to sticking with long-term allocations, then change course and start shifting money when the market starts to wobble. Not you, of course. But some people we know…

Your basic price/earnings ratio question

The next question flies in the face of normal stock valuations. It is based on the widely held assumption that a stock whose price/earnings ratio is at 20 is fully valued and has little room for growth.

“True or False: It’s OK to invest in a stock with a price/earnings ratio multiple of 30.”

If you’ve read the investment advice literature, you’re supposed to say no. But the answer is:

“True — sometimes. What matters most is not the nominal P/E, but the relationship between the P/E and the company’s expected earnings growth. As a rule of thumb, a stock is inexpensively valued if its P/E is less than 1.5 times the company’s expected earnings-growth rate, especially if the company has “high-quality” characteristics such as market leadership, major competitive advantages, a strong balance sheet and a long history of sales and dividend growth.”

Or, good stocks just keep on making money.

If you’ve been around long enough to remember when the ravages of inflation struck three decades ago, you’re definitely going to get the next one wrong.

Say yes to inflation — sort of

“True or False: The worst thing that could happen in 2008 is a return of inflation.”

All those with their hands up saying, “Yes! Yes!” — put them down. The answer is:

“False. As bad as a mild bout of inflation would be, a recession — and the corresponding bear market that likely would accompany it — could have a more severe, lasting impact. Recession-related job losses and bear-market-related declines in household wealth could seriously crimp U.S. consumer spending, which has propped up the economy despite a housing-market downturn that appears to be the worst in many decades.”

Mr. Lanyi is not leading the cheers for inflation, he’s simply searching for the lesser of two evils in a tricky situation. A return of inflation would not be welcome, he readily acknowledges.

The “alarmingly high” Consumer Price Index and wholesale price numbers for November put the market in a tizzy and caused the yield on 10-year Treasury notes to rise sharply in a matter of days. This puts us between the proverbial rock and hard place.

“Bond yields reflect inflation, so further signs that inflation is back could cause interest rates to move higher — which will hurt corporate earnings and consumer spending.”

Looking at the erratic behaviour of the markets, it is altogether possible that we may have to pick our poison. Although the way things are going, even the highest monetary authorities may no longer have any control over which poison we get.

At this point, it is customary to hand out grades for the quiz. As in: if you got all three right, you’re in the Warren Buffett class, and so forth. We’re just going to give everyone a passing grade and move on.

The answer is 13 famous brands

Here’s one more quiz. Except this one is a reverse quiz, as on Jeopardy.

The answer: Bailey’s Irish Cream. Beaulieu wine. Captain Morgan. Crown Royal. Dom Perignon. Gordon’s. Guinness. Harp. Hennessey cognac. Johnnie Walker. Moet & Chandon. Smirnoff. Tanqueray’s.

The question is: What does Diageo (NYSE-DEO) make? Diageo, which has its headquarters in the United Kingdom, is the number one maker of alcohol in the world. A number of its liquor brands are number one in their category.

In these days of market uncertainty, Diageo fits the profile of a recession-proof stock. It may not be as necessary as food and other household products, but consumption of alcohol remains pretty steady. (We leave aside all arch remarks about how many stiff ones investors might need in markets like these.)

Diageo’s revenue is twice as much as that of its closest competitor, Pernod Ricard. It has locked up many of the best distributors in the U.S. In fact, it has one distributor in each state, while its competitors rely on distributors with much larger areas to cover. That gives Diageo’s products prime shelf space, an obvious advantage in sales. It also gives the company operating profit margins of 30 per cent in the U.S.

More cocktails

Drinking trends are also moving in the company’s favour, writes Mr. Nikolas Lanyi. “Diageo has also been helped by rising interest in cocktails among young American drinkers in recent years.” In the previous decade, microbreweries were all the rage, but the mixed drink has caught on again.

In its latest fiscal year, Diageo saw its North American revenue rise 7 per cent, while operating profit grew 12 per cent. Yet volume growth was only 3 per cent, which indicates “excellent pricing power.”

Mr. Lanyi reiterates the recession-proof nature of the stock: “And because alcohol sales historically have held up well even in times of economic weakness, most analysts think Diageo will continue to thrive even if the U.S. falls into a recession.”

But that’s just a small part of its potential, adds the editor. Overseas, the prospects are even more tempting. In the past fiscal year, sales rose 13 per cent and profit was up 7 per cent. In the International Division (all countries outside North America, Europe and Asia) sales rose 18 per cent and profits 19 per cent. The biggest inroads were made in China, India and Brazil.

This international growth “seems poised to reap the rewards for many years to come.” The only area that is not growing is Europe, where sales remained unchanged from fiscal 2006 to fiscal 2007. But that’s not really slowing down the company’s growth.

Diageo’s finances are as strong as its drinks, with plenty of cash flow and relatively low debt. It also sticks to its knitting, as the British say: it spun off Burger King and General Mills in recent years, and seems content to focus on its existing liquor business.

Why not? Its revenues should grow by a 5 to 6 per cent annual pace in the years to come, with earnings growth of some 10 per cent per year. It buys back its own shares regularly and pays a sizeable dividend of $1.64, which is yielding 4.06 per cent.

“Yet the stock trades at less than 16 times analysts’ consensus estimate for fiscal 2008 earnings per share,” concludes Mr. Lanyi, “a bargain price for this high-quality growth stock.”

Since we’ve successfully completed the quiz, it’s time to reward ourselves with a drink (whether it’s cognac or cranberry juice is all the same to us). Let’s hope the right answers also bring rewards on the market in the questionable months ahead.