Glass half-empty or half-full?

But that has all changed over the past year. Trading across the developing world has been hit by series of largely disparate problems, from political unrest in the Middle East and Eastern Europe to a clampdown on credit and graft in China. For Diageo and SABMiller, who derive a respective 44 and 63 per cent of their revenue from emerging markets, this has been a real problem, with weaker sales growth compounded by currency depreciation. From the Brazilian real and Indian rupee to the Indonesian rupiah, Turkish lira and South African rand, emerging-market currencies clocked double-digit declines in 2013, creating a major head-ache for companies that report in sterling or dollars.

Unfortunately for the global beverage groups, the currency problem looks set to persist throughout 2014. Diageo, for instance, is battling against a £280m currency headwind, while Pernod will suffer a negative impact worth some €160m. SABMiller, ABI and Heineken (Europe: HEIA) all face similar challenges.

Small is beautiful

A longer-term problem for the big brewers - Carlsberg, Heineken, SABMiller, etc - is the craft beer revolution that has taken Europe and the US by storm. In the UK, private beer producer BrewDog is expanding fast, funding growth through successful, over-subscribed online share offers. In the US, craft beer accounts for 6.5 per cent of total volumes, forecast to rise to 10 per cent by 2017, according to research from Nomura. Overall, the sub-sector is growing by 7 per cent a year globally.

Unsurprisingly, the major brewers want a piece of the action, but this comes at a price. Having spent millions streamlining operations into ultra-efficient mass brewing, they're now being forced to take a margin hit by introducing artisan varieties.

Scraping the M&A barrel

Acquisitions can be a means of combatting muted top-line growth, but for the beverage sector this seems unlikely. After 15 years of consolidation in the beer market - the top four companies now account for 42 per cent of volumes - analysts at Nomura reckon there's little scope for further M&A activity.

The spirits market remains highly fragmented, with the top four companies producing just 17 per cent of total volumes. But even here major M&A activity is unlikely. Despite a significant de-rating in 2013, the sector trades at a 25 per cent premium to the wider stock market, so any acquisitions would come at a high price. Bolt-on deals in emerging markets may be more probable. And the analysts at Nomura also expect innovation to replace acquisition as a capital-light way to achieve growth in mature markets.

So where will growth come from?

The bad news is that the City consensus points to further de-rating in the beverage sector. Analysts at Deutsche Bank reckon that, until investors get more comfortable with emerging markets, so-called staples are likely to continue to underperform in the short term.

Yet if you can look beyond the near-term hurdles, there's still a lot of long-term potential in beverage stocks. They have demographics on their side: the global population is set to soar and alcohol consumption will rise as emerging economies grow richer. In many emerging markets companies like Diageo and Pernod have barely scratched the surface. Per-capita consumption of vodka and whisky in emerging markets, for instance, remains at just 10 and 16 per cent that of consumption levels in the developed world, while beer consumption is half that of developed economies.

Bear in mind, though, that spirits probably offer better growth prospects. Researchers at both Nomura and Deutsche Bank have pencilled in extremely weak growth for beer, but are more optimistic about hard liquor.

SAB Miller

This supports our sell recommendation on SABMiller (Sell, 2,992p, 10 Oct 2013). The vast majority of group profits are generated in emerging markets, where earnings are being held back, and trading is also tricky in North America and Europe, where lager volumes are falling. Raw-material costs are also expected to rise.

Diageo

Diageo, meanwhile is one of our sector favourites. Currency headwinds and emerging-market weakness will persist throughout 2014, but Diageo's ability to drive earnings growth through efficiency savings puts it in a strong position to ride out the current troubles. It also boasts a wide product range, skewed toward spirits like high-end whisky.

Stock Spirits

There's also a fresh entrant to the beverages sector to consider: newly floated Stock Spirits (STCK) offers investors a chance to gain exposure to a 'mini Diageo' at a cheaper price. The company, which manufactures and distributes alcoholic beverages across Central and Eastern Europe, is highly cash-generative, with free cash flow last year of £83.3m thanks to a cash conversion rate of more than 75 per cent. Cash profits have soared 37 per cent in the past three years, and this year sales are forecast to rise at a double-digit clip.

The company's strategy is to accelerate organic growth through product innovation. Flavoured vodka has already been a hit, and last year also saw the completion of Project Polar, a major initiative to sell chilled vodka to Polish consumers by installing branded fridges in corner shops. Unlike UK consumers, who prefer to mix vodka, Poles like theirs neat and chilled for consumption soon after purchase.

But the real opportunity for Stock Spirits lies in acquisitions in what remains a highly fragmented market dominated by local brands. The company is already in discussion with a number of targets. “Eastern Europe offers significant growth potential. The big guys don't have a large presence there and aren't interested in the small local brands, but we see this as a big opportunity," says finance director Lesley Jackson.

It's also encouraging that Stock has secured guaranteed revenue streams through distribution agreements with Beam and Diageo, while boasting one of the cheapest manufacturing bases in the industry. Margins are in line with international peers, even though the group lacks the big boys' premium portfolios. On a forward PE ratio of 14, the shares trade at a significant discount to their peer group. "We are not the next Apple or Dyson, but we are steady and solid," says Ms Jackson.

Source: S&P Capital IQ