Tesco - should you be selling... or buying ?

Friday, Jan 20 2012 by
12
Tesco  should you be selling or buying

Tesco (LON:TSCO) is the largest supermarket in the UK with over 2,000 stores here and around half a million staff worldwide.  It’s a monster.  It’s the dominant player in a recession-proof industry and has Warren Buffett on board as a major investor.  So if the Christmas results for a single year were a bit disappointing, investors would just shrug it off… right?

Wrong.

As is so often the case the short-term market players have the power, at least in the short term.  With so many retailers struggling and more falling by the wayside every day, even the slightest bit of bad news seems to have massive repercussions regardless of who they relate to.

So the question is:

Was Buffett wrong to invest in Tesco?

Let’s take a look at a long term price chart:

That’s not quite as miserable for long term shareholders as some other companies, but we are still back at prices seen previously in 2005, some 6 or 7 years ago.

Investors over the last few years may be a bit disappointed (except those that bought in the depths of the credit crunch), but what about now?  How does the investment case stack up from the point of view of an ‘average’ investor?

For this type of company I use a 6-step process for the initial review, which is an extension of the principles outlined by Ben Graham for what he called ‘defensive’ investors, who were typically people building or living off of a retirement fund.

 

Focus on defensive qualities first

Risk management is important for defensive investors, hence the name.  Ben Graham suggested three main steps to check that an investment has sufficient defensive qualities.

If you already recognise that Tesco is a pretty indestructible company, feel free to skip on ahead to the ‘pay a low price’ section below.

 

Step 1 – Look for diversity

This primarily relates to holding a sufficient number of companies in a wide range of unrelated industries, but it also applies to the individual companies themselves.

There are many ways that a company can be diverse and for Tesco it comes primarily from operating in many different locations, both within the UK and internationally.  If a particular store or geographic region performs badly because of local issues, the rest of the company should be relatively unaffected.

 

Step 2 – Demand long term success

Graham felt that the defensive (retirement fund generating) investor should focus on successful companies.  He gave them various names, but typically he used words like large, leading, prosperous and prominent.  The thread that ties all these terms together is long term success.

In Tesco’s case it has been growing profitably for at least the last 10 years and hasincreased revenue, earnings and dividends on a per share basis in every single one of those years.  That’s pretty amazing.

You can see this success in the table below which shows approximate per share results:

 

Step 3 – Avoid excessive debt

Debt is a corrosive substance.  As Warren Buffett has said, “Leverage is the only way a smart guy can go broke”.  For a defensive investor there is no reason to take the risks that come with highly leveraged companies.

Fortunately, Tesco seems to have an aversion to excessive debt even though they are in a very stable industry and could probably borrow far more than they currently do.  The interest payments  are covered around 11 times by earnings and total borrowings are only about 3 times operating profits.  Both of those figures are relatively conservative and in no way excessive.

So far Tesco ticks all the preliminary boxes for a safety first, defensive holding; but what about excess returns?  Surely the whole point of stock picking is to beat the market in the long run?  Indeed it is, so let’s turn from Defence to Value.

 

Pay a low price relative to the V-A-L-U-E of the investment

Price is what you pay and value is what you get, as many have said.

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The value that you get from an investment can be broken down into 3 main parts and these are steps 4 to 6 in the initial analysis phase.

 

Step 4 – Buy as much long term earnings power as possible

The future is uncertain, but some companies have already proven that they are capable of generating a certain magnitude of earnings.  Companies that have generated consistent and unbroken profits for many years are more likely to continue to generate a similar level of profit than those that have not.

One way to measure this earnings power is by using the 10 year average of historic earnings.  This number provides a baseline figure that may be a reasonable expectation for future earnings.

As an investor it would make sense to get as much of this earnings power as possible for each pound invested and so a key metric is the PE10 ratio, or the current price relative to the 10 year earnings average.  For this ratio, a lower value is better and currently the FTSE 100 index has a PE10 figure of around 13.9 (with the index at 5,690).

For Tesco the PE10 is 14, so it’s almost identical to the index that most investors are trying to beat.

 

Step 5 – Look for a high and sustainable dividend yield

Most investors focus on capital gains as that is where the action is.  Price swings of 5 or 10 percent in a single day have an amazing ability to focus the mind.  Generally though, this is a mistake.

Many studies have shown that the dominant factor in long term returns is reinvested dividend income and so a high yield combined with a sustainable dividend are likely to be far more important than the gyrations of the stock market.

The FTSE 100 currently offers something like a 3.5% yield which history shows is probably as sustainable a dividend income as there is.  The chances of the dividend being stopped or even just cut are slim.  On top of that the dividend is likely to continue growing at something like the historic rate of 5% or so.

Tesco, on the other hand, currently offers investors a dividend yield of around 4.9%, almost 1.5% clear of the index.  While that may not sound like much, it is true that every little helps.  What may be more important is the possible future growth rate of that dividend.

Step 6 – Prefer growing companies but do not overpay for them

As the results table above showed, Tesco has grown in every one of the last 10 years.  The growth rate of earnings is around 10% a year which is comfortably above the market’s growth rate of around 5% a year.  This growth rate, plus the fact that they retain around 60% of earnings means that they are generating something like a 19% return on retained earnings, which is pretty solid.

Given that we already know that the PE10 is about the same as the market’s at 14, it’s unlikely that the current price could be considered ‘overpaying’ for Tesco.

 

Future total returns

Sadly the future returns are completely unknowable.  But, it is possible to say something simple about what they could be.

With a dividend yield of about 5% and a growth rate of around 10%, if we assume that the PE ratio stays where it is then future total returns over a period of years may be in the region of 15% a year which is more than reasonable.

If the share price refuses to budge back up towards 400p then you’d have a share that yields 5% with a yield growing at close to 10% a year.  In 5 years the yield would be close to 7.5% if the share price stayed flat.

So you either have Tesco with a growing share price giving a 15% return per year, or a Tesco with a flat share price yielding 10% more every year.  Either way, that sounds pretty attractive.

 

So what does that all mean?

In direct comparison to the FTSE 100 (UKX), the price (PE10) you’d pay for Tesco is about the same, but both the current dividend yield and the historic growth rate are considerably higher.

For investors looking to beat the market with a diversified portfolio of leading companies I think Tesco should definitely be on the short-list.

P.S. You may have noticed that I didn’t analyse the current bad news surrounding the poor like-for-like Christmas sales figures.  Those kinds of minor bumps in the road will typically have next to zero impact on the long term intrinsic value of a company like Tesco.  The only time you should care about that kind of news-fluff is when they create fantastic buying opportunities.

 


Filed Under: Value Investing, Stock Picks,

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Disclaimer:  

This article is for information and discussion purposes only and nothing in it should be construed as a recommendation to invest or otherwise. The value of an investment may fall and an investor may lose all their money. Any investments referred to in this article may not be suitable for all investors.  Investors should always seek advice from a qualified investment adviser.


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Tesco PLC, incorporated on November 27, 1947, is engaged in retailing and associated activities in the United Kingdom, China, the Czech Republic, Hungary, the Republic of Ireland, India, Malaysia, Poland, Slovakia, South Korea, Thailand and Turkey. The Company also provides retail banking and insurance services through its subsidiary, Tesco Bank. The Company’s operations in the United Kingdom is the within the Company, with over 3,000 stores. The Company’s in-store picking model is complemented by a small number of specialized dotcom-only stores, which allow the Company to respond to customer demand. The Company’s Click & Collect service is a part of its multichannel offering and enables customers to pick up their shopping when and where it suits them. It has over 1,500 Click & Collect collection points for general merchandise and over 150 Grocery Drive-thrus in the United Kingdom. more »

Share Price (Full)
193.8p
Change
-9.2  -4.5%
P/E (fwd)
9.6
Yield (fwd)
4.4
Mkt Cap (£m)
16,490



  Is Tesco fundamentally strong or weak? Find out More »


17 Comments on this Article show/hide all

Fangorn 20th Jan '12 1 of 17
1

Have been short of food retailing exposure for a while now ever since I sold my Northern Foods. The profits warning from Tesco, and the subsequent drop in all three supermarkets was as good a time to get back in as any in my view given their defensive qualities.

Not personally a fan of Morrisons, hence it was always going to be either Tesco or Sainsbury. Have habitually preferred Sainsbury myself, a better divi ,and underpinned by the potential of a Qatari bid (They hold a significant stake still so there's always a possibility they will return for another go)

But the large fall in Tesco on results day,and the drip the following day was just too good an opportunity to miss. Whilst Tesco is struggling in the UK it does offer ,as you say, better opportunities for growth given its emerging market and US exposure.Something Sainsbury lacks. So tucked away a few Tesco shares and was then relieved to see Warren increase his stake several days later to 5.1% (3.6% previously).

If it's good enough for him, it's good enough for me as a LTBH.

Thanks for the write up.

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UK Value Investor 20th Jan '12 2 of 17
1

In reply to Fangorn, post #1

Hi Fangorn, no problem. I think within 5 years Buffett is likely to be proven right about this one (again). I guess because he's looking for longer term growth ('forever' is one of his catchphrases) he'd look at Tesco first because of the international stuff, as you say.

That doesn't mean that other big retailers aren't a bargain on a shorter than 'forever' time frame though. Personally I'm more likely to go with M&S than Tesco at the moment, even though Tesco is likely to be the better very-long-term bet. But either way there are quite a few leading retailers that look attractive. You just have to separate the wheat from the chaff as they say!

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UK Value Investor 20th Jan '12 3 of 17

In reply to UK Value Investor, post #2

Also the table in the article is cropped to 2009. The growth story does continue into 2010 and 2011 but you'll just have to trust me on that (or check it out on Stockopedia Premium).

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emptyend 20th Jan '12 4 of 17
3

In reply to UK Value Investor, post #2

I'm in two minds about Tesco. This fall does look inviting, for such a core stock - and especially given Buffet's endorsement (though increasingly that is a function of liquidity needs on his part, IMO).

However, I'm reminded of what happened to M&S when Rick Greenbury retired - and I wonder whether something similar may happen at Tesco, now that Terry Leahy has stepped down.

His are big shoes to fill - and the temptation for new managers coming in is to stamp their own mark on the company by making some relatively radical changes. The risk of that is that, in so doing, they destabilise the balance of a pretty finely-honed organisation - which then starts to fray around the edges and slowly begin to question every aspect of its activity....especially ways of doing things which have been unchallenged for years.

In the aftermath of Greenbury (IIRC), there was a major change to sourcing policy at M&S (which had previously a well-deserved image for sourcing mainly from the UK) - and that resulted in a loss of direction that took many years to recover from......

....and my fear would be that Tesco start mucking around with their supply chain and retailing machine in a similar way.

This week I received a market research questionnaire from Tesco (I think) via YouGov. I suspect that they will be looking at making some important changes to their retailing offer to customers, especially in the UK. For example, they could change the balance between clothing, housewares, electricals, wine and food - and move some of their retailing towards online-only?

I'm also aware that they look (from local proposals) to be likely to build more food-centric stores and perhaps de-emphasise or reprofile their Extra stores

Difficult to know what effects such changes will have to the bottom line - but IMO they would do well to get such changes right first time! Over the next year, the shares will either recover the ground lost or we will see another leg down. On balance I'd be waiting to see, especially with retailing in general remaining under pressure.

ee

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Steven Dotsch 20th Jan '12 5 of 17
5

Was Buffett wrong to invest in Tesco?

Absolutely not! He is a man of his word, so his pledge (in November last year) to buy more shares in Tesco if the price would come down had to be fulfilled, or, lose credibility.

Dividend Income Portfolio had an initial averaging down limit order outstanding, as communicated to our premium subscribers - pre announcement - at £3.53 (when the share price was trading around the £3.90 - £4 mark), which was filled at £3.45. Subsequently, we issued another limit order, as communicated to our premium subscriber, at £3.19 which was subsequently filled a day later at £3.17 (our rules state that we inform our subscribers in advance - one trading day - before issuing a buy or sell limit order via our ISA brokers).

On adding any more shares in Tesco . . . I have communicated in Dividend Income News as follows; "Our shareholding in Tesco represents now more than 10 per cent (in fact 11%) of the Dividend Income Portfolio. In order to benefit from the diversification of income sources within the portfolio, our portfolio management rules preclude us from holding more than 10 per cent of a single shareholding. We are unlikely to add further to our Tesco shareholding, unless the portfolio grows substantially in value, in the short term, and, if, at that time, Tesco shares are still historically undervalued."

On the dividend ‘front’ I have communicated as follows: "Is the dividend safe? Good question. I have been mulling about this for some time now. I still believe Tesco will increase its dividends for calendar 2012, albeit at a substantial slower pace in comparison to earlier years. Perhaps even below 2012 inflation rate. Important is to remember that Tesco is the only FTSE100 company with a track record of increasing its dividends during the last 27 years. I am sure they do not want to lose that record. Even a token increase should ‘calm’ long term dividend income investors. During the last 12 years, Tesco’s calendar CAGR dividend increase rate amounted to a massive 9.8 per cent. This even includes last year’s dividend annual growth rate which amounted to just 4.83 per cent. At this stage, we suggest that the 2012 dividend growth rate will not be more than 2.5 per cent. I have to admit, currently, I just cannot fantom what would happen if Tesco would decide to not to increase its dividends, or even cut its dividends, during 2012. Surely, its shares would be slaughtered as a result."

Steven Dotsch - Managing editor - Dividend Income Investor.com

Book: Guide to Dividend Investing
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nigelpm 20th Jan '12 6 of 17
2

FWIW, I think WB is taking a risk on Tesco. Albeit only a smallish one.

The key questions I'd ask are :

Where is the growth going to come from?
How can Tesco's sustain such a dominant position in the UK without losing margin?
Was Tesco's all about Terry Leahy?
Lots of internal boardroom struggles and politics - how will this affect the business going forward?


I did however think at £3.15 it was too cheap and also loaded up. I did feel it a shame Berkshire bought some though as the price would likely have breached £3 and I could have got some cheaper!

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kenobi 21st Jan '12 7 of 17
2

ee,

I tend to agree, I must admit I considered selling my shares when Terry Leahy left, would have been a good move with hindsight, must get some of them glasses. You mention an example, another is Sainsburys they were once the darlings of the supermarket business, and now they've been in the doldrums for a decade or more. Is this the fate awaiting Tesco ?? who knows?

Buffet has faith, I guess we have to hope that the profits in the uk can be grown enough to support expansion plans abroad ? Now is the time that super markets should be buying up land banks and progress new stores for when the recover comes. (surely one day ?), it can't help confidence to have these terrible figures. I for one wish they'd paid Leahy whatever it took to keep him on,

Cheers K

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extrader 22nd Jan '12 8 of 17
1

Hi kenobi,

I welcome your suggestion that Tesco should plan to expand abroad.

Where we may differ is how Tesco goes about growing profits in the UK : in my (East Midlands) town, they have two superstores within a mile of each other - the second the opportunistic occupation of a large exWoolworths that was patently intended to frustrate the opportunity for a competitor (Asda is 12 miles away, Waitrose 25 milesaway) to move in.

I 'm sure that the resulting 'cannibalisation' means that - in this area at least - Tesco is underperforming (not getting the benefits due a superstore with its 'own' constituency).

From the consumer perspective (and I admit to using the 1st store because of convenience), the limitation/denial of choice that has resulted is a negative........and don't get me started on the demise of the smaller shops on the High Street....!

ATB

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Daytona 22nd Jan '12 9 of 17
1

In reply to emptyend, post #4

This week I received a market research questionnaire from Tesco (I think) via YouGov.

Snap ! and they were my thoughts exactly. It's interesting how revealing these surveys are about the way companies are thinking.

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mrfigure 23rd Jan '12 10 of 17
3

In reply to Fangorn, post #1

Wow you got in before Buffet, legend !

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kenobi 23rd Jan '12 11 of 17

extrader,

I'm not defending tescos approach, I don't even know much about it,

but

>>I 'm sure that the resulting 'cannibalisation' means that - in this area at least - Tesco is underperforming (not getting the benefits due a superstore with its 'own' constituency).

underperforming relative to what ? to if they'd let lidl or aldi take the old woolies store ? that might have hurt them a whole lot more than canabalising their own sales,

but like I say, I'm not defending their approach, I'm not telling them to expand abroad, though that seems to be an obvious strategy as the uk market becomes saturated,

cheers K

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nigelpm 14th Feb '12 12 of 17

Well, topped up again at 314p - appeared rude not to.

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emptyend 14th Feb '12 13 of 17
1

In reply to nigelpm, post #12

mmmm....see post #4. I don't think anything has changed. If they hit or exceed market expectations for their next numbers then no doubt there will be something of a recovery. If not, however, the market will start to price in a continuation of a two-quarter trend......and I'm personally not sure the economy is strong enough for investors to rule that out!

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nigelpm 14th Feb '12 14 of 17

In reply to emptyend, post #13

Agreed ee. As I posted in #6. This is very much a long term hold and take the almost 5% dividend unless of course it does jump back to £3.80 in which scenario I'd probably happily take the capital return.

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Fangorn 15th Feb '12 15 of 17
1

Very much my line of thinking as well Nigel, on all accounts.

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Elias Jones 10th Mar '12 16 of 17
7

The latest Kantar figures indicate that Tesco's market share has dropped to 29.7%, which is its lowest level for almost seven years. This is a big concern in a very competitive marketplace. Obviously it is still the dominant force within the domestic market, but Tesco seriously needs to arrest the slippage and claw back their lost share ASAP, or this train could potentially be coming off the rails.

For me as a consumer Tesco is definitely not the best value for money nor is its stores the most welcoming and friendliest and they often have an air of being untouchable about the way they operate. What it does have is excellent locations stocking a wide range goods and of course their key tool the club card.

I often discuss the supermarkets with farmers who supply the big four with their cattle, and one supermarket always comes out on top in terms of the quality they demand and prices they will pay, and that is Morrisons. Not going to mention any names but some supermarkets will literally accept anything, even poorly reared and dirty animals with the brown stuff embedded onto their outer.

Over the years a lot farmers have been bullied to accepting prices below the COP, one instance I came accross is where they phoned up a supplier for a couple fields worth of carrots the day before delivery to say they were dropping their previously agreed price to below cost, the farmer ploughed them all back into the ground on principle. Local authorities have been bought with new schools, surgeries, libraries – only for the local retailers to close down one by one. Tesco have made a lot of people happy and wealthy over the years, but they have also left a lasting imprint on many less fortunate members of our communities. So is this reduced market share, the start of pay back time from the British consumer?

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MadDutch 12th Mar '12 17 of 17
1

In reply to Elias Jones, post #16

"they phoned up a supplier for a couple fields worth of carrots the day before delivery to say they were dropping their previously agreed price to below cost, the farmer ploughed them all back into the ground on principle."

Good for him, but I would have done it differently. I would have offered the carrots to Tesco's competitors at half price, and copied the offer to the bully.

I would also consider a Small Claims Court action for £4000, payable to a charity, with me as plaintiff in person, and notified the media.

MD

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My name is John Kingham and I'm the editor of UKValueInvestor.com, a website and newsletter for defensive value investors. Defensive value investing combines defensive investing (buying large, successful companies with long track records of profitable dividend growth) and value investing (buying those companies at low valuations and with high yields). The site includes a unique stock screen and a model portfolio which is managed using a systematic investment process.  The goal is to produce a high income and growth portfolio with below average risk, which is easy to manage in just a few hours each month.   more »



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