FTSE Friday: Supermarkets, house builders and words of wisdom from Terry Smith

There has been plenty of juicy content for private investors to seek their teeth into this week. Announcements from retail sector continue show (or at least make it appear) that ‘everything is ok’, weakness in the housing market is being reflected in the numbers from some listed companies, and a profit warning from Robert Walters hints at trouble in the employment market.

But I would argue that the most useful content to grace the internet this week is Terry Smith’s annual letter to shareholders. As ever, it is fabulously written, but runs to a length of 19 pages so I would recommend finding a quiet moment over the weekend to sit down with a cup of tea and maybe some snacks and digest the full thing properly. Here are my key takeaways:

• The era of easy money has been caused by economists and central bankers looking to patch over crises. Now that seems to have come to an end the poorly run companies which relied on this so-called easy money will not survive. That shouldn’t worry investors who only seek high quality businesses.
• The sector allocation of certain companies should be taken with a pinch of salt (something that BnB also noted in my article earlier in the week).
• The structural challenges facing the tech sector (beyond over-hyped valuations) could force a retreat from over-ambitious investment projects (not necessarily a bad thing).
• Fundsmith itself is a very high quality business which generated a return on capital employed (ROCE) of 32% last year (double that of the FTSE 100). Note: This isn't the return of the fund's holdings which were down 13.8% in 2022. 
• Mr Smith is not all that optimistic about the growth outlook for his portfolio companies this year (”If 1% growth worries you it may be wise not to read next year’s letter”).
• High quality businesses shouldn’t be afraid to disclose mistakes and listen to their long-time investors (and virtue signalling is pointless).
• Removing non-cash items from non-GAAP accounting (e.g. share based payments and depreciation) not only gives investors an unrealistic picture of performance but could also cause management to make poor investment decisions.

It is, of course, worth noting that fund managers’ letters to their shareholders are generally used as marketing material and, we can’t all invest like Terry Smith with enormous sums of money. (And even if we could, it wouldn’t necessarily result in outperformance, the fund massively underperformed the FTSE All Share in 2022, because - just like most of us - it wasn’t exclusively invested in the energy sector). But even so, there is a lot to learn from the letter.

And now onto the big company stories that caught my eye this week. I’ll be taking a look at:

• Resilience at the supermarkets: price inflation or high volumes?
• Evidence of housing market weakness
• An improving outlook for the automobile sector

Supermarkets: Increasing revenues on higher prices

According toTesco (LON:TSCO) andJ Sainsbury (LON:SBRY), Brits had a merrier Christmas than they did last year. Revenues were up by more than 7% at both companies in the six weeks to 7 January - ahead of the 5% increase in sales in the third quarter (which includes the Christmas trading period for Sainsbury, but not for Tesco).

But neither company admits whether this has come from an increase in volume or an increase in price. Tesco discusses the 7.4% increase in the volume of its Low Everyday Prices range, which sounds pretty good, but doesn’t say how much those goods contribute to overall sales. Management also point to the high number of goods which are now matched to Aldi prices, but Aldi is passing on its inflation costs as well and so matching those prices doesn’t mean a great deal.

Sainsbury’s says that its own price inflation is under that of actual inflation - but as actual inflation is currently significantly higher than the revenue growth reported by the company, that doesn’t tell us much. The charts used in the company’s presentation are more helpful (although they don’t have numbers on them so are less helpful than they could have been!)

Volumes seem to have declined at all of the big British supermarkets in the third quarter (the stats in this chart come from Kantar):

And prices have increased (although at Sainsbury they have increased the least):

Aldi and Lidl have performed especially well: despite substantially higher prices (something that is being reflected by anecdotal evidence on Twitter), they managed a big volume increase in the final quarter of 2022 and continue to take market share away from the big four supermarkets.

At the other end of the value scale, we also had numbers from Marks and Spencer (LON:MKS) this week. Food continues to be a solid contributor with revenues up 6.3% on a like for like basis in the 13 weeks to December. Management says that was driven by strong volume and value (although it’s not clear what value means - is it cheaper items which appeal to the every day consumer or is it fancy goods for special occasions?) The clothing and home division (a long time disappointment for M&S shareholders) also had a good quarter. Although management point to the fact that they are doing a much better job as an ‘omnichannel retailer’ it is likely that M&S benefited from the same trends as Next: the Covid-threat weighed more on sales last year than many of us realised.

One big omission from all these companies updates was a comment on margins and profits. All of them spoke a lot about value and discounting (even though it seems that prices have risen overall). When set alongside the inflation in the price of raw goods, that could have a severe impact on profits. We will find out more when the companies release their full results later in the quarter.

Housing market slowdown

Higher mortgage rates have impacted property companies at all ends of the value chain. House builders Barratt Developments (LON:BDEV) and Persimmon (LON:PSN) this week both revealed a huge drop in private reservations - there are fewer buyers in the market for new builds. Estate agent Savills (LON:SVS)said the same problems have restrained the commercial rental part of its business.

But the latter has said that the market for prime real estate has held up - non-doms buying multi-million pound homes in London with cash are less concerned about mortgage rates than first-time buyers. (A comment on normal residential property was conspicuously absent in this week’s trading update, especially as the non-London residential market is the single biggest contributor to Savills revenues). Savills says that the re-opening of China should support the higher-value part of its business in the coming months.

House builders meanwhile are facing additional pressures from the end of help-to-buy, which provided a huge boost to demand until the scheme was terminated last year. The outlook for the sector is still bleak.

But technical indicators for both Persimmon and Barratt are more upbeat. Both companies’ share prices have been consistently crossing their 50-day moving average in recent weeks as momentum ticks up slightly. They both exhibit the kind of quality and value metrics that markets are currently favouring. Mark talked about the indicators he looks for to ‘surf the StockRanks’ successfully this week - both Barratt and Persimmon could be contenders for the ‘paddle out’ stage.

But with house prices still rising (revealed by a higher average price of home sold by Persimmon in the latter part of last year compared to the first six months), there are fears that many potential homebuyers are holding off making a purchase in anticipation of a big fall.

Carmakers are bouncing back

Anyone for a Rolls-Royce Phantom II, painted in Dark Emerald, with a custom mounted drone landing zone on the boot and an internal roof lining bedecked with fibre optic lights to reflect the night sky? RRP: £500,000.

“Yes please,” said over 6,000 customers in 2022, mainly from the US and Middle East. That helped to boost Rolls Royce sales to record levels last year according to the company’s owner BMW.

The company and its German peer Mercedes have also benefited from strong domestic demand for electric vehicles, attributed partly to a planned phaseout of EV subsidies. Both companies have been investing in their EV infrastructure and have now said that supply chain bottlenecks have started to ease, meaning vehicle delivery should pick up in 2023.

As the challenges of recent years starts to ease for the automobile sector, there could be some turnaround opportunities. Here are some highlights from our analysis of the numbers at some of the biggest:

• Price to Earnings Ratio (rolling): 4.5x at VW compared to 24x at Tesla

• Relative Strength (6 months): +18% at Mercedes compared to -50% at Tesla

• Operating Margin (last year): 12% at BMW and Tesla compared to 2% at Ford

• Tesla’s enterprise value has fallen below its £300bn - a bit more reasonable than recent years (although not when compared to group sales - see chart below.

  

In the long-term, the trajectory for electric vehicles is undeniably upward. Ignore the noise created by Tesla and politics and there should be some decent opportunities to be unearthed in companies (even the British ones) that have exposure to the market.

One of them, Ab Dynamics (LON:ABDP) provided the market with a short update ahead of its AGM this week. The company has pursued an acquisition strategy to increase its software offering, which helped send recurring revenue up to more than 40% of sales last year. The company says it has a strong order book and is well placed for the year ahead, but it hasn’t given specific numbers. And investors might be put off by the fact that, as Graham wrote earlier in the week, “it is valued as if it is a US tech stock”.