SIF Folio: Why Tesco could be a good defensive buy

This hot, dry weather appears to be affecting my stock market activities, which have also dried up. Just 11 stocks qualify for my SIF screen. And almost 40% of the SIF fantasy fund is now held in cash. The part of my personal portfolio which mirrors the SIF is also running an unusually high cash balance.

I don’t have a problem with this in principle. I’ve written before about my hope that when the market looks overvalued, the SIF screen will detect the warnings signs and move progressively into cash.

So far in 2018, this hasn’t happened. I’ve added 14 stocks to the portfolio and sold 14. But new buying opportunities have become fewer recently, so the next couple of months could see a more decisive shift to cash.

In any case, I’m in no rush to buy stocks, as I think that much of the market is fully priced. What I would welcome is the chance to pick up a couple of defensive dividend payers at sensible valuations. My exposure to defensive companies is pretty minimal at the moment:

Because of this, I was interested to see that Tesco now qualifies for the relaxed version of my stock screen. (This is a fork of my main screen that accepts stocks with slightly more demanding valuations, as long as they satisfy all of my other rules.)

As the UK’s largest supermarket, Tesco could provide an attractive defensive backstop and a growing dividend income. The shares aren’t obviously cheap, but both the share price and the business appear to be performing well. Stockopedia also likes the shares, awarding them a StockRank of 81. So I thought it would be interesting to take a look at both this week in order to get a better understanding of what’s on offer.

Value lies in the future

Tesco shares are delivering almost indecent levels of earnings growth at the moment. Last year saw headline earnings climb 62.7% to 11.88p per share, as the group’s recovery continued. Further progress is expected this year, some of which has already been priced into the stock. All of this means that value isn’t the stock’s strongest suit:

The shares may look pricey, but I don’t think there’s nothing obviously wrong here. One attraction for me is that earnings and free cash flow are broadly matched. This suggests that the group’s recovery is being built on solid foundations.

I should also comment on the earnings yield of 6.4%. This is below my normal screening minimum threshold of 8%, as it’s one of the rules I relax when I’m looking for more expensive stocks. But a figure of 6.4% isn’t bad, and the green bar in the graphic above shows this is enough to put it in the top third of UK companies ranked on Stockopedia.

Turnaround quality

Given Tesco’s turnaround status, I wouldn’t expect too much from its quality metrics. Let’s see what we’ve got:

The franchise factors at the top appear to suggest that Tesco is a basket case. Of course, we know this isn't true. I’ve written before about the importance of looking at the trend behind Stockopedia’s five-year average figures. And that’s certainly essential here, given the turmoil and recovery in this business over the last five years.

Here are the numbers we need to consider:

I’ve highlighted the three rows that interest me. It’s not hard to see when Tesco’s fortunes reached a low point in 2015. But what’s interesting is how the group’s operating margin, return on capital employed and free cash flow are making a concerted recovery.

Those pesky 2015 figures are skewing the stock’s five-year average quality figures. But the current situation appears to be much more impressive. And importantly, the trend is improving.

In fact, we probably didn’t need to look at these figures to reach this conclusion. The supermarket’s Piotroski F-Score of 8/9 should have been enough to tell us that this was a good, improving business. I often use this fundamental health score to get a snapshot of how a business is performing. Here’s how Tesco’s F-Score breaks down:

When you see this much green alongside these nine rules, it’s usually a good indicator that a business is firing on all cylinders.

We now know that Tesco’s recovery is going well. What we don’t know is how much further there is to go before this FTSE 100 big cap returns to a comfortable life of low growth and generous dividends.

Momentum overshoot?

The final piece in this jigsaw is momentum. Stockopedia’s computers rank the stock very highly in this department, with a MomentumRank of 95. It’s not hard to see why this might be:

Tesco’s share price momentum is currently very strong. The stock has held onto the rapid gains triggered by the group’s results in April and is currently at a post-2014 high.

However, I wouldn’t be surprised to see a period of consolidation in the near future. Technical traders will notice that the stock’s RSI (relative strength) and momentum have been weakening since May, even as the shares have continued to rise. This divergence could indicate that the shares have got ahead of themselves:

What about earnings momentum? June’s Q1 trading statement doesn’t seem to have triggered any major changes to analysts’ forecasts. Broker upgrades seem to have levelled out, after a period of strong gains.

Despite this, the overall picture for earnings growth is very encouraging:

With earnings still expected to grow by around 20% per year, the stock’s forecast valuation starts to look more reasonable.

Tesco is targeting an operating margin of 3.5%-4.0% by 2019/20. Based on that guidance, my estimates suggest there could be a little more upside on the broker forecasts shown above. What I’m less sure about is how much further growth to expect once that target is reached.

My verdict

On balance, I’m tempted to say that Tesco shares look fairly valued at the moment.

In any case, my rules state that I can only buy stocks from the relaxed version of my SIF screen if I’ve had a dry spell of four weeks or more. That’s not the case here, as I added Bovis Homes earlier this month. So I won’t be buying Tesco for SIF this week.

But if the shares fall to around 225p, I may be tempted. And if I was building a long-term income portfolio, I would certainly consider buying some at this level. I expect dividend growth to outpace earnings over the next few years, improving the yield significantly.

What’s your view on Tesco? Has CEO Dave Lewis successfully handled the group’s past problems and returned the group to growth, or is this just a temporary respite for a declining business?