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Does Tesco’s sell-off signal a buying opportunity?

29 August 2014

The supermarket giant's share price took a hammering today after it issued a profits warning, but analysts say the worst may be yet to come.

By Jenna Voigt,

Editor, FE Investazine

Ailing supermarket Tesco surprised the market this morning after it issued a profit warning and slashed its dividend by 75 per cent.

The share price was down more than 6 per cent at the time of writing, after the supermarket was hard hit in early trading on the back of the news. Tesco is down 23.81 per cent year-to-date. The FTSE 100, by comparison, has gained 3.66 per cent so far this year.

Year-to-date performance of stock and index


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Source: FE Analytics

When a sector or a stock is facing a raft of negative news, it can often be a good time for value investors to pick up a quality company on the cheap. But fund managers warn now isn’t the time to go piling into the UK’s biggest supermarkets.

Ardevora partner Jeremy Lang has been negative on the established supermarket chains for some time, expecting the discount model from shops like Lidl and Aldi to continue to flourish.

Lang, who heads up Ardevora’s UK Income and Global Equity funds, thinks the big supermarkets are focusing on all the wrong things when it comes to developing their propositions.

“The fundamental problem for the likes of Tesco and Morrisons is that their stores are the wrong size. If you look where the growth is coming from, it is not in the big stores – it is from convenience stores, discount shops or online outlets,” he said.

“The issue for Tesco, as well as similar chains, is it tries to do everything: cheap food, expensive food, clothes, toys – but ends up lacking in most areas. The idea it can easily adapt its existing store base is mistaken – we believe it is wedded to its previous business model. While this was extremely profitable in the past, the world is changing.”

“Essentially, Tesco has been left with a legacy store base, which does not make sense given the new trends in the market. Our interpretation of how management is behaving, by dissecting the balance sheet and investment decisions, is that it the company significantly underestimates the market’s structural evolution.”

Lang’s concerns were echoed by analysts at Shore Capital, who said in a research note last month that UK supermarkets were “largely un-investable”. They predicted considerable downside potential for both Tesco and Morrisons as the chains faced stiff competition and a structural challenge from discount retailers.

“The market reports on the Kantar monthly supermarket share data for June records a market that remains demonstrably weak and where we suggest gross margin investment is depressing basket values and pressurising the return on sales for superstore groups,” Shore said.

“The British supermarket scene remains in turmoil, coming to terms with a consumer that seeks lower prices, is wasting less at home, is buying smaller basket more frequently, eating out more and possibly reducing calorific intake per capita.”

“With channel shift to online and into convenience and discount, these trends represent a potent cocktail that led us to call the sector largely ‘un-investable’ in early 2014, a view we continue to stand by.”

Value manager George Godber, who runs the Miton UK Value Opportunities fund alongside Georgina Hamilton, says he thinks they will buy into supermarkets eventually, but the price just isn’t low enough yet to consider them low-hanging fruit.

ALT_TAG “We do expect at some point to be investing because things will continue to get ugly,” he said. “But they’re not there yet for us valuation-wise, but we’re very mean.”

Godber says Tesco’s sell-off is only natural because the price had got up to “insane valuations” for what the stock was. He thinks it’s still too expensive today in spite of its protracted decline.

Godber instead prefers to play the value opportunity in supermarkets through indirectly-related stocks like Bargain Booze chain Conviviality Retail, which is the largest off-licence and convenience chain in the UK.

The manager says stocks like these are cheaper than supermarkets and offer more potential upside to investors.

Year-to-date the stock is up just 0.8 per cent, but it’s well ahead of the FTSE 350 Food and Drug Retailers index, which is down a sharp 21.76 per cent.

Year-to-date performance of stock and index


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Source: FE Analytics

Old Mutual’s Richard Buxton also said he was eyeing up the sector in an FE Trustnet article at the end of July, with Tesco being the supermarket to watch.

However, the manager said he wasn’t yet ready to “press the button” and buy the beleaguered supermarket.

However, star contrarian manager Alastair Mundy bought back into the supermarkets earlier this year in his Investec Special Situations fund. The manager thinks the competition the likes of Tesco and Morrisons face from their discount counterparts has been exaggerated and sent the stocks on unfair discounts relative to the market.

Some 16 funds in the IMA universe hold Tesco in their top 10, including the Schroder Income and FF&P UK Equity Income funds.


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