UK Edition
Gut instinct is an investor’s greatest foe. It prompts short-termism that can lead to large losses when markets crash, since an investor’s instinctive reaction to rising share prices is to buy more shares.
Similarly, it produces vast “opportunity costs” because investors instinctively avoid buying cheap stocks during bear markets, which invariably transition into bull markets.
Indeed, the natural reaction of all investors to the current economic outlook is to sell stocks en masse and run away.
Britain, and in particular its retail sector, face an extremely tough winter; the prospect has already prompted consumer confidence to fall to its lowest ebb since records began in 1974.
With interest rates rising, inflation stubbornly high and the economy in recession according to the Bank of England, the performance of retailers such as Tesco could materially worsen over the coming months.
In Questor’s view, however, investors must ignore their gut instinct to sell and instead focus on the facts. Tesco’s shares have already fallen by 30pc this year.
This suggests that the market has already largely factored in the prospect of a downturn in its performance. Its shares now trade at 9.6 times forecast earnings, which implies a relatively wide margin of safety.
Furthermore, the company has a solid financial position, which will help it to overcome temporary economic difficulties. It may even be able to use its relative strength to improve its market position vis-à-vis other major supermarkets and retailers that carry more debt.
Its recently released interim results showed that it reduced net debt by 5pc over the first half of the year. This means it has a modest net-debt-to-equity ratio of 73pc, while net interest payments were covered more than four times by operating profits during the period.
The company is also making efficiency savings to further strengthen its financial resilience and partially offset high inflation. It expects to deliver £500m in cost savings this year as part of a goal to reach £1bn in cost reductions by spring 2024. This helped the company to maintain full-year profit guidance at the time of its half-year results, albeit at the lower end of its previous range.
Consumers are likely to become increasingly price conscious over the coming months as they experience falling discretionary incomes. Tesco is better placed than many rivals to overcome this.
Thanks to its policy of price matching various products with no-frills supermarkets and discounts for its 20 million or so Clubcard members, not to mention its vast size, consumers are likely to associate it with offering value for money. This could make them more loyal and less likely to trade down to budget competitors.
Indeed, the company’s “net promoter” score, which measures customer experience levels, now beats that of any other full-line grocer. And with a 35.9pc share of Britain’s online grocery market, it is well placed to capitalise on a likely continued transition towards digital retailing over the coming years.
Encouragingly, the company is pressing ahead with a £750m share buyback programme due to run until April next year. Its timing could prove to be perfect, given the stock’s low valuation.
Its dividend policy of paying half of profits to shareholders means it raised dividends by 20pc in the first half of the year; the shares currently yield 5.4pc following their recent fall.
In spite of this decline they have gained 7.9pc since our buy recommendation in October 2017.
In doing so, it has outperformed the FTSE 100 by around 18 percentage points. While a similar level of outperformance seems unlikely over the short run, the company’s solid finances and strong market position make it well equipped to emerge successfully from the present economic woes, which will not last forever.
Investors who ignore their gut instinct and buy Tesco shares are extremely likely to be well rewarded as economic conditions, the retail operating environment and investor sentiment ultimately improve.
Questor says: buy
Ticker: TSCO
Share price at close: 202.1p
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