Should You Add Supermarket Stocks to Your Trolley?

2019 was the worst year on record for retail sales, according to the British Retail Consortium, so not surprisingly many UK investors have shunned the sector.

Apart from Next, the high street seems a hazardous place for investors. But what about the UK’s supermarkets? Recent sales from the listed big three, Tesco (TSCO), Sainsbury’s (SBRY) and Morrisons (MRW), don’t make for pretty reading: Tesco’s sales were up 0.4% over the festive period, Sainsbury’s 0.7% lower and Morrisons’ down 1.7% on the same period last year.

Despite this tough environment, some of Britain’s most respected fund managers, including Merian's Richard Buxton and Investec's Alistair Mundy, are keeping faith with the UK listed names. Many managers bullish on the sector own more than one of these three, according to Morningstar Direct data.

Meanwhile, Ocado’s (OCDO) recent stellar performance – it was the best performing stock on the FTSE 100 in 2019 with a gain of 57% - suggests there are still growth opportunities in the online grocery market.

Tech giant Amazon (AMZN) also sees promise in the UK grocery market – it has teamed up with Morrisons as well as offering its own rival service, Amazon Fresh, in certain cities. And Marks & Spencer (MKS) also hopes to benefit from Ocado’s technology after it struck a deal with the online grocer last year. So, rather than being a staid sector, there’s plenty of disruption to come.

Tesco Turnaround

Tesco was the standout performer among UK supermarkets at Christmas, continuing its turnaround after a difficult five years, which included an accounting scandal and profit warnings.

John Moore, senior investment manager at Brewin Dolphin, says: “Tesco remains a slowly unfolding story of redemption. The core heartbeat of Tesco – the UK business – is now getting stronger in terms of its operational and cashflow performance.” Morningstar analyst Ioannis Pontikis rates Tesco as a three-star stock, which means that it is fairly valued relative to its current share price just below 250p.

Who Invests in Tesco?

Tesco is held by a number of managers who are highly rated by Morningstar analysts: the Silver-rated Investec Special Situations fund, run by value investor Alistair Mundy, has more than 4% of its portfolio in Tesco. He also runs the Temple Bar Investment Trust (TMPL), which has a Morningstar Analyst Rating of Silver and allocates 3.55% of its assets to the stock

Mundy thinks that Tesco, along with other UK-focused stocks such as Lloyds and Next, is already benefiting from the “Boris bounce” as global investors turn their focus back to the unloved UK equity market.

Tesco is also backed by contrarian fund manager Richard Buxton. The UK supermarket giant makes up around 4% of his Silver-rated Merian UK Alpha Fund.

Reason to Buy

• Strong recovery under Dave Lewis

• Well established online presence

Reasons to Avoid

• Dividend yield half that of Sainsbury’s

• No economic moat

Undervalued Sainsbury's

Sainsbury’s shares have yet to recover after the competition regulator scuppered its deal with Asda, which would have given the combined group a 30% share of the UK grocery market, leapfrogging long-time rival Tesco.

But the group's its 2016 acquisition of Argos continues to be a strong contributor to sales outside groceries; Argos is particularly strong for same-day “click and collect” orders. Of the three main listed supermarkets, Sainbury’s is the only one to have a four-star rating, which means Morningstar analysts think its shares are undervalued because of its focus on quality, strong online presence and convenience store network.

Who Invests in Sainsbury's?

Sainsbury’s ownership structure is different from its rivals as the Qatari sovereign wealth fund owns 22% of the company. Invesco UK Growth is one of the highest rated funds that owns Sainsbury’s, with a Morningstar Analyst Rating of Silver and a 3.44% weighting to the supermarket chain. Investec’s Alistair Mundy owns both Tesco and Sainsbury’s in Investec Special Situations and Investec Total Return funds.

Sainsbury’s also makes up a large part of the portfolios of two-star rated TM Crux UK Opportunities (4.83%) and three-star rated Invesco UK Focus Fund (4.25%).

Reasons to Buy

• Shares trading below fair value

• Dividend yield above 5%

Reasons to Avoid

• Asda deal failure a major blow

• Non-food sales disappointing recently

Morrisons Underperforming

After the Christmas trading update showed a near 2% fall in sales year on year, Morningstar retail analyst Ioannis Pontikis lowered his “fair value” estimate Morrisons shares to 203p, down from 208p. The stock has a three-star rating, which means that it is fairly valued.

Despite the ultra-competitive retail environment, Morrisons looks committed to expanding via a number of new partnerships. Morrisons only launched its online grocery delivery service in 2013, 13 years after Tesco, so it had some catching up to do in ecommerce terms. Its deal with Amazon is seen as a positive move by many retail analysts: Amazon Prime Now customers can add Morrisons products to their basket for same-day delivery in many cities, and this range is expanding in 2020. Morrisons did a deal with convenience store McColl's in 2018 to supply its 1,300 convenience stores and some of these shops are being rebranded as "Morrisons Daily", in direct competition to Tesco Express and Sainsbury's Local.

Who Invests in Morrisons?

Smaller than Tesco and Sainsbury’s, Morrisons is nevertheless backed by some big-name fund managers. There is some overlap between those who own Tesco and those who own Morrisons, for example the JOHCM UK Equity Income fund and Temple Bar Investment trust. The managers of the JOCHM fund, James Lowen and Clive Beagles, have recently topped up their holdings in both Morrisons and Tesco.

While the almost-3% dividend yield on the stock makes it an attractive target for income funds, Morrisons is also popular with value managers expecting a turnaround after a year or so of underwheling share price performance. Silver-rated Schroder Recovery, for example, has more than 4% of its portfolio in the stock, while Bronze-rated Schroder Global Recovery has a 2.5% weighting.

Reasons to Buy

• Tie-up with Amazon suggests it is catching up with rivals

• Decent, growing dividends that are well covered

Reasons to Avoid

• In direct competition with Aldi and Lidl

• Lagging Tesco and Sainsbury’s in market share

Online Disruption

It’s clear that what’s good for shoppers – lower prices, greater competition, increasing ways to buy groceries – is not good for profit margins. But investors are not expecting grocery stocks to shoot out the lights and prize them for being reliable income payers with defensive qualities. Ocado offers a riskier but potentially more rewarding pitch as a growth stock.

Despite the weak sales environment, there are reasons to be optimistic about the sector, particularly with technological changes offering opportunities to the existing players. The UK was an early adopter of online grocery shopping, particularly in comparison with Europe, but the online retail only makes up around 10% of the overall market.

Morningstar analyst Ioannis Pontikis says that the largest supermarkets are being forced to adapt to the changing retail landscape: “As retail markets remain highly competitive and the consumer outlook uncertain, online grocery continues to grow dynamically, creating the need for brick-and-mortar grocers to strategically rethink their market position.”