Last Updated February 24, 2014
In 2012 Tesco PLC announced its first profit warning in 20 years. Immediately, Tesco’s shares fell off a cliff. The Sun newspaper said it all: “Tesco profits warning wipes £4.3bn off company”. The question is, were those investors right to sell?
One of the basic principles of value investing is that you are looking to buy shares when they represent good value for money. In most cases this means you buy after the shares have fallen, which is the opposite of what most people want to do.
After all, who wants to buy an investment that’s going down?
Most people would say they wouldn’t, which is why value investing remains a niche activity, but a profitable one.
I have written a review of Tesco’s shares before, shortly after the profits warning and on the exact same day that Warren Buffett upped his stake in Tesco to 5%. It’s a company that I often use as an example of what a defensive investment looks like.
A few months later I joined Buffett as a shareholder, although with slightly less than 5% to my name. You can see how the shares have done from just before the profits warning until today in the chart below:
When the profits warning came Tesco’s shares were trading at about 385p each, and by the time the market had finished panicking they had fallen all the way down to 312p. A drop of almost 19% in a couple of days is certainly not what most defensive and income focused investors sign up for.
When I bought in June 2012 I allocated Tesco a 3% slot in my portfolio (both my personal pension and the UKVI model portfolio) at the slightly lower price of 300p.
My decision was based on Tesco’s long-proven ability to generate a growing stream of sales, profits and dividends, combined with a dividend yield of 4.9% and a very low price relative to the company’s past earnings.
In other words it was a defensive company being sold at a “value” price.
Tesco’s shares have now been in the portfolio for almost 16 months, so what have the returns been for those shares, given that the company was “reeling”, “in crisis” and it’s “crown had slipped”, according to various media reports?
So far the model portfolio has received 4.9% in dividends and the shares have appreciated by 18.8% (to a share price of 361p as I write). That gives a total return of 23.7% and annualised gains of 18.1% per year.
Unless you Warren Buffett that’s not a bad return at all from an apparently struggling blue-chip company.
Although looking at short-term performance (anything less than 5 years) can be a dangerous game, I think Tesco’s profit warning is a good illustration of how the future is far more uncertain than most people think. The profit warning itself was unexpected, and the share price gains after the initial panic were also unexpected.
The Great Tesco Profit Warning Panic is also a reminder that buying successful companies when everybody else is selling is a sound basis for a sensible investment strategy (especially when you’re on the same side of the deal as Warren Buffett).
John
Is this an example worth writing about? If you compared it with the FTSE 100 over the same period you would be 0.5% down from the benchmark. Now only that but Tesco was more volatile than this benchmark, so you carried more risk.
Another argument to buy a cheap index fund.
Yes, I think Tesco has been a good example of investors selling out of a high quality business because of some minor bad news. The performance of the FTSE 100 over the period is just noise (and therefore not predictable), whereas I think the performance of Tesco was far more predictable given the share price (after the fall) relative to the ability of the company to generate sales, profits, cash and dividends.
Buying a cheap index fund is a good idea for most people, but you can’t beat the index by owning the index (unless you can time the market which is a whole different argument).
Hard to find the predicability argument. If I measure this by volatility I would say it was less predictable than FTSE 100 as it carried more volatility. But let’s not use the volatility argument for now, as we don’t believe in the MPT, do we?
However the drop has gone, some changes took place at Tesco: they don’t sell horse meat anymore (‘every little helps’) but more important is that they sold the US operations.
Are going to hold on the Tesco stock for now and what are your arguments?
I have to say that I was totally underweight this sector apart from holding Ocado which I sold a bit too early. I could have made 600% when I only made 480%. To be honest when I bought it I thought I would only made 200%. It was my cake for this year.
Going back to the timing issue you mentioned, it is better from time to time to take a break and enjoy the benefit of investing. In my case I decided to cash the majority of my growth companies and I am buying a bigger house. Making money for the sake of making money is not useful if you don’t enjoy them. I don’t see a bigger house as an investment but as an increase of my quality of life: a bigger kitchen, a game room and a paddock will certainly increase it.
I’m going to hold Tesco until it isn’t good value anymore. I expect that to be through an increase in the share price rather than a decrease in the ability of the company to generate profits and cash. My argument is that the company has a long history of making profits and cash, and the odds are that they will continue to do so.
So in the light of yesterday information is Tesco still good value or not?
It is not the figures that made me think bad about Tesco, it is more about the explanations about the client segmentation that affects Tesco now. Losing the top segments of the clients is definitely worrying. People from the higher segments orders their groceries at home, and from my experience, including research on my clients the last thing they want is a Tesco delivery van parked in front of their house.
There is another issue that affects Tesco now, the competition at the pump, in petrol and diesel prices which Tesco seems to lose at this moment.
In my opinion the main issue is the management, there is a need for reshuffling at the top.
The interim results don’t change my opinion at all. I’m interested in where a company and its shares will be five years from now, and those results are unlikely to have much relevance over that timescale.
So I was having a closer look at Tesco. The price is almost back to the bottoms it had after the big drop.
Do you re-buy when you see a stock you already own drop significantly (assuming nothing material has changed at the company)?
The P/E of Tesco is a little tricky to work out, as they took a lot of write offs last year – even a 5 year average will be pushed around by that. The peak EPS of recent years is around 36. If you pick 2009, where their EPS was 28.9 (and the least profitable year out of 2009-2012), then they’re on a PE of around 11.
Having a quick look at M&S, Sainsbury and Morrisons, this PE around 11 puts them as slightly more expensive than Sainsbury and Morrisons. M&S looked quite a bit more expensive, but I didn’t dig into their figures. Tesco’s current PE is more like 21 because of the write-offs last year. So M&S could be affected by something similar. Dividends at the competitors were similar, in some cases slightly higher.
Anyway, my thinking is that Tesco does look a little cheap – the PE and dividend combination looks better than the FTSE 100. But compared to their peers, it is perhaps not standing out strongly as the obvious choice to buy.
The real telling part will be if Tesco regain their mojo. If they do, they’re quite cheap. If not, they’re slightly attractive. So now it becomes a little bit of a faith game – do you believe they’ll return to their former glory? Or will it be more of a standard path with the mix of ups and downs?
Do you buy just Tesco, or buy a few different supermarkets for their shared attractive dividends and PE ratios?
Hi Bob, no I don’t make additional purchases of an existing holding if the price drops. I like to keep things simple so I only make one buy or sell decision per holding. So I bought Tesco in one lump, I’ll hold it for some number of years, and then I’ll probably sell it at some point when the price or the company is no longer attractive.
As for Tesco versus its peers, I think all of the major supermarkets look quite cheap and I own some of them along with Tesco. I think the threat of the discount stores like Aldi is overblown and that people will switch back to the majors once the economy really gets going again (although that’s not really why I bought into the big supermarkets as my decisions tend to be based more on price and past financial performance rather than what I think might happen in the future).
“So now it becomes a little bit of a faith game” – That about sums up the stock market! However, I don’t think it takes too much faith to see Tesco at least keeping up with inflation for the next few decades. There will be highs and lows along the way, but I think that’s the most likely outcome. Then it’s just a case of holding on, collecting the dividend, and waiting for a decent exit price. And if there isn’t one, then I’ll just keep holding.