When I added Tesco to the UKVI model portfolio in mid-2012 the company was still riding high, having produced an amazing run of rapid and consistent growth over the previous decade.
Even the financial crisis seemed powerless to stop Tesco’s march towards global domination.
Despite this success, in mid-2012 its share price had fallen back to levels last seen in the depths of the financial crisis and first seen in 2005, when the company was literally half its 2012 size.
As a result the dividend yield was very enticing at 4.9%, especially given the company’s historic dividend growth rate of almost 10% per year.
The share price in mid-2012 was low following a dramatic near-20% decline in early January, which came as a reaction to a disappointing Christmas trading statement.
It was becoming increasingly obvious that some of the company’s international expansion efforts of recent years were not working, while the core UK business was coming under increasing price competition in a tough post-financial crisis world.
At the time I thought it likely that Tesco would easily cope with these issues, but I was wrong. The company’s fortunes went from bad to worse as Tesco became a classic value trap, as shown in the share price chart below.
Although I have continued to hold Tesco through this rocky period I have now decided to sell up and move on, largely because the company failed to pay a dividend for the 2015/16 financial year.
One of my most basic requirements is that all holdings in the model portfolio must have a ten-year unbroken track record of dividend payments. Tesco no longer meets that criteria so it is no longer a suitable investment for the portfolio.
I have therefore removed Tesco from the model portfolio and my personal portfolio this morning, giving the following final results from this investment:
- Purchase price: 301p on 11/06/2012
- Sale price: 159p on 06/05/2016
- Holding period: 2 Years 11 months
- Capital gain: – 48.2%
- Dividend income: 10.1%
- Annualised return: -12.6%
Obviously losing money on an investment is not ideal, but it is important for investors to be aware that occasional losses are inevitable.
As long as you have a diverse portfolio (the Tesco holding was about 3.5% of the portfolio at the time of purchase) and as long as winning investments far outweigh losing investments (the record so far for the model portfolio is 20 winners and 2 losers including Tesco), there should be nothing to worry about.
Rather than crying over spilt milk, it is far more important to learn from every loss in order to improve your stock selection process and your portfolio’s future performance.
So in the rest of this article I’ll outline why I bought Tesco, what I’ve learned and why the Tesco of mid-2012 would never make it past the stock selection criteria that I use today.
Buying what appeared to be “God almighty”
As usual, when I bought Tesco I was on the look out for a company with a long and consistent record of dividend growth supported by revenues and earnings growth as well. Tesco fit that description admirably, to the point where Charlie Munger (Warren Buffett’s business partner) called it “God almighty in England”.
Although I doubt Tesco’s status as a deity, the company was successful enough for Buffett’s Berkshire Hathaway to have been an investor since 2006, eventually going on to become Tesco’s largest single shareholder. The chart below clearly demonstrates Tesco’s impressive history of success.
To some extent the consistency of Tesco’s results is understandable; after all it’s a supermarket, and few businesses are more defensive than a mature supermarket which is deeply ingrained into the physical and mental lives of the local population.
However, it was the speed of Tesco’s growth which most impressive me, especially given its already massive scale in the UK. There are many theories about why Tesco became so dominant, with my own being its early and aggressive use of a loyalty card scheme, but whatever the underlying drivers, the results spoke for themselves.
Despite its successful past, at the time of purchase the company was struggling, having recently announced its first profits warning in 20 years. For a value investor this is entirely normal, and the lower share price gave a more attractive entry point, as shown by the company’s key stats in the table below.
The quality and profitability score are N/A (not applicable) because they didn’t exist in mid-2012. I didn’t start using the quality score (a measure of financial consistency) until September 2012 and it took me until November 2014 to add profitability to the UKVI stock screen.
However, going by the metrics I did use at the time, Tesco was clearly an above average company trading at a below average price. It’s problems seemed to be relatively minor and run of the mill, so I decided to join Warren Buffett as a Tesco shareholder by adding it to the model portfolio and my personal portfolio.
Holding on while Tesco fell apart
Having bought Tesco in a tough economic environment where shoppers were tightening their belts, I expected a relatively subdued future for Tesco, at least in the medium-term.
Beyond that I thought the most likely outcome was that the economy and the company would get going again at some point, and its international expansion would continue. To begin with, that’s more or less what happened.
Through the rest of 2012 and 2013 Tesco’s existing growth-focused strategy remained largely in place, although growth expectations were watered down to around 5% per year.
The company’s weaker businesses in the US and Japan were ditched and more than 100 sites which had been due for development were mothballed. Tesco was focusing on capital discipline, cost cutting and refurbishing existing stores rather than opening new ones, and that seemed entirely sensible.
In 2014 sales and profits started to fall. However, the CEO’s statements continued to be upbeat, stating that the company’s foundations had been strengthened as Tesco prepared to lead the industry through this period of transition to lower prices and more online shopping.
Gradually though, the news began to carry more and more stories about how Aldi and Lidl were taking massive chunks out of the Big Four supermarkets (Tesco, Sainsbury, Morrison, Asda).
The prolonged recession-like conditions of the post-financial crisis world gave shoppers more time and less money because they were working fewer hours.
The combination of more free time and less money led millions of shoppers to realised that they were better off spending more time picking and choosing which shops to buy from in order to get their groceries at the lowest possible price, even if that meant multiple trips to multiple supermarkets.
This left Tesco’s previous strategy of targeting weekly or monthly “big shops” in massive superstores completely out of step with the frequent, local, smaller shops that more and more shoppers were actually doing.
By July 2014 both the CFO and the CEO had ‘resigned’ and in September news emerged of a £250m overstatement of recent profits.
In October the dividend was cut by 75% as management announced that the company’s future performance was uncertain. In January 2015 the dividend was cancelled and has yet to be reinstated.
The chart below shows just how dramatically the company’s results collapsed.
The critically important post-sale autopsy
The scale of Tesco’s problems became obvious (to me at least, and at last) during 2014 and at that point I began trying to understand what went wrong.
Eventually I decided there were three main problems with Tesco which were visible in mid-2012:
Problem 1: Mediocre profitability and pricing power
Most people don’t really care if they shop at Tesco or at one of its competitors. As long as the store is close by and nice enough, the queues at the checkout aren’t too long and the prices are good, that’s all that matters.
As a result Tesco has little ability to set prices where it wants. Instead it has to set prices more or less in line with its major competitors which means it can only generate fairly average profits.
If a competitor works out how to sell at a lower price (think Aldi and Lidl) and if consumer tastes change so that price is the most important factor (as it has for a large portion of Tesco’s customers in recent years), then those who are not the lowest cost provider (i.e. Tesco) are going to either lose a lot of customers or have to lower prices drastically.
Both of those are of course very bad for profits and that’s more or less what happened to Tesco.
I don’t mind investing in companies with mediocre profitability, but the additional risk that come with weak pricing power has to be offset with a lower purchase price.
To allow profitability to be taken into account I added a profitability score to the UKVI stock screen in November 2014.
Tesco’s profitability score of 9.3% in 2012 was below average, but it wouldn’t have broken my rule of thumb for profitability:
- Rule of thumb: Only invest in companies where the profitability score is above 7%
However, if the stock screen had included that profitability score in mid-2012 then a lower price than the 301p I paid would have been required for the stock to rank highly on the screen (and therefore to have been a potential candidate for investment).
I don’t know what price would have been attractive, but if it was below 280p then it would have been mid-2014 before the price fell that low. By that stage the CEO and CFO had already left and as a result Tesco would probably have never made it into the portfolio.
Problem 2: Large financial obligations
Another problem for Tesco was its relatively extensive use of debt. This wasn’t flagged as a problem when I bought the shares in 2012 because although I used a debt ratio at the time, it was more liberal than the one I use today.
After a spate of debt-related issues with portfolio holdings in 2014 (of which Tesco was one) I changed the debt ratio to its current, more conservative incarnation, including this rule of thumb:
- Rule of thumb: Only invest in defensive sector companies if the debt ratio is below five
If I had been using the post-2014 debt ratio in 2012 then Tesco would have had a debt ratio of 5.3 (the ratio of total borrowings to five-year average profits), which breaks my debt rule of thumb. On that basis it’s unlikely I would have invested in Tesco in mid-2012.
Tesco also has a relatively large and growing defined benefit pension scheme, which is something else I look at today but didn’t look at in 2012. At £8 billion in 2012, it came to 3.6-times the company’s five-year average profits, giving it a pension ratio of 3.6. My rules of thumb for pensions are:
- Rule of thumb: Only invest in a company if its pension ratio is below 10
- Rule of thumb: only invest in a company if the sum of its debt and pension ratios is below 10
Tesco’s pension liabilities wouldn’t have broken any rules of thumb, but combined with the company’s high debts it would certainly have made me think twice (its debt and pension ratios sum to 8.9, which is almost as much as I’m willing to stomach).
Problem 3: Large capital expenditure requirements
The final nail in Tesco’s coffin is that it consistently makes very large capital expenditures for things like property and equipment. This is also something I didn’t look at in 2012, but now I use the following rule of thumb:
- Rule of thumb: Be wary of companies that consistently spend more on capex than they make in profits
The reason is partly that capex-heavy companies tend to have higher fixed costs which can lead to substantial profit declines, even if sales fall only slightly (just look at Tesco’s financial results above for an example).
If that capex rule of thumb had been in place in 2012 then Tesco would never have made it into the model portfolio as its total capex in the decade to 2012 came to 170% of total profits. High capex requirements alone aren’t necessarily a reason to not invest Tesco , but combined with high debts and weak profitability, I think it was; at least for the model portfolio.
So Tesco was a value trap and of course it’s disappointing to lose money on an investment, but I would say two things:
1) Occasional losses are inevitable and should not cause too much distress, as long as they are small and occasional;
2) My stock selection process is better today than it was in 2012 largely because of this investment in Tesco. To some extent bad investments are actually necessary in order to drive improvements in the stock selection process, as long as they are massively outweighed by good investments in the long-run.
Given these lessons and their related improvements, I am confident that a low profitability, high debt and high capex company would never make it past the stock selection process that I use today.
So at least I have that to thank Tesco for.
Note: You can read the full pre-purchase review of Tesco in the June 2012 issue of UK Value Investor (or the Defensive Value Report, as it was briefly known) here (pdf).