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).
Dividend Growth Investor says
Thank you so much for writing this post-mortem review of an investment in Tesco. Not all investments will be winners unfortunately. It is very good that you are using this as way to improve your process and learn from it
I wish you good luck in your investment journey!
John Kingham says
Thanks DGI, and you’re welcome.
No offense, but “hindsight is a wonderful thing”.
Why do you not invest in a FTSE All Share tracker, never touch it again and retire to the Bahamas?
Why are the returns of your county’s industry not good enough for you and you want more than your fair share?
John Kingham says
Hi Frank, I used to invest in index trackers but the bear market of 2000-2003 made me realise I had no idea what I was doing, so I set out to learn. That eventually led me into stock picking and value investing and the rest, as they say, is history.
As for fair share, it would depend on how you define ‘fair’. In today’s stock market your fair share is proportional to the amount you invest, so it’s impossible to get more than or less than your fair share. You buy shares or an index, get a dividend income (maybe) and a capital gain or loss. That’s your fair share.
Fascinating, good to learn from mistakes, and boy am I doing some learning at the moment!
The Terry Smith view is interesting as well:
I hadn’t appreciated how badly Warren Buffet was stuffed!
John Kingham says
Hi David, it was actually that Terry Smith article that led to my profitability metric. There was so much fuss about the article in investment circles that I thought it really was about time I factored in profitability and, in part thanks to Terry, I ended up basing it around return on capital employed.
And yes, it was a major blunder from Buffett, but I think he’s earned the right to get it wrong on the odd occasion!
diy investor (uk) says
As ever, great analysis of the Tesco story over recent years.
I do not blame you for your decision however I have decided to hold on for the time being to see if the new management team under Dave Lewis can turn the large ship around – The latest annual report outlined some promising signs.
Capex has reduced from £1.8bn to £1 bn and also debt has started to reduce following some major disposals with more to come. As a result the balance sheet is now more solid than it was a couple of years back and cashflow is much stronger.
Like for like sales are showing signs of returning to positive both UK +0.9% and global +3.8% for 4th quarter with the 6 wk Xmas period up 1.5% – profits for the year up £1bn compared to the £6bn loss the previous year due partly to write-downs.
The pension scheme has moved from final salary to DC – staff costs reduced by £400m including a 25% reduction at head office.
It seems to me this could well be a classic recovery play from here so, fingers crossed I will continue to hold for a while longer. I am hoping the share price can get back above the 200p level – would it be too much to hope for 250p by the end of the year? – probably!
John Kingham says
Hi John, I think you’re probably right about Tesco eventually recovering. I still think it’s the best supermarket company in the UK; it just had too much debt, too much of a pension (in deficit too) and management that failed to spot major shifts in the pattern of demand. To be honest I think a rights issue might have been a good idea to lower debt; it just gets it out of the way quickly and would have speeded up the recovery process.
But for me I can’t stay invested as it’s broken what is perhaps my primary rule of having a consistent record of dividends. If things have gotten so bad, and the company run so badly that it can’t even pay a dividend, then I’m not interested. It’s a shame but there you go, and with hindsight I shouldn’t have invested in it anyway.
And yes, 250p by the end of the year seems optimistic, but when it comes to the stock market, never say never!
John Spencer says
I held shares in Tesco for a few years and managed to get out with about a 33% profit. The reason for my sale was that I saw the cashflow went negative and to me negative cashflow is always a sign to sell. It was an expensive lesson I learned with Chemring but sometimes the best lessons are the most expensive ones eh?
John Kingham says
Hi John, yes Tesco’s free cash flows have been pretty weak for a long time and never really seemed to be sufficient for the dividend. I keep an eye on cash flows but don’t yet have any rules about them, although I do prefer to see free cash at least covering the dividend most of the time. However, I’m not worried about the occasional weak or negative free cash flow value as it may just mean heavy investment in something or other. But repeated weak cash flows, yes I do think that’s a problem.
Chemring is an interesting one as I still own it, although probably not for much longer. It’s the worst performer I’ve had, although in my defence it was one of the first “defensive value” stocks I bought back at the start of 2011. As you say, in some ways it’s useful to see the occasional capital loss as an educational investment, and from that point of view Chemring was also a worthwhile “investment”, although not one I’d like to repeat too often!
Ken Newton says
Thanks for the analysis. I avoided Tesco and all other supermarkets, because they seemed to be playing in almost a zero sum game for customer spend. The total grocery and household goods market is not going to have massive growth in the uk. However most supermarkets did seem to be opening more and more stores to compete for this fairly static customer spend, so growing sales per store seemed unlikely. Sainsbury was tempting due to the value of its property portfolio, which appeared to offer some downside protection but, fortunately, not tempting enough.
John Kingham says
Hi Ken, I would agree that the UK market is saturated and that growth in the region of GDP is all that’s likely in the longer-term. Tesco is slightly different to the others because of its international exposure, but that hasn’t really worked out so far. I think if it can start to grow internationally again, but more slowly and carefully this time, then it could work. If it does then I think in the long-run Tesco is still the most attractive UK supermarket, but there are a lot of unknowns, and I still wouldn’t invest given the issues highlighted in this post.
Nigel Birch says
Hi, great analysis of Tesco. It is interesting to see how adding new investment rules may have avoided this, and other, value traps. I guess the only worry is that if there are too many rules, then the stock selection may become very meagre. Not sure if you are finding this, or whether there are still plenty of opportunities that meet all the criteria?
John Kingham says
Hi Nigel, this is always one of my major concerns. It’s easy to reduce risk (or at least volatility) in a portfolio; you simply stay in cash! Of course that’s not much good at beating the stock market, so I’m always wary of 1) being too cautious with any new rules, 2) having too many rules which have a negative impact on the aggregate results, 3) having so many rules that there are no stocks which meet all the criteria.
I’m fairly comfortable that the current system works okay, although of course it can and will be improved in the future. I think the best way is to tread carefully with any new rules and not to make them too strict to start with. Generally I don’t make much more than one change to my process each year, and even after five years of being a defensive value investor I feel like there is still much testing to be done.
But as for opportunities, yes there are plenty. I think the market would have to be ludicrously overvalued for there to be no attractive stocks, and even then there will always be some area of the market that is out of favour.
John Spencer says
Hi Nigel, IMHO ending up with a very meagre stock selection would be a good thing. If you only come up with one stock pick in a year that meet your criteria I think you are doing very well. After all as a small investor looking after your capital (avoiding losers) and waiting for the ‘fat pitch’ is more important then when you are fund manager and afford to back a few losers ‘swinging for the fences’ to rob another Buffet simile.
Do you automatically sell a stock if it eliminates the dividend or simply if it cuts the dividend? How strictly do you adhere to the ten years of unbroken dividend payments rule?
John Kingham says
Hi Andrew, I only sell on a prolonged (greater than 1yr) dividend and don’t sell automatically on cuts alone. This is something which I stick to 100% as the first thing my stock screen does is exclude companies that missed their dividend payments for a year or more out of the last ten. So Tesco doesn’t make it onto my stock screen anymore and therefore I can’t compare its value to my other holdings or say anything sensible about its share price.
Having said that, Tesco is the first holding in more than five years to suspend the dividend for more than a year, so it hasn’t been a common occurrence and hopefully won’t be in future.
Jonathan Merrick says
Excellent analysis and you are completely right – there is great value in investing in a loser like Tesco.
I remember subscribing to a tip sheet run by one of the Big Four banks which urged me to buy Polly Peck (advice which I unfortunately followed!). Two months later they were bust.
Having lost my shirt on that one it remains my worst investment ever. But also in another way my best.
Because I realised I did not have a clue about investing and the Bank in question were probably itching to dump the stock on mugs like me! It taught me not just to follow tips but at least put in place some analysis – even if it was flawed.
I think your investment model is great; there are always going to be a few losers in there. With a portfolio of 30 shares the performance of any individual share is pretty unimportant anyway – it is the performance of the group as a whole that is important as you have stressed in the past.
This was brought home to me relatively recently when I was on the verge of buying BG just before Shell made a takeover bid. My immediate annoyance was put into perspective when I realised the 30% uplift was probably no more that I made or lost on my portfolio in a day in any event. So no big deal.
For the same reason where I once rejoiced when one of my portfolio members was taken over at the prospect of a short-term windfall I now have very mixed feelings, as it is one less attractive investment for my money.
Keep up the good work!
John Kingham says
Thanks Jonathan, yes you definitely have to think about why someone’s suggesting you do this or that. Unfortunately it is often to benefit them rather than you.
As for your feelings about diversity and the relative unimportance of individual stock performance, I am off course in total agreement.
In fact I like to look at my portfolio’s biggest winners and losers each month to remind myself just how volatile individual stocks are (often up or down by more than 20% in a single month). In most months all that volatility more or less cancels itself out with the overall portfolio only going up or down by a percent or two.
Most of it is much ado about nothing, as someone once said.
Nice write up!
I personally have come to the conclusion that I won’t invest in any company that doesn’t have pricing power (in your first point), and in reality, ultimately a retailer (and especially physical presence retailers) doesn’t have this.
Consequently retailers will not be in my portfolio — that includes Next.
John Kingham says
Hi LR, that’s a common sentiment among defensive investors. I have moved somewhat in that direction, but not to anything like the extent you describe. For me being so restrictive means missing out on many potential ‘bargains’, but also increases the risk of hitting value traps.
I guess only time will tell whether I stay where I am or move more towards defensive and away from value.
Stephen Golding says
Thanks for the post-mortem.
What I love about looking back at Tesco is how many things Tesco got right. They were quick offering online delivery and very quick establishing smaller convenience stores – much quicker than their competitors who then raced to keep up.
Ultimately, their competitive advantage in large supermarkets (which was real) was reducing through under-investment in stores and an unwillingness to reduce margins to thwart competitors. In any case, demand for large out-of-town weekly or fortnightly supermarket trips has reduced considerably. However quick they were to offer online delivery, it takes a long period of investment in fixed costs and the ability to build a critical mass that gives profitability – which happens when the van delivers to say 4 homes on the same street rather than just the one. In most of its overseas territories it did not have a competitive advantage so money was being poured down the drain. Protect the moat at all costs!
Another fascinating aspect is how wrong the conventional analysis was of what consumers wanted. It told us that consumers loved the choice of having twelve different bottles of ketchup to choose from. Actually, Aldi and Lidly proved that if they could offer one bottle and ensure it was the cheapest, consumers were willing to forgo the ability to choose their favourite from a wide variety and instead wanted the one that was the best value. An interesting point to learn from, and it is the basis of the successful business model the discounters have used. However, it is easy to forget that smaller store discounters in various forms have been around for decades and the big supermarkets were at one point able to defeat them.
With hindsight back in 2012 many intelligent investors could have had little idea of what would happen even though the evidence was all there at the time – if that makes sense.
John Kingham says
Hi Stephen, that’s a great summary. Regarding the discounters and the fact that they have been around in various forms for decades, I think that is a very telling signal. Kwik Save didn’t take over the world in part because the economy picked up after the early 90s recession and just kept getting better. Not many people care about how cheap their ketchup is when they have a good income and lots of discretionary spending. Aldi and Lidl may find this out when the UK economy eventually gets going again.