Like banks, supermarkets were once seen as super-defensive investments, capable of delivering steady growth regardless of the economic environment.
Of course, we now know that supermarkets are not quite as low risk as we thought.
Tescos, Sainsburys and Morrisons have all cut or suspended their dividends in recent years and Buffett sold all of his Tesco shares while wishing the company the best of luck for the future.
The problem was not so much that supermarkets are not defensive, because they are. Instead, these supermarkets ran into trouble because of a “perfect storm” of:
- Self-induced weakness following a long period of easy growth
- A tough economic environment following the financial crisis
- Rapid changes to shopping habits which perfectly suited the up and coming German discounters, Aldi and Lidl
After several years in my portfolio, Morrisons is still in turnaround mode and I am not especially enthusiastic about its future. However, the share price has largely recovered so I have decided to sell and move on to better things.
- Purchase price: 293p on 07/05/2013
- Sale price: 239p on 07/07/2017
- Holding period: 4 years 2 months
- Capital gains: -19.8%
- Dividend income: 17.6%
- Annualised return: -0.6%
Buying what appeared to be a defensive company at a good price
Although supermarkets may seem like slow but dependable blue-chip companies, the period leading up to the financial crisis saw all of the major UK supermarkets growing rapidly. When I looked at Morrisons in May 2013 it had a ten-year growth rate of 17.5% and growth quality of 90%.
This made the company very attractive at first glance, as the chart below shows.
During that period, the company’s earnings and dividends almost tripled, which is very impressive. However, revenue growth was much slower at 6% per year, which was perhaps a more realistic long-term growth rate for this sort of company.
Overall, Morrisons’ fundamentals were impressive (or at least they were as I interpreted them back in 2013), and its valuation ratios weren’t bad either:
Low profitability was a sign of weakness that I missed
One thing that’s missing from the table above is profitability, i.e. ten-year average returns on capital employed. This is an important metric for me today because high profitability is a common feature of high quality businesses, but in 2013 I didn’t use it at all.
Looking back at Morrisons’ results, I’ve calculated its 2013 ten-year average profitability to be 7.6%, which is quite low. In fact, it’s only just above my minimum acceptable value of 7% and is some way below the FTSE 100 average of 10%.
This isn’t necessarily the end of the world, but this sort of low profitability is usually found in companies that have weak or non-existent competitive advantages, and I think that’s a good description of all the UK supermarkets.
Although this low profitability wouldn’t have been enough to stop me from investing, it would have pushed Morrisons down my stock screen and away from the top ten or 20 stocks where I typically select investments from.
To get back into the top 20 stocks, Morrisons’ share price would have to have been much lower, as the lower (and more attractive) valuation would have offset the company’s relatively low (and less attractive) profitability.
This means that if I had been looking at profitability in 2013, then I would only have bought the company at a significantly lower price than the 293p I actually paid.
That one small change would have massively improved the returns from this investment.
Sadly I don’t have a time machine so I can’t go back and change the purchase price, but I can stick to investing in higher profitability stocks in future (as I’ve already been doing for a couple of years now).
Massive debt-fuelled capital investment was the real killer
In the years leading up to 2013, Morrisons had repeatedly made enormous capital investments (capex) in order to expand and modernise the business.
Unfortunately I didn’t look at capex back then, but I do now and Morrisons’ capex record raises at least two red flags.
The first red flag was that Morrisons spent more on capex during the ten years leading up to 2013 than it made in post-tax profits.
Having a capex/profit ratio of more than 100% is not necessarily a bad thing, but in most cases it means the company has to invest lots of cash up front (to build factories, supermarkets, infrastructure and so on) before it can generate a penny of profit.
This is a risk because it makes expansion more expensive and, once built, these capital assets often come with unavoidable fixed costs, such as maintenance. Fixed costs are then a further risk because they make it harder to cut costs if there’s a fall in revenues.
The second red flag was that Morrisons’ capital investment was consistently more than twice the amount of capital depreciation.
In order to expand and modernise itself, Morrisons spent more than £5 billion between 2009 and 2014 on opening new stores, updating IT systems and improving other operational infrastructure.
In contrast, its capital asset depreciation over that period (which can be used as a rough estimate of the investment required to maintain the company’s existing assets) came to just £2 billion.
So not only was the company investing more in capital assets than it made in profits (capex/profit ratio over 100%), it was also investing more than double the amount required to replace its existing assets (capex/depreciation ratio over 200%).
Clearly this was a period of massive expansion, modernisation and (hopefully) improvement. These are all things that we usually want, but there are risks.
To much expansion can lead to oversupply, especially if everyone else (Tesco, Sainsbury etc.) are expanding as well. These days everybody moans about there being too many supermarkets, and the result is an expensive asset which generates weak returns on the capital invested.
Today I have a rule of thumb which says:
- Don’t invest in a company if its capex/profit ratio is over 100% and its capex/depreciation ratio is over 200%
This would have stopped me from investing in Morrisons because the risk that the company (and the whole sector) was expanding too rapidly was too great.
This situation is made even worse if much of the capital investment is paid for with borrowed money, which is exactly what Morrisons did as it tripled its borrowings from £0.9 billion in 2008 to £3.0 billion in 2014.
Massive capital investment and high debts may be just about sustainable if the economic environment remains helpful, but if the economy falters and sales fall then those high fixed costs will demolish profits in no time at all.
If things get really bad then the dividend and the CEO will get the chop, and that’s precisely what happened at Morrisons.
Holding on as Morrisons begins to repair the damage
Of course, hindsight is a wonderful thing, and if I’d known in 2013 what I know now about profitability, debt and capex, I wouldn’t have bought Morrisons in the first place.
But I did buy the company, and this is what happened:
Initially, things seemed to be going okay as the company focused on its expansion into convenience stores and developing an online presence and delivery capability. These were two areas where Morrisons lagged significantly behind the other big supermarkets, so getting up to speed here was important.
However, by early 2014 it was clear that Aldi and Lidl were benefiting massively from two key changes to the way people did their grocery shopping:
- Shoppers were feeling the pinch from the great recession and becoming more value conscious
- They were making more frequent, smaller shopping trips to convenient local stores rather than doing the traditional “big weekly shop” at the weekend
This squeezed all of the big supermarkets, forcing them to reduce prices aggressively to maintain sales volumes, and this squeeze eventually led to dividend cuts at Morrisons, Tescos and Sainsburys.
To some extent then, Morrisons was a victim of external events rather than the perpetrator of an unforced error.
But the previous management team (which were replaced in early 2015) are not entirely innocent, in my opinion.
Some say their biggest error was in trying to go upmarket during the great recession, offering customers misted asparagus when all they wanted cheap baked beans.
That may be true, but for me there were two big avoidable mistakes:
- Going too far too fast with the capital investment program
- Loading up on debt so that the dividend could continue to grow at 10% per year
I can understand the desire to improve and expand the company through a program of heavy capital investment, but the dividend policy really stumps me.
Why on earth did Morrisons’ dividend grow from 5p in 2009 to more than 13p in 2015, almost tripling in just six years?
After all, this is a mature supermarket, not a high growth tech stock like Amazon.
Morrisons’ operations were simply not generating enough cash to keep up with the growing dividend and the massive capital investments being made, so the gap was filled with borrowed money.
Of course increasing borrowings levers up the balance sheet, lumps the company with a growing interest expense and puts power in the hands of lenders, none of which are good.
Having briefly crunched the numbers, I think a more reasonable dividend policy of 2% growth per year from 2008 all the way to today would have been sustainable.
The company would have held on to more than £1 billion of cash, rather than handing it over to shareholders. Debts could have been more than £1 billion lower and the dividend cut could have been avoided. The CEO and Chairman could also have remained in their jobs.
But the dividend policy wasn’t cautious, the debts did pile up and a large divided cut was required.
Selling because the shares have re-rated while the recovery is far from over
Here’s why I’m selling:
Aldi and Lidl have worked out a way to open smaller stores in the middle of town that still benefit from economies of scale. This local and cheap combination perfectly suits the modern convenience shopper, and undermines the local monopoly of the traditional big supermarket.
This means that supermarket margins could be depressed for years, which would not be good for future profits, dividends and share prices.
Clearly, I’m somewhat gloomy about Morrisons’ future, but the market disagrees. The company’s share price has increased by 70% since 2015, despite profits that continue to decline.
And that’s why I sold the shares earlier today.
Sadly, Morrisons did not provide me with any direct profits. However, like Tesco, it did provide lessons which can be used to generate indirect profits through improved future investment decisions (you can read my post-sale review of Tesco here).
As usual, I will be reinvesting the proceeds of this sale into a new holding next month.