Investment Column: Food for thought if you want a stake in grocers

I think Tesco might look cheap by the end of the year, so it's time to take a punt and buy

If you want to buy shares in supermarkets as well as your food, entertainment, electricals, toys, even banking and insurance, you have a problem. Your investment is going to have to run very fast just to stay still.

It is true that the supermarkets are perhaps the most defensive play in the retail sector. Their core offering – food – is something everyone has to buy. They've managed to increase their share of the shopper's pound by adding the other product lines, which they can often sell cheaper with their scale and buying power.

But it is where the shopper wants to spend that pound that is causing difficulties: namely online or in convenience stores. These are the fastest-growing parts of the supermarket business. The trouble is they aren't very fast at all when it comes to profitability.

If you have a big out-of-town aircraft hangar you can pack it full of all sorts of stuff, with relatively few staff, cheap land and rates, and easy access for your lorries. It's a wonderfully efficient form of retailing.

Convenience, with much smaller town centre stores, imposes much higher costs. So does online, where you have to fill the customer's shopping basket for them and then pay someone to deliver it to their door at a time convenient to them. Which they don't want to pay extra for.

Margins, already tightish, are going to come under pressure. Long- term, if you're looking for really exciting capital growth, you're best to look elsewhere.

However, that ignores the good bit. Supermarkets still make lots of money, enough to sustain very juicy dividend yields. They have huge property portfolios, which gives all the big groups' shares a natural floor. And notwithstanding the difficult economy and competition from discounters such as Aldi (a serious threat), people still spend a high proportion of their shopping budgets with a member of the big four.

Three of which are quoted, and all of which have recently offered trading updates. The most recent was by WM Morrison, which has been struggling. Yesterday it continued to report falling sales, down 1.8 per cent in the first quarter, though some analysts had expected worse, and the rate of decline is at least slowing.

There's been a lot of talk of some sort of tie-up with Ocado, the online grocer, and promises of setting up an online operation too. But progress has been slow. Theoretically Morrison's has a lot to shoot for. It's smaller, and so ought to be more fleet of foot than larger rivals. It has little presence in convenience, an area it has been targeting, with a lot of room for growth. Some analysts even detect signs of light at the end of the tunnel. But the shares have been run up very strongly recently and I'd like to see firmer evidence.

Morrison trades on 11.4 times forecast earnings for the year ending 31 January 2014, which implies a yield of 4.3 per cent. That makes it looks very comparable to Tesco, in terms of valuation. Tesco too has had its problems, but Morrison's would appear to be deeper, with less evidence they are being tackled. So I'd continue to steer clear, though the shares are a fair bit higher than the 268.8p at which I made the same recommendation at the end of November.

As for Tesco, I said hold at 339.6p in December, and since then the shares have put on a balmy 10 per cent. It didn't hurt that Christmas was a happy one for the chain, and calling time on its cack-handed attempt to break into the US was also well received.

Despite its problems in the UK, Tesco has something that the other chains don't have: exposure to growing markets overseas. It is dominant in the internet sphere, and its decision to spend cash rejuvenating its UK stores was the right one. While last year was one to forget financially, Tesco could fly again if the numbers fire this year, and on 11.4 times earnings for the year ending 28 February 2014, with a tasty 4.1 per cent prospective yield, it is not overly expensive for a company of its size.

Equities have done well as an asset class, and even though my local shop is a good example of what Tesco (still) needs to put right, I think Tesco might look cheap by the end of the year. So I'm going to take a punt. Buy.

The last of the big three supermarkets is Sainsbury's, making waves with its decision to take full control of its banking arm and because of speculation that the chief executive, Justin King, is thinking about stepping down. He says he's not. Good, because he's a rare CEO who might just be worth what shareholders have to pay for his services. The recent numbers were as solid as ever, with underlying profits up 6 per cent at £756m for the year to 16 March.

Sainsbury's shares are on the pricey side, although they've been winners for this column after I said buy at 331.8p at the end of November. They're about 14 per cent ahead of that now. But Mr King deserves a premium.

Sainsbury's margins are lower than rivals' but it has the best forecast yield (4.6 per cent) and doesn't have the "issues" of rivals. So hold on.

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