Trading Strategies: do Tesco shares offer long-term potential?
With its share price near an 11-year high and ahead of the hugely important Christmas trading period, analyst Robert Stephens studies the retail giant’s competitive position, growth opportunities and strategy.
28th November 2024 14:23
by Robert Stephens from interactive investor
The UK economy’s third-quarter growth rate was hugely disappointing. Having bounced back from a recession in the second half of 2023 by posting growth of 0.7% and 0.5%, respectively, in the first two quarters of 2024, the economy subsequently expanded by a barely positive 0.1% in the most recent quarter.
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Clearly, a restrictive monetary policy is likely to have acted as a drag on the UK’s GDP growth rate in the third quarter. Although the Bank of England began to cut interest rates during the period, implementing a 25-basis point reduction in August, Bank Rate remained close to its 16-year high of 5.25%. And with the presence of time lags meaning that any further loosening of monetary policy is likely to take many months to have its desired impact on GDP growth, the UK economy’s performance could yet worsen before it improves.
In addition, uncertainty regarding the Autumn Budget may have weighed on the economy’s third-quarter growth rate. With higher government spending announced in the Budget having the potential to cause a higher rate of inflation than previously expected over the coming years, interest rate cuts could prove to be more modest than anticipated prior to the fiscal event.
Furthermore, cost rises for businesses, notably higher national insurance contributions and growth in the minimum wage, could hold back the UK economy’s performance to at least some extent over the medium term.
Looking elsewhere
An uncertain economic outlook may naturally prompt some investors to consider avoiding UK-focused companies. They may determine that because all but one of the G7 economies grew at a faster pace than the UK in the third quarter, while central banks in the US and the eurozone are cutting interest rates more quickly than the Bank of England, there are better opportunities to generate capital growth elsewhere.
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While geographic diversification is a sound idea due largely to its risk-reduction effects, investors should not give up entirely on UK-focused stocks just yet. Crucially, they offer good value for money in many cases, with investors seemingly having priced in an uncertain near-term economic outlook. Low market valuations not only provide a degree of protection against future stock market volatility, they also offer scope for more generous long-term returns due to the capacity for upward re-ratings.
An upbeat long-term outlook
Furthermore, one disappointing quarter of economic growth should not necessarily be relied on when making long-term decisions regarding where to invest. Although annual inflation rose by 60 basis points to 2.3% in October, it is still set to remain low enough for the Bank of England to implement further interest rate cuts. In fact, the central bank’s November Monetary Policy Report stated that it expects annual inflation to be 2.7% in the final quarter of 2025 and 2.2% in the fourth quarter of 2026.
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A gradual loosening of monetary policy should have a positive impact on the economy’s performance, once time lags have passed, thereby providing an increasingly upbeat operating environment for firms that are reliant on the prospects for the UK economy. Indeed, the Office for Budget Responsibility (OBR) forecasts that the economy’s growth rate will be 1.1% this year, up from 0.1% in 2023. It then expects the UK economy to expand at an annualised rate of around 1.7% over the next five years.
Clearly, the share prices of firms that are reliant on the UK economy may prove to be volatile in the near term. This, though, could create an opportunity for long-term investors to purchase high-quality companies while they trade at temporarily low prices. Doing so could lead to relatively high returns as history suggests that the UK economy, and stock market, are likely to return to their long-term average growth rates in the coming years.
Solid performance
Performance (%) | ||||||||||
Company | Price | Market cap (m) | One month | Year to date | One year | 2023 | 2022 | Current dividend yield (%) | Forward dividend yield (%) | Forward PE |
Tesco PLC | 363.3p | £24,379.80 | 2.74 | 25.1 | 28 | 29.6 | -22.7 | 3.4 | 3.7 | 13.4 |
Source SharePad. Data as at 28 November 2024. Past performance is not a guide to future performance.
Having surged 26% higher in the first nine months of the year, Tesco (LSE:TSCO)s share price now trades on a price/earnings (PE) ratio of 13.4, which suggests the retailer offers good value for money given its long-term growth potential.
The UK-focused firm’s recently released half-year results showed that sales rose by 4% year-on-year, while earnings per share were up 23.7%. They were driven higher by an increase in profit margins, as well as the impact of the company's share buyback programme. Share repurchases in the first half of the year totalled £575 million, with the remaining £425 million of share buybacks set to be completed by April 2025.
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The firm plans to implement an additional share repurchase programme once the current £1 billion programme has ended. This follows the sale of its banking operations to Barclays, which completed earlier this month. The incremental share repurchase programme could help to support its market valuation, while the decision to concentrate on its core operations may provide greater focus in what remains a highly competitive grocery sector.
Stronger-than-expected volume growth in the first half of the year meant that the firm upgraded its full-year financial guidance. It now expects retail adjusted operating profits of £2.9 billion, up from a previous figure of at least £2.8 billion. Its upbeat performance during the six-month period also meant that net debt moderated. It fell by 2.1% year-on-year to £9.7 billion, which equates to a net debt-to-equity ratio of 84%. This provides the company with a relatively solid financial position through which to invest for long-term growth.
Sound fundamentals
Tesco has a strong competitive position through which to generate further profit growth. It has a 34% share of the UK online grocery market, which means it is well placed to benefit from renewed interest in e-commerce among UK consumers. Indeed, according to the Office for National Statistics (ONS), the proportion of UK retail sales conducted online has risen year-on-year in every month since April this year.
The company’s Clubcard loyalty scheme also boosts its competitive position. Around 23 million UK households have a Clubcard, which could provide scope for higher margins as customers may be less likely to switch to rival operators. This competitive advantage may also help to support Tesco’s sales in the near term should trading conditions become more challenging.
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Of course, the end of the cost-of-living crisis means that the retail sector faces an improving outlook. Wage growth in the UK has been positive in real terms since April last year, which means that the purchasing power of consumers has been gradually increasing.
This trend could continue as a result of a forecast inflation rate that is close to the Bank of England’s 2% target and interest rate cuts that are widely expected be implemented. Continued growth in the purchasing power of consumers may mean they become less price conscious, which may allow for price rises and higher profit margins that have a positive impact on Tesco’s profitability.
Long-term potential
Clearly, the upcoming Christmas trading period is hugely important for the company’s annual results. An update on its festive period performance, which is due to be released in early January, could therefore have a significant impact on its share price over the short run.
Over the long run, the firm’s solid competitive position, growth opportunities and sound strategy mean that its share price could resume an upward trend following its recent dip. With the operating environment likely to improve as the economy’s growth rate gathers pace, the company remains relatively attractive compared with its internationally focused industry peers.
Robert Stephens is a freelance contributor and not a direct employee of interactive investor.
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