Whenever I think of what Tesco (LSE: TSCO) and Wm Morrison (LSE: MRW) need to do to regain their ascendancy over the upstarts at Aldi, I’m reminded of the old joke about “Which is the best way to Dublin please?“, with the answer “Ooh, I wouldn’t start from here if I were you“.

Because that really is the problem. The big UK supermarkets kept expanding their operations and growing their margins, with Tesco in particular trying its hand at banking, insurance, car dealership, and international expansion. And they grew complacent in their increasingly affluent niches without noticing that the old and ignored “pile it high and sell it cheap” market segment was just sitting there waiting to be exploited, the way Tesco and Morrison had done in their long-forgotten pasts.

So now, while Tesco and Morrison have been closing stores to try to shed some of their cost overheads, and Morrison has offloaded its chain of convenience stores, Aldi is starting from a much leaner cost base and is doing exactly the opposite with its plans to open 80 new UK stores this year and create 5,000 new jobs. The net result will be 700 Aldi stores across the country, employing 32,000 people.

A big shift

Thomas Kuhn famously wrote of the “paradigm shift” that happens when a scientific advance overturns current understanding or assumptions, and the recession we have just endured has done something similar to the retail environment. While at one time we were all happy shopping at Tesco, Morrison and the rest, and looking askance at that funny Aldi with its shelves full of strangely-labelled foreign tins (“Ooh, Pumpelsqueezl, how nice“), millions of us have since taken a much closer look and we’ve seen equal quality (and often superior) goods at lower prices.

Do Tesco And Morrison have to go back to day zero and start all over again from the ground upwards? Well, no, and they couldn’t anyway. There is still a very large market segment for the approach that Tesco in particular takes, with its focus on various ranges of goods at different prices and perceived qualities — I’m always surprised at the popularity of expensive “Finest” ranges of packaged food products.

But they, and all the rest, have no option but to accept the shift to a focus on cut-throat margins and intense price competition, and I can see price deflation hurting their bottom lines for some time to come.

Still too expensive

After years of collapsing earnings, Tesco is forecast to finally rebound in 2017. But its shares would still be on a stretching P/E of over 19 based on today’s 178p share price, with dividends yielding only 1%. And at Morrison we’re looking at a forecast 2017 P/E of 16 on a share price of 177p, although with dividends at 3.1% (which I think is a mistake — we should have had a cut in 2015).

I wouldn’t be buying either of these now — with there being so many better bargains out there, why take your chances in such a highly competitive sector? It will be enlightening to look at the UK supermarket sector in, say, another five years. Will there still be room for all of the competitors or will we see any takeovers? I wouldn’t be surprised by the latter, and I see Morrison as perhaps the most vulnerable.

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Alan Oscroft has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.