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Why I’d drop Tesco plc and BP plc right now

License: CC0 Public Domain

According to market research company Kantar Worldpanel, during the 12 weeks to 9 October, Tesco (LSE:TSCO) increased its sales by 1.3%. That’s quite an event because it’s the first period that the firm has increased sales since as far back as March 2015.

Kantar reckons Tesco grew ahead of the overall market where sales increased just 0.8%. It looks like Britain’s largest grocer is making real turnaround progress under chief executive Dave Lewis.

Squeezing out profits

Meanwhile, BP (LSE: BP) reported third-quarter results this week with underlying replacement cost profit up almost 30% compared to the previous quarter but down nearly 50% on last year’s third quarter. The firm is working hard to squeeze out profits by controlling costs and announced a further decrease in its capital expenditure plans to $16bn down from earlier guidance of $17-19bn.

The lower price of oil forced the firm to ‘reset’ its cost base. The firm’s chief financial officer reckons it can “rebalance organic cash flows next year at $50 to $55 a barrel,” which suggests Brent Crude at today’s $47 or so could be a problem for the company.

Share prices riding high

It’s possible to glean something cheerful from the news in both cases. Maybe that’s why these firms’ share prices are riding high. At today’s 211p, Tesco is up almost 52% since January, and at 454p, BP is up just over 46% over the same period.

I ‘get’ the case for investing in these two. Even Tesco’s projected annual pre-tax profit of just over £1bn for the year to February 2018 is still around just a quarter of what the company made during the year to February 2012 — this turnaround has potential to go much further. And the price of oil languishes around 66% below the peak it touched during 2008 — just think what a recovery in the price could do for BP’s cash flows.

My problem is that both firms look overvalued, and I’d argue that neither is suitable as a long-term investment. I certainly wouldn’t trust my retirement funds on the pair today.

Wider challenges

Today, Tesco’s forward price-to-earnings (P/E) ratio runs at just over 21 for the year to February 2018. To me, that’s too high and already anticipates a return to higher profits for Tesco way down the road, beyond 2018. 

Investors are too optimistic, I reckon. Tesco ‘should’ be trading at no more than a P/E ratio of 15, tops. The firm is making a little headway now with its business, but a wider threat continues to gather in the supermarket sector as rapidly growing challengers Aldi and Lidl make market share gains that walk all over Tesco’s. I reckon a return to peak profits for Tesco seems unlikely in inflation-adjusted terms — ever.

BP’s forward P/E rating around 14 for 2017 seems to build in a return to higher profits that may never arrive. Recent events show me that BP’s cyclical business is even more dependent on high oil prices to really thrive than I suspected. Cyclicals like BP deserve a lower rating and even then the risk to the downside for investors remains large.

If I had gains with Tesco and BP I’d cash in right now and reinvest in firms with higher quality businesses.

A better road to riches

Why not invest in better companies that are defensive and growing for a steadier route to riches? Tesco and BP offer a very uncertain outcome in total returns for investors right now and I wouldn't risk my retirement funds on them.

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