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Why I’d sell this growth stock despite 150% gain in 5 years

Photo: Ocado plc. Media Use.

Paying over the odds for high-growth shares is difficult to avoid. After all, a stock which is able to deliver consistently impressive bottom line growth over a long period is likely to trade on a premium valuation. However, there comes a point where even the most enticing growth stocks begin to appear overvalued. Following a 150% gain in five years, this company appears to fall into that category.

A changing landscape

Ocado (LSE: OCDO) has proven to be a relatively successful business. The release of its trading statement on Tuesday showed it is making consistent progress. For example, gross sales were over 13% higher and average orders per week grew by almost 17% when compared to the same quarter of the previous year. This is largely because online grocery shopping is becoming more popular, with consumers more willing than ever to order online rather than visit their local supermarket.

The changes in grocery shopping are likely to continue and Ocado should therefore be a beneficiary. Its business is solely focused on online shopping, which means it does not face the same challenges as other grocery shops such as Tesco (LSE: TSCO). The latter is seeking to refocus part of its estate on convenience stores and online, with a number of plans for large supermarkets mothballed or even cancelled due to weakening demand from consumers.

Growth potential

While Ocado has long-term growth potential due to changes within the grocery industry, its near-term outlook is somewhat mixed. In the current year it is forecast to record a fall in earnings of 24%, followed by a return to growth of 58% next year. This is somewhat disappointing, although perhaps understandable since the UK economy may experience difficulties associated with weak consumer spending caused by Brexit. However, this outlook means that the stock trades on a forward price-to-earnings (P/E) ratio of 115, which appears to be excessive given the investment appeal of its sector peer.

By contrast, Tesco is expected to record a rise in its bottom line of 28% this year and 32% next year. Therefore, its growth potential is superior to that of Ocado, with its new strategy being the key reason. It is focused on delivering efficiencies and higher levels of productivity. They should improve the company’s margins and also make it more competitive on price versus rivals. Since Tesco has a superior growth outlook and trades on a forward P/E ratio of 14.8, it appears to be by far the more attractive option.

Brexit difficulties?

As alluded to, both companies face an uncertain future due to Brexit. However, in Tesco’s case its cost-cutting strategy and improving financial strength should allow it to outperform the rest of the industry. Its acquisition of Booker may also provide much-needed synergies over the medium term. In Ocado’s case, its online focus and the increasing demand for its services may protect it from weakening consumer confidence. However, given its high valuation, it seems to be worth selling rather than buying.

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Peter Stephens owns shares of Tesco. 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.