Is It Time To Buy Underperfoming J Sainsbury plc, WM Morrison Supermarkets plc & PureCircle Limited?

J Sainsbury plc (LON:SBRY), WM Morrison Supermarkets plc (LON:MRW) and PureCircle Limited (LON:PURE) have underperformed the market this year.

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Shares in Sainsbury’s (LSE: SBRY) and Morrisons (LSE: MRW) have been bolstered on speculation of a potential purchasing partnership or a merger between the two supermarkets.

This news sent shares in Sainsbury’s 2.2% higher to 275.3 pence, whilst Morrisons gained 2.9% 185.0 pence, in afternoon trading.

Societe Generale believes that recent consolidation activity in the grocery market in Europe could spread to the UK, with a deal between Sainsbury’s and Morrisons being most likely to happen. A merger between the two is less likely, but even just a purchasing partnership could help to cut costs and improve margins.

Societe Generale also upgraded its rating on Sainsbury’s shares from “hold” to “buy”, and raised its target price from 260 pence to 315 pence. The broker said that its “strong differentiation” and “efficient marketing policy” meant that the supermarket has been more resilient than many had feared.

Also today, UBS said it expects the UK grocery market is past the point of peak disruption from the discounters. This confirms analysts at Cantor Fitzgerald, who earlier this month, suggested that the grocery market is close to the bottom of the cycle.

Although the worst seems to be over, trading conditions for the incumbent supermarkets remain difficult. Operating margins are now wafer-thin, as aggressive price competition have compressed them from 4-5% back in 2012. Food price deflation is reducing sales, causing both top-line and bottom-line shrinkage.

Morrisons’ recent sales data offer a glimmer of hope, as it was the only incumbent supermarket to return to sales growth. Sales in the 12 weeks to 24 May grew by 0.1%, according to data from analysis firm Kantar Worldpanel. Having benefited from the launch of its Match & More loyalty scheme and robust online customer growth, Morrisons needs to sustain this momentum.

Sainsbury’s differentiation and its relative outperformance means it is the best buy of the incumbent supermarkets. Its focus on quality and continued expansion on convenience stores has helped it to better defend market share. Although the dividend has been cut by 23.7%, Sainsbury’s still pays a prospective 4.0% dividend yield, and is covered by 2.0x earnings.

Its valuation on earnings is also relatively attractive. According to Societe Generale, shares in Sainsbury’s trade with at 11.0x 2015-2016 estimated earnings. This compares favourably to Morrisons and Tesco, which trade with at multiples on expected earnings of 17.3x and 27.7x, respectively.

PureCircle

PureCircle (LSE: PURE) produces stevia sweeteners, which are derived from the natural sweetness of the stevia plant. The global stevia sweetener market is seeing rapid growth, as companies seek to lower the sugar content in their products with healthy and natural substitutes.

Although the stevia market is highly competitive, PureCircle leads in product innovations by making its sweetener perform close to sugar in taste. This has helped it to secure a major deals, including one with Coca-Cola to supply stevia sweeteners for its lower-calorie Coca-Cola Life drink.

Ramping up production is expensive, and PureCircle may need additional capital to fund investments. With sky-high potential growth in the industry, its shares have a forward P/E of 98.2. But, analysts expect its forward P/E will fall to 32.1 in the following year, based on forecasts of 2016 adjusted EPS of 11.6 pence.

Investing in small caps is high risk, but potentially very rewarding.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Jack Tang has a position in Sainsbury's. 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.

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