2016 is shaping up as a good year for investors in Tesco (LSE: TSCO), which is up 38% since January, Wolseley (LSE: WOS), up 27%, and 3i Group (LSE: III), which has surged by 42% since the beginning of the year.
Is it too late to buy these 2016 winners, or is there more to come during 2017?
Solid progress
Tesco’s share price momentum seems driven by operational progress. Chief executive Dave Lewis’s turnaround plan is working, as October’s interim results demonstrate. At constant exchange rates, sales for the half-year were up 1.3% compared to a year ago, operating profit ballooned by 34% and net debt was down a massive 49%.
Much of the profit improvement comes from squeezing out costs and Tesco plans even more of that. However, I reckon the biggest long-term battle concerns the fight for top-line growth.
Profit improvements can’t continue forever unless revenues keep growing — there’s only so far a firm’s management can go with cost reduction. Tesco hopes to win customers back but competition is stiff and the likes of Aldi and Lidl are increasing their share of Britain’s grocery market by double-digit increments.
Meanwhile, at today’s share price of around 206p, Tesco trades on a forward price-to-earnings (P/E) ratio of 21 for the year to February 2018. That’s too rich, in my opinion, and seems to anticipate ongoing double-digit advances in profits for years to come. I’d argue that the low-hanging fruit has already been gathered when it comes to profits. Going forward, operational progress looks like it will become harder to deliver, so I’m cool on Tesco’s shares for 2017.
Cyclical to the core
In early December, plumbing, heating and construction products distributor Wolseley reported like-for-like sales up 1.8% for the firm’s first quarter of the year and profit up 1.4% compared to a year ago.
However, although trading in the US was good, the firm warned of a weak UK heating market and deteriorating Nordic construction markets. That’s important because Wolseley is one of the most cyclical shares listed on the London stock market. If the macroeconomic outlook turns down, Wolseley’s shares will plummet. Make no mistake about that.
Yet enthusiasm for the shares runs untethered and, at today’s 4,936p, Wolseley trades on a forward P/E ratio of 17 for the year to July 2017. To me, that’s more expensive as they ‘should’ be at this point mid-macroeconomic cycle, so I’m avoiding Wolseley for 2017.
Trading well and priced to buy
Of these three firms, I reckon 3i Group has the best chance of delivering for shareholders during 2017. The company invests in smaller firms and develops them, which leads to a rising net asset value.
At 688p, the shares trade around 25% above the 551p net asset value declared in November, and the forward dividend yield runs at 3.4%. The directors seem confident about the firm’s ongoing prospects and unfazed by current political turmoil and the macroeconomic outlook.
As a stock, I don’t think 3i is troubled by overvaluation, which should help drive returns for investors in the years ahead.
