Want to beat the FTSE 100? Why I’d buy Ferguson and sell Sainsbury

Roland Head gives his views on FTSE 100 (INDEXFTSE:UKX) firms Ferguson plc (LON:FERG) and J Sainsbury plc (LON:SBRY).

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Where are the best buying opportunities in the FTSE 100? Today I want to look at two contrasting big-cap stocks, one offering value and one with strong growth credentials.

At the growth end of the scale is plumbing and building supplies group Ferguson (LSE: FERG). Formerly known as Wolseley, this business has shifted its focus from the UK to the USA, where it now makes more than 90% of its profits.

Strong growth continues

Ferguson’s sales rose by 9% to $20,752m last year, according to figures published today. The group’s trading profit climbed almost 15% to $1,507m, excluding the impact of exchange rates.

The group’s underlying operating margin rose by 6.5% to 6.9%, suggesting good pricing power and cost control.

The booming US economy has helped to support the firm’s growth. But acquisitions are also playing a role. Management completed 13 acquisitions for $415m last year, and has already agreed another five deals totalling $240m this year.

I’d normally be nervous about so many acquisitions. But these small deals should be manageable and are helping the firm to consolidate the fragmented US building supplies market. As long as Ferguson doesn’t pay too much for these businesses, I believe this strategy makes good sense.

Keep buying?

Growth so far in 2018/19 is said to be broadly in line with last year, although management said September was slower than August. The shares are down by 5% at the time of writing, perhaps because of this cautious outlook.

As a shareholder, I’m not too concerned. The stock has had a good run and analysts expect earnings to rise by 19% in 2018/19. This puts the stock on a forecast P/E of 16 with a prospective yield of 2.3%.

If the US economy remains strong, I think Ferguson could provide a profitable hedge against a bad Brexit. I’m happy to continue holding and might consider topping up after today’s news.

Supermarket sweep

After surging higher in May on news of a planned merger with Asda, J Sainsbury (LSE: SBRY) remains one of this year’s more successful big-cap picks, up by 31% against a flat FTSE 100.

However, my enthusiasm for the stock is fading. Firstly, I think the shares are starting to look fully priced. Excluding the potential Asda merger, earnings are only expected to rise by 3% next year. Given this, the forecast price/earnings ratio of 15 and 3.4% yield are starting to look expensive to me.

Another reason to be cautious is that while the Argos acquisition has helped sales growth, it also seems to have reduced the group’s profit margins. Sainsbury’s operating margin has now fallen from 3% in 2016 to just 1.8% last year.

It’s this last problem which has prompted the firm to seek a tie-up with Asda. If the group can’t increase grocery prices, it wants to cut costs by achieving economies of scale.

This deal could work, in my view. But it’s big and complex and hasn’t yet been approved. The Competition and Markets Authority has identified 463 sites where the two chains overlap. To eliminate any overlap, as many as half of these might have to be exited, out of a combined total of around 1,200 supermarkets.

In my view, Sainsbury is priced for success and looks riskier than its two UK-listed rivals. I’d shop elsewhere for my supermarket stocks.

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 considered so you should consider taking independent financial advice.

Roland Head owns shares of Ferguson. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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