Is now a good time to buy Tesco shares?

After a strong rally last year, the Tesco share price has stalled. Roland Head gives his view on investing in the UK’s largest supermarket.

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I think FTSE 100 stalwart Tesco (LSE: TSCO) could be a reliable performer if the UK economy slows down over the coming year. But are Tesco shares cheap enough to buy today?

In this piece I’ll share my thoughts on whether I should buy Tesco stock for my portfolio.

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Every little helps

To explain my attraction to Tesco I need to take a step back for a moment. When former CEO Dave Lewis took charge in 2014, this business was not in a good place.

The supermarket had issued five profit warnings in one year and was facing an embarrassing accounting scandal. Tesco also had too many large stores, and its reputation for value and customer service was under threat.

Lewis launched a turnaround plan that included some big changes. But he also focused on making many smaller changes. Together, these led to big improvements in the supermarket’s customer offering and its profitability.

I think that this approach – which reminds me of the company’s “every little helps” motto – has transformed the business. Tesco is now the largest and most profitable UK supermarket, with a 27% share of the UK grocery market.

Unfortunately, many investors who have owned Tesco shares since before Lewis’s arrival are still sitting on losses. At 280p, the shares remain a long way from historic highs of over 400p.

Will Tesco shares ever return to 400p?

The reality is that the supermarket sector is less profitable than it was a decade ago. This is mainly thanks to the growth of discounters Aldi and Lidl.

Back in 2012, Tesco reported an operating profit margin of 6.5%. Last year that figure was just 4.2% — and that was better than UK rivals.

In 2020, American retail executive Ken Murphy took over as Tesco CEO. In my view, Murphy was chosen to keep Tesco running smoothly, while finding ways to deliver improved shareholder returns.

So far, he’s shown a strong commitment to the dividend. He’s also launched over £1bn of share buybacks, using some of the group’s surplus cash.

At current levels, my sums suggest that £1bn of buybacks could add around 5% to future earnings per share. Buybacks can also support dividend growth, because the payout is divided among fewer shares.

Reliable dividends and buybacks should help to support the share price, but I don’t think they’ll be enough to get Tesco shares back to 400p in the foreseeable future.

What I’m doing now

The latest broker consensus forecasts put Tesco shares on 13 times current year earnings, with a dividend yield of 3.9%. Like all forecasts, this could change based on future developments. 

This level of yield is above the FTSE 100 average of 3.5%, so I can see some attraction here as an income investor.

However, these forecasts suggest Tesco’s dividend could be flat this year, before returning to growth next year. That highlights my main concern about Tesco stock – this business is both very mature and relatively low margin. I think there’s a risk Tesco may underperform the wider market over time.

I’d be quite happy owning Tesco shares at current levels. But if I was buying the shares for a new position, I’d like a slightly higher yield to reduce the risk of slow growth in the future. For now, I’m going to wait for a better buying opportunity.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco. 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.

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.

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