Why Tesco shares could be a bargain hiding in plain sight

The question of a durable competitive advantage is key… Tesco shares pass my simple three-step test!

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Choosing which stocks to invest in doesn’t have to involve complex financial calculations. Answering ‘yes’ to a few simple questions can be enough:

  • Does the company operate in a sector whose products or services are virtually certain to remain in demand for many decades to come?
  • Does the company have a durable competitive advantage over its rivals?
  • Am I prepared to own the stock for the long term?

I see a strong case for answering ‘yes’ to these three questions when I look at Tesco (LSE: TSCO). Let me elaborate.

Essential

The first question is easy to answer in the affirmative. Tesco clearly operates in a sector whose products or services are virtually certain to remain in demand for many decades to come. After all, food is essential to human life.

Two-part question

The answer to the second question isn’t so black and white. It requires an element of judgement.
 
I think Tesco currently has — and has had for many years — a competitive advantage over its rivals. And I think it would be hard to argue against that. Where the element of judgement comes in, is on whether the advantage is durable.

Sector dominator

Size is a well-recognised competitive advantage in many sectors. Economies of scale give larger companies an advantage over smaller ones.

Tesco’s share of the UK grocery market has never been less than 25% over the last two decades. According to data from market-watcher Kantar, its share currently stands at 27.3%. The next two largest chains, Sainsbury’s and Asda, have market shares of 14.9% and 13.7%, respectively.

Tesco is far and away the dominant force in UK grocery retail. Indeed, you’d be hard pressed to find another sector in the UK where one company has such a commanding market share.

Economies of scale

Tesco enjoys a number of economies of scale. It has purchasing economies from buying larger quantities of goods than smaller grocers, giving it lower per-unit costs.

It generates vastly more cash than its rivals, so it can afford to invest more in newer and smarter technologies that bring greater efficiencies. For example, unrivalled data and analytics — on a far larger number of shoppers than its competitors — give it better insight into individual customer behaviour, as well as into emerging trends within the broader grocery market.

It also enjoys financial economies of scale. Lenders generally see larger businesses as more reliable and creditworthy, and offer lower interest on borrowings than they offer smaller businesses.

Durability?

The competitive advantages Tesco enjoys seem reasonably clear. But are they durable?

There’s a line of argument that says discounters Aldi and Lidl are sweeping all before them. And that Tesco’s market share will steadily be eroded.

Undoubtedly, Tesco was complacent and underestimated the immediate, and longer-term challenge posed by the rise of the discounters during the 2008/9 recession.

New equilibrium

It’s taken some time, but Tesco has successfully adjusted its operations and reset its profit margins to mover closer to the discounters.

Meanwhile, in expanding beyond their original regional and demographic heartlands, the discounters have moved closer to Tesco. They’ve had to increase the range of products they offer and enter areas — the emblematic ‘leafy Tunbridge Wells’ — where costs (notably property) are higher.

It may not be quite there yet, but as far as I can tell, the UK grocery market is getting close to a new post-discounter-disruption equilibrium. And Tesco remains the dominant player, with a durable competitive advantage.

Overcoming setbacks

One of the things about a high-quality business, with a competitive advantage and prolific cash generation, is that it can survive setbacks and go on to prosper.

A misjudged expansion into a new sector or geography, a failure to anticipate an evolving dynamic in the market or tardiness in responding to it, can ultimately be overcome.

Which leads me to the third question…

Am I prepared to own the stock for the long term?

When I say long term, I do mean long term. The impact of management missteps or simple market disenchantment with the growth prospects of a business can persist for a surprisingly long time.

For example, investors in Coca-Cola Co endured a ‘lost decade’ of negative returns between 1998 and 2009. Nevertheless, the great Warren Buffett — Mr Long-Term Investor himself — is now sitting on a terrific return on the shares he bought in 1988.

Such precedents among great businesses are why I’m looking at Tesco — which suffered a similar negative-return malaise between 2007 and 2016 — as a bargain stock hiding in plain sight today.

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.

Graham has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco PLC, J Sainsbury PLC and Coca-Cola Co. Views expressed on any 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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