The Warren Buffett Bull Case For Tesco PLC

Many investors who focus on a low price-to-earnings (P/E) ratio and high dividend yield in their search for value will have a hard time swallowing the maxim legendary investor Warren Buffett lives by: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

Today, I’m considering whether FTSE 100 supermarket Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) is a wonderful company, and whether its shares are trading at a fair price.

A wonderful company?

Buffett’s Berkshire Hathaway investment company has held Tesco shares since 2006. Buffett has upped his stake over the last few years. On 22 June 2010, Berkshire’s holding went above 3% — just two weeks after long-time chief executive Sir Terry Leahy announced plans to step down.

Buffett’s vote of confidence in new chief executive Philip Clarke should not surprise us. Buffett favours committed managers who are passionate about their companies. Clarke started out with a part-time job in a Tesco store during 1974, while still at school, and worked his way up.

Buffett bought more Tesco shares during 2011. A couple of months later, he told CNBC: “If the price came down some on Tesco, I’d buy some more of that”. He was true to his word. When Tesco issued its infamous profit warning in early 2012, Buffett increased Berkshire’s stake to 5%.

So, why does Buffett think Tesco is such a wonderful company? One thing that may surprise you is that in the CNBC interview, Buffett said about assessing companies: “I don’t worry about whether they have emerging market exposure … I’ve used the same criteria for 60 years”.

I think a clue to the real appeal of Tesco for Buffett came at Berkshire’s 2011 shareholders’ conference. While discussing the company’s ailing US Fresh & Easy business, Buffett’s partner, Charlie Munger, said: “Tesco is God Almighty in England”.

Like Wal-Mart in the US — another of Buffett’s favourite companies — Tesco is far and away the dominant player in its home market, giving tremendous economies of scale and bargaining power with suppliers. In a low-margin sector, this gives Tesco a big advantage, and has enabled the company to deliver a strong long-term return on equity of over 15%.

A fair price?

When Buffett added to his Tesco holding during 2011, the shares were trading at about 370p. At the time of the CNBC interview, when he was talking about buying more — “if the price came down some” — the shares had been trading above 400p. After the profit warning of 2012, Buffett piled in at 320p.

Clearly, Buffett feels that despite the recent problems, Tesco remains a wonderful company and can return to its former glory. We know he’s been prepared to pay between 320p and 370p for the shares, so at the current 358p I’d say Tesco is within Buffett’s ‘fair price’ range.

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> G A Chester does not own any shares mentioned in this article. The Motley Fool owns shares in Tesco.