Why I’d Sell Tesco plc And Lloyds Banking Group plc For NEXT plc And ARM Holdings plc

The shares of Tesco (LSE: TSCO) and Lloyds (LSE: LLOY) have rallied in recent weeks.

They look a bit expensive, don’t they?

There are cheaper alternatives right now, such as Next  (LSE: NXT) and ARM  (LSE: ARM), in my view. Here’s why. 

Warning Signs

Tesco stock has surged more than 10% since the multi-year low it recorded in mid-October. The shares of Lloyds have risen by 10% after hovering around their three-month lows on 16 October. Lloyds stock is not far away from its highest level since 2008. Are these warning signs? 

If you are invested in both companies, you may be tempted to switch to Next and ARM, both of which have underperformed Tesco and Lloyds as well as the FTSE 100 (+8.6%) since 16 October. Back then, the index tested its 22-month low. 

Tesco & Lloyds On Their Way Down? 

Choosing the right investment isn’t easy in this market, but there are reasons to believe ARM and Next could be top performers into 2015, while Lloyds and Tesco may be the laggards. 

Tesco and Lloyds are destined to disappoint investors in the next few quarters, in my view. Fierce competition comes at a time Tesco must execute a difficult turnaround, while Lloyds’s massive mortgage portfolio will come under scrutiny next month. December won’t be a stroll for banks’ shareholders, who should fear the Bank of England stress test. 

The fortunes of the largest grocer in the UK and those of Lloyds are tied to consumer preferences. For both, growth is nowhere in sight, so they need to cut costs. How can they offer better retail/online services than their rivals? 

It’s very possible that recent trends will be confirmed. As it invests in lower prices, Tesco will continue to lose customers, at least for a couple of quarters, while Lloyds  — which is cutting thousands of jobs — will find it more difficult to add precious basis points to its operating profitability going forward. 

Next and ARM On Their Way Up?

Next stock has gained only 4.5% since mid-October, a performance in line with that of ARM.

You know what you buy with Next: the shares of a solid company, whose management team has delivered over time. Next’s equity valuation has been hit by a recent profit warning, but seasonal trends are unlikely to have an impact on the long-term performance of the business and its stock value.

Next’s balance sheet is strong, and it can be argued that the retailer’s free cash flow (operating cash flow minus capex) yield of 5% could grow even if the market value of Next appreciates fast. Estimates are for Ebitda growth of 37% to the end of 2014. Next offers rising earnings per share and hefty dividends. 

Talking of high cash generation, strong management, rising earnings and dividends, there you go: ARM is another outstanding candidate for value investors. Its shares are worth about £10 a share, according to my calculations, but trades only around £900p.

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings. The Motley Fool UK owns shares of Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.