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Why J Sainsbury plc Beats WM Morrison Supermarkets PLC

It was a good idea to buy shares in supermarket operators WM Morrison Supermarkets (LSE: MRW) and J Sainsbury (LSE: SBRY) at the end of last year near their share-price lows. Morrison is up about 31% and Sainsbury around 21% since then.

Of course, that’s easy for me to say now, after we can see what happened to the shares. It wasn’t such an easy call when the news flow was glum and the shares were making new lows — for a start, we didn’t know if a ‘low’ was a ‘low’ or whether the shares had further to fall.

Waiting for the change

Fundamentals and valuations aside, one way of calling an entry point into a recovery play is to wait for a change in share-price trend from ‘down’ to ‘up’. That might sound superficial when we immerse ourselves in valuation models, forward trading forecasts, and the like but, really, it’s just a sensible precaution.

Calling a change in trend without actually seeing it first is like tossing a coin — you’re at the mercy of the randomness of the outcome. We might form a firm opinion about the prospects of a firm, but opinions are often wrong, as Jesse Livermore, the famous investor/trader, used to caution. Waiting for the change might lose us a few ticks on the share-price chart, but it could save us from catastrophic capital loss if we happen to be wrong.

Where are we now?

If we look only at P/E ratings both firms look expensive. Morrisons has a forward ratio of 17 for 2016 and Sainsbury’s is at 13. Yet as investors, we’ll be looking ahead.

Earnings for both companies are down from the recent peaks they achieved and, if we are betting on recovery, we’ll be hoping for a return to the profits both firms achieved not so long ago. If we assume that Sainsbury is capable of achieving earnings equal to the peak it achieved during 2014, and that Morrisons can match its 2012 performance on profits, the notional P/E ratings around the current share prices become just over eight for Sainsbury’s and Just under eight for Morrisons.

In theory, the market is pricing both supermarket chains equally, with Sainsbury’s share price at 274p and Morrison’s at 199p. However, there’s a big problem with that theory in that it assumes that the supermarkets will eventually regain their profit mojos. I think that is far from certain. With discounters like Aldi, Lidl, Poundland and others nibbling constantly at market share, it seems more likely that value wars and bottom-end pricing will be the new normal for the mainstream supermarkets in Britain. Whichever way we look at it, giving more for less and cutting margins to the bone is rarely a formula for bumper earnings.

The decider

We could argue that Morrison is cheaper than Sainsbury thanks to its 29% discount to net asset value compared to Sainsbury’s 12 % discount. There’s good reason for that, though — Morrison’s profits collapsed further than Sainsbury’s.

Therein lays the clue to the clincher in this contest for me. If I had to back either company from here, I’d go with Sainsbury because of its stellar past record on execution. Compare that to Morrison’s patchy performance and carousel-like array of past management and it really is no contest at all.

I'm cautious on all supermarkets because structural change seems to be the biggest trend of all in the sector. Had I bought the lows of Morrison and Sainsbury last year I'd likely be selling now. You may see things differently, but here's another idea.

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