Why I’m holding my supermarket shares, despite a 48%+ gain

Supermarkets have been among the big stock market winners in 2016. At least some of them have. My shares of Wm Morrison Supermarkets (LSE: MRW) are worth a whopping 46% more than they were at the start of the year.

With Morrisons’ stock now trading on about 20 times forecast earnings, it’s tempting to believe that a full recovery is now priced-in. However, I’m not sure this is true. In this article, I’ll explain why I’m holding onto my Morrison shares. I’ll also reveal why I’m starting to think about buying shares in another supermarket.

Untapped potential?

Morrisons was quick to abandon its attempt at operating a chain of branded convenience stores. But an announcement this week shows that the group is still hoping to profit from this important market.

The company announced details of two new initiatives on Tuesday. The first is a trial of 10 convenience stores in petrol station shops, managed by leading forecourt operator Rontec. Morrisons is already running a convenience store trial with another forecourt operator, Motor Fuel Group. This new move suggests to me that it sees potential in this area but wants to gather more data before making a larger commitment.

The second new venture is a move into the wholesale market. Morrisons will resurrect the Safeway brand and offer a range of “hundreds of convenience products” to independent retailers.

Both of these efforts show that Morrisons is thinking flexibly and trying to find ways to penetrate the competitive convenience market without making large investments. Like the group’s deal to supply products for Amazon’s food delivery service, these new ventures are also designed to make the most of its capacity as a food producer.

I believe its food business could give it a long-term advantage over its peers as it has the potential to generate growth and improve profit margins.

In the meantime, cost savings, and tighter control on working capital, mean that Morrisons trades on just six times trailing free cash flow. That’s very cheap indeed. I’m happy to hold on to see how the firm’s growth initiatives pan out.

A contrarian opportunity?

It’s not been such a good year for J Sainsbury (LSE: SBRY). Investors aren’t excited by the group’s decision to acquire Argos-owner Home Retail Group. Sainsbury shares have fallen by 10% over the last six months.

However, I’m beginning to think this sell-off has been too hasty. Unlike Morrisons, Sainsbury trades on a modest forecast P/E of 11.5. The group’s forecast dividend yield of 4.4% should be covered twice by earnings this year.

Debt levels are also relatively low, despite the Home Retail acquisition. Sainsbury’s net gearing is just 16%, compared to 33% for Morrisons.

Making a success of the Argos deal may not be as difficult as it seems. The group’s plan to cut property and logistics costs by moving Argos stores into supermarkets requires competent execution, but doesn’t seem particularly high risk. As long as Argos sales remain fairly stable, profits from this division should improve.

A further attraction is that Sainsbury has a £7.2bn property portfolio, and currently trades below its net asset value of 297p per share. I still want to do some more research, but I’m beginning to think this out-of-favour supermarket could be a contrarian buy.

Do the Fool's experts agree with me?

I'm happy with my exposure to the UK supermarket sector. But the Motley Fool's analysts aren't convinced. When they selected five stocks for their ultimate income portfolio, they didn't include any supermarkets.

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Roland Head owns shares of Wm Morrison Supermarkets. 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.