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Why I’m avoiding these two Footsie stocks in 2017

It’s fair to say that during 2016 UK supermarket retailers surpassed all expectations. After a rocky 2015, when the arrival of the so-called discounters caught the UK’s big four by surprise, heading into 2016 expectations were low as supermarkets appeared to be struggling to fend off the competition. But 12 months on and the market seems to have regained confidence in the sector. 

Indeed, over the past 12 months shares in Tesco (LSE: TSCO) have surged by more than 30% while shares in Morrisons (LSE: MRW) have risen 56%. However, after these gains shares in these two retailers look stretched because, for much of the past year, the sector’s fundamentals have only deteriorated. 

Hostile environment 

Over the past two years, Tesco and Morrisons have been struggling to convince customers that their offerings are better than those of the German firms Aldi and Lidl. This operation has failed for the most part. The market share of both UK retailers remains significantly below where it was before the price war began in 2013. 

And the discounters have done more damage to Tesco and Morrisons than just stealing market share. In an attempt to match Aldi and Lidl’s rock bottom prices, other retailers have slashed prices to customers and sacrificed lucrative profit margins. As a result, the sector is no longer the profit powerhouse it once was and is unlikely to return to its previous state any time soon. 

Unfortunately, in addition to falling prices and contracting profit margins, supermarkets are now having to grapple with increasing costs. Higher wage bills and pension costs are already weighing on profitability but over the next year, a new menace will hit margins: inflation. 

Costs rising 

Since the UK voted to leave the European Union, the pound has fallen in value by as much as 20% against the US dollar. As most commodities are priced in dollars, this has become an issue for supermarket suppliers. While currency hedging programmes have allowed suppliers to navigate weaker sterling over the past six months, according to City analysts hedges will start to expire over the next few months, which will ultimately lead to suppliers hiking prices.

When Unilever tried to do this last year, the spat between the company and Tesco became a front page story, and ultimately Tesco won. However, a large number of Tesco’s and Morrisons’ smaller suppliers won’t be able to absorb higher costs themselves. So the retailers may have to just accept even tighter margins. 

Paying a premium 

Despite all of the headwinds mentioned above, shares in Tesco and Morrisons trade at premium valuations which leave little room for error. Based on current City forecasts shares in Tesco trade at a forward P/E of 27.4 for the year ending 28 February, a multiple more suited to a high growth tech company than a struggling bricks and mortar retailer. Shares in Morrisons trade at a forward P/E of 22 and yield 2.3%. 

So overall, after taking into account all of the above, even though shares in Tesco and Morrisons outperformed during 2016 it doesn’t look as if this performance will be repeated again during 2017. 

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