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3 reasons why I’d buy Tesco shares and sell Sainsbury’s

The Tesco (LSE: TSCO) share price rose modestly this morning, after the UK’s biggest supermarket reported “strong” Christmas trading despite “a subdued UK market”.

In fact, Tesco’s UK sales were flat over the holiday period, but even so, investors were pleased.

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In contrast, J Sainsbury (LSE: SBRY) reported rising sales over Christmas on Wednesday, but the smaller supermarket’s share price fell.

Tesco shares have risen by over 15% over the last year. Over the same period, Sainsbury’s have fallen more than 15%. Here’s why I think the market is right to be bullish about Tesco and worried about Sainsbury’s.

1. What’s the point of this business?

Sainsbury’s shares currently trade at a 36% discount to their net asset value of 357p per share. This is unusual for a profitable retailer. Tesco stock, for example, trades at a 76% premium to its net asset value of 143p per share.

Sainsbury’s valuation means that its shares trade below the breakup value that might be achieved if its property portfolio and banking business were sold. I can only see one reason for this, which is that the group’s trading business is not currently profitable enough to justify its existence.

Looking back over the last year, Sainsbury’s reported an operating margin of 1.9% and a return on capital employed of 3.3%. I don’t think that’s enough of a return to justify the money tied up in the group’s operations.

In contrast, the equivalent figures for Tesco were 4.0% and 6.4%. Those are much more appealing numbers, in my view.

2. Why are Sainsbury’s margins so low?

In my view, Sainsbury’s has two main problems.

One is that the group has tried to maintain its upmarket reputation while cutting prices to be more competitive. Competing with Tesco is tough, given the larger firm’s economies of scale.

I believe that the second problem is Argos. I was bullish on this acquisition at the time. But I’ve since changed my mind. Argos has to compete against larger retailers such as Amazon and Dixons Carphone on high-value sales. Profits margins are very slim indeed – lower than for groceries, according to my sums. The end result is a business that turns over lots of cash, but appears to make very little money.

In contrast, when Tesco went looking for new growth opportunities a few years ago, it decided to expand into wholesale. The acquisition of Booker provided growth and higher-margin sales. It was a very smart deal, in my view.

3. The growth problem

Talk of growth leads me to the final reason why I’d buy Tesco instead of Sainsbury’s.

In 2014, Sainsbury’s reported an after-tax profit of £716m. Last year, that figure was £186m. The group has not yet figured out a way to return to growth.

Tesco has had problems, too. But in 2014 it reported a net profit of £970m. By last year, that figure had recovered to reach £1,320m.

The outlook for the year ahead mirrors this pattern. City analysts expect Sainsbury’s to deliver earnings growth of about 2% in 2020/21. Forecasts for Tesco suggest that its earnings will rise by about 8% over the same period.

For me, it’s an easy choice. Sainsbury’s 4.6% dividend yield may be tempting, but I think the business has problems that will be tough to solve. I’d feel much more confident buying Tesco for my portfolio.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Roland Head owns shares of Dixons Carphone. The Motley Fool UK owns shares of and has recommended Amazon. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.