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Should you invest in Tesco shares?

I used to view supermarkets such as Tesco (LSE: TSCO) as boring, defensive dividend-paying shares. But that changed when the sector nose-dived a few years ago.

In today’s full-year report, Tesco’s chief executive, Dave Lewis, explained the company has spent the past five years focusing on “serving customers better, re-engaging our colleagues, completely resetting our relationships with our suppliers.” In short, the firm has conducted a bottom-up, root-and-branch turnaround strategy. But that’s complete now, according to earlier communications from Lewis.

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What I want from Tesco

What we are left with now is really what we always had. That is, a low-margin, high-volume business operating in a cutthroat sector with disruptive competition nipping at its heels. And such a set-up comes with risks for shareholders.

Indeed, the company proved over the past few years that those comparatively small numbers it produces for profit can be fragile. That’s not surprising when you consider that the figures for revenue and costs are always huge. Indeed, it doesn’t take much of a shift in the big numbers to dramatically change the small figures for earnings.

So, before entertaining an investment in the sector, I want adequate immediate compensation for the risk I’m taking on. The closest we can get to that is the shareholder dividend, and I want a yield north of 5% at least.

In the report, the directors declared a final dividend of 6.5p per share making the total dividend for the year 9.15p. At today’s share price close to 213p, the yield works out at just under 4.3%, which falls short of my requirements. For me, Tesco remains over-valued. I reckon that’s because the valuation rose when the company was turning itself around and posting big increases in earnings.  

Trading well through the pandemic

Meanwhile, the coronavirus pandemic has been challenging the firm. There’s been a “material impact” on operations and “significant” additional costs. For example, the payroll has risen because the company has been recruiting additional staff to meet demand and cover the work of those absent on pay because of illness. 

The increase in costs for the trading year to February 2021 is “hard to predict”. But the firm is pencilling in a range of around £650m to £925m. Those figures will include additional payroll, distribution and store expenses.

But it’s not all bleak news. Tesco reckons that if customer behaviour returns to normal by August, food volume increases, 12 months’ business rates relief in the UK and “prudent operations management” will likely offset additional cost headwinds. One thing does seem certain. Tesco is in a good position to trade through the crisis, unlike some sectors that have seen the complete collapse of revenue.

Nevertheless, I’m not interested in investing in the company because of the valuation issue. In this case, I’d rather diversify my capital over many underlying shares by investing in a FTSE 100 index tracker fund.

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Kevin Godbold has no position in any share mentioned. 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.