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Are Tesco shares the perfect defensive stock?

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In a crisis, consumers will always need food and drink. In fact, grocery sales have increased during lockdown by around 14.3%. With a market share of nearly 30%, Tesco (LSE: TSCO) is the largest of the UK supermarkets and could therefore be an excellent defensive stock. But with potential problems on the horizon, would I buy Tesco shares at the moment?

Recent trading update

On the face of it, Tesco’s Q1 results looked fairly impressive. Totally quarterly revenues increased by 8% to £13.4bn, and this underlined the heightened demand throughout lockdown. But the increase in revenues coincided with sharp increases in costs. In fact, Tesco had to hire an additional 47,000 staff members to deal with the increased demand, while also introducing costly safety measures. Growth was also affected by the underperformance of Tesco bank, where earnings dropped significantly, and it has since cut its interest rate to zero percent. Since the Q1 results were released, Tesco shares have subsequently fallen by around 8%.

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The future of Tesco shares

One significant problem in the supermarket sector is the significant amount of competition. This competition has been especially strong in recent years, with the impressive rise of the discount chains Lidl and Aldi. This has meant that Tesco’s market share has fallen. But things have started to look up for the firm recently. For example, it introduced its ‘Aldi Price Match’ this March, and this has seen customers switch from Aldi to Tesco for the first time since Aldi was launched in the UK. An increase in cheaper products could see greater customer loyalty, and this bodes well for the future growth of Tesco shares, as long as margins aren’t hurt too much.

Tesco also agreed to sell its operations in Thailand and Malaysia for £8bn in March. At the time, its CEO stated that the sale would allow Tesco to “further simplify and focus” its business. This money was able to help reduce debt and be returned to Tesco shareholders in the form of a special dividend. The current dividend also yields over 4%, and it has dividend cover of over 2. As a result, Tesco shares can be considered a very good income share.

Would I buy?

Tesco shares are currently trading at around 215p, which is a 16% year-to-date fall. As a result, they are trading with a price-to-earnings ratio of less than 13. This doesn’t make Tesco shares a bargain, but as a market leader in a defensive sector, I can certainly see upward potential for the share price. Yet while I think Tesco is the best supermarket stock, I’m still not buying. I believe that the supermarket sector is overly competitive, and this will strain profit margins over the next few years. Therefore, I’d prefer a market leader in a sector with less competition, and greater opportunities for growth.

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Stuart Blair has no position in any of the shares 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.

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