Will Warren Buffett Buy Back Into Tesco PLC?

So, it’s come to war.

I’m not referring – thankfully – to Russia’s moves on the Crimean region of Ukraine. Rather, I’m thinking of the supermarket price scrap that Wm. Morrison Supermarkets (LSE: MRW) kicked off last week.

Alongside revealing dire results and admitting that it might need such new-fangled whatchamacallits as loyalty cards, websites and convenience stores after all, the embattled Morrisons also said it would spend a £1 billion in cutting prices over the next three years in an attempt to recover its customers.

Investors in all the supermarkets have taken fright. Morrisons shares are 10% lower than the day before its latest update – but its operational performance was even worse than investors feared it would be, and warranted a big markdown.

Shares in Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) are 4% lower, too, though, and J Sainsbury (LSE: SBRY) (NASDAQOTH: JSAIY.US) is off 6%.

While the latter has since come to the market with its own miserable news about falling like-for-like sales, the bulk of both declines happened in the immediate aftermath of the Morrisons’ revelations. I think they can at least partly be chalked up to fears that a price war will hurt everyone.

But will it?

Pricing power

There’s little doubt that Morrisons’ prime targets are Aldi and Lidl, the discount chains that have made such inroads in the grocer’s heartlands in the North.

But how far its other rivals will accept that line of thinking remains to be seen.

Cheaper prices are cheaper prices, and they resonate with customers. Sainsbury’s, for example, has a price-matching guarantee on baskets of branded goods, but that counts for naught if the consumers have already gone through Morrisons’ doors instead in search of a cheaper loaf of bread.

Retailers do have different levers to pull besides price – they can try to improve the experience of shopping, improve customer service and introduce new reasons to visit, like Tesco is doing by putting its Giraffe restaurants into its larger destinations.

But, ultimately, a basket of goods is pretty much a basket of goods, and the lowest price will be the most attractive to many people — which is why hard-pressed consumers are defecting to Aldi and Lidl, and forcing Morrisons’ hand in the first place.

Buffeted about

So what does all this have to do with Buffett, and Tesco?

Well, for starters Buffett already owns Tesco shares. While he has reduced his stake by a quarter in the past year, the so-called Sage of Omaha (as opposed to the sage you’ll find on special offer in aisle three) continues to own a 3.7% stake in Tesco.

While he’s made no comment, it seems likely Buffett has sold down his stake because Tesco has turned out to be less wonderful than he initially calculated. It’s struggled to get traction overseas – indeed, it’s abandoned its expensive US venture altogether – and it’s been losing sales and market share at home for the first time that anyone can remember.

Many would argue all this bad news is in the price. Tesco is trading on a P/E of 10 and boasts a dividend yield of very nearly 5% — both far more attractive metrics than the market as a whole. Doesn’t Buffett like to buy cheap?

Also, the sector as a whole is pretty loathed right now.

Doesn’t Buffett like to be greedy when others are fearful?

Retail is ruthless

Both true, but there’s an interesting third reason why I think Buffett would probably still pick Tesco as his chosen wrestler in the brutal UK supermarket arena.

And that’s to do with the business, not with its share price.

In his biography The Snowball by Alice Schroeder, you read how Buffett discovered just how tough retailing was the hard way. For example, he invested in a department store that competed head to head with other department stores in a war of mutual destruction. It wasn’t his finest – or most profitable — hour.

Buffett knows that in a largely commoditised sector – nearly everyone lives near at least a couple of the major supermarkets, after all — it’s usually best to go with the lowest-cost company, especially if there’s a price war going on.

And in the UK grocery business, that’s Tesco.

You can tell this by looking at the operating margins. As of the latest figures available, Tesco’s were a sector-leading 6%, whereas Morrisons’ were 4.9% and Sainsbury’s a woeful 3.5%.

Every little helps

What this means is that in simple terms, Tesco has deeper pockets to fund a price war than its rivals. Indeed, some analysts were already urging it to cut prices to respond to its own woes, even before Morrisons made its move.

I think therefore that if Buffett was buying into a UK supermarket today, he’d still plump for Tesco.

It’s important to note that Tesco’s margins are already slated to drop when it reports in April, but it should still have the juiciest margins to cut if it has to.

So, would this be enough to see Buffett reverse his recent Tesco share sales and load up on them again, now the share price has fallen to around £3?

I don’t claim to know his mind, but I doubt it.

You see, like all wars, a price war can be long and bloody, and even the victor is not necessarily a winner. If prices come down across the board it might be good for consumers, but it could take a long time for Tesco to get those prices back up again, even if it did triumph over its rivals.

Good for consumers, but bad for shareholders. I suspect Buffett would rather sit on the shares he has and watch from the sidelines!

It all goes to show that even the world’s best investors can’t always pick companies that will serenely advance from year-to-year, untroubled by competition or mishap.

The best you can do is try to find the companies with the strongest ability to respond to threats as they emerge, and then to get them at the right price.

That’s what our analysts have done for their exclusive report, 5 shares to retire on.

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Owain owns shares in Tesco and J Sainsbury. The Motley Fool owns shares in Tesco and has recommended shares in Morrisons.