Why I’m Putting Tesco PLC On My Watch List

tesco2There are no points for original ideas in investing. It only matters if your ideas are any good or not. The proof of that shows in your returns.

It isn’t any secret — backed by many academic studies — that dividend stocks outperform the market over the long term. When stock prices fail to reward — as they have done this year, with the FTSE 100 declining 2% — dividends give investors a regular income stream and, most importantly, a reason to stay invested.

Day to day the market has a 50% chance of moving up or down, but a smart investor — with a time horizon of 20 years or more — will at worst see low single-digit upside on a diversified share portfolio.

All the more reason to hug your income shares.   

We’re in a fierce bear market for the UK’s supermarkets. Tesco  (LSE: TSCO) (NASDAQOTH: TSCDY.US), having long reigned supreme, has lost nearly half of its value in 2014, with shares of the iconic retailer sinking to an 11-year low.

There’s nothing to suggest the shares won’t get cheaper, with a skittish market stampeding for the exits after each new trading statement, and pressure piling on from unforeseen angles, like the accounting inaccuracies that have resulted in an investigation by the Financial Conduct Authority (FCA).

If a leading FTSE 100 member drops 50%, I feel you have to at least take a look. The question is whether the new chief executive, Dave Lewis — who has so far been impressive, promptly suspending four senior directors over the £250m profit anomaly — can deliver a successful turnaround strategy.

Tesco’s roots go back nearly a century to a market stall in East London. Until now, there has never had an outsider in charge. Mr Lewis has only made fairly general statements so far — things like placing an emphasis on ‘putting the customer first’ — and I’m eager to hear more detail on his vision.

The board decided to slash the dividend by 75% to 1.16p which, in and of itself, needn’t be seen as a negative. Tesco must deliver sustained growth, and if it needs more financial flexibility to make sensible strategic investments, then it’s a move I favour. What isn’t sensible is a wholesale investment in price.

I could start selling eggs, bread and milk for 10p on the street and do pretty well in terms of sales. Could I do it forever — without bumping up the price — and make a profit? Of course not. Tesco needs to tempt customers back into its stores from Aldi and Lidl, but not by lowering prices kamikaze-style. Finding a strategic price level that strikes a balance between sales and profitability makes more sense. I’d rather see investments in infrastructure and IT so Tesco can grow its e-commerce channel.

Tesco is interesting as a turnaround or deep value situation, but it's not an ideal fit for income investors right now. Meanwhile, an attractive small cap opportunity has caught my eye. The Motley Fool's lead smaller companies analyst has discovered a £250m hidden gem which could double profits within the next four years.

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