Category: Weekly share tip.

The market has been on an outstanding streak as of late. Shrugging of Brexit and an interest rate rise in the USA to get close to its all time 7000+ high last Thursday. But, I feel that the market is about to enter an exciting period of decline.

Finally, it seems that common sense is prevailing and the market is waking up to realise that it’s grossly over valued.

JUST TAKE A LOOK AT THE FTSE’S 5 YEAR P/E!

As we can see from the above graph, the FTSE’s price to earnings ratio has spiked massively from bumping around under 15 to over 35.

Simply put, the FTSE has been driven by demand as opposed to underlying earnings growth from its constituents.

A quick glance at some FTSE constituents valuations will further illustrate the eye watering prices being paid by investors for stocks in pursuit of yield and in hope of earnings growth.

Brexit will smash high p/e stocks.

Investors have shaken of Brexit nerves but this is only relative to pre-brexit market levels that were already overvalued. (As shown on the FTSE 100 5 year illustration above)

When investors buy high p/e stocks they are buying future growth prospects. These prospects and material. Simply best guesses. When these don’t deliver, these stocks will tank.

Why?

Consumer confidence has dipped since the Brexit vote but action by the BoE has helped steady nerves.

With a clear decline since Brexit, BoE action has led a recovery in consumer confidence since then, but confidence remains in negative territory.

Further to this, Brexit hasn’t even happened yet and the full effects of the vote are yet to be realised.

I believe that investors are relying on a false self sense of security simply hoping that the UK will get a good deal and that BoE action will avoid a recession. BUT, once article 55 is triggered and the negotiations properly begin consumer confidence will once again decline.

When consumers lack confidence they don’t tend to spend money on non-essentials. Instead, they consolidate.

With less money being spent by consumers, inflated p/e ratios suddenly become harder to justify as uncertainty weighs on forecasted earnings.

Just look at what happened to ABF’s share price on the news that Brexit related events would weigh on profits;

So what do these two things have to do with each other?

The first section of this article outlined that the FTSE 100 was grossly overvalued on a historical basis even before Brexit.

The second section of the article outlined declining consumer confidence that will lead to lower consumer spending. With lower spending and more economic uncertainty due to Brexit, high p/e stocks will find it hard to meet their forward valuations.

Applying this logic one could conclude that the FTSE100 will find it hard to justify its high valuation and correct to a more historical average of a p/e ratio of around 15.

Kicking the FTSE while it’s down?

Another worry for the FTSE lies across the atlantic, in the USA.

I have argued for quite some time that the FTSE’s valuation is also being propped by income seekers buying high yielding stocks. This is why I sold BP.

Although future rate rises keep getting kicked down the road by the federal reserve, great unemployment data from the USA may lead to a rate rise sooner rather than later.

If US rates were to rise, investors may begin to switch their money from these risky high yielding stocks to safer bank accounts to fulfill their appetite for capital appreciation.

Conclusion

The lesson remains, never try to time the market. Even with p/e ratios this high, I have still been buying.

But, I think the declines of Friday and Monday are exciting signs of a correction that will hopefully lead to an over reaction on the downside for many excellent, but pricey, dividend stocks!

I’ve got my eye on picking up some stocks;

USA stocks: JNJ + MCD
UK stocks: RB, ULVR, WHTB

Don’t panic! This is an exciting time for dividend investors. TIME TO GO SHOPPING!

Tesco’s (TSCO) share price has been languishing since the company was embroiled in accounting scandal and made a £6.3bn loss. With a turnaround in progress and the company returning to profit, investors may think that this is an ideal opportunity to buy. It’s not.

The supermarket sector.

Tesco finds itself between a rock and a hard place. Whilst competitors with defined markets steam ahead Tesco is having a bit of an identity crisis.

Whilst Aldi and Lidl dominate on pricing and Waitrose and M&S (MKS) dominate on quality, Tesco is left wondering what it stands for.

You may think that Tesco has inserted itself right in the middle, focusing on price and quality but I’m afraid it’s a case of trying to please everyone, and in turn pleasing no-one.

Sainsbury’s have managed to insert themselves into Tesco’s traditional niche of ‘quality at a reasonable price’, leaving Tesco with no apparent core market.

The future – Where is Tesco positioning itself?

Moving forward, Tesco’s strategy is to focus on price and a superior customer shopping experience. The current plan appears to have had limited success.

UK like for like sales are positive again (albeit by a mere 0.3% last quarter), but this comes of negative growth in the previous 3/4 quarters.

*Tesco Q1 results – investor relations sector on their website.

The company is also “redirecting coupon spend” into ensuring lower shelf prices in a bid to compete with Aldi and Lidl. From what it looks like to me Tesco’s strategy  simply boils down to competing directly with Aldi and Lidl for price-focused consumers. Bad move!

By fighting Aldi and Lidl at their own game, Tesco is spending time and resource to offer what’s already on offer. 

Aldi and Lidl continue to grow their market share and Tesco can do nothing but wait until their customer base bottoms out.

Here’s the current state of affairs, drag the slider in order to compare dates.

Another major concern for Tesco is that Asda which is owned by US giant Walmart (WMT) is also weighing in on the price war. This will surely further pressure Tesco’s market positioning. The sheer scale of Walmart and its dominance of the U.S market would surely mean it would outlast Tesco in any war.

Consumer spending

As if things weren’t bad enough, consumer spending on groceries and non-alcoholic beverages in the UK remains under pressure. Despite glimpses of hope for the sector with increased spending on food in March this year (0.2% increase) – It appears that as the UK’s voted to leave the European Union has de-railed progress and caused families to tightening their belts. The most current Consumer price figures showed that spending on groceries is down 2.6% since the Brexit vote.

Source: http://www.tradingeconomics.com/united-kingdom/inflation-cpi

Financial position

Believe it or not, Tesco grew monstrously to become much more than a supermarket. It owned Garden centres, Coffee shops and even restaurants. Whilst this may be thought of as an advantage, these projects grew to become a burden on the company by distracting it from its main supermarket offering.

Thankfully, new CEO Dave Lewis offloaded these companies, using the proceeds to pay off debt (£6Bn from the sale of Korean assets) leaving Tesco’s balance sheet looking healthier.

He also eliminated the dividend, freeing up much-needed cash flow for the battle against Aldi and Lidl. But, the company’s debt remains stubbornly high with a £2.6bn pension deficit leading to a total debt of £15bn.

Increased competition in the supermarket has slashed Tesco’s margins from 6% in 2012 to only 2% today. As competition continues, so will the pressure on Tesco’s margins leading to lower profits for longer. It’s really hard for me to see any easing in Tesco’s financial position in the near term.

Value.

Just by looking at the share graph, many people assume, wrongly, that Tesco’s share price is appealing. Tesco’s share price has dropped from near 500p in 2007, to half that today, but that doesn’t make the share’s at all appealing.

Whilst there are some positive signs for Tesco such as;

• A return to a positive FCF
• An impressive £6.5bn cash pile

I’m afraid that Tesco’s share price offers little value to investors.

Reported EPS for 2016 come in at 3p giving us a p/e ratio of 53. This is much higher than FTSE 100 peer Sainsbury’s (SBRY) that trades at a p/e of 11.

Even if we take the highest analyst earnings estimates for Tesco in 2017 (earnings of 8.25p a share) the shares are still trading hands at a p/e of 18.7.

Summary – lower for longer

It appears that the market has already priced in any 2017, 2018 gains for Tesco. This is despite continued competition which makes achieving analyst estimates challenging.

Tesco has never traded for such a high earnings multiple (over 50) . It would therefore be reasonable to expect that they won’t in the future.

It seems that investors are pricing Tesco as if it was still the dominant force it was in 2012. We must remember that Tesco today is far smaller. It sold £6.5bn of Korean assets, Dunnhumby (owner of its clubcard division), coffee shops Harries and Poole and Giraffe restaurants. It also has a smaller share of the grocery market and lower margins on products (2% in 2016 vs 6% in 2012).

A return to fortune is already priced into the shares at current levels. Even at 159p a share Tesco’s share price remains too high.

Usually, I don’t dip into the FTSE250 looking for purchase opportunities but with the usual dividend growth stocks trading at high valuations (See MCD and JNJ for just two examples) I felt the need to search elsewhere for some value.

Last week, I analysed Britvic PLC, and my dividend discount model showed that the company was potentially 10% undervalued, well today it’s time to take a look at another FTSE250 stock – Greggs Plc.

One thing that really stuck with me from reading Jason Feiber blog in my early investing days was the need to understand what a business does. Well, with Greggs it really doesn’t come much easier to understand. Greggs sells pastries, and Brits love pasties. In recent years Greggs has also diversified its business from a traditional bakery to a food-on-the-go retailer that offers anything from a pasty to pasta, there is even talk about the company branching out into stocking Sushi! Greggs has also moved swiftly with consumer trends by introducing ‘Balanced choice’ products which contain around 400 calories.

Greggs is present on most UK high-streets and has also been successfully expanding into motorway service stations. Overall Greggs now has around 1,700 stores with plans to expand to 2,000.

With it’s share price down 13% year to date, and nearly 20% since January, is now the time to buy?

Value

At nearly 19 times earnings the stock appears expensive, and taking look at its historical p/e ratio we can immediately see that the stock has traded at far lower multiples in the past. It traded for 12.5 p/e in 2010 and 11.4 p/e in 2011. but by 2014 the stock has skyrocketed to multiples of 19.9 and in 2015 the stock was trading hands for a ridiculous 23.5 times earnings, namely due to lower EPS.

I absolutely hate paying above fair valuation for any stock, so why on earth is Greggs in my portfolio?

Why buy at a relatively high multiple?

In 2013 Greggs appointed a new CEO who embarked on an ambitious shift in strategy in order to aggressively target a growing food-on-the-go market. The company quickly shifted the format of their stores by focusing on a new bakery food-on-the-go format that has proven to be very popular with consumers.  The company also quickly re-launched its improved blend coffee range in 2014. That coffee ended up being its fastest growing product.

Greggs is now uniquely placed in the food-on-the-go market with its ability to offer hot or cold products and fresh coffee for a competitive price. This really sets the company apart from competitors such as supermarket chains due to the freshness of the offering and from high-end competitors such as coffee shops by its pricing. The shift in strategy has evidently paid off with EPS growth of 42% between 2013-2014 and further EPS growth of 29% from 2014-2015. Whilst we don’t have a mystic ball to predict future growth we can be confident in the company’s plan moving forward in an industry that’s growing 9% annually.

Minimum wage advantage

In addition to this, Greggs has a step up on its competition in relation to costs. With chains such as Costa announcing that they will have to raise prices in order to pay staff the new £7.20 minimum wage, Greggs already paid staff £7.11 an hour meaning that they can maintain prices.

Dividend

Greggs currently has a dividend yield of 2.72% which isn’t bad, but nothing to get excited about. But what really does excite me is the company’s commitment to grow the dividend. The company managed to grow its dividend by 30% from 2014 to 2015 with a juicy special dividend of 20p per share.

There’s no doubt that Greggs struggled before its turnaround but it was still committed to annual dividend increases and even increased its dividend during the financial crisis of 2008. It has now increased is dividend every year since 1999, bar a freeze between 2013-2014 where it maintained its payout in order to fund the turnaround.

 With a payout ratio of 52% there is also still room for maneuver to increase the ratio should sales somehow disappoint.

What about fair value?

It’s really hard to find a fair value for Greggs simply because we don’t know if the turnaround will continue to deliver such outstanding EPS growth. It’s currently 2 years into its 5-year turnaround plan and I don’t know a psychic in order to help me predict the future. But, what I do know is that the first two years have been successful and management seem worth their wages from what I’ve seen so far.

I’m not going to put a figure on this stock but am happy in owning its dividend factory at an ok yield with a steady dividend growth history.

Summary

Dividend growth investors look at companies that have a history of annually increasing their dividend and Greggs has certainly proven its ability to do so. With a successful turnaround in full flow and an enviable position in a growing market I can see no reason why Greggs can’t continue to pay me dividends. This stock won’t be a core holding in my portfolio and I’ll be closely monitoring its turnaround progress. Should its success continue and EPS continue to grow I’m looking forward to some nice dividend paydays!