Oil prices have risen and geopolitical risks continue to rise. Some investors are looking for defensive options. Regardless, people need food so supermarkets can be a popular choice, alongside sectors such as energy distribution and tobacco. Tesco (LSE: TSCO) is the country’s biggest supermarket business – so should I buy Tesco shares in my portfolio?
Defensive stocks are not as easy as they may seem
One question you should ask when buying a defensive share is how defensive it really is.
But there is a second question that I believe a good investor asks himself when buying anywhere sharing – and that includes defensive ones. That question is the price of the shares being offered.
That may be especially relevant for defensive stocks because, when markets become defensive and investors start selling them, they can lose a lot of value even if the underlying business performance is strong.
People continue to eat, in good times and bad
Let’s tackle the first question to start with: how defensive are Tesco shares?
My opinion – based on what we have seen in recent years – is that Tesco has some defensive qualities, but not as many as it might first appear.
The protective feature comes from to seek side of the equation. People need to eat and do other household chores, so demand in the grocery sector is resilient, broadly speaking.
That demand may shift between players, so for example, a recession could see shoppers leave discount stores. Marks and Spencer or Waitrose favors the cheap ones. But with Tesco being competitive on price, I see demand for their supply being strong.
Tesco may not be as protective as it first appears
But demand is only one side of the equation. It translates into revenue, the so-called ‘top line’ of the company’s accounts.
Between the top line and the ‘bottom line’ (profit), the company needs to account for costs. Here, I think Tesco looks less secure compared to, for example, industries with controlled costs.
Rising oil costs could mean Tesco’s distribution becomes more expensive.
It can also fuel inflation. A retailer can only pass some of that on to consumers in the form of higher prices without losing sales volumes. Asda’s weak pre-Christmas performance reflects that.
This is not just a theory. We saw it happen during the crisis, when Tesco’s operating margin was squeezed.
Because of its economy as a market leader, it may be affected by smaller competitors. But, especially given the profit potential in the retail industry, there is limited room for maneuver when inflation bites.
Is the price right?
Tesco shares are up 12% so far this year, compared with 5% for FTSE 100 An index of the best overall companies.
Along with recent strong business performance, I think that may reflect investors’ hunt for defensive options in volatile times.
But that means the share is now trading at 22 times earnings.
Yes, Tesco has a large customer base, world-class operations, a strong brand, and a proven model. Compared to global peers like the US behemoth Walmarttrading at 47 times earnings, Tesco shares may look cheap.
But Walmart’s valuation seems too high to me. Even Tesco’s is way higher than I want to pay for a grocer. I will not invest.
