Can Rolls-Royce and Tesco shares stay ahead of the FTSE 100?

Robert Stephens, CFA, discusses the prospects for Tesco and Rolls-Royce following their strong share price performances.

While the FTSE 100 index has delivered a 3.5% gain in the past six months, Rolls-Royce (LON: RR) and Tesco (LON:TSCO) shares are up 33% and 16%, respectively.

Investors appear to have responded positively to their encouraging updates, improving operating conditions and upbeat assessments regarding future growth potential.

As such, could further FTSE 100 index outperformance be ahead? Or, do their valuations suggest the two stocks now lack margins of safety?

Tesco

Tesco’s share price surged higher following the release of its half-year results that included a slight upward revision to full-year profit guidance. It now expects to deliver adjusted retail operating profit of between £2.5bn and £2.6bn versus a previous market consensus of £2.47bn.

The company’s dominant online position could aid its long-term prospects. It has a one-third market share of the UK online grocery industry. With consumers increasingly switching to home deliveries, which has been accelerated by the pandemic, Tesco may have a competitive advantage over sector peers. In particular, longstanding competition from no-frills operators Aldi and Lidl could ease to some degree due to their lack of online exposure.

Tesco also has a relatively high degree of customer loyalty via the presence of its Clubcard scheme. Additionally, it reported improving customer satisfaction levels across all segments in its latest half-year results. This may help to protect margins to some extent should consumer spending levels come under pressure. Indeed, rising inflation could lead to more challenging near-term prospects for the retail sector that acts as a drag on sales growth.

However, with a forward price-earnings ratio of 14 and the firm forecast to post an annualised rise in earnings per share of 8% over the next two years, Tesco shares appear to offer good value for money. As such, they could continue to outperform the FTSE 100 index.

Rolls-Royce

Rolls-Royce’s share price has also been catalysed by the company’s improving financial prospects. The firm released half-year results that showed it is making progress in implementing its restructuring programme. It is expected to deliver at least £1bn in savings in the current financial year.

In addition, the business has moved ahead with its disposal programme. For example, last month it agreed to sell its ITP Aero division for €1.7bn as part of an overall strategy to raise at least £2bn. This may not only strengthen the firm’s balance sheet, but also allow it to focus on core activities to generate higher profitability and cash flow.

Meanwhile, Rolls-Royce could be a major beneficiary of a likely, albeit gradual, dissipation of Covid-19 travel restrictions. The lack of international travel opportunities means it has previously suffered from reduced demand for its aircraft engines, as well as lower maintenance opportunities.

Clearly, the future path of the pandemic remains a known-unknown and may yet pose a threat to the firm’s financial performance. In addition, the company’s forward price-earnings ratio of 72 is extremely high. However, its earnings per share is forecast to quadruple over the next two years. This suggests it has the capacity to further outperform the FTSE 100 index.