Why Tesco and Sainsbury’s are poised to deliver share price growth

Robert Stephens, CFA, discusses the investment potential of UK supermarkets Tesco and Sainsbury’s in the face of changing consumer behaviour.

Covid-19 has had a dramatic effect on the shopping habits of British consumers. Notably, lockdown measures have encouraged a larger proportion of retail sales to take place online.

In addition, grocery shopping baskets have increased in size as containment measures have reduced the scope to eat and drink outside of the home.

Recent results from Tesco (LON:TSCO) and Sainsbury’s (LON:SBRY) highlight the strong growth being experienced by the sector. In my view, their online presence, low valuations and income potential could make them sound investment opportunities on a long-term basis.

A changing British grocery market

UK online grocery sales have recorded exceptional growth in 2020. For instance, fast-moving consumer goods (FMCG) sales, which include the types of items sold by Tesco and Sainsbury’s, grew by over 100% in the four weeks to 5 September.

This builds on a longstanding trend within the UK retail segment. Consumers have gradually been shifting their spending from in-store to online over the past two decades. Covid-19 has quickened the pace of this transition, which is likely to continue in future.

Growing online sales bode well for the performances of Tesco and Sainsbury’s. They have well-established positions in e-commerce that have allowed them to capitalise on growing demand for online grocery deliveries. For instance, Tesco has a 33% market share of the UK online grocery market. Sainsbury’s, meanwhile, recorded total retail sales growth of 8.5% and a doubling of digital sales in the first quarter of its financial year.

Even though online grocery sales still only account for 12.5% of total grocery sales, their growth trend is likely to continue. Changing consumer spending habits are likely to have become entrenched having now been in place for over six months since lockdown measures began. This may suit Tesco and Sainsbury’s, since their established online positions provide them with a competitive advantage over other value-focused retailers, such as Aldi and Lidl, who lack an online retail presence.

Investment opportunities

The high cost of responding to Covid-19 means that many retailers are set to experience declining profitability in the short run. For instance, the costs associated with higher staffing requirements during the pandemic and large investment made in online services are set to offset rising sales in the current year.

However, Tesco and Sainsbury’s are forecast to report profit growth next year. In spite of this, they trade on prospective price-earnings (P/E) ratios of 12 and 10 respectively. Moreover, their prospective dividend yields of 4.4% and 5.4% indicate that they offer income investing potential while many companies have question marks about their own income prospects.

Additionally, the two retailers could display defensive credentials in the short run. Should lockdown measures increase in breadth and scale in future, demand for groceries may spike as consumers stay at home instead of visiting pubs and restaurants.

Therefore, the two supermarkets could offer long-term investment appeal in my view. Their business models seem to be adapting successfully to rapid change, while their low valuations and robust income prospects could contribute to improving returns.