Three of the top risers in the FTSE 350 so far this year are Tesco (LSE: TSCO), WM Morrison Supermarkets (LSE: MRW) and JD Sports Fashion (LSE: JD).
Each of these major retailers has kicked off the year with better-than-expected trading updates. Should you keep buying, or does disappointment lie ahead?
Tesco
The UK’s largest supermarket reported a 1.3% rise in UK like-for-like sales during the festive period, defying the City that had been expecting a 2% fall in UK sales.
Does this mean now is the time to buy into a Tesco recovery? In the long term, I believe Tesco’s current valuation probably is quite attractive. I expect that trading will improve and profit margins will stabilise. So I’d rate Tesco as a long-term value and income buy.
I’m not sure there’s any rush though. The shares currently trade on a 2016/17 forecast P/E of 18. A fair level of recovery already seems to be priced into the stock and Tesco’s £10bn net debt remains a big concern.
You may also want to hold off making a decision until the various investigations into Tesco’s accounting scandal have all been completed.
Morrisons
Morrisons was the first supermarket to report after Christmas. The Bradford-based group surprised the market with a 0.2% rise in like-for-like sales, which had been expected to fall.
However, it’s what lies beneath that makes Morrisons such an appealing buy, in my view.
Unlike Tesco, Morrisons still owns the freehold for the majority of its stores. This provides valuable asset backing for the shares, which currently trade on a price/tangible book value of just 1.25.
Strong cash flow means that Morrisons’ net debt is falling faster than expected. The firm’s guidance is for a year-end figure of £1.65bn to £1.8bn, down from £2.3bn at the end of the last financial year. Strong cash generation also means that the group can offer a decent dividend. The current forecast yield is 3.2%.
A final bonus is that Morrisons’ big property portfolio and attractive cash flow may also make the group attractive to a private equity bidder. I rate Morrisons as a buy.
JD Sports
JD shares rose by 127% last year, thanks to continued strong profit growth. The group put in a bumper performance over the Christmas period, during which like-for-like sales rose by 10.6%.
This strong year-end performance means that adjusted pre-tax profits for the year ending 31 January are now expected to be up to 10% higher than previous forecasts of £136m.
However, I believe investors with an eye on fundamentals might want to consider taking some profits. JD shares now trade on 20 times 2015/16 forecast earnings and offer a dividend yield of less than 1%. That doesn’t seem cheap, given that earnings growth is expected to slow to 10% per share during 2016.
This is reflected in JD’s PEG ratio (P/E divided by earnings growth rate), which is expected to rise to 1.9 this year. Growth stocks with a PEG ratio of less than one are typically said to be attractively priced. JD’s forecast PEG ratio of 1.9 suggests to me that the stock may now be quite fully priced.
In my view, the risk of a correction is starting to outweigh the potential gains at JD, so this isn’t a stock I’d buy today.