The UK economy is facing a recession. How long this will last is anyone’s guess but I like preparing for the worst in any case. My portfolio is value oriented, so I have faith that it’s well positioned to ride out the worst effects of a recession. Nevertheless, I’m open to buying stocks that could perform well in this environment. And I think Tesco (LSE:TSCO) shares — on paper at least — may fit the brief.
Defensive qualities
My experience tells me the valuations of defensive stocks are more resilient than cyclicals in downturns. For me, supermarket chain Tesco embodies the idea of a defensive stock. It sells many of the necessities that people will buy regardless of circumstances. By way of being the market leader, I believe that its earnings can remain relatively stable during a down cycle. This should have a positive effect on the valuation of Tesco shares.
Furthermore, I see Tesco as a relatively strong income payer, regardless of the conditions. The grocery giant offers a higher dividend yield (6%) than the FTSE 100 average (4.1%). It has also been increasing its dividend coverage ratio for years — a positive indicator of its financial health. So, the combination of high sustainable payouts with share price stability, is a safe bet for me.
The company’s share price was hammered in September as concerns for the UK economy rose. It’s down by a third (30%) since the start of the year. This type of discount is often a buy signal for me. That said, I have a few lingering doubts about Tesco’s longer-term prospects.
The cost-of-living crisis
I’m worried about the discount war kicking off between the big supermarkets. I sense that higher inflation and interest rates will continue to tighten wallets. Shoppers will have no choice but to shop at the places with the cheapest prices. Ominously, Aldi and Lidl have been grabbing market share at an increasing pace. But Tesco has been losing market share.
To its credit, I’ve noted a spirited response from the company. It has gone from boosting its online presence to increasing its product discounts. But price slashing can be problematic for supermarkets. It certainly is for Tesco, a company with already wafer-thin profit margins.
The more immediate headwind for Tesco is the weak pound. It sources products internationally. Therefore, it will need to pay more money in pound terms to buy the same products.
Headwinds abound
I remain confident that Tesco can be a resilient stock in this recession. But simultaneously, I’m put off by the headwinds in the shape of intensifying competition and the greater costs it’s facing.
I also see limited upside in the share price because its price-to-earnings ratio is well above competitors like Sainsbury’s and Asda. I take this to mean it’s already generously priced.
Overall, I’m finding more negatives than positives about Tesco shares. I think September’s fall indicated a broader price correction by the market. Yet while I won’t be buying now, it’s a stock I intend to continue monitoring.