Why we got Tesco right and the analysts got it wrong.
As members know I am a bit of a fan of Warren Buffett. This is not just because he has made a cartload of money but also because I respect his common sense methodology and the fact that we can all use it. The trouble with most analysts, apart from the fact that they are idiots, is that they try to over complicate things. Buffett likes to invest in companies within his 'circle of competence.' He defines this as: The limits of one's ability to judge the economics of businesses, intelligent investors draw a thick boundary and stick with companies they understand.
The Sage of Omaha is famous for buying companies whose products he likes as a customer and whose business he understands. Below are the evaluation rules that he uses:
Buffett Evaluation Rules
1. Is the business understandable ?
2. Are the CEO and top executives focused and capable based on the firm?s previous track record of sales and earnings and how the business is run?
3. Does management report candidly to shareholders ?
4. Does the company have top quality, brand name products used repeatedly and high customer loyalty ?
5. Does the company have a wide competitive edge and barriers to potential competition ?
6. Is the business generating good owner earnings; free cash flows ?
7. Does the business have a long-term history of increasing sales and earnings at a favourable rate of growth ?
8. Has the company achieved a 15 percent or better return on shareholders equity and a return that compares favourably with alternative investments ?
9. Has the company maintained a favourable profit margin compared with the competitors profit margin ?
10. What are the goals of the business and the plans to achieve them?
11. What are the risks of the business ?
12. Does the business have good financial strength with low or manageable debt requirements ?
13. Is the stock selling at a reasonable price relative to future earnings and price potential ?
Buffett and Tesco
As I did with British Airways I like to take Buffett's evaluation rules and then apply them to my potential trading candidate. I have had Tesco in my pension portfolio for a number of years. As a customer I am impressed by their service and I have never heard any complaints about them. Though Asda is well run I do not consider them in the same light as the former go for the more cost conscious shopper, whilst Tesco go for both ends having excellent 'value' and 'finest' ranges. Tesco have excellent management. Their head office is no temple to extravagance, more to Calvinism ! All staff share the same canteen, which only serves Tesco products. In terms of the business evaluation rules Tesco matches up to almost every single Buffett rule, something that is very much a rarity in the FTSE 100.
After establishing a long or short candidate from the Buffett rules we then bring in our own criteria. These are based on technical analysis, market dynamics and market hype and they are essential in helping us with the timing of trades. Technical analysis can be pretty subjective at the best of times but market dynamics and the hype factor, if correctly interpreted, are not. As I constantly spout on: the markets are not rational and when we have a company we are looking to buy for the long term we are on the look out for irrational downside moves, exacerbated by negative and generally incorrect commentary from analysts and the financial media.
On January 9th this year Supermarket Group Morrison's made a bid for Safeway. This subsequently resulted in heavy selling of Tesco when nearly ALL investment analysts said that this was an awful outcome for Tesco, as this would affect their market leading position. We disagreed strongly and wrote the following on January 15th
'Now, finally, we get to analysts' views. Why oh why do people bother listening to them? Take the supermarket free for all currently in play. When it first broke, my initial thought was - good for Wm Morrison - they could do with expanding a bit - they do a decent job at the lower end of the market and they even give Dixon's a run for their money selling DVDs at Xmas! Enter Sainsbury into the fray. There's no way that the competition authorities are going to let them take over Safeway's and concentrate most of the supermarket power in the hands of two firms (Tesco and Sainsbury). That would be sheer stupidity. Enter Wal-Mart/Asda. Who cares if they've got pockets so deep they could buy the World. They can have Safeway - who cares ? Safeway and Asda would be a decent match. What is the likely outcome of all this ? Well, one thing's for sure - the decision will take forever and as we are all aware that will breed uncertainty. Uncertainty will lead to employees becoming disgruntled - this will translate into worse customer service than normal and these consumers will go elsewhere. Sainsbury's will be left out in the cold, hopefully, with some customers left, who haven't defected to Tesco like they have over the last few years. Safeway won't have any customers. Morrison's will be trundling along nicely. Asda will continue along the same lines. Leaving Tesco still as market leader, still the best quality of all the large supermarket chains and.... still with loyal customers, who won't bother making the trip to the 'down-market' stores even if they do play the old price war card. And guess what ? They'll still be making money ! Tesco is the clear winner out of all of this. It's not complicated to work out. No restructuring costs, no eye taken off the ball (i.e. the customer and the current business plan) and potentially, their biggest competitor, Sainsbury left even more out in the cold than it is at the moment. Get a life, analysts or at least think it all through!'
This example perfectly illustrates why investors should look at all the available information when making stock selections, BUT don't be suckered into thinking that the so-called pros necessarily analyse the situation correctly ! It is also proof of how you can outsmart the market just by using straightforward analysis. Back in January, analysts were of the unanimous opinion that Tesco would lose out to the eventual merged firm. However, what they failed to understand is that Tesco has some very loyal customers and why that is. They have a loyal customer base because Tesco always delivers in terms of its quality and it delivers this quality at what consumers believe to be a fair price. Loyal, happy customers tend to equate to a steady profit stream, particularly if the company possesses a savvy management team, as Tesco does ! Also, supermarket consumers tend to visit the same store week in, week out. How often do these analysts change the store where they do their weekly shop ? The problem is that most of them probably shop in Marks and Spencer?s in the City and haven't actually visited a 'real' supermarket in years; so, they would have no idea how Tesco fares versus its main rivals, of which M+S is not one !
It seemed pretty likely back in January that Morrison's would be the favoured existing supermarket chain to get the nod, but, given Tesco's on-going expansion plans why was that outcome going to cause Tesco to forego its profit potential. Those analysts ought to go and spend some time with Tesco's management (or would the Cheshunt HQ surroundings not be up to standard compared to their normal investment banking suites?). The management team obviously spotted the need to establish an international presence a few years ago and this strategy is now reaping its just rewards. During this period of expansion analysts were still not convinced that this was the correct strategy for a UK supermarket chain to follow ! Quite why, I'm not sure because whilst the UK market continues to grow, there was/is far greater growth potential to be exploited in certain European/Eastern European and Far Eastern markets and this is exactly the market that Tesco has tapped. They have achieved this growth in earnings/profit performance with very little increase in net debt, which, again should have been spotted by analysts if they were at all in touch with the management team. Small increases in net debt, coupled with continued earnings growth tends to lend a bid to a company's stock ! At the same time as achieving this favourable outcome, the company also manages to increase its dividend by 10% and still the analysts are not content, citing that such an increase is too much, despite crying out for dividends from every listed company less than 3 months ago !
So, we await the decision on Safeway from the Commission and this is expected in the near future. Tesco may well not get a share of the action, but, is this really going to knock them off their perch, especially given their very successful expansion into the retail clothing sector with the fastest growing fashion line in the UK amongst ALL retailers and not just supermarket chains !
What's the betting that the same analysts who came out back in January knocking Tesco will all now be rushing to upgrade all their forecasts and adding Tesco to Buy or Market Outperform lists etc. etc.? It certainly looks like their trading desks were listening to them - massive selling volume back in January near the lows and massive buying volume right now up at the highs.
We reiterate our view ... and continue to add Analysts to our Market Under perform list but what about Tesco from here ? I am glad I have Tesco in my pension portfolio but I am also glad I don't have to make a decision whether to buy them here. They are currently at 245.50p and though there is resistance at 250p and then 300p I really don't care. They are a great company and like Buffett I am going to sit on this position until they stop being one.
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