It seems the supermarkets had plenty to cheer about over the festive period with shoppers flocking back to stores and treating themselves to Christmas dinner with all the trimmings, despite concerns over the cost of living crisis.

Which begs the question, are the supermarkets a good investment or is their current good fortune just a flash in the pan helped by high grocery prices?

A GAME OF MARKET SHARE

Over the last 10 years, the share prices of both Sainsbury’s (SBRY) and Tesco (TSCO) have more or less halved, driven by the perception that the discounters are gradually taking more and more of their customers and profits.

While it is certainly true that the discounters, led by German duo Aldi and Lidl, have made significant inroads into the UK grocery market over the last six or seven years, it hasn’t all been one-way traffic.

According to weekly till roll data processed by Kantar Worldpanel, between the start of 2016 and the onset of the pandemic Aldi and Lidl increased their joint share of UK grocery spending at supermarkets from 10.4% to 14.3%, inflicting losses on all of the Big Four chains.

Tesco saw its share decline from 28.1% to 26.8%, Sainsbury’s from 16.4% to 15.3%, Asda from 16.3% to 15% and Morrisons from 10.6% to 10%.

However, we should point out the till-roll data isn’t like-for-like and during this period both of the discounters undertook a huge expansion programme while the Big Four reined in store openings.

By opening new stores, Aldi and Lidl – which offer a much more limited assortment of products – were able to compete more effectively with the full-line supermarkets.

Yet a funny thing happened during the pandemic – the big chains, which offered delivery services as well as Click & Collect, rebuilt their market shares at the expense of the discounters, and for two years Aldi and Lidl made no headway.

It was only at the start of 2022, when grocery prices started to increase sharply due to higher input costs, that they once again started to win a bigger share of customer spending.

Crucially, both Sainsbury’s and Tesco have managed not just to keep their pre-pandemic market shares but to increase them slightly, while Asda and Morrisons – both now privately-owned, as it happens – have been the ones to give up ground.

IS FOOD INFLATION HERE TO STAY?

According to Kantar, UK grocery sales in the 12 weeks to 25 December were up 7.6% to £31.7 billion, with spending in December jumping 9.4% to a record £12.8 billion, but with food inflation running at 14.4% during the month, the volume of goods sold was down 5% on the previous year.

Inflation is most severe in fresh food, with fresh meat and poultry prices currently 15% to 20% higher than last year, milk between 35% and 45% higher, eggs 25% higher and fresh vegetables including potatoes 15% or more higher according to the latest figures from the ONS (Office for National Statistics).

While there are some indications inflation is beginning to peak, that doesn’t mean prices are falling, rather it means they are rising at a slower rate, and they could stay high for some time to come.

One of the less obvious and most pernicious forms of inflation, particularly in tinned and packaged foods, is ‘shrinkflation’, where manufacturers reduce the size of their products but charge the same price.

The question is, do we have to get used to inflation or is there a chance prices could come down in the future?

Unfortunately, at least where fresh produce is concerned, the omens aren’t good.

High costs are forcing arable farmers to reduce potato acreage while poultry farmers are shutting down production due to bird flu and other pressures at the same time as demand continues
to grow.

Also, farming is expected to be left out of the Energy Bill Discount Scheme, which is designed to reduce wholesale gas and electricity prices for non-domestic customers, as the government doesn’t consider it to be a high-energy sector.

Farm consultancy group Andersons estimates UK farming’s overall profit may drop by as much as a third this year to the same level as 2000 as the full impacts of rising fertilizer and energy prices take effect.

Andrew Meredith, editor of Farmers Weekly, fears 2023 could be the year farmer anger ‘erupts’.

‘This year is set to drive many farmers even harder to stay solvent if input costs remain high and output prices come under further pressure,’ says Meredith.

All of which points to shortages of fresh food and vegetables in the supermarkets, meaning high prices are likely here to stay.

HOW ARE THE SUPERMARKETS FARING?

Sainsbury’s and Tesco recently released their Christmas trading updates, to a fairly lukewarm response it must be said even though both firms had an extremely successful campaign with holiday sales up 7.1% at Sainsbury’s and up 7.8% at Tesco’s UK and Irish stores.

Sainsbury’s said it expected profits for the year to the start of April to be towards the top end of its forecast range of £630 million to £690 million, while retail free cash flow would be around £600 million compared with its previous guidance of at least £500 million.

Meanwhile, Tesco reiterated its guidance for the year to the beginning of March for retail operating profit of between £2.4 billion and £2.5 billion, and retail free cash flow of at least £1.8 billion, so both firms are clearly feeling confident about their ability to continue attracting customers.

Both reported an increased level of in-store shopping as consumers hit the shop floors to compare and contrast the festive offerings, with Sainsbury’s claiming it outperformed the market in terms of meat, fish, poultry, fruit and vegetable sales over Christmas.

Tesco’s premium Finest range enjoyed an 8.2% uplift as customers treated themselves, while Sainsbury’s Taste The Difference range posted a 10% increase in sales.

At the same time, shoppers sought out value in everyday essentials with Tesco seeing a 7.4% volume increase in its Low Everyday Prices range and more customers than ever taking advantage of its Clubcard Prices and Aldi Price Match deals.

Take-home ready meals also surged in popularity as households chose to eat in rather than go to restaurants or order takeaways, and as the squeeze on budgets continues this trend could continue at the expense of the hospitality trade.

TESCO IS THE STOCK TO BUY

Both Sainsbury’s and Tesco have seen their share prices halve over the last decade, but Tesco has done a much better job of protecting its profits.

We estimate Tesco has grown its earnings per share by around 5% per year on average since the early 1990s, with a faster pace of growth up to 2012 then a slower pace over the last decade.

Sainsbury’s on the other hand has destroyed profits by around 0.5% per year over the same period, leaving earnings per share today lower than they were in the early 1990s.

With its greater market share, and more levers to pull through its Aldi Price Match and Clubcard offerings, we think Tesco is a good defensive proposition.

At the current price, investors are being asked to pay 10 times current earnings and less than seven times cyclicallyadjusted earnings, which have been smoothed out over more than 30 years to eliminate the peaks and troughs, with the added attraction of a 4.4% dividend yield which is more than three times covered by earnings.

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