LONDON -- Which of the U.K. supermarket giants should you invest in? Few industries spark the same level of debate and disagreement among investors as the grocery business -- and everyone seems to have a favorite brand. Today I'm looking at my two favorite U.K. grocers, Tesco (LSE:TSCO) (NASDAQOTH:TSCDY) and Morrisons (LSE:MRW), and explaining why I think you could own shares of both.
But is it sensible to own shares of more than one supermarket in the same portfolio? Are the businesses too similar? And why own shares in a supermarket, anyway?
The economic characteristics of the supermarket industry are unusually attractive. Cash generation is both generous and consistent. Capital expenditures for maintenance are relatively low once stores are opened and infrastructure is in place.
Retained cash flows can usually be deployed predictably, with lucrative returns on capital, by expanding or opening new stores. Crucially, supermarkets fill an important and persistent need for consumers. These attractive characteristics mean I'm happy to own more than one supermarket, at the right price, if they offer sufficiently diverse future prospects and services.
But are Tesco and Morrisons really that different? I think they're both great businesses in their own right.
Tesco vs. Morrisons
Tesco is easily the market leader in U.K. groceries, with more than 30% market share and about 3,000 U.K. stores. But that's less than half of the story. Tesco is rapidly expanding abroad, with almost 4,000 stores now located in "growth regions" such as Turkey, Thailand, Poland, and South Korea.
Morrisons, meanwhile, has been cautious, rather than cavalier. Facing Tesco's U.K. dominance, Morrisons has flourished by picking its fights intelligently. For example, Morrisons has seemingly waited until the last possible moment to move into express stores, opportunistically poaching shops from bankrupt high-street chains Jessops, Blockbuster, and HMV. Where Tesco has led the way in market innovations such as online groceries, Morrisons will attempt learn from its rival's mistakes and gain a "last-mover advantage."
With less than 600 shops, Morrisons has only a fraction of Tesco's store base and no international prospects. While shoppers will associate Morrisons and Tesco as direct competitors in the U.K., the companies are notably different and seem likely to grow though separate channels.
One thing both Tesco and Morrisons do have in common, though, is an undemanding valuation. Both companies are valued at roughly 11 times their earning power and offer prospective dividend yields of more than 4%. By comparison, the shares of many high-quality consumer brand companies currently trade anywhere between 17 and 25 times their normalized earnings.
Neither Morrisons nor Tesco is priced for above-inflation growth. But for two different reasons, I believe both companies have opportunities to grow, which the market is underestimating. For Morrisons, it is the low-hanging fruit of expansion into express stores, online retailing, and more shops in the south of England. For Tesco, it is the continued expansion into new high-growth international markets and retail banking. I believe both companies will also enjoy greater per-store profitability in the U.K. as cyclical consumer spending recovers.
Successful growth is far from guaranteed in either case, of course, but the inexpensive valuations provide some margin for failure. Meanwhile, success relies on relatively modest, visible assumptions of expansion, founded on impressive track records.
The bottom line
There's a risk that buying both Morrisons and Tesco could overexpose your portfolio to the U.K. groceries market. In my view, the modest valuations and defensive industry characteristics mitigate this to an extent. Neither company is likely to disappear overnight.
I think Morrisons and Tesco are sufficiently different in service, size, and geographical mix to coexist in the same portfolio. While their future growth may come from different sources, I believe investing in both Morrisons and Tesco will provide satisfactory long-term business results.
For these reasons, I'm strongly considering an investment in both companies this summer.
Don't take my word for it
Fortunately, I'm not the only one who sees Tesco as an ideal investment for the long term. In fact, I'm in very good company -- with the richest investor in the world!
Legendary investor Warren Buffett is known for buying wonderful businesses with durable competitive advantages, when the price is right. Over the last decade, he has added more than 400 million Tesco shares to Berkshire Hathaway's investment portfolio and now owns 5% of the U.K.'s largest supermarket. If you want to learn more about why the Oracle of Omaha has built such a large stake in Tesco, The Motley Fool has compiled this special report, detailing the logic behind Buffett's investment. Just click here for your free report!