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Tesco is Undervalued and Pregnant with Yield, says Schroders

THE VALUE INVESTOR: In a flat market it can help to identify the stocks trading at less than fair value. Silver Rated Schroders Recovery fund manager Nick Kirrage picks three

Emma Wall 22 January, 2015 | 9:40AM


Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and here with me today to give his three stock picks is Nick Kirrage, Manager of the Silver-rated Schroder Recovery fund.

Nick Kirrage: Hi Emma.

Wall: So, what's the first stock you have for us today?

Kirrage: The first stock I'm going to mention is Royal Bank of Scotland (RBS). Banking remains a sector that's very out of favour. One of the things that's quite interesting to us is, over the last seven years massive amounts have changed in the underlying businesses but very little has changed in the valuation. They still trade as stocks that are very disliked and for reasons that people think are very real and in some cases, they are. There is still regulatory pressure. There is still potential cyclical pressure.

We still have concerns about levels of capital and regulation. But actually the thing that's most interesting is the underlying risks, bad loans, the levels of capital, have changed dramatically from that five, six years ago. And I think as we look forward, these businesses, which were for decades and decades very boring, dependable, yield stocks in many cases, hopefully will go back to being quite boring dependable yield stocks with higher share prices.

Wall: Keen viewers will know that when you came in last year RBS was one of the stocks that you mentioned. What's to say it's not just going to continue to move sideways in the next year?

Kirrage: It is very difficult to say, isn't it? Many people would say, well, isn't that the definition of a value trapper, a business that moves sideways? But one of the things that we always look with businesses is, is actually anything changing? The share price might be moving sideways, but is the business moving on? And we believe there is a lot of change going on and the underlying business is moving on and that will put it in a better position to grow profits and its book value over the next five years and over time that suggests that the shares will reflect that. But of course, it's very difficult to know if that will be the next 12 months. So, I dearly hope I'm not here in 12 months' time recommending it again. I hope we've got other ideas and that's done well.

Wall: Okay. What's your second stock today?

Kirrage: The second stock I'm going to pick is Debenhams (DEB). It's interesting because the U.K. retail space is an area where things have actually improved quite a lot and many share prices have done quite well and we've been a beneficiary of that. But Debenhams is a good example of stock that's been held back. I think a lot of those pressures are self-inflicted. They've made some mistakes kind of strategically and operationally. They currently have margins that are below peers and well below their own history which is a flag to us. And we all are asking ourselves why can't this business make a higher level profits in the future? And we don't really see any particular structural obstacles to that happening. The brand is much maligned in some instances, but in other instances well respected and footfall is very high and actually we see great opportunities for share which is a very lowly-rated and has a reasonable balance sheet.

Wall: One of the things that differentiated the retail players is whether or not they have managed to dominate ecommerce. Next (NXT), for example, has done quite well in that space. What's Debenhams sort of ideas about that? Is it something that's important or as you say, is footfall high enough to keep them as an old school high street retail stock?

Kirrage: Yeah, it's interesting. I mean, ecommerce has gone from being something which was a value-add, kind of something that stood you out from the crowd to something that is simply de rigueur, you must have it, you must be good at ecommerce. I think we see threats within ecommerce because of course there is a natural cannibalization. If you go online, people perhaps will buy a little bit more but many people won't. They will just do it instead of coming to a store and you have to keep the store obviously. So there is a double cost there. But well-managed ecommerce can be a very, very kind of important driver of sales and of marginal profitability over time and of course, Debenhams are investing in that as others are. We've yet to see the fruits of that. But again, it's another classic example of us asking ourselves why can't this business do ecommerce? And we don't see a good reason it can't versus some of those other stocks that you talk about.

Wall: What's the third and final stock?

Kirrage: The third and final stock is Tesco (TSCO). I can almost hear the gasps down the cameras I say that. It's interesting what a difference a couple of weeks make. If we've gone back a month, people would have said, perhaps it was lunacy to recommend that stock. But now, post a reasonable trading statement, has changed your strategy, a big cut in CapEx and some short-term improvements in like-for-likes, people might be willing to take more of a gamble on Tesco.

To my mind that kind of tells you a lot about the stock market and peoples' emotions rather than the reality. We're look at businesses and asking why can't Tesco improve its situation? Clearly, there are structural factors going on in the market, the rise of ecommerce, the rise of hard discounters, Aldi and Lidl. But these are incredibly competitive businesses with very entrench positions that frankly a bit of a challenge has not stopped them before and a huge proportion of U.K. supermarket shopping in the next 10 years will continue to happen in boxes rather than just online.

So, when we look at that we say, there is a combination of factors here, better discipline in the industry, less rolling out of new space, more focus on the ecommerce piece and cutting your costs. And with a little bit of focus we think these are businesses which post a dramatic collapse could go on to be very, very valuable investments for shareholders.

Wall: Do you think losing the chief executive is enough? Do you think more heads have to roll for people to be convinced that Tesco has changed its ways? I know there are new strategies into place and in fact, there is a new strategies team, a brand new strategies team in place that I think went across last March. Are these things enough?

Kirrage: Well, I think when a new chief exec comes in, it's a bit like a football coach, isn't it? He comes in and suddenly his whole backroom staff comes with him. There will be other changes. One of the things we're always very clear about is that with the business as big as Tesco one man does not define a company. It's the 100 most important guys underneath Dave Lewis who make a really important impact on that business.

But I would put it the other way, which is, I don't think Tesco went from being a darling one of the best operators in the entire industry overnight to being a terrible operator. There are actually some incredibly talented people within that business but they need to be given a remit, time, freedom to take the business and be innovative in the way they were over the last 10 years. So, I think absolutely there is that opportunity and you can see that that the business is able to kind of move forward and improve. Even in a short period of time the tweaks to strategy and there is no reason to my mind that that won't lead to Tesco, if not going back to a position of dominance, certainly becoming much more competitive and profitable over the next 12 to 18 months.

Wall: And hopefully, reintroducing the dividend?

Kirrage: And hopefully. I mean, one of the things that we look out with those kind of businesses is we say, today it doesn't pay you, but it is a natural yield stock over time and it's pregnant with a dividend. You can't see it in the short term, they can't pay it. But over time, of course, investing for income, which is another part of what we do quite often, people would say, how can you look at a business without a yield and we would say, well, actually the thing is, that's why the shares are depressed. You get a cheap share price and as the dividend is reinstated over the next year or two, you'll get strong dividend growth and hopefully strong share price growth and that's very important for income unitholders as well.

Wall: Nick, thank you very much.

Kirrage: Thanks Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Next PLC6,640.00 GBP0.00
Schroder Recovery A Acc217.60 GBP0.46
Tesco PLC235.10 GBP0.00
The Royal Bank of Scotland Group PLC222.70 GBP0.00

About Author

Emma Wall  is former Senior International Editor for Morningstar

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