Holly Black: Welcome to the Morningstar sector roundup. I'm Holly Black. With me is Ioannis Pontikis. He is equity analyst at Morningstar in Amsterdam. Thanks for joining us.
Ioannis Pontikis: Thanks for having me, Holly.
Black: So, today we're talking about the UK groceries sector. It's a stock area that people think is a sort of defensive staple in their portfolio. But actually, there's a lot of headwinds facing the industry. What are some of the biggest challenges you see?
Pontikis: Yeah. So, the UK consumer is increasingly looking for convenience and value in their everyday shopping trips. So, we see the traditional grocers are not offering those services as efficiently as channel specialists, such as Ocado for the convenience segment and Aldi and Lidl for the discounter segment.
Black: So, we can see that you have doubts over the major four players in the UK, because you have a no moat Morningstar rating on all of them. What does that mean?
Pontikis: Yeah. So, the no moat rating means that there are no competitive advantages. That is, the return on invested capital for those grocers are not higher than their cost of capital in the past and in the future. So, from an intangible assets perspective, we believe that brand equity accrues to the owner of the brand and goods sold in the store not on the operator of the stores.
Black: Do you think these big supermarkets can change and update their business model enough to really take their market share back from the upstarts? We had some talk about mergers and Tesco moving out into other areas, but is it enough?
Pontikis: Yeah. So, Tesco, for instance, tried to enter the discounter space with Joe's stores. They tried to tap into the wholesale market with some more dynamic and high growth market in the UK The same goes for Morrisons. Obviously, those are incremental things that they can do to boost the growth. There are questions about the profitability of those channels still. But there is a fundamental difference between business model, the business models that can serve those rising dynamic channels such as the convenience, the online and discounter markets. And there are big differences between the business model so far of Lidle, for instance, and the business model of full range supermarket like Tesco and Sainsbury's.
Black: So, does this mean that investors should be entirely avoiding this sector? Or are there still areas of investment opportunity?
Pontikis: We think that purely on valuation grounds our best picks for the sector are Sainsbury's and Marks & Spencer. So, both stocks have been underperforming for quite a while now, but for different reasons.
So, Sainsbury's have been underperforming since the failed attempt to acquire Asda earlier in the year. Whereas Marks & Spencer's underperformance is primarily due to a host of negative headlines in the last couple of months, beginning from its CFO's resignation, the listing from FTSE 100 index, and a dividend cut, plus, a number of strategic missteps of the past.
We think that share prices right now imply a continuation of market share losses in the future and strong margin reset. We disagree. We think that Sainsbury's is in a good position to extract the necessary cost savings to invest back in their prices, to make their product offering more competitive. Now, for Marks & Spencer, we think that – we expect the company to continue improving their availability in clothing and investing in supply chain and take full advantage of their recent partnership with Ocado on their online grocery segment by growing more profitably through previously untapped online grocery market.
Black: Ioannis, thank you so much for your time.
Pontikis: Thanks for having me, Holly.
Black: And thanks for joining us.
