Was Neil Woodford right to pick Morrisons over Tesco?

Neil Woodford’s latest purchase of Morrisons makes him the company’s largest shareholder.  This move is in stark contrast to Woodford’s exit from Tesco just over a year ago.  We know that Warren Buffett prefers Tesco, so which supermarket is the better investment?

Before I get into the details, I have to admit that sometimes I feel sorry for Neil Woodford.  Sometimes… but not very often.  The poor man has every move scrutinised to the nth degree by commentators everywhere, and recently I seem to have become one of them.

More than anything, this is because I’m interested in the same sort of large, high-quality, dividend-paying companies, and Woodford effectively walks around with a target painted on his back as the UK’s uber-investor.

It’s also that Woodford is a man whose approach to investing is one that I usually admire.  He generally runs a concentrated portfolio, he takes very long-term positions (with a holding period typically measured in years rather than the industry average of several months), and he actively tries to improve the businesses in which he invests rather than just being a passive trader of shares.

But he isn’t always right, so it’s instructive to see how his moves compare to your own thinking, or in this case, my thinking.

Morrisons vs Tesco

I guess it’s pretty obvious that these businesses are very similar.  In both cases, the core business is supermarkets, which is unsurprisingly a fairly defensive industry, where investors can generally expect reliable profits and dividends.

Of course, there are many differences between the two companies as well, of which I’d say Tesco’s wide international presence is perhaps the most significant.  However, I’m not going to focus on the nuances of strategy, market focus, strengths, weaknesses, opportunities, threats and all the rest of it.

A core part of my investment philosophy is that economies, industries and companies are, for the most part, unpredictable.

They are complex adaptive systems, and they exist in a world full of thousands of other companies, each of which is also a complex adaptive system. Together, they make up the universe of companies, which in total is a hugely complex adaptive system which nobody and nothing can predict in detail.

So, with that theoretical and philosophical rant over, I will focus on what I prefer to look at, which is the long-term ability of a company to generate returns for shareholders and the price that we’re being asked to pay for that company’s future returns.

Which has the highest intrinsic growth rate?

Without growth, your investments will be eaten alive by inflation, so even in the most steady and stable dividend-paying companies, growth is important.

Morrisons has managed a very impressive track record of growth over the last decade.  Very impressive means that my estimate of the company’s intrinsic growth rate is over 17% a year.  Of course, that’s unlikely to be sustainable in the very long term, but it’s still way above the FTSE 100’s intrinsic growth rate, which is nearer 4%.

But… growth is ultimately limited by top-line growth, and for Morrisons, the revenue growth rate is around 6%, so unless that starts moving up more quickly, it will eventually be an upper bound for earnings and dividend growth too.

Tesco also has an impressive growth rate, just not as impressive as 17%.  However, it’s not all doom and gloom, as the company has an estimated intrinsic growth rate of around 10% over the last decade, which is nothing to be ashamed of.

For Tesco, the revenue growth rate is 10%, so in this case, my estimate of intrinsic growth (which is a combination of revenue, profit and dividend growth) is close to the top-line growth that the company is able to generate.

And the winner is… Morrisons

Although I think in reality it’s closer than the 17% versus 10% numbers I’ve quoted suggest.  And remember that there is generally a low correlation between past growth and future growth, so it may be worthwhile looking at just how reliably these companies can generate growth.

Which has the highest quality growth?

Growth is one thing, but if it comes in fits and spurts or just once or twice a decade, it’s hard to rely on it with any confidence.

On the other hand, companies that can consistently generate a growing stream of profits and dividends may have something in either their industry or themselves which makes their growth more predictable and reliable.

For Morrisons, their growth quality rating is 90%, which effectively means that 90% of the time, they have produced growing sales, profits and dividends.

Tesco, on the other hand, has a growth quality rating of 98%, which pretty much puts them in the “elite” class in terms of past reliability.  Very few companies can manage more than that.

And the Winner is… Tesco

In this test, Morrisons suffered from some weak results in the middle of the last decade and falling earnings after the start of the Great Recession in 2008.  Tesco managed both periods better, perhaps due to its wide international diversification.

But both companies have a good track record of growth quality when compared to the average of dividend-paying FTSE 350 stocks.  Those companies manage an average growth quality rating of 82%, so clearly, being a supermarket does add consistency to both profits and dividends.

Which has the highest dividend yield?

This is a pretty simple test using the latest announced dividends.  For Tesco, the yield is 3.9% and for Morrisons the yield is 4.3%.  In both cases, this is above the FTSE 100’s yield of 3.4%.

And the winner is… Morrissons

However, this is a pretty thin margin and could well change even by the time I publish this article.

Which has the lowest valuation?

It’s all well and good looking for companies that have consistently generated high rates of growth, but if you overpay for a company, it can negate an awful lot of growth in the underlying business.

I think it’s far better to underpay for a business and then reap additional rewards if and when the shares are re-rated to a more normal level.

I like to measure valuation using the cyclically adjusted earnings of the company because this helps to iron out the minor ups and downs that are inevitable in any given year or three.

By this measure, Morrisons is expensive relative to the average FTSE 100 company, with a cyclically adjusted PE of 16.5 compared to the FTSE 100’s 13.9 (not adjusted for inflation).

Tesco is even worse off with a cyclically adjusted PE of more than 16.

But once again, there is a “however”… PE ratios are a pretty blunt instrument for determining value.  For example, a high PE can be reasonable if there is consistent and high growth (true for both of these companies).  Also, the PE can be high if a larger than average portion of earnings is paid out as dividends, and yet the company can reinvest retained cash at high rates of return and, therefore, still generate above-average growth rates (true of both these companies).

So a high PE is often a sign of quality at a reasonable price (QARP to perhaps coin an acronym) rather than mediocrity at a high price.

And the winner is… Morrisons

Using this crude (but perhaps effective) measure of value, Morrisons comes out on top once again.

Morrisons wins the battle…

But does it win the war? 

Using these kinds of metrics can be a helpful way to find high-quality businesses which are available at unreasonably low prices (which I prefer to the “reasonable” price referred to in GARP or QARP).

Both of these companies have produced high growth rates more consistently than average.  In that regard, they are both high-quality businesses.

They also both have higher dividend yields, which suggests below-average prices.

They have higher than average cyclically adjusted PE ratios, but this is misleading as quality companies deserve a premium relative to an average company.  When compared to other dividend-paying FTSE 350 companies that have growth quality ratings above 90%, they are both cheap.  The median CAPE for those high-quality growth companies is 28, compared to 14 and 16 for these two supermarkets.

So I would say that both Morrisons and Tesco are high-quality businesses operating in a defensive industry, and they are both available at a price which could easily be described as cheap.

But is one better than the other?  That’s hard to say and is by no means obvious, at least to me.  Although Morrisons comes out on top by winning on growth rate, dividend yield and valuation and only losing to Tesco on growth quality, the margins between them are generally quite small.

Using the UK Value Investor Stock Screen, Morrisons ranks at number 23 out of about 160 dividend-paying FTSE 350 stocks, while Tesco comes in at number 15 on the list.  Both of them rank way above average, and both are so close to each other that I doubt there is any material difference between them.

So back to the original question: Do I think Neil Woodford was right to sell Tesco and buy Morrisons?

My opinion is that in the next five years, they will both probably beat the market, but which one will beat the other will be more down to luck than anything else.

I think Woodford’s switch between the two is an example of an investor selling on bad news and buying on good news, which is an appealing but dangerous game to play.

Disclosure – I own shares in Tesco, and Tesco is held in the UK Value Investor Model Portfolio.