Better buy: Tesco plc vs Unilever plc

The Motley Fool
Marmite, Unilever
Marmite, Unilever

Unilever (LSE: ULVR) shares have risen by 60% since November 2011. The group's dividend is 50% higher than it was back then. Over the same period, Tesco (LSE: TSCO) shares have lost almost half of their value, while the supermarket's dividend has been suspended.


There seems to be a growing belief that this situation is now permanent. Supermarkets are seen as weak businesses with thin margins. Consumer goods groups, such as Unilever, are seen as highly profitable, with good growth potential.

Stock market history suggests it's a mistake to assume that this kind of divergent performance will last forever. While Unilever has been an excellent investment, it's also become quite expensive. In contrast, Tesco's trading is starting to recover, and the firm's stock looks cheap relative to historical profits.

Marmite could be turning point

Are we about to see a rebalancing between the two sectors represented by Tesco and Unilever? After all, their businesses are quite closely related. Supermarket groups such as Tesco are important customers for Unilever.

The recent Marmite spat -- where Tesco refused to accept a price increase from Unilever -- suggests to me that the group is not prepared to cut its profit margins in order to support rising profits for big suppliers.

It's worth remembering that Dave Lewis, Tesco's chief executive, was formerly a senior executive at Unilever. He has an insider's understanding of Unilever's business, and should know where to look for price reductions.

Is Unilever about to crash?

Unilever shares have fallen by almost 15% from their 52-week high of 3,807p. The stock already looks much more attractively valued than it did a couple of months ago. However, I'm not suggesting that Unilever stock is about to crash.

This £40bn group remains a very superior business, with a lot of valuable brands in diversified markets all over the world. Unilever's reliable free cash flow and growing dividend put Tesco's years of misguided expansion to shame. Paul Polman, Unilever's long-serving chief executive, has served shareholders' interests very well.

However, the reality is that Unilever's reported earnings per share have only grown by an average of about 3.5% per year since 2010. Unilever shares still trade on a forecast P/E of 20, and offer a dividend yield of only 3.3%. That's significantly less than the FTSE 100 average of 3.8%.

My hope is that Unilever's slide will continue in 2017, giving me the chance to top up my personal holding at a more attractive price.

Don't underestimate Tesco

The market was prepared to write off Tesco a year ago, amid suggestions that a rescue rights issue would be needed to cut debt. Boss Dave Lewis has managed much better than expected. Net debt has fallen by about a third, and profits are rising fast.

Although Tesco shares trade on a forecast P/E of 28 for 2016/17, earnings per share are expected to rise by a further 35% in 2017/18, giving a forecast P/E of 20 for next year. That's similar to Unilever's valuation. The big difference is that Tesco appears to have strong earnings momentum at the moment.

Mr Lewis is expected to restart dividend payments next year. I believe trading will continue to improve for several more years. At current levels, I don't think it's too late to buy Tesco.

Our experts' top buy!

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Roland Head owns shares of Unilever and Tesco. The Motley Fool UK owns shares of and has recommended Unilever. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.