Which of the UK 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 favourite brand.
Today I'm looking at my two favourite UK grocers, Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) 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 UK groceries with over 30% market share and around 3,000 UK 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 UK 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 UK, 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 over 4%.
By comparison, the shares of many high-quality, consumer-brand companies currently trade at anywhere between 17 and 25 times their normalised earnings.
Neither Morrisons nor Tesco are priced for above-inflation growth. But for two very 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 UK 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 over-expose your portfolio to the UK 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 co-exist 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, the world's most famous investor has added over 400 million Tesco shares to Berkshire Hathaway's investment portfolio, and now owns 5% of the UK's largest supermarket. The billionaire is known for his uncanny ability to spot a bargain and act decisively, and has bought another $1 billion of Tesco shares in the last year alone!
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!