Buying the market leader isn’t a guaranteed way to succeed in the investment market. But history tells us that size and economies of scale often help companies to deliver reliable results where rivals struggle. In my view, that’s an attractive characteristic for a potential investment.
Today I want to explain why I remain a buyer of the UK’s largest supermarket, Tesco (LSE: TSCO). I’m also going to look at a smaller company that’s focused on delivering similar benefits to its shareholders.
Making progress
Tesco recently announced that it plans to stop offering mortgages through Tesco Bank and intends to sell its current book of mortgages. With just 23,000 mortgage customers and a total lending balance of £3.7bn, the supermarket isn’t big enough to compete profitably in the UK’s highly competitive mortgage market. So it’s not going to try.
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I think that’s a sensible decision. It’s also a good example of how group chief executive Dave Lewis has reshaped the business since taking charge.
Troublesome or loss-making activities have been culled. The range of stock carried in stores has been optimised and the company has made considerable cost savings. Mr Lewis has also identified a key opportunity for growth and expanded into the wholesale market with the acquisition of Booker.
The results are already impressive. The group’s operating profit margin has risen steadily and reached 3.4% last year. That’s significantly higher than Morrisons (2.1%) or Sainsbury (1%).
Tesco probably can’t get much bigger as a supermarket. But I think it can expand in wholesale and continue to profit from economies of scale. The share price has cooled recently and the stock now trades on 13 times 2019/20 forecast earnings, with a 3.5% dividend yield. I would be happy to buy more at this level.
A dividend + growth opportunity?
If you’re looking for a company with more growth potential, my second pick, Biffa (LSE: BIFF), may be of interest. This £570m waste management group floated on the London market in 2016, since when its shares have risen by nearly 30%.
Results released today show that nearly 60% of the group’s £1.1bn revenue last year came from collecting waste from industrial and commercial customers. Of the remainder, the majority came from recycling and energy-from-waste operations.
Both areas are more profitable for companies operating at scale. Biffa’s aim is to be a consolidator in this industry, buying up and integrating smaller firms.
Since its flotation, the group has completed 17 acquisitions. This would normally be a warning flag for me, but the balance sheet remains healthy and underlying free cash flow is very strong.
Although this strategy will require continued financial discipline and skilled management, I’m comfortable with the situation. I believe there’s an opportunity for this company to continue expanding, especially if the political environment remains supportive.
Looking ahead, Biffa shares trade on less than 11 times forecast earnings for 2019/20 and offer a prospective yield of 3.3%. I think BIFF stock could be a good long-term buy.
