Idea of the day supermarkets

What: Supermarkets dominating the leader board on the FTSE on Tuesday. Tesco and Sainsbury have rallied over 4%, whilst Morrisons has also gained 3% during the course of the morning session. Let’s have a look into what is going on.

The rally in super market stocks has come following a report by Goldman Sachs that suggests that the tough times for these food retailers could soon start to ease.

Traditionally supermarkets fair better in high inflation environments. High inflation allows them to boost profit margins. This is because they can increase the price of stock, passing the costs onto the customers, yet they can use their purchasing power with suppliers to keep input costs relatively low in comparison.

Since the Brexit vote in June 2016, the pound has dived, pushing inflation steadily higher, to reach a 5 year high. So, it would be reasonable to expect the performance of these firms to have improved more or less in line with inflation.

Yet that hasn’t been the case. This is mainly down to the German discout supermarkets, Aldi and Lidl. The rise of these two chains in the UK prompted an intense price war which made supermarkets wary of passing on any price rises to consumers. This has meant that although costs for the supermarkets have been rising, as inflation ticked higher, consumer prices were not being pushed up to the same extent, leaving supermarkets to swallow the difference. Obviously, this is not a profitable strategy and the profit margins of supermarkets have been squeezed considerably.

However, at last the gap between food price inflation and supermarket costs is starting to narrow. Importantly, even Aldi and Lidl have started to pass on the higher costs to customers, which is a huge turning point. This could potentially cause a huge change to pricing behaviour and encourage a more “rationale” approach to pricing across the sector. A more rationale approach to pricing could mean higher profit margins moving into the new year and beyond.

Tesco was labelled by Goldmans as potentially the biggest beneficiary of the trend. We are in agreement, given Tesco’s extensive cost cutting and restructuring programme, they are well positioned to take advantage of changes in the sector.

How: Tesco is currently trading 4.5% higher on the day at 203p. The stock has previously struggled to make any meaningful break above 200p over the past 5 years. However, Tesco has been on a steady uptrend since the middle of the year, climbing over 22%. The stock could finally have the momentum it needs to for a breakout.

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