In a jittery market, could Tesco shares be a defensive choice?

Oil prices have gone up and geopolitical risks continue to mount. Some investors are looking for defensive options. No matter what happens, people need to eat and so supermarkets can be popular picks, alongside sectors like energy distribution and tobacco. Tesco (LSE: TSCO) is the country’s biggest supermarket business by far – so should I buy some Tesco shares for my portfolio?

Defensive shares aren’t as simple as they can look

One question to ask when buying a defensive share is how defensive it really is.

But there is a second question I believe a good investor asks themselves when buying any share – and that includes defensive ones. That question is what value the current share price offers.

That can be especially relevant for defensive shares because, when markets become less defensive again and investors start selling them off, they can lose a lot of value even if the underlying business performance is robust.

People keep eating, through good times and bad

Let’s tackle the first question to begin: how defensive are Tesco shares?

My view – based on what we have seen in recent years – is that Tesco has some defensive qualities, but not as many as it may first seem.

The defensive aspect comes from the demand side of the equation. People need to eat and perform other household chores, so demand in the grocery sector is resilient, broadly speaking.

That demand may move between players, so for example an economic downturn could see shoppers leave pricier shops like Marks and Spencer or Waitrose in favour of cheaper ones. But as Tesco competes on price, I see demand for its offering as resilient.

Tesco may not be as defensive as it first looks

But demand is only one side of the equation. It translates into revenues, the so-called ‘top line’ of a company’s accounts.

Between the top and ‘bottom line’ (profit), a company needs to account for costs. Here, I think Tesco looks less defensive compared, for example, to industries that have costs regulated.

Soaring oil costs could mean Tesco’s distribution becomes more expensive.

It could also feed inflation. A retailer may only be able to pass some of that onto shoppers in the form of higher selling prices without losing sales volumes. Asda’s weak pre-Christmas performance illustrates that.

This is not just theoretical. We witnessed it happening during the pandemic, when Tesco’s operating margin was compressed.

Due to its economies of scale as the market leader, it may be affected less than smaller rivals. But, especially given the supermarket industry’s razor-thin profit margins, there is limited room for manoeuvre once inflation bites badly.

Is the price right?

Tesco shares are up 12% so far this year, versus 5% for the FTSE 100 index of leading companies overall.

Along with solid recent business performance, I think that may reflect investors’ hunt for defensive options in volatile times.

But that means the share now sells for 22 times earnings.

Yes, Tesco has a large customer base, world-class operations, strong brand, and proven model. Compared to global peers like US behemoth Walmart, selling for 47 times earnings, Tesco shares may look cheap.

But Walmart’s valuation looks far too high to me. Even Tesco’s is much higher than I want to pay for a grocery retailer. I will not be investing.

The post In a jittery market, could Tesco shares be a defensive choice? appeared first on The Motley Fool UK.

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C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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