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Down 20%, are Tesco shares a bargain?

Girl buying groceries in the supermarket with her father.

Many products at supermarkets such as Tesco (LSE: TSCO) have been going up in price. But the opposite is true of Tesco shares. The retailer’s share price has tumbled 20% over the past year.

Does that make them a bargain for my shopping basket? I think it may, although there are some risks I would consider.

The long-term investment case

As a long-term investor, I do not completely ignore what goes on in the stock market in the short term. A fall in price can offer me a more attractive cost basis for buying shares in a company, for example. But my main focus is always on what the investment case for a business will be over the long term. I like to hold shares for years.

In the case of Tesco, I see the long-term investment case as quite compelling. Demand for groceries and household goods is set to be resilient, even if the economy fares badly. Although shoppers may switch to cheaper products, they will still be eating and cooking for decades to come.

As the leading retailer in the UK, Tesco has a strong position. It benefits from economies of scale as well as a large customer base it aims to make more loyal through its Clubcard scheme. That could help support revenues and profitability down the line. In the past decade, Tesco’s ambition beyond the British Isles has reduced significantly. That makes it a more focused operator that can benefit from a deep understanding of its home market.

Risks to profits

Although I like the investment case for Tesco I also see risks, both in the short term and further afield.

In coming years, tightening consumer budgets may make shoppers more price-conscious. That could be bad for profit margins at retailers. On the other hand, it may also open up an opportunity for them if customers switch to own-label products instead of costlier brands.

There are longer-term risks too. One concern I have is about profit margins. The retail industry often has high sales volumes but low profit margins. Last year, Tesco reported £54.8bn of sales but a pre-tax profit of just over £2bn. Most of the sales are eaten up by the cost of generating the sales, such as buying in the goods and running shops.

Intense competition in the sector is a risk to profit margins. The cost of fulfilling digital orders could also erode profits, although I think digital sales channels may help Tesco build customer loyalty. Once shoppers have spent hours refining their online purchase preferences, it would take some effort for them to start afresh with a competitor.

I think the stock is a bargain

Tesco’s business looks resilient and I expect future sales growth. It boosted its interim dividend 20% last month. The dividend yield of 5.2% is attractive to me.

With Tesco shares trading on a price-to-earnings ratio of around 10, I see them as a bargain. If I had spare cash to invest today I would buy them for my portfolio.

The post Down 20%, are Tesco shares a bargain? 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. 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.