Comment: Is Tesco or Sainsbury the better investment?

By Christopher Beauchamp, chief market analyst at IG.

The arrival of Tesco’s first half numbers today means that we can take a clear look at the two listed firms that dominate the supermarket space in the UK (apologies to fans of Morrisons and Ocado, but the real battle is all about Sainsbury vs Tesco).

The orange-branded supermarket saw sales fall 1.1% in its second quarter, which was a deterioration from the 0.8% drop in its first quarter.

Sainsbury's clothing sales were also weaker, while the only real bright spot was the jump in like-for-like sales at new acquisition Argos, which rose 2.3% compared to a rise of 0.1% in the first quarter.

Tesco, by contrast, seemed to have nothing but good news, at least where sales were concerned: the group reported a third consecutive quarter of sales growth, up 1.1%, while operating profit jumped 38% to £515m.

The fly in the ointment was the ballooning pension deficit, which grew to £5.9bn, a rise of nearly 100%, thanks to lower bond yields.

Tesco has promised to work to boost margins, and the trend looks encouraging, as operating margins rise from a low of below 1% in February of 2015 to their current level above 2%.

However, there is still a lot of ground to be made up to get back to the targeted 3.5-4%, and even this would be disappointing compared to the margins seen in the heady days of 2011 and 2012.

The problem for investors right now is Tesco’s valuation. It currently trades on a forward p/e ratio of around 24, compared to 16.9 for the UK supermarket sector as a whole and against a Sainsbury’s p/e of 12.

Tesco’s current valuation is more than one standard deviation from the average, a level not seen since October 2015 and April 2016. Between 9 October and December 15 2015, the shares fell 26%, while they dropped 17% from mid-April 2016 to mid-June.

Tesco, having surged 11% on the release of interim numbers on Wednesday and a whopping 40% in the year-to-date, now looks decidedly expensive, with much of the good news baked into the price.

By contrast, Sainsbury’s is, at 12 times forward earnings, only a whisker above its long-term average of 11.6.

While this might not suggest boom times ahead, Sainsbury’s is not priced for disappointment, whereas Tesco most certainly is.

With Argos likely to make an increasing contribution, the fundamental case is much more supportive of Sainsbury’s than Tesco.

Momentum investors will probably stick with Tesco for the time being, but the value case for Sainsbury’s will appeal to many, while income hunters will be much more excited by the Sainsbury yield of 4.8% versus Tesco’s 3.6%.