Stockwatch: Ignore the City, buy and hold

Is there further upside at Morrisons? The FTSE 100-listed supermarket finally appears to have its marketing act together, yet on a technical basis its stock remains one of the most shorted on the London market, despite stock-on-loan reducing from well over 20% to 15.8%.

It all coincides with the price recovering from 140p barely a year ago to about 200p last autumn, recently reaching 250p before settling at 239p currently. I first drew attention at 158p after director buying and again at 210p as I believed the new chief executive's initiatives would create a short squeeze.

Does this strategy still apply for buy and hold investors?

The long and short of it

Investors shouldn't short stock because it's overvalued; the saying "the market can stay irrational longer than you can remain solvent" comes to mind. Instead, there need to be factors like a deteriorating story, a weak balance sheet and/or dodgy accounting.

Yet Morrisons' story and balance sheet are improving and its numbers are clean. Yes, the retail sector has had a buoyant Christmas which may reflect rising wages that are yet to meet an incoming tide of price rises, as retailers no longer wish to absorb the higher costs of imports. Consumers may also use credit, the cost of which will rise in due course.

Morrisons is seen as a good value retailer for quality produce, compared to 'classy' M&SBut even though Morrisons is "more geared to Christmas" with like-for-like sales (excluding fuel) up 2.9% for a nine-week period, compared with the 15 weeks it took Sainsbury's to achieve a 0.1% increase, there is marketing and operations progress.

Effectively, Morrisons has copied Sainsbury's "Taste the Difference" branding to extend its range of "Best" produce, which worked well at Christmas as people treated themselves. This momentum may continue now more people have trialled the range - only time will tell.

Morrisons does also offer an "M savers" range which matches Sainsbury's "Basics" as a discounting response to Aldi and Lidl.

Morrisons is perceived as a good value retailer for quality fresh produce, compared to modern and classy grocers Marks & Spencer and Waitrose.

Customers returning

Lidl appears to be facing a marketing crisis. Like Aldi, its limited stock range makes it tricky to do an entire food-shop, so its appeal is selective and largely based on price.

But Lidl's prices have recently ticked up and news that its German head office had replaced the UK stores' chief executive last year suggested dissatisfaction with marketing.

Morrisons has had positive like-for-like sales for five consecutive quarters, so is getting plenty rightEven under a new boss, its allure is fading. I've heard Lidl shoppers complain that the various Christmas items that had sold out weeks before 25 December were not replaced, with recent price rises meaning no real difference to Morrisons.

Tesco is also seen as good value, but Morrisons is the key benchmark for Lidl/Aldi shoppers, some of whom can easily switch allegiance.

This isn't explained in media reports on Morrisons' strong Christmas figures but it seems a factor - and potentially long-lasting. You can read of superior sales figures from Aldi/Lidl, but these are total sales boosted by new store openings.

The justification for Lidl replacing its CEO was reportedly negative like-for-like sales, but it's hard to be sure when the discounters don't have to disclose like UK-listed supermarkets.

Yet Morrisons has now achieved positive like-for-like sales for five consecutive quarters, so is getting plenty right. The story shows how a new chief executive can have a wide-reaching effect.

Valuations too high?

The chief reason some traders remain short on Morrisons is a high price/earnings (PE) multiple and low yield. Fair enough, when a cyclical trades on a high PE in anticipation of greater revenue and operational gearing then boosts profits; but the five-year table shows operating margins more-thanhalving from about 5.5% to 2.0%.

With the prospective payout halved, the yield barely makes it above 3%Even if the German-owned stores prioritise other territories as Brexit gets underway, margins are unlikely to recover much. Investors who held onto Morrisons when its stock price halved during 2013/14 did so on grounds of modest PE and attractive yield, but the underlying financials have de-rated.

Even after management upgraded underlying pre-tax profit expectations for the year to end-January 2017, from a consensus £308 million to £330-340 million, it still represents 22-23 times earnings. With the prospective payout halved as well, the yield barely makes it above 3%.

Despite inflation being perceived as benefiting supermarket revenues, price rises for imported food will have some effect to check demand. In this narrow sense it is only a matter of time before the stock has "a moment of truth" and slumps.

Strong cash flow

In the broader financial context, however, Morrisons has very strong cash flow per share at nearly four times earnings. Last September's interim results also confirmed the £2 billion free cash flow target had been achieved ahead of schedule. This conveys the power to cut debt, which explains the interest charges.

Also helping operational progress and finances are new IT systems, as cited by the CEOThe 31 July balance sheet showed £1.75 billion of non-current debt, down from £2.14 billion the year before, albeit £202 million of current debt was up from £14 million and cash had risen from £169 million to £620 million.

Meanwhile, interim net finance costs were £81 million, or 36.2% of operating profit; hence cash flow can enhance profits despite there being limits to margin recovery.

Also helping operational progress and finances are new IT systems, advancing Morrisons from a notepad-and-pen stock re-ordering process, which the chief executive cites as a real benefit.

Various such improvements mean Morrisons should keep beating expectations, although there is cautious sentiment among analysts.

Brokers targeting 130p-230p

Being a Morrisons bull around 240p means disregarding City analysts - and not just hedge funds. The consensus looks for intrinsic value roughly 25% lower, viewing 180p as more in line with fundamentals. But excess stock-on-loan does induce a market premium to fair value.

With the new chief executive having a far-reaching effect, this retailer is on the rise and positioned to keep beating cautious expectations. This is why shorters keep closing out.

Stock may blip around current levels, but any drop will likely be seized by shorters looking to closeEven if a consumer recession follows, it is hard to envisage the story changing so adversely: grocery sales were not badly affected in 2008/09. Morrisons has a relationship with Amazon and vertical integration - owning UK suppliers - will mitigate inflation from imported food.

The balance sheet also shows £7.1 billion-worth of property/plant with 85% ownership of stores, only £453 million goodwill and a pension surplus. Such aspects mitigate downside risk.

The stock may blip around current levels, but any drop is likely to be seized by shorters looking to close and present an opportunity with fresh money.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.