UK food-price inflation accelerated to 16.4% in October – up from 14.6% the previous month – according to the Office for National Statistics, adding further pressure to household budgets.
But while people will cut back on discretionary spending as we enter a recession, they are not going to stop buying food. For investors, this could be an opportunity to profit from higher food prices. We look at the stocks you should invest in and the ones you may want to avoid.
Stocks to avoid
Tesco (LSE: TSCO) and Sainsbury’s (LSE: SBRY) have both seen their share price slip by almost a quarter this year.
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That’s because both supermarkets talk about investing hundreds of millions of pounds to keep prices lower than competitors. The lag from passing on higher food prices has meant that sales have not kept pace with inflation and margins have been hit.
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Despite having a roughly one-third market-share of the UK market, Tesco has delivered an average return on capital employed of 8.5%. Over the same time period, the same measure of profitability for Sainsbury’s is even lower – 4.3%.
Share-price performance has been underwhelming and both companies trade on a prospective price/earnings (p/e) ratio of around ten. In order to secure a re-rating from the low p/e multiples, the supermarkets need to use their high market shares to pass on costs to households and start generating higher returns.
But that’s not happening at present. Competition looks as strong as ever, while trying to raise prices ahead of inflation may result in unwanted media and political attention.
Food companies have not fared much better. Shares in US-listed Beyond Meat (Nasdaq: BYND), the vegan burger and sausage company, have fallen by 76% so far this year. Similarly Oatly (Nasdaq: OTLY), the plant-based milk company is down by 73% this year.
The larger, more established food brands do appear to have some pricing power. Earlier this year Tesco picked a fight with Kraft Heinz (Nasdaq: KHC), whose market value is $46bn; it has an earnings before interest and taxes (Ebit) operating margin above 20%. When Heinz increased the price of a tin of beans and ketchup, Tesco claimed that the price rises were unjustifiable. In July this year the supermarket reversed course and agreed to Heinz’s price rises.
Kellogg’s (NYSE: K), the breakfast cereal company ($24bn market cap) has similar market power, with a ROCE of 16% and an Ebit margin of 15%.
During the pandemic both companies raised revenue guidance as consumers sought comfort in processed foods. Indeed, the risk to the likes of Kraft Heinz and Kellogg’s may come from another direction: their marketing of processed foods high in sugar but positioned as healthy.
Meanwhile, the likes of Britvic (LSE: BVIC) and IrnBru maker AG Barr (LSE: BAG) were negatively impacted by the “sugar tax” introduced in 2018 by the government.
One stock to invest in to profit from rising food prices
That leaves investors with few palatable options, so I highlight London-listed Associated British Foods (LSE: ABF), which owns brands such as Kingsmill bread, Ryvita, and Patak’s.
ABF is more diversified than most food businesses (it also owns retailer Primark) and the investment case is built on an improvement in profitability. Earlier this month ABF reported that group revenue rose by 22% to £17bn and statutory profits before tax (PBT) gained 48% to £1.1bn in the year to mid-September 2022.
Within that, food sales are growing 10%, whereas Primark (just under half of sales) saw revenues climb by 43% as the prior year was affected by lockdowns.
Aside from Primark, ABF is split into four food divisions (grocery, sugar, agriculture and ingredients). Its largest food division, grocery, makes up 22% of revenue and 26% of adjusted group profits, and reports a return on capital of 29%.
There is also a “crop protection business” – presumably PR speak for pesticides – that has had a much stronger year. The ingredients business, which makes bakers’ yeast, as well as more sinister-sounding food additives, saw revenues rise 19% to £1.8bn and adjusted PBT up 3% to £159m.
The group’s profitability should continue to rebound as Primark operates without the disruption of further lockdowns. For the food divisions, rising input costs have put pressure on margins in the short term but management believes eventually it can pass on price increases, so we should see profitability stabilise and then recover later in 2023.
The shares are on a price/earnings (p/e) ratio of 13 for the year to September 2023, well below the three-year average p/e of 20. ROCE has been falling from a peak of 15.5% achieved in 2017 to 7.3% last year. That resulted in the share price derating, but as profitability recovers that ought to drive a rerating.
