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Why UBS thinks Wesfarmers Ltd and Woolworths Group Ltd are set for a near-term re-rating

There’s light at the end of the tunnel for our supermarket stocks which had just about everything, including the kitchen sink, thrown at them over the past two years or so.

While optimism is starting to creep back into the sector, the share prices of our biggest supermarkets are still trading at a discount to their historical valuation.

You’d only need to compare the share price performance of Wesfarmers Ltd (ASX: WES) and Woolworths Group Ltd (ASX: WOW) to the market to see what I mean. Over the past two years, Wesfarmers is down around 6% while Woolworths is just a tad above breakeven.

In contrast, the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index is hovering just slightly in the red. The underperformance is starker if you look at the stocks’ enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBIT) discount to the broader market.

If the worst is over for supermarkets, you’d expect to see the owners of the Coles and Woolworths chain outperform to a much greater degree.

You may not need to wait much longer. UBS thinks the re-rating is about to come as it notes that the supermarkets trade on EV/EBIT discount of circa 21% currently.

This discount is usually 5% during “normal” times but blowed out to 22% as competition intensified with offshore rivals such as Aldi and potentially Amazon.com muscling in on our grocery market.

But there are signs that the pricing war between the supermarkets is over and rational pricing is returning. We are also seeing encouraging signs that food price deflation is easing as the price on some food products have started to rise.

The planned spin-off of Coles from Wesfarmers is also seen as a positive for the industry as Coles may be more reluctant to cut prices if it doesn’t have the balance sheet from a conglomerate to back it.

However, a return to the normal level of EV/EBIT discount for the sector might be too much to hope for, according to UBS. The sector isn’t out of the woods yet and the poor ABS retail figures for supermarkets that was released this week shows why we can’t bank on a quick return to the mean.

Even then, the discount should narrow considerably from here and the broker thinks there is a 10% average upside for stocks in this sector, which also includes Metcash Limited (ASX: MTS). As they say the tide lifts all boats!

Having said that, UBS does have a favourite. It thinks Woolworths represents that best bang for your investment dollar at the moment as it has the most medium-term upside in the sector.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Wesfarmers Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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