Capital should be flowing into food-led pubs and the segment should be expanding more rapidly than restaurants, reflecting overwhelming trends in consumer demand, according to a leading analyst.

Douglas Jack at Numis said that restaurants are going to have to be increasingly careful about where they expand, given that recent supply growth has been unsustainably high.

He said: “Food-led pubs are materially outperforming the sector. For example, their drink volumes rose 3.4% in 2013 despite the number of food-led pubs increasing by just 0.2%. In comparison, restaurant drink volumes grew by just 0.9% despite a 6.0% increase in restaurant supply. In addition, pubs have been able to raise menu prices more than restaurants over the last year, reflecting competitive advantages in location and amenity.”

Jack said that the sector’s trading backdrop has improved to the point where consumer confidence is positive and growing, yet cost and regulatory pressures are benign, according to a leading analyst.

He said: “Longview Economics is forecasting a 1.8% real increase in discretionary post tax income and credit growth in 2014 (+4.3% nominal) versus 2013’s slight real terms fall. This reflects faster economic growth, rising private sector employment and low cost-inflation/mortgage service costs. Also, record inbound tourist expenditure is providing an additional boost for London in particular.

“Overall, cost inflation is typically around 2.5-3.0% before mitigation initiatives, such as utilising better management information from new IT systems. Most operators indicate that they need to grow LFL sales by 2.5-3.0% to hold margins. So far, LFL sales are exceeding this level and our forecast assumptions, but pubs face tough summer weather comps.”

Jack highlights Domino’s Pizza and Spirit Pub Company as his key picks based on growth and upgrade potential and valuation.

He said: “Domino’s Pizza is valued on an 11% discount to historical average, excluding Europe, which should be considered as a valuable long-term option. Excluding Europe, and valuing the company in line with the sector’s current 14% EV/EBITDA premium to historic average, would equate to £6.90/share on forecasts that have good upgrade potential, in our view.

“Spirit Pub Company has the lowest rating amongst its peer group even though it is generating the highest national LFL sales and has a profit orientation to managed pubs that regional brewers must envy.”