Before you jump straight to the comment section to call me a moron or claim I'm a troll, I should disclose up front that I do realize what I'm about to get into.
I know that investors love McDonald's (NYSE:MCD). It was a safe haven during the last recession, it's been growing impressively in a slow-growth world, and it boasts a sporty 3.25% dividend yield. In today's world of investor sentiment and psychology, that's the magic trifecta. Who among us, institution or amateur, doesn't love a stock that held it together during the crisis years, exploded out of the gate in the recovery years, and has been paying us some handsome income along the way?
If you scroll back through Seeking Alpha articles on MCD (and you should because there are a lot of good ones) you'll find that about nine out of ten are positive. In the analyst community, sentiment is just as high. This month there are 4 strong buys, 8 buys, and 15 holds. No sells. That's actually an improvement from three months ago where somebody had the balls to give it an "underperform!"
The median target is 106 with a high of 120. The low target on the stock is 91. In other words, the most pessimistic analyst on the street thinks that McDonald's deserves barely a three percent decline.
What's interesting about McDonald's is that it's only around 65% owned by institutions and mutual funds. In the context of the entire stock universe, that's low. This means that it's a stock owned in larger part directly by the investment public. Again, with its magic trifecta, there aren't many stocks that are an easier sell to the direct public, especially since it's a business that many individuals can see or touch on a regular basis. For reference, Disney (NYSE:DIS) has an identical institutional ownership rate. And Jack in the Box (NASDAQ:JACK), a good example of a business everybody knows that individual investors, for some reason, are unwilling to touch, is 91% owned by institutions and mutual funds. Go figure, as JACK has dramatically outperformed MCD over 1, 2, and 5 year intervals (but lags by about 400% since 1993).
McDonald's apparently has this air of blue chip quality that makes it easily digestible for the mainstream.
How to Properly Seek Alpha
The smartest thing I ever learned about shorting stock was something I heard once from Doug Kass. He said that investors should never short a valuation or a concept; only short business models that are broken.
I've worked in the hedge fund industry for a little over a decade and have talked to more than a few long/short funds over the years. Sadly, these guys -- technically professionals -- spend a disturbing amount of time shorting valuations and concepts. I suppose they have to short something, and the reality is that there aren't really a whole lot of broken business models to go around. Being a short-seller is a difficult existence.
So while I won't call McDonald's an outright short, I will say that this stock is one that the massive swath of the public who owns the stock -- a disproportionate number of whom are individuals, the types of people who read Seeking Alpha -- ought to reconsider. I think a lot of people may have fallen asleep on their McDonald's analysis.
Put another way: there's a whole lot more risk in McDonald's than most people realize.
Along those lines, another thing that's interesting about short-sellers is their unconventional way of measuring alpha. As an example, consider a fully-loaded short portfolio that loses 2% in a period where the market goes up 10% (assume for the sake of argument it's a beta-neutral portfolio). That's a huge win! This short portfolio has generated 800 bps of alpha. But many investors, even a lot of sophisticated institutions, don't look at it that way. They look at the guy that lost 2% and say, "what a loser, this guy lost 2%."
On the flipside, avoiding stocks like McDonald's can generate alpha for your portfolio. As an example, let's say you own McDonald's today and you swap it for the SPY. If the market then goes down 5% while McDonald's goes down 10%, that's a decision that generated 500 bps of alpha.
Technically, the market is the wrong benchmark to use here for MCD. But the theoretical point remains the same. Whatever benchmark you wish to define for McDonald's, I believe MCD will underperform it. If you own McDonald's, I believe selling it is an alpha-generating opportunity.
Now I'm going to show you why.
A Drive-through of Fundamentals
We'll start with some basic fundamentals.
On the surface, the current 17x PE doesn't seem so bad. "Well," I can hear you saying, "technically it's a 15x forward PE."
That's pretty much in line with the rest of the S&P.
Here's the thing, though. MCD has spent most of its history with a PE below the market. The PE averaged around the mid 13x range between 2004 and 2009 (even lower when adjusted for cash). Somewhere in late 2010, something clicked, and McDonald's was somehow deemed worthy of a more aggressive multiple. The PE went to 15x, then 18x by the end of 2011 and currently stands at 17.3x today.
Is it because earnings skyrocketed?
The top line did grow 12% in 2011, but only 2% in 2012 and 0.8% in the last twelve months. That's less than the 6ish percent it averaged during the 2004-2010 when it carried a lower multiple.
Is it because investors are looking deeper and EBITDA is blowing up?
EBITDA has been slowing down.
Is it because future earnings are supposed to be really, really good?
Perhaps! Analysts are expecting EPS growth of at least 10% per year for the next 4 years. It's been a long time since McDonald's has sustained that level of EPS growth. But I shouldn't discount the possibility that here in 2013, with McDonald's the biggest it's ever been, the company is about to exhibit better sustained bottom line growth than we've seen in the last decade.
If that doesn't happen, if there's any kind of hiccup in earnings and investors recalibrate their projections to more closely match what McDonald's has done in the past, then the stock will react. The sensible base case in that scenario (absent any other macro noise) would be a correction to a more historically normal 13-14x PE.
That's a potential 20% drop in the stock price if we discover analysts were too optimistic in their estimates.
If you like stocks that are priced to perfection, go ahead and chow down. But if you're like me and you like to relate risk to reward, steer your appetite elsewhere.
Bad puns aside, seriously, what's the upside in McDonald's? Do they grow their earnings 15% instead of the already aggressive 10%? The stock may ultimately be fine, but only if everything goes exactly according to plan and even if it does, it still leaves any kind of excess returns (alpha!) as a low probability.
The risk doesn't end there, either.
Meanwhile, the balance sheet is far from pristine. McDonald's carries nearly $14 billion in debt, for a debt/equity ratio of 0.9x. Long-term debt had been declining from $9.3 billion to $7.3 billion between 2003 and 2007; in the years since the crisis, it's nearly doubled.
I won't fault management here, since arguably, borrowing money is exactly what a company like McDonald's should be doing in the Era of Negative Real Rates. And a debt/equity ratio of 0.9x is hardly worth panicking about, especially with a business as operationally sound and well managed as McDonald's. But let me tell you a little secret: when recession-induced bear trends grab hold or when everybody collectively freaks out, the market likes companies that don't have debt a whole lot more than it does ones that do.
In an ordinary market and an ordinary economy, McDonald's debt presents zero trouble. In a chaotic one, it's going to give you heartburn. Remember when GE couldn't roll over their short-term paper?
I could go on about McDonald's with long-term data like stagnant margins, declining free cash flow, and declining earnings yields. I could show you DCF matrices like this:
And before you dismiss my model as garbage -- which it may very well be -- at least let me point out that this exact same model was telling a very different story back in the pre-crisis years. DCF is a handy tool, but like every other fundamental or technical tool, it's not very good on its own and much more effective when used in conjunction with other tools.
I also won't touch on macro factors such as changing taste preferences. I have no idea if upstarts like Chipotle (NYSE:CMG) or Panera (NASDAQ:PNRA) will eat into McDonald's market share. When you think about it, those companies do the same thing McDonald's does: a fast meal at a fair price. McDonald's is really smart, though, and their management team knows what's what. They've successfully responded to threats from the fringe with things like McCafe and a better array of healthy eating options.
The point here is that I don't know how to fold any of these qualitative factors into the analysis. Maybe these underlying trends are good or maybe they're bad. Who knows. Feel free to use them to support whatever narrative you'd like to subscribe to.
The Technical Take
Technicals are ultimately a reflection of fundamentals plus psychology. Always, and by definition.
On this front, it's been a great ride for McDonald's. But people, the long-term trend is clearly changing.
Even more disturbing is what those technicals look like on a shorter-term basis.
Look at that chart!
That is an ugly, ugly chart. Lower high following lower low following lower high following lower low. Sure, it's a little oversold right now and a 5-10% bounce is highly likely, but if it can't make a new high, this all spells trouble. In fact, I will say that if you do want to take a shot on getting long MCD, this is definitely the spot to do it. Don't wait until after that bounce happens if it does.
The stock is also under its 200day moving average and it has violated all recent major support. On a purely technical basis, a medium duration move to 90 or 85 is as likely as any outcome.
Perhaps this is a situation where this summer, savvy investors have been catching on while the public perception is still reciting the narratives of 2009?
Long story short, this is a stock that is, let's just say, "aggressively priced" relative to the type of business it actually is. There are presently a host of risk factors ranging from pricey valuations to disturbing trends.
McDonald's may not exhibit outright weakness, but the first problem with stocks that are priced to a best-case scenario is that they leave virtually no room on the upside. I know we buy these things because we want to have both growth and capital preservation. But in the case of McDonald's, I think there are some major questions regarding how good a job the stock can do on either of those fronts.
I have zero trouble accepting risk in my investments, but only when there is proportional reward to be had. In the case of McDonald's, the risk/reward ratio is tilted significantly away from investors.
The Thesis is Totally Backwards
I guess this is what I'm really trying to say.
Ask any investor on the street or even any professional fund manager and they will almost certainly tell you that they're in McDonald's for all of the following reasons:
- The stock performed well during the last recession and has exploded with growth in the recovery years.
- The yield is attractive.
- The company is high quality.
- The stock is recession-proof.
That makes for one heck of a narrative, but I would submit the following counterpoints as a reality check:
- The stock performed well during the last recession because it went in with a low valuation. The valuation today is 25% higher, and when we enter the next recession, the stock will not preserve capital the way it did during the last.
- 3.25% is a decent yield, but with a 54% payout ratio and shrinking free cash flow, it may only qualify as stable during halcyon environments. If you're in McDonald's for just the yield, you're in it for the wrong reasons and can do better elsewhere.
- McDonald's is a quality company, but probably not as high quality as you think. When you look a little harder at the balance sheet and trends on the income statement, you quickly see that this isn't quite the bastion of cleanliness it has the reputation for.
- I do believe that McDonald's has a recession resilient business. But don't forget that a company's stock and a company's operations are two totally different things. One is easy to understand and divine. The other is downright impossible.
Every so often, I'll pick myself up a Sausage McMuffin because they're tasty and cheap and I know exactly what I'm going to get. In fact, that's the pillar of McDonald's operational success. They know how to perfectly manage customer expectations, delivering the exact same thing anywhere you go. Investors may think the stock works the same way, but it doesn't.
OK, full disclosure. If you want to hold my feet to the fire, MCD was a staple in my Dividend & Income portfolio for years. I'm OK with a stock like this during a recovering economy and rising market. But right now, given the current market valuations and frontier of economic outcomes, I'd rather restructure a long portfolio around capital preservation rather than growth and income.
And the key problem is that I believe there's a significant disconnect between perception and reality. Investors believe that this is a safe, defensive stock that's going to hold it together during the recession and I really don't that it necessarily will.
I understand that this is a variant view and I understand that investors don't like hearing that their beloved McDonald's has such a meaningfully negative skew between potential risk and reward. I understand that convincing narratives are what really shape our behavior, and it feels good to be invested with a stock that features such a rich, tasty backstory. Just like that Sausage McMuffin. Yummm.
I'm a data guy, though. I pay attention to calories. Maybe you're the same way. Sometimes when we chase that data all the way, we wind up in uncomfortable or unpopular places. That's OK. It keeps us fit and healthy.
You don't have to short MCD right here -- in fact, Doug Kass would tell you not to do so. But there are thousands of other stocks in the marektplace, and of those, dozens that could legitimately give you the type of thing you were looking for in McDonald's.
Grab yourself a farewell McMuffin and go look at those instead.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. For additional disclosure, see cornicecapital.com/AlpineAdvisor/legal-notice/