Throughout the last few years there have been countless articles in financial media discussing the future of McDonald’s (MCD). Sales growth has been pretty flat, and that has led to the usual doubts about whether the company still has a place in the ‘new world’ of picky and health conscious consumers. For what it’s worth I find that theory to be overblown nonsense, something that seems to be confirmed every time I walk past a busy McDonald’s outlet.
McDonald’s In The 2000s
What I find interesting are the similarities with the early-2000s, a period when an investment in McDonald’s shares could well have delivered a 70% loss. Towards the end of the 1990s the stock was flying high along with most others in the dot-com bubble. Its value had pretty much doubled in the space of two years, and the company was growing sales and profit at a double-digit annual clip. As the millennium came to a close, along with the stock market boom, McDonald’s shares traded at something like 30x annual earnings.
The rest, as they say, is history. In the following three years revenue growth slowed while reported earnings per-share dropped by half. The stock went on to lose over 70% of its value in the bear market of the early-2000s. That kind of tough environment produced exactly the same kind of concerns regarding McDonald’s long-term future as we hear today.
What do shareholders do in the face of moderately difficult trading conditions and a torrent of concerns about their company’s place in an ultra-competitive industry? Many would have undoubtedly bailed out as the stock price continued to decline. Some were probably unfortunate enough to sell right at the bottom, which meant a 70% drop from the peak of 1999/2000.
The underlying business, however, was actually pretty stable. The stock may well have been overvalued, but revenue and free cash flow were rising. Headline earnings had dropped due to impairments and the economic conditions of the time, but the core earnings power of the company was intact.
More importantly, the McDonald’s moat never showed any serious signs of coming under pressure. If you look at the free cash flow return on invested capital – that is how much free cash flow the company was generating for each dollar of capital in the business – there was never a hint that the profitability of the underlying business was being eroded.
What investors did see, though, was a brutal compression of the stock’s earnings multiple; something that was nearly all down to the market value during the bubble. An earnings yield of 3% in late 1999 doesn’t exactly look attractive given that risk-free 10-year U.S. Treasuries were offering a yield around the 6% mark. Either the market was baking in some amazing growth for McDonald’s going forward, or the stock was overvalued. It was the latter that proved to be the case.
The stockholders that didn’t sell enjoyed the benefits of a company that continued to pay a growing dividend and continued to repurchase its own shares on the market. The fact that the shares were falling heavily in value only amplified the effect: more shares could be eliminated at a cheaper price, thus increasing per-share earnings and per-share dividends at a greater rate. Investors who reinvested those dividends also got a larger slice of the company’s cash flow and future profits.
Hitting The Bottom
The malaise of the early 2000s also set the stage for the huge returns that came next. McDonald’s stock finally bottomed sometime in 2003 when it was trading at just under $13 per-share. Four years earlier the shares were trading at over $45 per-share. The earnings multiple, which had been as high as 30x during the dot-com era, fell to a value of about 10x forward earnings. Averaged over the whole year, the P/E ratio was only about 14x earnings and the shares were also throwing off a 3% forward dividend yield. Finally, whereas the earnings yield in 2000 was under 3% (versus the risk free 10-year Treasury yield of over 6%), by 2003 McDonald’s was trading at an earnings yield of over 9% (versus just over 4% for 10-year Treasuries). Needless to say that was a much more reasonable valuation.
Perhaps it was due to investor burnout at having seen the stock collapse 70% during the bear market. Or maybe investors were really buying the narrative that competition and healthy eating would kill McDonald’s. Either way, the fact is that at those prices McDonald’s stock was showing serious value. I know it’s easy to say in hindsight, but being able to invest in the shares at that kind of valuation was a gift, especially given the quality of the company’s underlying profitability.
It is almost inconceivable that picking up McDonald’s shares at a 9% earnings yield will not deliver good returns over any reasonable time frame. And that’s pretty much exactly what happened over the last thirteen years. Whilst the Dow Jones Industrial Average recovered from the bottom with 5.4% annual gains, McDonald’s stock destroyed it with gains closer to 20% per annum over the same period. To borrow a Peter Lynch phrase: that’s a ten-bagger in under fifteen years.
Returns From A $10,000 Investment
Let’s look at the actual returns that an investor in McDonald’s stock would have seen over that entire period. At the peak back in late 1999 a $10,000 investment would have bought you 218 shares of the company’s stock. Assuming you held for the entire period, those shares would be worth $28,000 today. That’s despite seeing the value of those holdings decline all the way to about $3,000 at one point.
What keeps you in the game when you’re looking at those kind of losses? Two things in my opinion. Firstly, and as mentioned above, the underlying business keeps doing well. The company’s earnings have gone from roughly $1.45 per-share in 2000, to around $5.50 today. Even in the worst period of 2000 to 2003, the underlying cashflow remained intact. Secondly, the company paid out cash dividends worth around $26.88 per share. That works out to around $5,860 in dividend cash on the initial $10,000 investment.
The total return, and this assumes that the dividends were not reinvested, would have been $33,860. What if those dividend payments were continuously reinvested into more McDonald’s shares instead of accumulating? Well, in that case the total return would have grown to approximately $46,700, equivalent to a 10% annual return. In the scenario in which those dividends were not reinvested, the returns would have been 7.9% compounded annually.
All-in-all those aren’t bad returns for buying in at the peak. Above all it’s a good lesson in how a high quality company with decent earnings growth can make up for some poor investing decisions given a suitable length of time. You just have to be prepared to tough it out.