Throughout the last few years there have been countless articles in financial media discussing the future of fast food, and in particular the future of McDonald’s (NYSE: MCD). Sales growth had been pretty flat which led to usual doubts about whether they still had 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.
Now even for those who eschew short term movements it’s been hard not to notice that McDonald’s stock has been on an absolute tear the past six months. It looks the apparent demise of one of the best businesses on planet Earth been greatly exaggerated after all! The funny thing about that is the similarities to what happened in the early 2000s; a period when an investment in the shares could well have delivered a 70% loss.
Towards the end of the 1990s McDonald’s stock was flying high along with most other stocks in the dot-com bubble. The value of the shares had pretty much doubled in the two year period between December 1997 and December 1999 and annual growth over the previous few years had been good, coming in at around the 10% compounded mark in terms of the top and bottom line. As the millennium came to a close, along with the stock market boom, McDonald’s shares were trading at something like 30x their annual earnings. The rest, as they say, is history.
- In the following three years growth in the top-line slowed, reported earnings per-share dropped by half and 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 about McDonald’s long-term future as we have heard over the past few years. 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 shareholders would have undoubtedly bailed out of the stock as the price continued to decline over that three year period. 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 though was actually pretty stable. The stock may well have been overvalued, but actual sales and free cash flow were rising.
More importantly the McDonald’s moat never showed any serious sign 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. Headline earnings had dropped due to impairments and the economic conditions of the time, but the core earnings power of the company was still intact.
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 particularly attractive given that risk-free 10 year U.S. Treasuries were offering a yield of around the 5.5-6% mark. Either the market was baking in some amazing growth for McDonald’s going forward or the stock was terribly overvalued. It was the latter that proved to be the case.
It’s worth repeating the point that for long-term orientated investors the most important thing was that the company continued to show the strong earnings quality that goes with their immense branding power and other competitive advantages. The stockholders that didn’t sell enjoyed the benefits of a company that continued to pay out a growing dividend and continued to repurchase their 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 which increased per-share earnings and dividends. Investors who reinvested those dividends would also get a larger slice of the company’s cash flow and future profits.
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 at under $13 per-share. Just 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, had returned to a forward value of about 10x earnings. Over the whole year the average P/E ratio was only about 14x earnings and the forward dividend yield was around the 3% mark. 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.
Perhaps it was due to investor burn out 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 long-term underlying profitability.
It’s almost inconceivable that picking up shares at a 9% earnings yield will not deliver good compounded returns over any reasonable long-term horizon in a quality stock like McDonald’s, and that’s pretty much exactly what has happened over the thirteen years since. Whilst the Dow Index recovered from the bottom with compounded annual gains of 5.4%, McDonald’s stock has destroyed it with gains that are closer to 20% compounded annually over the same period. That’s a ten-bagger in under fifteen years to borrow Peter Lynch’s phrase.
Let’s look at the actual total 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 fetched 218 shares of the company’s stock. Assuming one held for the entire period, through the tough bear market that wiped 70% off their value, 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 on 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 – 2003 the underlying cashflow stays intact. Secondly, the company also paid a continuous and growing dividend, which on a cumulative basis adds up to $26.88 per-share. That’s already more than 50% of what an investor was paying for one share right at the peak back in 1999.
That comes to $5,860 in dividend payments on the initial $10,000 investment. The total return, and this assumes that the dividends were not reinvested, was therefore $33,860. What if those dividend payments were reinvested into more McDonald’s shares instead of accumulating? In that case the total return would have grown to approximately $46,700, equivalent to 10% compounded annual returns. Even 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 though 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.