McDonald’s: Right Company, Wrong Time

by James Brumley | January 25, 2012 8:31 am

What a surprise. McDonald’s (NYSE:MCD[1]) beat its earnings estimate[2] for Q4 2011. It was the 14th time in the past 16 quarters that the world’s most recognizable restaurant chain topped expectations; the other two were merely “met estimates.” The announcement also topped off the sixth straight year of improved earnings, and I’m sure if I dug further back I’d find more of the same degree of raw earnings success.

Of course, the market repaid this ridiculously consistent growth by sending the stock more than 2% lower[3] on Tuesday.

How does that old cliché go? Buy the rumor, sell the news? Looks like we have a case of it right here.

Actually, it was 2012’s outlook that got the blame for McDonald’s demise yesterday. Apparently the market isn’t keen on the company’s plan to keep spending, especially against a backdrop of exchange rates that are now going to be working against the company after working for it in 2011.

Might I propose a different reason for Tuesday’s dip, though — a reason investors might subconsciously feel, even if they don’t blatantly recognize it?

McDonald’s Ain’t Cheap

Some of very first investing advice I remember getting was something along the lines of “Don’t buy stocks — buy companies.” It was the cute and efficient way of remembering that stock-picking had everything to do with owning proven, successful companies, and nothing to do with an individual stock’s valuation measures.

It also was the worst investing advice I ever got.

Oh, the underlying idea is spot-on. A bunch of expensive (high P/E ratio) stocks have managed to dole out massive rewards while technically overpriced. Take Amazon (NASDAQ:AMZN[4]). The stock has not traded under a P/E of 30 since 2008 (and most of that time, the P/E was above 60), yet AMZN shares are 266% higher now than they were then. Amazon is a decided exception, though. In most cases, the valuation will catch up with you eventually.

Enter McDonald’s, stage right. Not that its trailing P/E of 19.3 is unthinkable for many of the market’s stocks, but for MCD, that’s the highest it has been in a normal environment since 2007. (McDonald’s deliberately dipped into the red ink once in 2003 and again for one quarter in 2007, pushing the P/E ratio above 19 at the time.)

Said more bluntly, it’s a frothier valuation than the company could have justified anyway, with or without concerns about this year.

The Rest of the Story

That last assumption might be feather-ruffling for many of you, considering how highly comparable Yum! Brands (NYSE:YUM[5]) is trading at a trailing P/E of 24.4, and 2012’s expected income isn’t going to help much on that front. Wendy’s (NASDAQ:WEN[6]) is in the hole for the last four quarters, and even if the current year goes as well as planned, it’s still priced at 24 times its anticipated 2012 earnings. McDonald’s shares already are cheaper than that, and I’ll even go one step further and say I feel McDonald’s is a better-managed (not to mention more reliable) company than Yum! or Wendy’s.

So what’s the problem?

Like I said above, sadly, the stock-picking game isn’t about finding great companies anymore. It’s about outguessing what the rest of the market is going to think about stocks six to 12 months from now, and getting out in front of the crowd before other investors make their move.

And that annoying reality is what makes McDonald’s doubly vulnerable now.

The market doesn’t expect much from Yum! or Wendy’s, and understandably so — neither has been a picture of consistency of late. Oodles of investors are counting on McDonald’s to keep cranking out earnings increases, though. And now that it might not meet those expectations, these same folks are likely to look down from the dizzying heights of the 72% gain since late 2009 and decide they don’t like the view.

Said another way, all of a sudden that 19 P/E turns from being an “acceptable premium for a quality company” to an “unacceptable liability.” Funny how that happens as often as it does when a stock gets as overbought as MCD is right now.

Bottom line: McDonald’s is a great company, to be sure, and I suspect fears of weak results in 2012 are overblown — MCD always finds a way. Nevertheless, investors looking to get into this great company can only do so by getting into the stock … and the stock is apt to be much cheaper within a few weeks now that the weight of the recent gains is bearing down.

As of this writing, James Brumley did not hold a position in any of the aforementioned stocks.

  1. MCD:
  2. beat its earnings estimate:
  3. sending the stock more than 2% lower:
  4. AMZN:
  5. YUM:
  6. WEN:

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