A Better Fast-Food Alternative Trade

The market tends to get caught up in tracking a couple of headliners as the stocks to watch in a particular sector.  You know them, Home Depot (NYSE:HD) and Lowes (NYSE:LOW) when it comes to home improvement stocks, Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) when it comes to retail, etc. …

The fast food segment is no different. For the market’s money, the names McDonald’s (NYSE:MCD) and Chipotle (NYSE:CMG) are synonymous with the fast food trade, as these stocks were on a tear until 2012.  Another company that gets mentioned, but not as much as it should, is Yum! Brands (NYSE:YUM).

Yum operates more than 38,000 restaurants in 120 countries and territories under the KFC, Pizza Hut, and Taco Bell brands.  The company has become the bright light in the Chinese fast food market, expanding quickly along with competitor McDonald’s.

Similarities between the companies continue when we begin to look at the sentiment picture.  Roughly 60% of the analysts covering MCD rate it a buy, while 66% rate YUM a buy.  I love the fact that both companies aren’t over- or under-loved by the analyst community as it suggests less potential for ratings changes to move the stock over the near-term.

Both companies are wrestling with operation costs as food inflation continues to climb.  This is where the two stocks part ways though.  The revenue and earnings data is showing that the fundamental picture for these stocks begins to favor YUM as earnings over the last year have been more robust and positive, indicating some elasticity to rising costs that MCD may not have.

The charts are telling two different stories too, as YUM is breaking to new 12-month highs and MCD is breaking to new 12-month lows.  The divergence of these two fast food rivals sets up what I believe is a great paired trade opportunity.

A paired trade is a strategy in which you play a strong and weak stock within the same sector.  You can take a few different approaches.  One approach is to go long the weak stock and short the strong stock in anticipation that they will converge.  Another is to go long the strong and short the weak, expecting that the divergence will continue.  I’m following the latter today.

Recommendation:

Buy to open YUM stock, short MCD stock (or sell if you own it).

I expect the trend to remain YUM’s friend as investors will continue to favor strong story stocks in this mediocre market.  Expect to see YUM start the New Year on new 12-month highs as we’re targeting a move closer to $80 by January.  For that reason, the stock is a good bullish trade at its current levels of just under $74.

Conversely, expect continued pressure to be placed on MCD shares as the analyst community and the media will continue to beat the stock up.  I won’t be surprised to see a price that is close to $80 before its next earnings announcement on Jan. 22, 2013.  I recommend shorting the stock with a target of $80, or selling it if you own it, based on this outlook alone.

Options Alternative:

Paired trades often use options when the trader has the right background and education, including awareness of the risks and potential returns.  For a paired trade using options the following is an attractive position…

Buy to open the YUM Jan 75 Call for a price of $1.75 per contract.

Buy to open the MCD Jan 85 Put for a price of 1.35 per contract.

The purchase of these options will profit handily if the stocks continue towards our targeted prices before January options expiration.  In the case that both go up or down , expect the options returns to still result in a positive bias since I would expect YUM to climb faster than MCD (resulting in larger profits for the YUM call than losses on the MCD put), or YUM to decline slower than MCD if both declined (resulting in larger profits for the MCD put than losses on the YUM call).