McDonald's - MCD
I'm thoroughly enjoying it.
I often peruse the Value Investing subreddit, as it’s a pretty good way to find bad ideas. If there’s a stock with name recognition that has dropped in price, those guys are buying it. It’s also educational to poke the hornet’s nest from time to time and criticize the orthodoxy of the community. Occasionally, I hit upon a good counterpoint from someone, and I learn something. That’s what happened and led me to invest in a stock none of them are talking about: McDonald's (MCD).
At the time, I had taken to pointing out how absurd it was that Toyota (TM) was trading at its book value. If a company is ever trading for less than its book value, the market is saying the company is worth more dead than alive since the market is discounting its equity. That the world’s leading automaker was bordering on that valuation was and is bizarre. When I brought this up, there was no shortage of people willing to argue with me. Most didn’t have much to say beyond quoting Munger and Buffett, who don’t like automakers. They would then get really mad when I asked if Munger and Buffett’s remarks applied to this situation. One guy, however, made a good point—well, sort of.
He mentioned Buffett’s emphasis on free cash flow and pointed out that Toyota had negative free cash flow for a while. Unfortunately, he promptly ruined the great point he was making by bringing up a discounted cash flow (DCF) analysis, which is useless and not used by the majority of investment professionals. However, what he said about free cash flow stuck with me before he went off track. I’ve always underweighted free cash flow in my investment decisions since I’d never seen it applied intelligently. My thoughts were, “Sure, it’s great that Warren Buffett values free cash flow, but I don’t know exactly how it affects his calculations, so there’s not much I can do with it.”
With automakers, though, it clicked. Cash from Operations – Capital Expenditures = Free Cash Flow. It’s the cash a business has left over after buying new equipment, conducting research, or developing new products or technologies .etc Negative free cash flow means a business is spending heavily on future development or renovations. They are either taking on debt or burning through existing cash trying to improve their business. An investor would view this as undesirable because the business doesn’t have much money to return to shareholders. That was when the light bulb went off—I think I now understand how Buffett uses free cash flow.
As a side note, I earned 9% on Toyota in less than a month, and it was—and still is—undervalued. But that was always a short-term trade; Toyota will never beat the S&P 500 on a sustainable, year-after-year basis.
I then did two things. First, people always say it’s hard to beat the stock market. It’s not. However, if you are investing in one specific company long-term, you better have a damn good reason to think it will beat a industry-specific ETF or a wider market index like the S&P 500 or MOAT. The first thing I did was simply look for businesses with a long, proven track record of beating the market. Kind of an obvious step. People will hit you with “past performance isn’t an indication of future success,” which is somewhat true. But if you find a financially sound, wide-moat business with a long track record of success and no discernible reason to believe that’s going to change, then yes, actually, past performance can be an indicator of future success. It’s why Tom Brady got paid so much.
McDonald’s vs. The S&P 500 since 1993:
McDonald’s vs. The S&P 500 since 2003:
McDonald’s vs. The S&P 500 since 2014:
McDonald’s vs. The S& 500 since 2019:
McDonald’s vs. The S& 500 since 2021:
McDonalds vs. The S&P 500 since 2023:
McDonald’s performance has been very impressive. We’ve had a tech bubble juicing the returns of the stock market since 2014 and McDonalds crushed the overall market during that time. Burgers and fries have also been putting up a good fight against tech companies head to head.
McDonalds vs. Meta last ten years:
McDonalds vs. Amazon last ten years:
McDonalds vs. Alphabet aka Google last ten years:
Okay, so maybe Amazon punched McDonald’s straight in the face. But the price charts of Alphabet and Meta show just how much hot air there is in the valuations of tech right now. When the bubble pops, McDonald’s wins.
Now we get to my light bulb moment. For a while, I had been trying to figure out an approach to investing in mature businesses that are very profitable but aren’t growing much. I just couldn’t find the justification. If something is outperforming, I won’t invest unless I understand why. Up to that point, my focus had been on revenue growth, either from an expanding business or one that had taken a hit and was on track to expand again. Then it hit me—free cash flow…
Cash from Operations and Free Cash Flow:
Total Shares Outstanding charted against Total Return Level:
Heres Shares Outstanding again but as a normalized percentage of change:
Percent change in the last ten years:
McDonald's absolutely kills, in a good way, when it comes to free cash flow. This high level of free cash flow means the business has an immense ability to return value to shareholders. This is what Warren Buffett likes about businesses with high free cash flow—not some ineffective DCF analysis. Buffett also prefers share buybacks to dividends because dividends are taxed by the IRS as regular income. Let’s say you earn $10,000 in dividends outside of a retirement account. The IRS taxes that just as it would income from your job. Therefore, Share Buybacks > Dividends.
Quite clearly, McDonald’s has a very long and proven track record of returning value to shareholders. Since 1985, they have repurchased over half of their common stock and have consistently paid a dividend.
But like with any mature business, revenue growth has been a struggle:
The bigger you get, the harder it is to keep growing. But this makes an excellent point—since 2014, McDonald’s has crushed the return of the S&P 500, and for most of that time, its revenue was actually declining. How did it perform so well as an investment? Free cash flow. Share buybacks manually push the share price higher by reducing the supply of shares on the market. Over the last ten years, McDonald’s bought back 26.29% of all outstanding common stock. Since the mid-1980s, it has repurchased 54.72%, with the trend accelerating in recent years. But that’s not the whole story, because McDonald’s also pays a dividend. So how much of an impact do dividends have on our total return?
Total Return and Share price back to the 1980’s:
Total Return and Share price in the last ten years:
This allows us to see the impact of McDonald’s dividends over the years, and it has been significant. The impact of share buybacks are factored into the share price, so the only difference between total return and share price is dividends. Thus, the impact of dividends is the sole reason why the total return and share price lines differ. Right now, the dividend yield is 2.25%, which at first seems small and not very impactful. However, that doesn’t mean much since McDonald’s dividend yield has never been particularly high. Therefore, its not as though some past higher dividend yield is responsible for the gap between total return and share price.
If you’re wondering why the two graphs look different: the one directly above shows dividend yield (Total Dividend Per Share / Share Price = Dividend Yield), while the graph further up shows the total dividend per share. The reason the yield hasn’t risen in tandem with the increase in dividend per share is that the share price has also increased keeping the yield down. But I want to return to the importance of the total return and share price lines. The only factors that influence total return are the rise in the share price and dividends. So, when the total return line is higher than the share price line, dividends are the sole reason for that.
A 2.25% annual dividend yield might not seem impressive at first glance, but over time it has a powerful effect. One critique of total return is that it assumes you reinvested your dividends, which might not always be the case. All my dividends get reinvested, though not necessarily into the same stock that paid them. Still, I consider the concept of total return a more accurate depiction of the value an investment has delivered than just looking at the share price alone.
Now, let’s put it all together since I’ve been throwing out charts for a while. Historically, about 72% of McDonald’s cash from operations translates to free cash flow, which is insanely high. They do a massive amount of share buybacks, which manually pushes the stock price higher. Even a multiyear decline in revenue didn’t slow down the upward march of the total return. Personally, I like to graph total shares outstanding in the same chart as total return because it’s a great sign when the two lines are negatively correlated and form an "X." This isn’t always the case; some businesses buy back shares while their business degrades, and the share price drops anyway. If I don’t see an "X" on that graph, it’s an important sign to take a closer look. Markets aren’t always rational, but most of the time they are. So far, whenever I have seen those lines moving in the same direction, I’ve agreed with the market consensus and passed on the stock. When you add the immense impact of their dividend, the picture becomes clear: McDonald’s is a fantastic investment. The current P/E ratio is 25, which I would normally consider high, but in this case, I don’t care at all.
But wait, isn’t there any bad news? I keep wanting to nerd out and do deep dives into financial statements to show off, but with these large, wide-moat, well-established companies, there just isn’t much to see most of the time. However, McDonald’s does have one point of concern.
McDonald’s has never had much in the way of equity:
In fact, over the last ten years, McDonald’s has typically had negative equity. Normally, this would be a huge red flag for me, and I’d never invest. But—here’s the catch—they don’t have that much debt either. With $7 billion a year in free cash flow and $58 billion in total liabilities (a figure that hasn’t grown since 2020), it’s not all that concerning.
I’ve shown you that McDonald’s is a high-performing investment, and I’ve explained why. But I haven’t yet discussed McDonald’s moat and why it’s likely they will continue to perform well far into the future.
Scale Economies
McDonald’s certainly benefits from economies of scale. Their vast size and international footprint give them significant pricing power and the ability to deliver food to customers at low prices. Fast food is supposed to be, well… fast and cheap. I think this is a big part of the reason why new nationwide fast food chains aren’t a common occurrence. Fast and cheap sounds easy to do but is in fact quite hard to do.
Network Economies
I wouldn’t say McDonald’s has a network economy. I don’t think more people eating at McDonald’s improves the service for others or creates any sort of snowball effect. Except, perhaps, that it leads to more franchise locations.
Counter-positioning
I suppose the fast food industry is counter-positioned against traditional restaurants. But does McDonald’s have a counter-position against Burger King and Wendy’s? No, I don’t think so.
Switching Costs
Nope. Nothing stops a McDonalds customer from switching to Burger King.
Branding
Yes, absolutely. Very few things are more American than McDonald’s. If you’ve ever seen the documentary Super Size Me, at one point, they talk about the purpose of the McDonald’s PlayPlace and the Happy Meal: to get kids in the door and start building positive memories with the brand. I think it’s spot on—many Americans have a sense of nostalgia tied to McDonald’s. It was also weird; while I was reading their financial statements, I swear I could smell french fries. The value of the McDonald’s brand is enormous. It’s the most iconic franchise chain in the country, and tens of millions of people have positive childhood memories associated with it.
Cornered Resource
No, McDonald’s doesn’t have the market cornered on burgers and fries.
Process Power
For this one, I would say yes. Process power was key to McDonald’s rise. In the movie The Founder, which follows Ray Kroc—the man who took over the business from the McDonald brothers and made it what it is today—a key part of the story was perfecting the production process. This allowed McDonald’s franchises to make food quickly, in large volumes, and with consistent quality. A Big Mac is a Big Mac, no matter which franchise you get it from.
This effect may have diminished over time, as competitors have had a chance to copy McDonald’s methods—just like Ford didn’t exclusively own the assembly line approach to auto manufacturing for very long. However, I still think it’s an impressive feat to watch how much food a McDonald’s franchise puts out at peak volume. It’s simply not something that’s easily reproduced.
To further prove a point, McDonald’s market cap is $213 billion. Wendy’s (WEN) market cap is $3.5 billion. Burger King is owned by a larger corporation, Restaurant Brands International (RBI), which also owns Tim Horton’s in Canada and Popeyes, so the exact value of Burger King is harder to pin down. However, looking at sales, Wendy’s has about $12.5 billion in annual sales, and Burger King has $11.5 billion. Meanwhile, McDonald’s has over $53 billion in annual sales. I think it’s safe to say that branding and process power are why no competitor even comes close to McDonald’s.
Well, there you have it. McDonald’s is a giant that has been crushing its competition for decades, and there’s very little reason to think that will change in the future. The only negative is its negative equity, but McDonald’s impressive free cash flow simply nullifies that concern. This is the light bulb moment that clicked for me. This is what Buffett is talking about when he discusses free cash flow—he’s not referring to some DCF analysis. He’s talking about wonderful businesses that are cash geysers with wide moats.
Investing for revenue growth can be dicey—the future is uncertain, and any number of things can stop a business from growing as expected. Growth stocks also tend to have much of that growth priced in by other investors and carry the risk of an inflated P/E ratio. Value stocks, as commonly recommended by unskilled value investors, are often companies that have fallen flat on their face and aren’t guaranteed to recover.
Why bother with any of that? It’s a hard game to play. At this point, if I’m not investing in an ETF like MOAT to capture the overall market or a focused ETF like ITB or PPA to capture the rise of a specific outperforming industry, I’ll be investing in businesses like McDonald’s. Well-established, wide-moat, cash geysers with momentum and sound financials. It’s far easier to estimate whether an already outperforming business will continue to outperform than it is to predict the rise or recovery of another.
I have to say one last time—I wouldn’t have had this epiphany if I had ignored someone who was disagreeing with me. Time will tell, but I think that mean person from the internet just made me a lot of money.
My Portfolio:
JPM, MCD, CSX, AFL, ITB, PPA, MOAT
*Disclaimer*
You can and will lose money in the stock market. You can lose all of your money. I can and will be wrong. I have been wrong in the past. I have lost money in the past. Investing in stocks is risky and should never be considered safe. Invest at your own risk.