Sometimes, when nearly all analysts think the same thing, it’s wise to do the opposite. For one fast-food giant, now might be such a time.
The vast majority of analysts that cover McDonald’s Corporation (NYSE:MCD) list it as a “buy” or “outperform.” In fact, not a single one recommends investors sell.
That might not sound strange since it is such a stable player and reliable investment over the years. But considering all of the macroeconomic weakness globally, consumer trends shifting far away from fast-food and declining revenues, there’s a real case to be made that these analysts are just plain wrong.
Now, don’t get me wrong. McDonald’s offers one of the most stable dividends in the market, reliable performance quarter after quarter and a recession resistance unparalleled in the marketplace. However, a simple look at what’s been happening on the ground – and on the account ledgers – show there’s a clear disconnect going on with its price tag.
First of all, it’s no secret consumers have been straying away from greasy burgers. Even the introduction and instant fascination with plant-based burgers hasn’t shifted consumer trends much. And while McDonald’s has been competing with rivals like Burger King and Wendy’s for decades, they’ve stepped up their games.
Wendy’s in particular has been investing heavily in both menu items and store renovations. It has forced McDonald’s to up its game on digital kiosks and delivery options – both of which have helped McDonald’s attractiveness to investors.
The market loves what McDonald’s has been doing moving into a new era of fast-food consumerism. The digital kiosk and delivery options have helped push interest and share prices way up over the last few years:
What market speculators, analysts and investors seem to be missing is that this rapid share price appreciation is only tied to MCD’s incredible ability to cut costs. Revenues have actually fallen significantly over the last few years.
In 2016, the company brought in $24.6 billion in sales. Over the last 12 months, that’s fallen to $20.8 billion. That’s a significant drop. Yet, it has been able to cut costs even further over the period, accounting for earnings growth.
I’m not saying it can’t continue to strengthen its margins going forward. But there’s only so much any company can do on that front. Some costs are just unmoving.
Now, I’ve noted that nearly all analysts rate McDonald’s as a “buy.” But a recent market note by one of these analysts indicated some short-term problems.
At the beginning of this month, JP Morgan issued a research note saying that its fellow analysts have overshot their same-store sales forecast for McDonald’s upcoming quarterly earnings announcement… set to take place next week.
Additionally, the company’s more popular changes – especially delivery – won’t have the kind of impact investors expect this quarter. The bank argues that while McDonald’s stock remains a “buy” for the long term, investors shouldn’t get their hopes up in the short term.
This brings up an interesting opportunity. With the company entering next week’s earnings announcement with nothing but “buy” ratings, the only real direction for it to go is south… at least in the short term.
A single “sell” or downward price adjustment from any of its analysts following next week’s call could easily send shares crashing temporarily.
This gives us a perfect contrarian trade opportunity. McDonald’s, you see, is far more likely to disappoint than it is to surprise to the upside. And that’s a real possibility. So far this year, the company missed one earnings target and barely met a second one. So, plenty of room for another let down this third quarter.
None of this is to say anyone should go out and short MCD shares now or probably ever. The company is still a rock-solid global brand with plenty of staying power. However, you don’t have to go out and short shares to play this potential near-term disappointment.
A Strategy For Short Term Bears
A bear put spread is a type of options trade that involves buying one put option and selling a second one with a lower strike price. The income from the latter, helps pay for some of the former.
It still results in a net debit to the trader’s account. But it significantly reduces both cost and risk. There is a price to pay for that, however.
As you can see here, the maximum profit potential for this strategy is capped:
Source: The Options Industry Council
For a company like McDonald’s however, that’s a tradeoff definitely worth the taking. After all, shares of MCD will only drop a certain amount. Even a devastating miss next week or several analyst downgrades would only shares tumbling so far. It’s not like anyone, me included, thinks McDonald’s is doomed to collapse in a big way anytime soon.
So, a cheaper entry price in exchange for capped – yet still quite large – returns is the best way to play this fast-food behemoth.
Let’s take a look at a specific bear put spread trade to see how this one could play out.
A Specific Trade on MCD
Right now, a trader can buy a November 15 $210 MCD put for $4.75 per share and sell November 15 $200 put for $1.44 per share for an entry cost of $3.31 per share. Since each put contract represents 100 shares of McDonald’s, that’s a net debit of $331 depending on how many contracts he trades.
That’s his total risk with this bear put spread trade… $331. The only way for him to lose that full amount would be if McDonald’s somehow outperforms the already too-optimistic analysts next week. Even still, shares would have to jump above $210 between now and November 15 for that to happen.
A far likelier outcome from all of this would be to see a near-term price retreat. Shares are already overinflated, especially considering the falling revenue. Even if the company meets analyst estimates this quarter, a drop to $200 or just below is still on the table.
If that happens, this trader maxes out his potential profit. To find out just what that is, take the difference in strike prices ($210 – $200 = $10), and subtract the entry cost ($10 – $3.31 = $6.69). Again, since each contract is worth 100 MCD shares, that’s a total potential profit of $669… clearly setting up an ideal risk/reward scenario for the trader.
In other words, if a single thing goes wrong for this company… or even doesn’t go right enough… this trade could produce a 202% return on the amount at risk.
There’s virtually no other way to triple your money off such a small, yet obvious, price adjustment on a stock like MCD. This opportunity left open by analysts’ preoccupation with McDonald’s margin management over sales trends is one definitely worth taking.