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An Investment Blunder of Epic Proportions

July 16, 2012 | About:
The Science of Hitting

The Science of Hitting

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While Ray Kroc is known to many as the man behind McDonald’s (MCD), the concept was originally developed by two brothers, Mac and Dick McDonald. While the brothers still maintained an interest in McDonald’s after striking a deal with Ray in 1955 (who franchised their restaurants around the U.S.), this arrangement eventually became burdensome and fraught with problems; the biggest concern from Mr. Kroc’s perspective was that the brothers were holding the company back from reaching its potential. As a result, Ray approached the brothers in 1961 about purchasing their interest in McDonald’s.

At the time, the McDonald’s brothers were receiving 0.5% of sales as a royalty, which wasn’t too bad of a deal; with 1960 sales equal to $37.5 million, the payout (dividend) for that year would have been equal to $187,500. However, the brothers didn’t anticipate the explosive growth that McDonald’s would achieve in the next half-century: 2011 revenues came in at $27 billion, which understates the actual company-wide sales that the McDonald brothers' royalty figure was based on (revenue from conventional franchised restaurants as reported in filings only includes rent and royalties based on a percent of sales). Using rough data from the beginning of each decade and assuming straight-line growth intra-period, we can estimate the back of the envelope fees income of roughly $1.95 billion forgone over the past 50 years:

1961-1970 $19M
1971-1980 $130M
1981-1990 $270M
1991-2000 $520M
2001-2010 $1B


Obviously, this figure needs to be discounted; the McDonald’s received their money 50 years ago, which is obviously preferable to an equivalent dollar amount today. Using Excel, I put together the following IRR chart, which determines the initial value (the NPV) that would need to be paid (from Ray Kroc’s perspective) to achieve the stated IRR:

10% $100 million
20% $16 million
30% $6.2 million
40% $3.2 million
50% $2 million


As we can see here, the McDonald's interest held by the brothers was worth a substantial sum; they could easily have sought $16 million, which would have left the new owners (Ray Kroc and his partners) with a fat 20% annualized IRR through 2011. Unfortunately for the McDonald brothers, they were not privy to the data that we have to date and seriously underestimated the potential success of the franchise: They sold their stake for the meager sum of $2.7 million; the estimated IRR on that cash outlay has been an astounding 43%, compared to an annualized return from the S&P 500 of roughly 10% over that same period.

The biggest reason has been decades of unimaginable growth: From 200 locations at the start of the 1960s, the company had well over 1,000 restaurants by 1970, and opened its 10,000th and 20,000th locations in 1988 and 1996, respectively. As of 2011, the company had more than 33,000 locations across the globe, equal to a compounded annual growth rate in store count of nearly 11% over the past 50 years. Because of this, an investor could have paid $35,000,000, or 180 times the fee income received in 1961, and still have achieved an IRR of 15% through 2011.

This story has a broader lesson as well: Since the IPO in 1965, McDonald’s has encountered countless problems, many of which looked highly problematic at the time. Despite this, anybody who has purchased a stake in MCD at any point over the 57 years since the initial offering has been handsomely rewarded (those who have held it the entire time have attained 15%-plus annualized returns); that should put the importance of monthly sales data into context.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.0/5 (13 votes)

Comments

Dr. Paul Price
Dr. Paul Price premium member - 2 years ago


You are assuming that the McDonald brothers would have had the same results by themselves that Ray Kroc achieved after he took over.

That is unjustified.

Some years ago a 3-year old horse named War Emblem won the Illinois Derby. The owner sold a 95% interest to trainer Bob Baffert. Baffert took the horse to California, trained it brilliantly, entered it into the Kentucky Derby and sent it on to victory.

Many thought the old owner got screwed. In fact he did great by selling. He had no plans to go to Kentucky nor was he qualified to get the job done in the same way world-class trainer Baffert was. He ended up with 5% of a very valuable Kentucky Derby winnner rather than 'just another good horse' on the minor league circuit.

Had the McDonald brothers not sold to Kroc most of us might never even have heard of MCD.
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Stockdocx99,

While I hear what you're saying, you are making the assumption that Kroc would have abandoned ship if the McDonald brothers didn't accept his offer; just remember that at the time he was getting 1.9% of franchisee sales (0.5% of which was going to the McDonald brothers), and had built a network of 200 locations from scratch - so I question whether or not he would be willing to start anew.

Thanks for the comment!
jameshou
Jameshou premium member - 2 years ago


Very fascinating guys!
hawsco
Hawsco - 2 years ago
Stockdocx99 made a good point. It is doubtful that the brothers had the business and marketing genius that Ray Crock had. They were much simpler men, with less lofty business goals. Based on what a buck bought back then, 2.7mil was a staggering amount, and they could just walk away.

This article is akin to saying the people who sold my house to me in 1995 for 175K "blundered" because it is still worth 400K now, and I bought a small apt. bldg for 250K when I refinanced with an increased LTV in 2007,renovated it and sold it for 990K in 2009.

Look at all the money they could have made!
The Science of Hitting
The Science of Hitting premium member - 2 years ago
Hawsco,

I hear what you're saying, and noted that in my response to Stockdocx99; in regards to the opportunity cost on that capital, that's specifically why I included S&P 500 returns over the same period and IRR figures. Thanks for the comment!

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