It’s hard to believe now, but in 2002 Wall Street had practically given up on McDonald’s. The company’s quest for revenue growth without regard to existing-store performance had resulted in declining same-store sales, unhappy franchisees and a slumping stock price.
Shares had dipped from a high of nearly $50 in 1999 to less than $20 in late 2002. Its share price eventually hit bottom at $12.12 in early 2003. But we believed McDonald’s had temporarily lost its way and investors had the opportunity to buy an iconic franchise with meaningful growth opportunities at a below-market multiple. There was also a margin of safety, as we believed McDonald’s owned real estate could potentially be worth more than the Company's entire market capitalization.
Patient investors who saw the potential in McDonald’s would eventually be rewarded. New management was brought on board to right the ship. Between 2004 and 2011, the company’s average global comparable sales grew 5.6% and its operating margin improved by over 1,500 basis points. By early 2012, the stock had risen more than fivefold to $101.74 per share.
Finding Value in Fallen Angels
McDonald’s is a perfect illustration of one of The Boyar Value Group’s favorite investment techniques. We love searching for value among former Wall Street darlings that are now unwanted and unloved.
In the same way herd behavior can push a company’s share price to insane heights, investors also can move in the opposite direction when a formerly high-flying company falls out of favor. In those cases, investors will often either leave the stock for dead or decide they can’t stick around to see whether the management can turn it around. As those investors move to the sidelines, share prices fall even further. Investors who can spot these opportunities and have enough patience to let things play out (and stomach paper losses) can find great bargains among these fallen angels of Wall Street.
In fact, this is one area in which individual investors have an advantage over professionals. Fallen angels typically don’t bounce back immediately and often fall far further than one could ever imagine. It may take years for a once-high-flyer to regain altitude. As a result, these stocks can be a real drag on the short-term performance numbers on which professional investors get judged. Individual investors don’t have to worry about losing clients, so they can take the long view—as long as they tread carefully. Since fallen angels can reach ridiculously low levels in terms of valuation, it may be a good strategy to buy into them slowly rather than jumping in all at once, leaving yourself a little dry powder to take advantage of lower prices.
Avoid Value Traps: Look for Catalysts
In a recent column, we talked about avoiding value traps when an entire industry or sector falls out of favor. In those cases, the key is to ensure the sector has an opportunity to recover—that it’s not an industry or a product category on its way to becoming obsolete. Once you’ve done that, you can look for the strongest companies in the sector and wait for a turnaround.
When you’re dealing with individual companies instead of whole industries, there’s less room for error if the expected recovery gets delayed or fails to take place. To succeed, you need a firm conviction that you’re not about to fall into a potential value trap. Telling the difference between a value trap and a fallen angel depends on identifying that catalyst which could drive the stock back up. If you can’t point to something specific, it’s more likely you’re looking at a value trap than a solid investment opportunity.
For example, we loved Sears in the 1980s and 1990s, when it owned great brands like Dean Witter and Allstate. At that point, we believed the sum of the retail giant’s parts was worth more than its market capitalization, so drops in its share price seemed like good buying opportunities. After Sears spun those brands off in the mid-1990s, we saw a company in decline. Its locations weren’t as good, and it wasn’t investing in its stores. When Eddie Lampert took over, many value managers flocked to the name, but absent a catalyst for a turnaround, we saw less reason to invest and were comfortable with the chance that we’d be proven wrong.
The Value of Patience
In our experience, most investors get impatient and sell their potential winners far too early. If a stock doesn’t perform well within a year or two after they purchase it, the average investor tends to ditch it and never look back. When it comes to fallen angels, that type of behavior can be costly.
Some of the biggest winners we’ve held floundered for several years before turning the corner. As the legendary trader Jesse Livermore famously said, “It never was my thinking that made the big money for me. It always was my sitting.” For example, Microsoft underperformed between 2005 and 2011, a period during which we purchased its stock for our clients at an average cost of around $29 per share. By 2011 it was selling for less than 10 times earnings, an attractive valuation for one of the most dominant franchises in the history of corporate America—especially considering that it was growing at almost 12% per year. That year it generated over $22 billion in free cash flow, which it used to buy back a tremendous amount of stock at bargain basement prices while also paying shareholders a generous dividend. We never could have predicted that Satya Nadella would replace Steve Ballmer and revolutionize the company, driving the share price up to $138. But we did know we had a statistically inexpensive stock that was still growing with a pristine balance sheet, that was dominant in its industry, buying back a significant amount of stock at attractive prices. We believed if we were patient, either Wall Street would see what we saw, or an activist investor would get involved and drive change.
We even got a second crack at McDonald’s (MCD, Financial) when its first rise from the grave stalled between 2012 and 2014. Once again, we saw fixable problems, and once again, the turnaround paid off—its share price has more than doubled in the last four years.
Is CVS a Fallen Angel?
CVS (CVS, Financial) has fallen from $113 per share to $55 per share. It’s the dominant pharmacy chain in the industry (80% of the U.S. population lives within 10 miles of a CVS) with a 26% share of the market, and, due to its recent merger with Aetna, also one of the largest health insurers and pharmacy benefit managers. At the same time, it’s trading at a lower multiple of its current earnings compared to its pharmaceutical and health insurer peers.
We believe the low valuation is a function of investor uncertainty regarding the impact of the recent Aetna merger. Also, pharmacy benefit managers’ operations are complex, as is the regulatory oversight under which they operate. CVS also took on debt when it agreed to acquire Aetna for $78 billion and simultaneously signaled a large-scale strategy shift to become a retail clinical provider of healthcare services. All of these factors created short-term uncertainties for investors. While some investors may be uncomfortable with CVS’s increased leverage, we note that the company generates a healthy amount of free cash flow and expects to delever to around 3x net debt to EBITDA by 2020 (from around 5x at the end of 2018).
Strategic transitions and mergers are difficult to execute and are a cause for concern. However, at current valuation levels, not much has to go right in order for the stock to do well—and investors are pricing in a lot of downside. The Aetna acquisition also provides a potential catalyst for CVS to join its peers in adopting a “captive pharmacy benefit manager” business. Accomplishing that transition should allow the company to streamline its operations, leverage its large scale and improve its ability to share data across the pharmaceutical supply chain. Given those prospects, investors with the patience to allow the transformation to play out could find themselves handsomely rewarded.
The Bottom Line
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It’s impossible to know for certain whether a company that’s out of favor with investors represents a fallen angel or a value trap. But with careful research, the presence of a catalyst that could spark a turnaround, and the patience to let that turnaround develop, it’s possible to profit from the second life of companies other investors have already left for dead.
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DISCLAIMER: The performance of McDonald's, Microsoft, and Sears is for illustrative purposes only and is not necessarily reflective of any Boyar Asset Management account. Boyar Asset Management owns shares in Microsoft, McDonald's, Allstate. and CVS. Nothing in this article should be construed as investment advice of any kind. Consult your financial adviser before making any investment decisions. Any opinions expressed herein represent current opinions only and no representation is made with respect to the accuracy, completeness or timeliness of information, and Boyar Asset Management and its affiliates assumes no obligation to update or revise such information. You should not assume that any investment discussed herein will be profitable or that any investment decisions in the future will be profitable. Past performance does not guarantee future results. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified and Boyar Asset Management or any of its affiliates is not responsible for third-party errors. This information is not a recommendation, or an offer to sell, or a solicitation of any offer to buy, an interest in any security, including an interest in any investment vehicle managed or advised by affiliates of Boyar Research. Any information that may be considered advice concerning a federal tax issue is not intended to be used, and cannot be used, for the purposes of (i) avoiding penalties imposed under the United States Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter discussed herein. Employees of Boyar Research and its affiliates have positions in the companies featured.
