Big returns from fast food in slow market

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Mark Jewell

Step into the McDonald’s in Port Chester, N.Y. on a Saturday, and there’s a good chance you’ll see Jon Burnham dining on the cheap with his wife. They’re McDonald’s regulars.

“Where else can two people go and have a really nice lunch or dinner for $10?” Burnham asked.

He knows how to spot a value, after more than five decades in the financial services industry and 16 years as a mutual fund manager.

The economy is in a tough spot, and Burnham expects consumers will continue to embrace low-cost menus at fast-food chains. He’s a particularly strong believer in McDonald’s stock, one of the top five holdings in his fund.

Its shares are trading at an all-time high, up 22 percent in a year when the stock market has edged up just 2 percent. That’s one reason why Burnham Fund (BURHX) has outperformed 94 percent of its large-blend stock category peers this year, returning more than 3 percent.

A bigger contributor is Burnham’s second-biggest holding, Chipotle Mexican Grill. Its shares have surged 62 percent this year, lifted by sales that are rising at a faster pace than at more established chains.

The sizzling results for restaurant chains extend beyond those two names. Strong performers include Panera Bread and Starbucks, both up 34 percent; Tim Hortons, 22 percent; Wendy’s, 12 percent, and Yum Brands, 11 percent.

But will gains continue?

Unfortunately, investors looking to spice up returns by adding those names to their portfolios now may find their potential is limited because the stocks have performed so well recently.

Industry profits are being constrained by rising costs for ingredients such as beef and coffee, which have triggered price increases at several chains. Still their menu prices remain low enough that the chains hold appeal at a time when many consumers are wary of spending too much to eat out.

Fund managers investing in fast food say they’re also drawn by the relative simplicity of the chains’ business models. And many chains have expanded into fast-growing emerging markets like China.

Fast-food chains offer relatively predictable growth prospects at a time when the outlook for economic growth in the U.S. and Europe is dim, said Ron Rohn, co-manager of the John Hancock Global Leaders Growth Fund (USGLX), whose top holding is Yum Brands, owner of KFC, Pizza Hut and Taco Bell.

Restaurant stocks to consider

Below we look at three top fast-food stocks, and perspectives from managers at funds with big stakes in them:

1. McDonald’s Corp.

The biggest burger chain is an industry bellwether, with more than 33,000 locations. With a market value of $95 billion, McDonald’s is a widely held stock, and one of the 30 names that make up the Dow Jones industrial average.

McDonald’s increased its third-quarter dividend by 15 percent, and expects to return about $6 billion to shareholders this year through dividends and share repurchases.

It has raised its payout each year since paying its first dividend in 1976. The current dividend yield is about 3 percent.

McDonald’s has been repositioning itself as a health-conscious option, adding salads and oatmeal. Earnings have risen for nine consecutive quarters, capped by a 9 percent third-quarter gain. But the company hinted that it may need to raise menu prices for the third time this year to help offset higher ingredient costs.

The stock is the top holding at the Two Oaks Diversified Growth Fund (TWOAX), whose manager argues McDonald’s is in good position to offset those costs. Blake Todd points to the chain’s expanded beverage lineup, including fancy coffee drinks.

Beverages are typically sold at higher profit margins than burgers, and ingredient costs are lower, helping to insulate McDonald’s from spiking commodity prices, Todd said.

He also credits McDonald’s for adapting to local tastes overseas, where menus vary widely from those here. The U.S. now accounts for just 31 percent of McDonald’s revenue.

2. Yum Brands Inc.

Yum’s KFC, Pizza Hut and Taco Bill chains give the company a diversified approach. Yum has more than 38,000 restaurants worldwide. With a $25 billion market cap, the stock’s dividend yield is about 2.1 percent.

The company recently said that it expects sales to drop in the fourth quarter in its struggling U.S. business, particularly at Taco Bell.

But Yum is faring well overseas, where it gets two-thirds of its operating profit. Nearly half comes from emerging markets like China. This year, the company expects to open 1,500 restaurants, maintaining last year’s pace of about four new restaurants each day outside the U.S.

3. Chipotle Mexican Grill Inc.

The chain of nearly 1,200 restaurants has expanded rapidly, employing a fast-casual service model, and emphasizing fresh, healthy ingredients in its burritos and tacos. It targets middle-class consumers willing to pay $8 to $10 a meal.

The 18-year-old company remains primarily a U.S. chain, but recently expanded beyond Mexican fare with new ShopHouse Southeast Asian Kitchen locations. Its stock debuted in 2006 at $45 a share. The company doesn’t pay a dividend.

Shares now trade for about $340, making the stock unusually expensive relative to the earnings the company generates. Chipotle’s price-to-earnings ratio of 53 is about triple the average P/E of stocks in the Standard & Poor’s 500 index. McDonald’s P/E is about 18, and Yum’s is 21.

One reason Chipotle’s stock is priced so richly is the company’s strong growth. Sales at restaurants open at least a year rose 11.3 percent in the third quarter, more than twice the 4.4 percent figure at McDonald’s U.S. locations.

Burnham said Chipotle’s management has a knack for adding restaurants in ideal locations, and the chain’s emphasis on natural and high-quality ingredients is clearly a hit with consumers.

He’s happy to hold onto the stock, which makes up about 7 percent of his fund’s portfolio. But he worries that any broad setback in the stock market could cause investors to start selling growth stocks like Chipotle, in favor of safer names.

“I think of McDonald’s as a core holding,” Burnham said. “But Chipotle needs to be watched, because it’s not so cheap.”

— AP