By Gerrit Smit, manager of the Stonehage Fleming Global Best Ideas Equity fund
A recession in the US, if it arrives, will be among the most anticipated in history.
Whether it materialises or not, investors are already preparing for lower growth and weaker consumption. Identifying which companies are best to own in such a scenario can be fraught with risk, and so it is wise, as a first step, to look to the past and identify those companies that have an established track record of outperforming during recessions.
One name that has more often than not delivered on this front is McDonald’s.
A classic defensive share, over the past 40 years McDonald’s outperformed in the 12 months running up to the start of all five US recessions that have occurred, and for the majority of those subsequent recessionary periods. Its average price drawdown over these recessionary cycles has also been materially less than the wider market.
For example, in the recession of 1981-82, McDonald’s stock gained 61% over the two-year period commencing 12 months before the official recession started and its maximum drawdown over this period was 15%. The S&P 500, by contrast, returned just 5% and had a maximum drawdown of 26%.
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Strikingly, during the Great Financial Crisis of 2007-09, McDonald’s returned an impressive 47% over the two-year period (again starting 12 months before the official start date), with a maximum drawdown of 21%. The same numbers for the S&P 500 were down 33% and 56% respectively.
There have been exceptions. When the COVID-19 crisis hit in 2020, the broad index outperformed the stock by 19% over the same two-year period as McDonald’s was forced to close many of its restaurants. But even then, McDonald’s returned 24% over the period, which was a unique circumstance incomparable to today.
The question is: why does it do so well in harder economic times? And will it again?
A key reason for its resilience is that McDonald’s is really a property business, owning the majority of its restaurants’ land and buildings, for which the franchisee operators must pay an inflation-adjusted rent (regardless of economic conditions and underlying restaurant sales).
With roughly 95% of restaurants franchised, this is a highly secure revenue stream that protects McDonald’s investors’ interests. The rental income McDonald’s receives, on its own, is 1.4x of that of McDonald’s combined dividend payment, debt interest payment and share repurchases.
McDonald’s rental income would only be at risk if was shutting down restaurants, and quite the opposite is happening today. In 2023 McDonald’s opened 400 new restaurants in the US, the first time it had built new stores in a decade, and it continues to accelerate its expansion globally today, adding further to its future rental streams and defensive characteristics. The Golden Arches remain to be one of the most attractive franchise to own on the planet today.
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It is naturally also paid sales-based royalties by its franchisees in return for use of the brand, ingredient sourcing, marketing and technology support. The market-leading scale of McDonald’s system enables it to provide these services at the most competitive cost. This is the source of McDonald’s second defensive driver: its value proposition to consumers.
McDonald’s can feed a family a tasty, safe, reliable meal at a price that few others can compete with, whilst remaining profitable. Whilst at the start of 2024 the chain was somewhat flatfooted in its response to the trend of US consumers eating more at home, and the competition were faster to promote their value meals, McDonald’s acted with speed and has improved the value elements of its menu through meal deals and other promotions.
In so doing it has shored up traffic and captured customers trading-down from more expensive peers. This has enabled franchisee royalties to remain more resilient than at its rivals.
While the US economy is cooling, McDonald’s sheer scale and free cash flow generation means it is well able to support franchisees financially should they struggle in more difficult times, as it did during the pandemic. Investing heavily in its supply chain means it can shield its franchisees from cost pressures and keep prices low, while maintaining its product quality standards – a key advantage over rivals.
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Of course, like most major brands, McDonald’s has faced challenges over the years. Not everyone is a fan of its size and ubiquity, or of processed foods. Its nadir probably came after the documentary ‘Super Size Me’, released in 2004, causing reputational damage (and the swift discontinuation of the ‘Super Size’ menu).
But the chain managed to weather that storm and bounced back stronger than ever through store expansion, menu innovation and technology adoption. Exactly the play-book it continues to execute on today.
More recently, the arrival of GLP-1 drugs (that reduce calories consumed) poses a clear potential risk, but one we believe is well factored into McDonald’s stock valuation, and that it can adapt to through menu innovation.
Its share price started to weaken at the start of the year as sales were hit by the value war, and we took the opportunity to top up our longstanding position. The stock has gained 18% since the end of June and is now close to an all-time high as investors remain drawn to the sustainable, quality growth that McDonald’s delivers.
