Buying the world’s most hated stocks

I want to own shares in better than average companies and hold them for the long haul. But I am also a bit of cheapskate. Paying huge multiples of a company’s revenue or forward earnings just isn’t something I am comfortable with.

To get around this, I try to enter an investment when the stock is disliked if not hated. This could happen because the business hits some kind of problem. It could be because the short-term outlook for a whole industry looks uncertain. Or it could be because returns have been poor and investors want out.

I recently shared a test that I carry out to find situations like this. It is very simple: I screen for Wide Moat stocks with five-star Morningstar ratings.

Doing this brings up a list of companies that, according to our analysts, are of the highest quality. Not only that, their shares trade at a large discount to our analysts’ estimate of intrinsic value. I then look for trends.

When I first wrote about this screen in June, I said that alcohol and drug companies looked out of favour. There were 25 or so companies meeting my criteria and these two industries made up far more than their fair share.

I could have also mentioned a third group of shares. But I didn’t because they kind of gave me the chills. Then I realised that this was stupid. If you are looking for areas of the market that are out of favour and potentially undervalued, those chills should attract you.

The stocks in that group can be summed up in one word: China.

Everybody hates Chinese stocks

People thought Chinese shares would rip once Covid restrictions were lifted. That didn’t happen. Then everybody started to worry about China’s economy, China’s property sector, deglobalisation, China’s aging population, and whether the Party was doing enough to save China’s economy. This has been reflected by dreadful stock market returns.

Over the three years to July 31st, the MSCI China Index lost an average of 13.7% per year in US dollar terms. That’s against a 7.4% per year average gain for the MSCI World Index. The Kraneshares China Internet ETF is down around 75% from its peak in February 2021. And the Nasdaq Golden Dragon Index, which tracks US-listed stocks doing most of their business in China, is down by around 30% over the past year. I could go on.

This isn’t just a short-term thing, either. Chinese shares have consistently lagged the country’s economic growth for various reasons, which probably include some concerns over investing in a communist country and the weaker property rights that might come with that.

Between 1992 and 2023, China’s GDP is estimated to have grown from below $500 billion to just under $18 trillion. From December 31, 1992 to July 30th of this year, the MSCI China index has returned an average of... 0.5% per year.

Some more checks on recent sentiment:

• In December 2023, Moody’s cut its outlook on China’s credit rating from stable to negative

• The Financial Times reported that 40% of poll respondents at a Goldman Sachs conference session on Chinese equities in January 2024 said that Chinese shares were “uninvestable”

• GlobalX shut 18% of its ETFs in January, with more than half of the closures coming in China related products

• A chart from JP Morgan’s recent market data summary ahead of Q3 showed that earnings estimates for Chinese companies have continued to trend down since Covid. Estimates in the other key equity regions (barring emerging markets, where China is 25% of the index ) all rebounded strongly.

That’s all pretty miserable stuff. And it goes some way to explaining why my stock screen came out the way it did. Of the 22 Wide Moat companies currently at 5-star prices, at least eight jump out as being linked to concerns over China.

Estee saw China grow from 13% of its sales in 2018 to over a third of revenues by 2021 The figure then dipped to 28% of sales in 2023. In dollar amounts, its Chinese sales grew from $1.78bn to $6bn between 2018 and 2022. That is average annual growth of 35% per year.

No wonder Estee’s stock and sentiment regarding China became so entwined.

Look at how similar the direction of moves in Morningstar’s China Equity index and EL stock have been on several occasions since 2021.

Two different investing lenses

We have spent most of the last few paragraphs talking about short-term things. We have spoken about stock and index price returns in the recent past. We have spoken about what analysts expect to happen in China’s economy and what they expect in upcoming earnings announcements.

As Joel Tillinghast says in his book Big Money Thinks Small, this is what most investors focus on, full stop. What will happen next? By focusing on something different – the competitive position and long-term prospects of a company – there is a chance to get different results.

I am not saying that China’s economic slowdown isn’t real. That expectations in certain stocks like EL didn't get ahead of themselves in the past. Or that investing in China doesn’t carry certain risks. I’m just saying that investors are prone to thinking that both good and bad times will carry on forever.

When the latter fever takes grip, it increases the chances of finding high quality companies trading at depressed prices. Which brings us to Yum China, a company I own a small position in.

Yum China Holdings ★★★★★

Yum China Holdings (NYS: YUMC) was spun out of KFC and Pizza Hut’s parent company Yum! Brands (NYS: YUM) in 2016.

Yum China has the exclusive right to operate and sub-license (franchise) KFC, Pizza Hut and Taco Bell restaurants in China. Yum pays the original Yum a percentage of revenue from those brands and also has other smaller ventures.

Here are the number of locations Yum China had for each venture by the end of 2023:

It’s clear that KFC and Pizza Hut are the key drivers here. And if that number of KFC locations seems huge, that’s because it is. China has more KFCs than any other country on earth.

The data below comes from Yum Brand’s Q1 report, 3 months after the data referenced above. In that time, China gained another 307 KFCs. For some rather irrelevant context, that’s more than Guzman’s entire Australian store count.

At the end of 2023, 86% of its stores were company owned and operated. Contrast this to the ASX listed Domino’s Pizza Enterprises (ASX: DMP), for example, which only operates 25% of stores themselves with the rest operated by franchisees.

Franchising out stores requires a lot less capital to grow profits. This is because the third-party franchisee foots the upfront costs and the franchiser simply collects upfront and royalty payments. Healthy store growth and sales (from which royalties are taken) can therefore lead to very attractive returns on capital and high stock market valuations.

Yum China is clearly different to many of the big fast food stocks in that regard. Yet it has still earned attractive returns on capital for several years on end.

This is partly because the KFC and Pizza Hut locations they are footing the costs for have very short payback periods. Management has said that KFCs have consistently taken just two years to payback their initial costs, while Pizza Hut has improved to a payback time of two to three years.

Morningstar’s Yum China analyst Ivan Su expects that the firm will continue to earn returns on investment above its cost of capital. This is because he thinks that Yum China has a wide economic moat.

Yum China's moat

Su’s Wide Moat rating for Yum China stems from intangible assets and cost advantages.

Yum China’s intangible assets include its well known brand names. Since opening its first location in Tiananmen Square in 1987, KFC has become China’s biggest fast-food brand with 5% share. According to data from AC Nielsen, it also China’s favourite fast-food option. 60% of surveyed Chinese consumers picked it as their top choice, compared to 34% for McDonalds.

Su’s report stresses that while KFC’s early success in China can probably be put down to novelty, it has morphed into an authentic Chinese brand. It has achieved this by offering highly localised menu offerings and a very different and more ambient vibe to KFCs in the west.

This doesn’t seem to be unique to China. Shani, my colleague here in Sydney, told me that Sri Lankan KFCs are seen as a great sit-down option for first dates. That is very different to what KFC tries to be in the UK. Putting my partner’s vegetarianism aside, I’m not sure a candlelit dinner at a Glasgow KFC would have done the job.

Moving beyond KFC, Pizza Hut is also China’s leader in its field as the most preferred western casual dining restaurant – way ahead of other pizza players like Domino’s and Papa John’s.

Yum China’s scale allows it to invest more heavily in innovation to avoid brand fatigue. One outcome of this is the number of new products it is able to develop and test. Yum China’s 2023 annual report claims that 500 new or updated menu items were introduced during the year. That seems like a lot.

Not just brands...

In addition to intangible assets, Yum China also has cost advantages that allow it to offer a superior combination of price and quality.

82% of China’s USD 700 billion restaurant industry consists of nonchains— mom and pop restaurants – compared to 46% in the US. By contrast to these mostly single-store operations, Yum China has over 14,000 restaurant locations.

Being the largest restaurant group brings considerable influence over suppliers and ensures access to food and other raw materials at predictable, competitive prices. This cost advantage is complemented by a supply and distribution network that is unrivaled in the region.

Because China lacked reputable food distributors when the company entered the country, KFC developed its own distribution infrastructure. This now encompasses 33 logistics facilities, six consolidation centers, and a fleet of more than 2,100 refrigerated trucks.

Yum China has previously said that its supply chain is run at a unit cost 50% lower than industry average, forming a material cost advantage over smaller peers. Su sees Yum China’s solid distribution backbone as a key enabler of its expansion strategy.

Growth outlook looks decent

Yum China’s management has set the goal of reaching 20,000 locations across the group by 2026. Ivan thinks sees this as a fairly realistic aim, driven mostly by expansion into smaller cities with a lower rate of penetration by chains. For instance, KFC is in 2000 Chinese cities already, but over 1000 smaller Chinese cities with no KFCs at all.

Ivan also expects chains like KFC and Pizza Hut to take more share of China’s highly fragmented restaurant market. He thinks this could be supported by three long-term secular trends: longer working hours for urban consumers, rapidly rising disposable income, and ever-smaller family sizes. 

Su expects this will see Chinese food chains grow their share of overall restaurant spend from current levels of 18%. For context, chains currently command 61% of spending in the US and 34% of spend across the globe. Thanks to its strong brands and supply chain advantages, Su thinks Yum China would be the prime beneficiary of any such increase.

Su also thinks that Yum China’s internal initiatives can continue to support healthy top line growth. This includes the menu innovations we spoke about earlier, new restaurant formats, the potential for Lavazza and Taco Bell to catch on, and further digital marketing efforts.

On the latter point, Yum China’s recent Q2 earnings featured the snippet that it has over 400 million loyalty program members and that around 90% of orders were made via digital channels. By harnessing past order data, Yum can give these customers an increasingly personalised experience through tailored menu orders and offers. For example, a customer that has chosen healthy options in the past may see salads more prominently.

Taken together, Su thinks Yum China can average 13% growth in its number of stores until 2026 and can grow sales at its existing stores by around 1.5% per year. He also points to the potential of higher profit margins, increased franchising and further share buybacks – for which over $600 billion is still set aside – to support earnings per share growth.

These assumptions underpin Su’s Fair Value estimate for Yum China at $76 per share. This estimate bakes in a high implied price-to-earnings ratio of 33, but Su feels that this could be justified by the company’s growth potential. At the time of writing this article, Yum China shares traded at around $30 and had a forward price-to-earnings ratio of 14.

Potential downside

It’s always important to consider downside risks as well as upside. Su has attached an Uncertainty rating of Medium to his valuation of Yum China, citing several potential factors that could affect the business.

As China's restaurant industry consolidates, Su expects chains to increasingly compete with one another on price and product offerings. He thinks that aggressive (and often irrational) promotional activity is likely to escalate.

In addition to rising competition, Yum China must contend with volatile GDP growth and consumer spending trends, state-mandated wage rate increases (which increase costs), and uneven commodity costs. All of these could negatively impact top-line growth and profitability.

Restaurants, in general, are also susceptible to negative publicity tied to food quality concerns, which can result in substantial drops in near-term foot traffic. Su believes that Yum China faces less than average risk on the product side, due to the firm's sophisticated supply chain systems.

He also points out that predicting the exact timing of a turnaround for Chinese restaurant shares (both in terms of traffic and sentiment) is impossible. Sales could easily suffer more in the short-term, but he does expect a long-term recovery.

Not so fast…

Yum Brands appears to have strong and durable competitive advantages. The growth outlook doesn’t look bad. The valuation looks undemanding. And market sentiment looks like it couldn’t be much worse than it has been recently.

Personally, those are four things I like to see. This doesn’t mean, though, that you should go adding Yum China to your portfolio. Any investment you make should align with your goals and a deliberate strategy for achieving them. See this article by Mark LaMonica for a step-by-step guide to making yours.

Another thing – this post wasn’t really about Yum China. It was about trying to focus on a company’s quality, long-term prospects and valuation rather than short-term sentiment. There may be more suitable ways for you to execute on this.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.