Check out the nine and a half minute mark of this charmingly clunky video from Peter Lynch. It contains the following quote:
“McDonald’s earnings have gone up, I think, more than 80 fold over the last thirty years. The stock has gone up 100 fold. What made McDonald’s earnings continue to grow? If they had just stuck with a cheap cheeseburger and a cheap hamburger at lunch, they probably would have run into earnings problems ten, fifteen years ago. But they expanded their menu, they kept their costs low, they added breakfast, they went overseas. Every day, they add two or three more restaurants. People thought there was no room for more McDonalds’ five, ten, fifteen years ago. They were wrong. If they had done the research that said, well, there’s a couple hundred countries out there. There’s lots of places to grow.”
In the 1990s, business magazines were convinced that Nike had saturated the shoe market and would be a dud stock because it had nowhere left to grow. The growth of the golf division, and then the rise of athletic-wear clothing, drove 18% annual returns as these new product offerings performed well outside the United States, too.
Sometimes, the insight you have will be the result of digging into a company’s balance sheet. Dine Equity shares, which is the parent company for Applebee’s, has exhausted just about every growth opportunity and has franchised its operations to convert the brand into a cash flow machine. There won’t be big growth from the Applebee’s brand, but luckily for Dine Equity shareholders, they also own IHOP which earns extremely high profit margins (word to the wise: if you’re thinking about starting a restaurant, create a pancake house. The 400% operating margins carry the day. It may be unglamorous, but a dollar from your pancake operations spend just as well as a dollar from ownership of a sports franchise).
Chipotle, on the other hand, has less than 1% of its locations that operates as a franchise. If it wants to convert its stores into a giant cash cow stream, it still has that lever to pull.
The obvious source of growth is product expansion into other countries. Firms like Hershey and Colgate-Palmolive only have about a tenth of the international scope of behemoths Coca-Cola and Nestle, and these unconquered frontiers give Hershey and Colgate a potential growth advantage. That doesn’t mean Coca-Cola and Nestle, which operate in 210 and 180 countries respectively, are in trouble. Their business models lend themselves to new product launches, product acquisitions, and market penetration from lagging products (e.g. Cherry Coke may have a full market position in Mexico, but other brands like Dasani may still have room for large growth there.)
I am not as concerned about the terminal point for mega-brands as other investors that cover the mega-cap stocks. By virtue of owning strong brands, the existing product base generally delivers 3-4% annual earnings growth in existing markets on its own (after all, the reason a business can receive a valuation in the tens of billions of dollars is because there has been such an excellent track record of demand for the product). With retained earnings that aren’t paid out as dividends, there is usually another point or two to pick up from acquisitions and share repurchases. Sporadically, a new product launch will find success. At a minimum, this usually translates to a terminal growth rate of around 5%. Often, these businesses have a dividend yield of 2-3%. That takes you into the territory of high single digit total returns, which is pretty close to the 10% average from the Ibbotson & Associates data 1925 through 2005.
I would be hesitant to conclude that a business with decades of high earnings growth is doomed going forward because it has grown too big and saturated. It is not that this never happens, but rather, that it is very easy to ignore a growth lever that is yet to be pulled.