How I caught an 'inflection point' in the stock of an American icon; Small-world connections in Edinburgh

1) When we sat down for lunch, I braced myself for withering criticism. Instead, the price of a meal at a New York diner bought me one of the boldest (and most lucrative) calls of my career...

You see, by early in my career from 1999 through 2002, fast-food giant McDonald's (MCD) had fallen on hard times.

McDonald's had been an incredible growth stock for several decades as Americans gorged themselves on more and more cheeseburgers, fries, and milkshakes. It had been one of the most widely held stocks in the U.S.

But then, the company went through a tough period...

It failed to come up with fresh new products, built too many stores (thereby cannibalizing its existing ones), and engaged in an insane price war with rival fast-food chain Burger King. All this led to 23 consecutive months of declining same-store sales.

Many people started believing that McDonald's would continue to shrink as Americans started eating healthier.

Investor sentiment was terrible – for example, CNBC pundit Jim Cramer called the stock "unownable."

As a result, MCD shares declined for more than three years – plunging from around $44 in 1999 down to around $16 near the end of 2002.

But I believed the stock was worth a whole lot more than that. So I established an initial 5% position.

I didn't think McDonald's – down about 64% from its peak – could possibly go any lower, but it did...

After reporting continued negative same-store sales in the first months of 2003, the stock sank to less than $13 per share by March.

My instinct was to buy more... But before doing so, I needed to be sure I wasn't getting sucked into a value trap (which I discussed at length in Monday's e-mail), so I set out to do some more research.

That's when one of my investors introduced me to an old friend of his who was a longtime McDonald's franchise owner.

When we sat down for lunch, I braced myself. I was expecting him to tell me what a big mistake I had made investing in this broken company... how frustrated he was dealing with corporate bureaucracy... and how the company hadn't released any new menu items in years.

But to my surprise, the first words out of his mouth were (I still remember them exactly!): "If I had $5 million today, I would put every penny of it into McDonald's stock."

The story my source told me was worth its weight in gold.

You see, over lunch, the franchisee confirmed for me that McDonald's had hit an 'inflection point'...

Keep in mind that one of the critical skills for long-term investing is the ability to catch inflection points.

As a reminder, as I explained in yesterday's e-mail, inflection points happen when a particular company runs into difficulties and the consensus view is that it will continue to stagnate or decline – resulting in a beaten-down stock.

But instead of struggling more, the company grows... and its stock takes off.

To catch an inflection point, I noted yesterday that you need to have a correct "variant perception," which requires a unique piece of data, insight, or analysis.

This is much more likely to happen when you're in your sweet spot – a country, market, or industry where you have deep knowledge, experience, or relationships.

And that's where my source for McDonald's came in...

Even before sitting down for lunch, the company's real estate had caught my eye. I estimated that it was worth $10 per share, and for an extra $6 per share, you got all of the company-owned restaurants plus the hugely valuable franchise fee streams. That's why I established my initial position.

I also had been following the company's efforts to right the ship. McDonald's brought in a new CEO, Jim Cantalupo. He was a company lifer, which Wall Street hated. Analysts thought the company needed new blood. But I saw greatness in the old McDonald's – before recent CEOs had started pandering to investors' short-term demands.

Over our meal, the franchisee gave me a much clearer picture of the turnaround. He told me about how Cantalupo was radically shaking things up, introducing new products, repairing relationships with franchisees, and ending the price war with Burger King.

It confirmed my initial investment thesis – that this was a great company that had fallen on hard times due to self-inflicted (i.e., fixable) problems.

And Cantalupo was urgently fixing them. He ended the price war and introduced new products like McGriddles breakfast sandwiches, all-white-meat McNuggets, and salads. But the results hadn't yet showed up in the reported financials.

So, armed with newfound conviction, I backed up the truck – more than doubling my position at less than $13 per share, which made McDonald's 10% of my fund.

Below is a slide from my 2018 presentation on my "make money" investing approach showing how the stock ultimately fell 73% (even though operating profit only fell 14%) – and how I took advantage:

Cantalupo's turnaround plan worked beautifully.

Two years later, the stock had doubled – and it didn't stop there. I ended up riding MCD shares up to the mid-$60s over the next five years, ultimately selling them during the bear market in 2008.

It was one of only two stocks in the Dow Jones Industrial Average that rose that year – discount retailer Walmart (WMT) was the other – so I was able to invest the proceeds into much cheaper stocks.

Now, I'll admit that I got lucky when my investor introduced me to the franchisee who gave me such insight into what was happening inside the company...

But it wasn't luck that I followed a good process.

I focused on a high-quality business and, when my investment quickly fell, I didn't panic.

I put my emotions aside, sought additional information, and bet big when I became convinced that my variant perception – a belief that a company will perform much better than most investors expect – was correct... and that I had uncovered an incredible inflection point for a turnaround.

(Again, I covered the concepts of variant perception and inflection points in more detail in yesterday's e-mail – for a refresher, check it out here.)

That's one of the keys to building a good long-term track record...

Recognize when you have valuable information that gives you an edge... and then bet accordingly.

2) After spending the day in Edinburgh on Monday, my parents and I were initially planning to rent a car yesterday morning and drive north for the next leg of our Scotland trip.

We were going to do some hikes in the Scottish Highlands, visit Loch Ness (and look for the monster), and then fly back from Inverness to London tonight.

But a local guide we hired instead suggested that we spend a second day in Edinburgh yesterday and then do a day trip to St. Andrews and the Highlands today and fly to London tonight from Edinburgh, so that's what we're doing.

And in an unexpected turn of events, I had two very small-world connections yesterday...

First, I met up with my friend Josie, whom I met when I volunteered at the Samaritan's Purse field hospital in Central Park (where she worked) during the worst of the pandemic in early 2020.

She moved here last year with her family for a three-year PhD program in theology at the University of Edinburgh, so when she saw my Facebook post she reached out and we got together for breakfast and dinner and stayed at her home last night.

Then, when I was walking down the street yesterday afternoon, someone I didn't recognize asked, "Are you Whitney Tilson?"

It was a longtime reader named Darren. He used to live in New York City but is now living in Edinburgh... because his wife is also doing a three-year PhD program in theology at the University of Edinburgh. I didn't expect to hear that!

We had tea for an hour and then he accompanied us to meet Josie and her family for dinner – and of course Josie knew his wife. Such a small world...

Here are pictures of Josie and me in 2020, having breakfast (with her husband) yesterday morning, in front of St. Giles Cathedral, and with Darren (I posted more pictures and descriptions of what we did yesterday on Facebook here):

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.