How to Treat Yourself to McDonald's for Years to Come

 | Mar 05, 2018 | 2:30 PM EST
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What can an investor do when a stock they want to own is not favorably priced?

They could simply wait for a pullback that might, or might not, eventually happen. But that can be frustrating when the stock in question continues to set higher highs without you on board.

Even when a selloff occurs you'd also need to determine at what price to commit, now that the shares are in decline. Nobody likes to "catch a falling knife."

No matter what, the first order of business for sound investing should always consist of figuring out the true value of the stock. Without knowing that how can you lay out a valid strategy?

Fast food giant McDonald's (MCD) had been a stellar performer from October 2015 through Jan. 20, 2018, as it rose steadily from near $110 to north of $178. At this year's peak the stock commanded its highest price-to earnings (P/E) multiple in more than a decade while offering the lowest yield since around 2005.

Those metrics compared to MCD's 2010 - 2017 average multiple of 18.7x accompanied by around 3.11% in current yield. The shares were clearly expensive.

Five of MCD's best six entry points since 2010 (green-starred below) launched from cheaper-than-average P/Es. All six offered buyers higher than typical yields.

Previous periods when traders became over-enthusiastic, in early 2012 and near the middle of 2016, didn't work out well. The January 2012 pinnacle was not permanently exceeded for more than three and a half years. MCD's 2016 peak was followed by around six months of downward action.

Nobody should be surprised, then, that MCD plunged by about $30 a share over the past month and half. A simple regression-to-the-mean valuation suggests MCD could dip as low to below $143 before becoming "fairly valued" on this year's estimate of $7.60 in earnings per share.

Reverse engineering the current $1.01 per share quarterly dividend to an average 3.11% yield implies a downside target of $130 or so, which is not out of the question.

Does that mean MCD can't go back up with hitting those targets? No. We've simply defined the expected risk that remains from last week's closing quote.

McDonald's is a high-quality, generally low-beta name with excellent predictability. Its share price performance, though, has been delivered in fits and starts. Over the long haul it has only beaten 55% of the 1,700 stocks covered in Value Line's main research universe.

How can traders take advantage of MCD's $30 pullback while still protecting themselves from the known remaining downside?

They should consider selling long-term (LEAP) puts on MCD out to Jan. 17, 2020. Last Friday's volatile market and greater-than-4% drop in MCD in particular, triggered some juicy option premiums.

Sellers of MCDs 2020 $135 strike price were pocketing $10.50 per share dropping their worst-case, if exercised price down to $124.50. Writing on $140s, $145 or $150 reduced the "if put" prices to $128.40 to $133.50, respectively, while bringing in more money up front than the $135's offered.

It is very likely that McDonald's will be earning more in 2019 than it did in 2017. McDonald's is also expected to raise its dividend during each of the years 2018 and 2019. Thus, MCD's "fair value" will creep higher between now and the options' expiration date of Jan. 17, 2020.

The present-day margins of safety illustrated will become larger over time if those things play out as expected.

Future stock market action can never be guaranteed. We can say for sure, though, that owning MCD at under $125 would have been a winning position 100% of the time during the previous 12 months.

Break-even points on the more aggressive strike prices would have been profitable all of the time dating back to around the middle of May 2017.

Big Mac lovers can feel content in partaking of MCD via put writing. They'll either buy stock they like at a great price or get paid more than enough to treat themselves to Happy Meals and/or all-day breakfasts for years to come.

(This article originally appeared on Real Money Pro at 7:00 a.m. ET on March 5. Click here to learn about this dynamic market information service for active traders and to receive Paul Price, Bret Jensen and others.)

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