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Lock In Your Gains On This Fast-Food Stock -- And Buy Its Rival

8/26/2013 11:00:00 AM
By: StreetAuthority
Referenced Stocks:MCD;WEN

It's unusual to hear someone in the financial media suggest selling astock -- particularly one they previously recommended.

But knowing when to close a position at the right time is just as important as getting into the right trade at the right time. That's why I'd prefer not to leave this loose endopen .

If you stepped into a Wendy's ( WEN ) position about ayear ago on my recommendation, I think it's time to lock in your 40%gain and use those proceeds to invest in McDonald's ( MCD ) .

A little more than a year ago, I concluded that "based on the company's plausible growth forecast,shares could be worth somewhere around $7 by the end of 2013 or mid-2014 -- about 60% higher than current levels." The stock actually hit $7 in late July and has since reached a high of $8.05.

But it's time to lock in the gain.

Don't misunderstand my intention. It's not a pessimisticjudgment of the company, and yes, the stock could move higher. But with a little more than a 60% gain to protect, any furtherupside potential just doesn't justify the inherent pullback risk built into a 12-month 60%rally .

Perhaps the biggest concern is the valuation. The stock's now priced at a frothy 33.8 times trailingearnings . That's not considerably more expensive than how Wendy's shares were valued a year ago. But a year ago, valuation wasn't the concern. Theturnaround effort was poised to be the driving force behind the stock. The turnaround is a done deal, however, and with earnings growth projected to slow to 13% in 2014, it's tough to imagine themarket willing to pump up the premium beyond its already lofty levels.

While Wendy's has been red-hot this year, McDonald's has been less than impressive. Shares are up for the year, but down 8% from April's peak and still falling at a decent clip.

The recent news hasn't been particularly encouraging, either. The world's largest fast-food chain has missed earnings estimates in four of its past fivequarters . To make matters worse, Subway recently announced it was aiming to open as many as 1,000 to restaurants in Europe next year, where McDonald's is already struggling.

Given that, why would an investor want to jump into an apparentlaggard ? For the same reason that now's the time to shed Wendy's -- nothing lasts forever. Bothstocks can (and have) stopped and turned on a dime, and McDonald's is due for a rebound for a handful of reasons.

© McDonald's

One reason is simply that traders have unduly punished the stock. Earnings misses or not, the restaurateur is still on pace to boost earnings 4.4% this year and projected to increase thebottom line 8.6% next year. That's in line with the growth rate the company has logged for years now. Point being, despite recent criticisms driven by unmet expectations, the company is still doing fine.

Another reason McDonald's shares are poised to start climbing again is the company's new push to keep as many units as possible open 24/7, and to serve breakfast after midnight. Investors weren't particularly impressed when the plan was unveiled. But hungry consumers have responded favorably to the new hours of service and expanded menu. Less than half of McDonald's 33,000 restaurants are open around the clock, but that figure should reach about 60% by 2016.

Finally -- though perhaps a little unfairly -- the company is really starting to take advantage of its franchise model by leveraging the clout of its name in a couple of ways.

Much like Wendy's, McDonald's is looking to get out of the company-owned restaurant business by converting as many locations as possible to franchises. Though doing so lowersrevenue , franchise fees are much higher-margin revenue. As part of those deals, the company usually keeps the underlying rights to thereal estate , and carries that property at cost on the books. Translation: McDonald'swill effectively own a bunch ofundervalued real estate.

But at the same time, McDonald's move is ruffled some franchisees' feathers. McDonald's franchise fees have increased to a hefty average of 12% of storesales . That equates to an average of $300,000 per year being forked over from franchisees to thecorporation , up from $212,000 (8.5% of sales) just five years ago. Franchisees are grumbling, but they have little choice in the matter.

Putting it all together, McDonald's has more going for it now than the market's giving itcredit for.

Risks to consider: Though unlikely to actually change the status quo, the recent movement to increaseminimum wage rates at fast-food restaurants will cast at least a modest shadow of doubt on the company's viability.

Action to take --> It's admittedly tough to jump off what seems like a rocket stock, but veteran investors know nothing lasts forever. Wendy's is a fine company, and the stock should do well in the future. But for the time being, shares are overbought and ripe for a pullback. It's better to be out too early than too late. On the flip side, McDonald's have been suppressed for a little too long and are due for better days.

The only consideration to make before booting Wendy's is just how close this idea is to incurring a long-termtaxable gain as opposed to a short-term taxable gain. The original suggestion was made on Aug. 16, 2012, so you've been in for nearly a year. It may be worth holding a tad longer if you're on the short-term/long-term taxable gain bubble.