Thursday, December 27, 2012

Yum Brands Disappoints With China Sales

One of the most consistent errors in investing is the determination to cling on to what behavioral psychologists call the fundamental attribution error. Now I know what you are thinking: yet another dreary hard-to-read article on a concept that doesn’t conclude with anything tangible even if you could make sense of it? Okay, well there will be some of that too (I promise), but bear with me -- there is a key point here and it relates to how many people view their investing.

Fundamental Attribution Error

Simply put, the fundamental attribution error (FAE) is the tendency to over-value personality based traits and under-value situational influences upon behavior. This sort of thing crops up a lot in investing. For example, you usually see it when a group of companies in a sector or theme start warning and one company reports a half decent set of numbers. The FAE then kicks in and investors start concluding that it’s the management stupid! They are somehow capable of generating growth against an industry downtrend simply because growth is dictated by the ‘personality’ or ability of the management.

Of course, we see this at its best (worst) in the banking sector where star traders and senior management are deemed worthy of huge swathes of shareholders' money. Well it’s funny, but these banks only seem to make money when the overall economy (and taxpayers' money) is in their favor. Moreover, I don’t recall any downgrades to EPS forecasts when Bob Diamond left Barclays. It strikes me that the easy way to raise earnings would be for stockholders to insist that salaries be cut. I doubt it would affect performance much.

Yum! Brands and the FAE

But I digress! I meant to talk about Yum! Brands (NYSE: YUM), which recently delivered something of a ‘shocker’ of a full year forecast statement which contained the prediction of a 4% decline in same store sales in Q4.  I used inverted commas because if you look back at this article linked here you can see that this decline is in line with a trend. It is also in line with McDonald’s (NYSE: MCD) patchy performance in China this year. Indeed, MCD recently announced that same store sales were negative in China in October. Throw in the fact that Yum now makes the majority of its operating profits from China and it’s not surprising that the market is selling it off.

The truth is that a number of companies have been reporting weaker conditions in China, so what makes Yum any different? Granted it is coming up against tough comparables, but it is an industry-wide problem.

Yum's China sales:




And with McDonalds aggressively expanding stores in China and Burger King (NYSE: BKW) also planning to open 1,000 restaurants with a partner in the next 5-7 years, there is no let up in expansion. Indeed, Yum itself is planning another 700 units in China for next year.

Good timing?

Don’t Rely on Emerging Markets

I think there is a good case to be made for being very cautious with China right now. Yes, it will still record GDP growth in excess of anything that the West will produce, but you must remember that a lot of companies have built up their hopes on APAC growth. Meanwhile companies with heavy European exposure are lapping some easier comparables and the US recovery appears to be on track. Investors will do what they have always done and continue to believe in yesterday’s story.

For more detail in the kinds of stocks that could suffer if China continues to disappoint, there are a couple of articles linked here and here. I’m not going to apologize for seeming to have the early onset of Asperger’s syndrome over the issue, because I may well have saved myself some losses as a consequence. Picking out any one company to focus on is perhaps unfair, but businesses like Caterpillar (NYSE: CAT), Rio Tinto, Burberry’s or even Coach do have heavy exposure to China. Caterpillar has the 'double whammy' effect of being exposed to China's fixed asset investment.

Moreover, I think it’s time to focus on those companies that are talking about slowing down expansion growth in China because it is far from clear that China is going to rebound in growth next year. There is plenty of time to get back into the China story, but some prudence is needed now.

Avoiding the FAE

Tying these points together leads to the conclusion that no company is immune from its sector/geographic conditions for too long. Committing the FAE is very tempting because we all like to think we invest in great managements. Indeed, Yum is clearly a very well run company, but it hasn’t managed to avoid conditions in China.

Forget the idea that Yum’s management (or others) can generate growth against a slowdown. My point is that if you buy Yum you are investing in a snapback in growth in China rather than the ability of the management per se. Don't commit the FAE!