2 Winning Stocks From 2016 That Surprised the Market

After a tumultuous year of headlines and a strong showing for major U.S. indexes, 2016 is finally nearing its end.

On this episode of Industry Focus: Consumer Goods, Vincent Shen and Fool.com senior contributor Asit Sharma take some time to reflect by sharing their favorite surprise winners of 2016 in the consumer and retail space, before turning their attention to some important trends and takeaways for 2017.

A full transcript follows the video.

This podcast was recorded on Dec. 19, 2016.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It is Monday, Dec. 19; we're recording a day early in the studio this week. Joining me via Skype is none other than Fool.com senior contributor, Asit Sharma. How are you, Asit?

Asit Sharma: I'm well, Vince, thank you very much.

Shen: I have to ask you, what do you have for your holiday plans?

Sharma: I just want to tell you about my immediate plans. You don't want to hear about the long, drawn-out deluge of business that I have planned. But, after work today, I want to challenge all listeners -- I'm going to do this too -- let's all hit the gym or take a run and clear out the way to eat, drink, and be merry. It's been a wild year, and I for one want to hit some comfort food over the holidays. (laughs) So my immediate plans are to work out and pave the way for some good eating over the next couple of weeks.

Shen: Absolutely, I think that's a very good note. The Motley Fool Answers team, they had an awesome episode in November, it was their "Maintain Don't Gain" episode, and there were some great tips from our chief wellness officer, Sam Whiteside. She talks about some ways to splurge and enjoy the great food that comes with the holiday season, but also not allowing that to start you off on too negative a trend toward the end of the year, and giving you a strong start to 2017 as well.

But, for our final new episode of 2016, I did want to spend some time with you, Asit, looking back on the year, and then finishing up with a view of the new year and beyond.

First off, we had some big surprises in 2016 in terms of the U.S. presidential election, Brexit, lots of other events. Overall, the broad market has been able to buck a lot of expectations. It's been really happily chugging along, the S&P and Dow have both delivered approximately 10% and 14% year-to-date gains, respectively. Recall that things were actually very rough earlier in the year. By mid-February, both the S&P and Dow were down more than 10%. At current levels, they have actually managed to jump a solid 25% in those ensuing 10 months or so. 

For our year-end part of our discussion, I wanted to look at a stock that surprised us in 2016. Asit, what was your pick for the consumer retail world for the company that really surprised you in 2016?

Sharma: Vince, a stock that took me completely by surprise this year was none other than Wendy's (WEN -0.10%). It's a perennial No. 3, world's third-largest burger chain, always trailing behind McDonald's and Burger King, which seem to be more in the conversation. Threw out some amazing numbers. Up 30% year-to-date on a total return basis. What's even more impressive is going back to Jan. 1 of 2015 -- the stock is up 57% on a year-to-date total return basis over these two years. Not something we usually correlate with the quick-service restaurant industry. Great margins since 2015, [with] the operating margins up over 50%. 

Wendy's is doing this in three ways. It's impressing investors by its cost-cutting. It's also remodeling stores at a pretty good clip. You may remember that McDonald's went through a big store refresh a few years ago. Now, it's Wendy's turn. It's also refranchising, that is, selling corporate-owned franchises to individual owners and teams of owners. It's going to a model where it will look more like Burger King, which is 100% franchised. Wendy's, by the end of this year, will have 6,500 locations, and only 5% of those will be corporate-owned.

Shen: Yeah. You touched on a few things. I'll have to say, you mentioned the perennial third among the big fast food chains. Wendy's is definitely a company that I don't think we've touched on very recently on the consumer retail-focused segment of Industry Focus. That operating margin increase of 51% is really impressive in this space, especially some of the gains that the stock has been able to enjoy. It's definitely not something you typically see from what would generally be considered steadier, more stable names like a McDonald's, for example. You mentioned some things, like the new store remodeling, which, yeah, that's definitely a trend we saw with McDonald's as well. I think that has been very helpful in terms of helping to improve some of their foot traffic and store visits. What else has the company been working on, or have they been able to deliver to help boost the stock and see some of these strong results that they've been able to enjoy?

Sharma: They have a few strategies that they're employing. One is called "buy and flip". Back in the real estate boom, everyone was discussing how flipping homes might be a good investment. That was before it all crashed. Wendy's take on "buy and flip" is, instead of selling all the restaurants to new people or new franchisees, they're actually buying some of those back, but they're not holding on to them. So, Wendy's will buy a franchise unit, or several units, and then sell it to a different franchisee, which is perceived to be stronger, has better operating efficiency, and really knows how to manage the restaurants well. So, you can think of this as transferring its own restaurants from one franchisee to another. It's called buy and flip. I think it's a really good strategy.

Also, they are focusing on the basics. Many companies lose sight of the basics that pull in traffic from day to day. Wendy's is one which has quietly always adhered to quality service, speed, accuracy, the types of things that you now hear McDonald's talking about to regain customers. I think, this fall, Quick-Service Restaurant magazine, does an annual survey of all the major fast food restaurants in the U.S. This year, they ranked Wendy's No. 1. It has an average drive-thru service time of 169 seconds. It's the fastest drive-thru service in America. McDonald's comes in at about 208 seconds, and Burger King comes in at about 201 seconds. By focusing on the basics, and combining that with this larger strategy of getting its own units into the hands of franchisees, which reduces its own operating costs and brings in that great royalty and rental income. They put together this total picture that's boosted earnings and enabled the stock to take off. I want to cite one last statistic. For example, this last quarter, Wendy's had $49 million in net income. A year ago, they had $7.5 million in net income. So, they are really generating very impressive margin gains year to date.

Shen: Thank you, Asit. The drive-thru number is really interesting. I think it's reflected, too, in other companies across the restaurant sector in general, when you look at some of the news recently around Chipotle and how management has talked about how they essentially took the eye off the ball in terms of their service. That is a really key component that's very important. McDonald's has obviously shifted to simplifying their menu, making sure that experience for customers is enjoyable, and helping boost loyalty, as you mentioned, that's so important. So, really interesting to see something like your drive-thru experience quantified with that average time.

If we can move on here, in terms of our surprise stocks, for me personally, this one was something that I previously on the show had talked about this company and some of its competitors, we kind of beat up on it at times, and that's SodaStream International (SODA). Previously, with Keurig Green Mountain, for example, with SodaStream, these were companies that were the whipping boy for a lot of people following the stock market, in terms of having hit these incredible highs -- for SodaStream, as recently as 2013, when their stock peaked at $70. They were in a position where there were some very interesting rumors at the time of an incoming buyout from potential industry heavyweights like Coca-Cola, Pepsi. These were at insane valuations, like $90 to $100 per share. Management was giving shareholders some really strong guidance. They said they hoped to hit revenue of $1 billion by 2016. That was just three years ago, they were talking about this in 2013. But those buyout rumors fizzled out. Growth started to decelerate and went into a full-on reversal. The stock went from those $70-plus peaks, and bottomed out at around $13 over the next few years. 

But, 2016 has been much kinder. It is up 140% year-to-date, having traded up from about $16 per share to its current level at over $38. I think it's really important, with some of that background, when the stock was at its highs, that it's really pivoted its strategy and been able to shift its focus toward what has been a very strong segment within the beverage industry, and that is with sparkling water. First of all, the company is called SodaStream, but it's pretty much, in some ways, abandoning its namesake market and embracing the sparkling water segment. You look at the news in 2016 about how soda consumption in the United States is down to 30-year lows. I don't know about you, Asit, but I myself drink soda less than ever. I don't know if you've ever been much of a soda drinker. What is your experience with sparkling water? Is that something that you've seen yourself start to take hold in terms of its popularity? A lot of these other brands like LaCroix, also becoming very popular?

Sharma: Personally, I used to drink a ton of soda, a big fan of Coca-Cola. I just gave up soda about four years ago on a whim, and it just grew, I didn't want to drink it anymore. And I think a lot of us can extrapolate this experience into the numbers for a company like SodaStream. We all want to be healthy. I think SodaStream is a great example of a company which actually was in decline and had a new market opportunity and took advantage of that. We should probably also mention that its primary competitor, which was going to be the Keurig Green Mountain, as you mentioned, with their Keurig Kold, which was primed to be a competitor to SodaStream, well that really never panned out. The company was sold off, and that has restored the moat that SodaStream claims. I think that is important as well. 

But, you've isolated what is really the prime advantage for SodaStream even moving forward. We've seen with a company like Dr Pepper Snapple, we've also seen this with National Beverage Corporation, sparkling water is a huge wave because its main advantage is it's lower in sugar, and the carbonation is still there. Because SodaStream was already positioned with the carbonated water, it's going to take advantage of this. Like many other people, I had given up on the stock. Speaking of waves, the stock chart of SodaStream over the last year or so looks like a surfer on one of those big Hawaiian waves. It has a great curve going up. It may be a little bit ahead of itself at this point, but again, this goes back to something we talk a lot about at The Motley Fool -- that is, if a company can establish a competitive moat, you want to be in that stock. I think many of us thought that advantage had slipped away, but circumstance and fortune have restored it in that its competitor, the Keurig Kold, is no more.

Shen: I want to add that, overall, bottled water is on the rise as compared to your sugary carbonated beverages like soda. Sparkling water is only a really small portion of that market -- the bottled water market -- overall. Last year, it saw incredible growth, I think it was 26% in 2015, which is pretty unheard of when you're looking at the beverage industry and something like soda, seeing these declines. I mentioned two things. You take that broader beverage segment tailwind, that SodaStream is enjoying with its pivot. 

I also want to combine it with something that you had mentioned to me previously, Asit, when we were talking about some of the supertrends we were seeing in the consumer retail sector. We didn't get to do an episode quite yet on this specific topic -- the fact that people are becoming more and more conscious and aware of the various social, health, and environmental impacts behind their buying decisions. We've been talking a little bit about Keurig Green Mountain. I think there was a huge uproar maybe a year or two ago about the billions of K-Cups that get trashed in single year, how they could circle the Earth something like a dozen times over. When people heard that, were able to visualize that kind of impact, there was definitely a lot of controversy, a lot of consumers basically started to rethink how they view that company and that consumption process. I think the same thing is happening for bottled and sparkling water, to an extent. My wife and I will often go to the store, we'll buy a six-pack or 12-pack of 1 liter bottles each week at the store if we want sparkling water. And even though we recycle those bottles, the idea of being able to use one refillable bottle with your SodaStream and one CO2 cartridge, or refillable cartridge with the SodaStream system that can make 130 liters, or 60 liters even, with the water, becomes much more appealing. 

The way that has materialized, ultimately, with the product growth of the segment that they're pivoting to, and plus the fact that that eco-friendly benefit that SodaStream, in the past, really marketed on coming back to the forefront. Revenue was down 27% in 2015, down from their 2013 peak. Operating margins were really taking a hit. They shed five percentage points, shrinking from 7.5% to 2.9%. Then, keep in mind that the way they generate the revenue between the beverage machine sales, but also the cartridge refills, and also their consumables, like the flavors. Their most recent couple quarters have shown a complete reversal, of course, with some, admittedly, much easier comparisons. Machine sales are up 33% year-over-year for the most recent quarter. That growth is accelerating. Refills are up 9%. I think the refill growth is important, because that's a good proxy for whether or not these devices that they're selling are being used in the market. Otherwise, management has been focused on reducing expenses, making production more efficient, and that has really allowed them to translate some of these top line gains into their bottom line growth, as well. Net income margin, for example, went from 2% last year to 12% this year. Huge, huge expansion there. 

I think, for this company, the recovery seems to be under way. I will personally be watching SodaStream closely in 2017. You mentioned, maybe it's gotten a little far ahead of itself. I would agree with you, generally. But I'm curious to see their results from the holiday season, since they have so much momentum going for them now. And, it's a reminder to me that if everyone's beating up on a company, but it has parallels with a strong growing market, it has a well-established brand, and has a pretty sizable network of established users, sometimes it's good to look in the other direction that everyone else seems to be looking, because you can find opportunities like this, with SodaStream up almost 140% year-to-date.

Sharma: Yeah, be a contrarian. I want to make one last quick point about SodaStream, if you're following it in 2017, I really like that the company focuses on the European market. Many growing companies go straight to Asia because the population growth is there, and the wage growth is there. But Europe, a developed economy, and really a prime market for SodaStream's product. They have a higher social consciousness, which you mentioned, and Vince, yeah, we'll tackle a show after the new year on this environmental and sustainably conscious investing. But this is an advantage for them. They know their markets very well, so go ahead and play in that.

Shen: Asit, wrapping up our last new episode of consumer and retail Industry Focus for 2016, we'll have to look ahead to look at 2017 a little bit. Is there anything in terms of trends, companies, announcements you're expecting, anything you're expecting to see, or anything you'll be watching closely for the new year?

Sharma: Sure. I have two. One is for investors: Be cautious around big-box retailers. I want to read our listeners the last trailing 12-months' revenue of some stores you'll be familiar with, ticker symbols you will know. The first is Wal-Mart. Its total revenue increased over the last 12 months, up 0.5%; Nordstrom up 1.4%; Macy's down 3.5%; Target down 4.5%; Amazon.com up 13%. (laughs) There's a simplistic conclusion that we can draw from this -- that Amazon is taking market share and revenue growth share away from the traditional big box retailers. We've been hearing this for years. But I want to point out that, very presciently, Starbucks' soon-to-be-retired CEO, Howard Schultz, said two years ago that we are going to see a real market transformation in the next -- I think he pegged it at one to two years -- that we're going to see a decline in physical store visits for retail stores, we're going to see online retail ramp up. So, while the trend has been there for several years, and we've all participated in that by buying more things online, I think 2016 for me was the year where it really became apparent in the growth that online retailing has had in this past year. Looking ahead to 2017, if you're going to buy a big box retailer, if you're going to go out and buy a Macy's or a Nordstrom, or even a Wal-Mart, which has diversified into groceries, be careful, and make sure you have a persuasive reason to buy that stock, and that the management team has a strategy to compete online. Of these, I look at Wal-Mart and I think, that strategy is evolving pretty well, and they've seen some progress with their acquisition of Jet.com. So, that's one trend that I want investors to join me in looking at in 2017.

Shen: OK. On my end, I think, something I really wanted to touch on really quick, it's a little bit bigger picture, but something to keep in mind for next year, a big theme of the year will be uncertainty. You hear it everyday, you see it in the news everyday, a lot of this uncertainty around, for example, what the first year of President Trump's term will be like. In general, you have things around politics and elections coming up next year with the rise of populism, for example, and how that might shake things up in the European Union.

But, all in all, I think, having read, in the past couple days, preparing for this show, I read at least a dozen 2017 outlooks from various financial firms like BlackRock and Morningstar and places like Business Insider, Newsweek, Time magazine. Some of them get really specific with their predictions. Some financial analysts will even peg what they think the S&P will close at specifically for 2017. The consensus that I could find seemed to be at 2,300. But, there's a little bit of futility in all of this. Look for the strong businesses, the ones with quality management that have something like a defendable moat. You really just need to take the Foolish view beyond 2017 and looking to the long-term because of the fact that, when you have all this other noise, it can sometimes make it seem really difficult to pick that right company with the right story with that long-term view. It will seem especially hard when you have some of these outside forces that can push stocks one way or the other because the politics, or because what the president's policies and how they come into play affect things. But, when you're looking out beyond 2017, five, 10, 15 years or longer, it really makes it a lot easier to stomach that, and not have to worry about things like that too much, and that uncertainty. 

But the one thing I will get a little bit more specific for is with labor and wages and the increasing momentum for higher wages across the country, and how that can, especially in our consumer and retail space, have a big impact on various companies and sectors, in terms of their expenses. Think restaurant industry, retailers, and how that plays into things. But, anything else you want to wrap up with, Asit, before we kick off for 2017?

Sharma: Sure, I wanted to go back to your point, Vince, it's a wonderful point about uncertainty. If you take the financial equivalent of uncertainty, it's probably volatility in the market. We can expect this year to be more volatile than the last. That may or may not pan out, but certainly, from what I've read, this looks like what's in store for us. But that doesn't necessarily mean that your stocks will end the year down. It doesn't mean they'll end way up. It simply means, as Vince says, that you should focus on the companies that have strong earnings, strong operating cash flow, access to market growth, market demand -- all those basic building blocks of a great investment are more important in an environment like this than they might be in other years, when that rising tide is lifting all boats. So, I absolutely agree with you there. It's going to be a more volatile year, most likely. So buckle down and do your homework. We'll try to help you with some of that in 2017, as always.

Shen: Yep. Call that foundation of these companies and businesses that we look at your constant. There will be a lot of other things happening, the volatility, even quantified with, for example, the VIX volatility index, that has had plenty of ups and downs, hit near five-year highs several times in 2016. But again, broad market up 10% to 14% for the S&P and the Dow. Otherwise, focus on those key components and themes. Otherwise, thank you Asit for a great year. That's a wrap for us in 2016.

Before we go, I want to give a huge thanks to all the Fools out there, old and new, for listening, spending your commutes, your workouts, whatever time you have, tuning in. It's been a fantastic year for me stepping into the host seat. I hope you've enjoyed it as much as I have.

Thank you again, and remember you can reach out to the entire Industry Focus crew via Twitter @MFIndustryFocus, or send us any questions via email at [email protected]. Go to www.fool.com/podcasts to check out our other awesome shows. Please rate us on iTunes if you have a chance. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!