McDonald’s (MCD) has been a great investment for a very long time…
$1 invested in McDonald’s stock would be worth $606.67 by the end of 2015 (including dividends). That’s an annualized return of 14.9% a year.
Wouldn’t it be great to generate solid returns without having to identify the ‘next’ McDonald’s?
Unfortunately, the days of McDonald’s generating double-digit returns are over.
Or maybe not…
On April 7th, 2014 McDonald’s stock closed at $97.01. The previous Sunday (April 6th, 2014) McDonald’s was first recommended in the Sure Dividend newsletter.
The company’s stock price closed at $122.56 on Friday, May 20th, 2016. This comes to an annualized return of 15.6% a year (including dividends).
The S&P 500 generated annualized returns of 7.3% (including dividends) over the same period.
McDonald’s did it again.
This case study examines:
- Why McDonald’s was recommended in April of 2014
- The difficulties of holding McDonald’s stock
- The Stock that reminds me of 2014 McDonald’s most today
- 3-Step Process to finding great businesses trading at fair or better prices
Why McDonald’s Was Recommended in April of 2014
Before reading any more, I want to clarify a few things about this case study.
First, not every investment works out the same using the method outlined in this article. Some work out well in the short run, others don’t. Some have performed better than McDonald’s, some worse.
Please don’t read this and think I have some ‘magic formula’ that picks 100% winners that only go up every year.
It’s not about a magic formula. It’s all about investing in high quality businesses trading at fair or better prices for the long-run. I have a systematic way of approaching this investment model, but it isn’t a magic formula that can’t miss.
Second, my investment in McDonald’s is not over. It could go up or down over the next year; I don’t know (and quite frankly I don’t care).
As an investor with a long time horizon, what matters is that McDonald’s keeps compounding its intrinsic per-share value over the long run. Around 2 years is not a long-term investment.
With that out of the way, back to why McDonald’s was recommended…
The 8 Rules of Dividend Investing identifies and ranks high quality dividend growth stocks trading at fair or better prices. The ‘Buy’ identification and ranking criteria are below:
- 25+ years of dividend payments without a reduction required
- The higher the dividend yield, the better
- The lower the payout ratio, the better
- The faster the growth rate, the better
- The lower the stock price standard deviation, the better
I didn’t select these metrics out of a hat… They are all based on research that shows each metric has historically either reduced risk or increased returns.
Rule 1 Analysis: McDonald’s Amazing Dividend History
McDonald’s had 38 consecutive years of dividend increases when it was recommended. The company was (and still is) a Dividend Aristocrat.
Dividend Aristocrats are stocks with 25+ years of consecutive dividend increases. You can see all 50 Dividend Aristocrats here.
The Dividend Aristocrats Index has outperformed the market by about 3 percentage points a year over the last decade, according to S&P.
The 1st rule of The 8 Rules of Dividend Investing is:
“Invest only in stocks with 25 or more years of dividend payments without a reduction.”
This includes all Dividend Aristocrats. The rule is a bit more inclusive than the Dividend Aristocrats rule. Even so, it only allows in businesses with a very long history of paying consistent dividends.
This limits Sure Dividend’s investable universe to only shareholder friendly businesses with long dividend histories. When you are selecting from a pool of (likely) great businesses, it is harder to make mistakes.
McDonald’s clearly passed the dividend test. The company has an excellent track record of dividend growth.
Why have Dividend Aristocrats outperformed by so much?
I believe that long dividend histories are proof of something else…
Namely, a strong and durable competitive advantage.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”
– Warren Buffett
For a business to pay stable or growing dividends for 2 and a half decades, it must have (or at least recently had) a strong and durable competitive advantage.
Rule 2 Analysis: High Dividend Yield of 3.7%
In April of 2014 McDonald’s had a forward dividend yield of 3.7%. That’s well above average.
One of the ranking factors for The 8 Rules of Dividend Investing is yield. The higher the dividend yield, the better (all other things being equal).
Why does dividend yield matter?
The common-sense answer is that the more your investments pay you, the better. I certainly don’t disagree.
Historically, higher yielding stocks have outperformed lower yielding stocks.
Source: A Review of Historical Returns by Heartland Funds
McDonald’s actually had the highest dividend yield in the Top 10 stocks the month it was recommended.
Rule 3 Analysis: Reasonable Payout Ratio & Valuation
High dividend yields are nice, but not if the company can’t sustain them.
That’s where the payout ratio comes into play. All things being equal, The 8 Rules of Dividend Investing prefers a lower payout ratio to go along with a higher dividend yield.
A company cannot sustain a payout ratio greater than 100%. The lower the payout ratio, the greater the ‘buffer’ a company has between its dividend payments and earnings.
Lower payout ratio companies can sustain their dividends even when earnings fall. Companies with dangerously high payout ratios must cut their dividend payments if earnings fall over a prolonged period of time.
That’s a good reason to prefer low payout ratios to high payout ratios.
But there is another reason…
A little algebra tells us that low payout ratio, high dividend stocks are also low price-to-earnings ratio stocks:
High-yield, low payout stocks are value stocks – they have low price-to-earnings ratios. When you combine a business that has a high dividend with a low price-to-earnings ratio, you get what I like to call a “paid to wait” situation…
You get to collect high dividends while you wait for the stock’s valuation multiple to rise.
High yield, low payout ratio stocks have historically performed very well:
Source: High Yield, Low Payout by Barefoot, Patel, and Yao
In April of 2014, McDonald’s was not a ‘paid to wait’ stock.
It was a high quality business trading at the low end of fair value.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”
– Warren Buffett
McDonald’s had a price-to-earnings ratio (using adjusted earnings) of 17.7 in April of 2014. The company had a payout ratio of 58%.
This isn’t value territory, but it is certainly not expensive, either.
Rule 4 Analysis: Market-Beating Expected Total Return
What makes a great business?
The first requirement is a strong and durable competitive advantage. The second is growth. What good is a competitive advantage if the intrinsic per share value of a business is not growing?
The 8 Rules of Dividend Investing prefer higher growth stocks, all things being equal.
McDonald’s days of rapid growth are over, there’s no denying that.
The company is still generating positive growth for shareholders. McDonald’s engages in sizeable share buybacks.
Every share repurchased makes your shares more valuable. That’s because there are fewer claims to ownership on the business. If a company were to repurchase half of its shares, its stock price would double – because the claim on ownership each share represents is now twice as much.
On top of buybacks, McDonald’s grows through:
- Menu tweaks like coffee and all day breakfast
- Improving efficiency (higher margins)
- Opening new stores
In April of 2014, McDonald’s 10 year historical growth rate (calculated using the lower of earnings-per-share and dividend per share growth) was 7.1%.
That’s not a breathtaking number…
But it isn’t too low either. With a 3.7% forward dividend yield and a 7.1% historical growth rate, I expected McDonald’s stock to generate total returns of around 10.8% a year if it could sustain its historical growth from the last decade.
10.8% a year is a high return for a safe stock – really for any stock.
The market has averaged earnings-per-share growth of around 5% a year and dividends of around 4% a year historically. In 2014, the S&P’s dividend yield was around 2%. Investors would have expected returns of around 7% a year from the S&P 500 (before valuation multiple changes).
McDonald’s offered favorable total returns as compared to the market in April of 2014.
Rule 5 Analysis: Low Standard Deviation Reflects Lower Risk
Stock price standard deviation measures how bouncy of a ride you can expect from holding a stock.
The higher the stock price standard deviation, the more turbulence you can expect.
That in itself is a good reason to prefer lower standard deviation stocks to higher standard deviation stocks (all other things being equal).
The real reason The 8 Rules of Dividend Investing includes stock price standard deviation as a ranking metric is this:
Low stock price standard deviation stocks have historically outperformed the market according to S&P.
McDonald’s had (and still has) a low stock price standard deviation. I believe this is because the company’s strong competitive advantage allows it to realize billions in profits every year regardless of the overall economy.
When bear markets happen, McDonald’s tends to generate more profits as consumers switch from more expensive restaurants to cheap restaurants like McDonald’s.
Here’s what I wrote about the company’s recession performance in the 2014 Sure Dividend newsletter:
The Difficulties of Holding McDonald’s Stock
The McDonald’s investment has worked out well so far from a total return perspective.
Despite McDoanld’s low volatility, it has not been an easy ride. Investors in April 2014 have had to hold McDonald’s stock through:
- CEO transition
- Tainted meat scandal in China
- An actual human tooth found in food in Japan (you can’t make this up!)
- Competition from faster growing investing darlings like Shake Shak (SHAK)
Note: SHAK is down nearly 25% since going public in February 2015 due to its absurdly high valuation multiples.
Take a look at McDonald’s performance chart below from April 2014 to now:
Source: Google Finance
It’s not a smooth steady growth trend. It’s around 18 months of no growth (and some declines) in the stock price.
Short-term investors would’ve bailed on McDonald’s and generated losses.
To hold McDonald’s through its difficult times, investors had to believe in the company’s strong competitive advantage – and watch dividends.
McDonald’s has continued increasing its dividends every year. The company is back on its growth track again – and the stock price has followed.
“The single greatest edge an investor can have is a long term orientation”
– Seth Klarman
Only invest in great businesses you will feel comfortable holding if they get into temporary trouble. If you are investing in a stock just because you want it to go up, you will not be able to hold when it falls in price.
Long-term investors invest in businesses. They don’t bet on stock prices.
Today’s Investment Which Most Reminds Me of McDonald’s
Reading this article, you may be thinking:
“That’s nice, but where can I find similar investments today?”
McDonald’s today is not as good an investment as McDonald’s in April of 2014 (or April of 2015).
That’s because the company’s price-to-earnings ratio is up considerably. The company’s stock is currently trading for a price-to-earnings ratio of around 24 (using adjusted earnings). This is simply not a good time to buy McDonald’s stock (it remains a long-term hold, however).
There are many undervalued high quality dividend growth stocks available today…
The investment that reminds me the most of McDonald’s in April 2014, today, is Wal-Mart (WMT).
Like McDonald’s, Wal-Mart tends to see earnings grow during bear markets.
Like McDonald’s, Wal-Mart is its industry leader by a wide margin.
Like McDonald’s (of 2014), Wal-Mart has a price-to-earnings ratio in its teens.
(Wal-Mart’s price-to-earnings ratio is currently at 15.1 using adjusted earnings-per-share)
Like McDonald’s, Wal-Mart has a low stock price standard deviation:
- 5% for Wal-Mart
- 4% for McDonald’s
Like McDonald’s, Wal-Mart investors are expecting somewhat modest total returns that should at least match the market.
Wal-Mart currently has a payout ratio of 43%, versus 58% for McDonald’s in April of 2014.
Wal-Mart stock currently has a dividend yield of 2.9%, versus 3.7% for McDonald’s in April of 2014.
3-Step Process To Find More Great Businesses Trading at Attractive Prices
The 8 Rules of Dividend Investing identify and rank high quality businesses using quantitative metrics. This removes (or at least greatly reduces) bias from the stock identification and selection process.
They find high quality businesses trading at fair or better prices suitable for long-term holding – like McDonald’s in 2014.
You don’t have to use the same rules and screen I do to find great businesses trading at fair or better prices.
The 3 step process below is a good start:
Find Dividend Aristocrats with:
- Price-to-earnings ratios below that of the S&P 500
- Dividend yields higher than the S&P 500’s
You can use the downloadable Dividend Aristocrats spreadsheet at this link to quickly accomplish step 1.
The S&P 500’s current metrics are:
- Price-to-earnings ratio of 24
- Dividend yield of 2.1%
Become familiar with the stocks that match these screens. Identify their competitive advantage. Reason whether or not the company will still have a competitive advantage 10 or 20 years from now.
Prepare yourself to hold through turbulence before investing. Make sure you define why you will sell. I believe the time to sell a dividend growth stock is when it stops becoming a dividend growth stock – when it cuts or eliminates its dividend. This is a clear sign the business has lost (or is afraid of losing) its competitive advantage.
Investing in great businesses trading at fair or better prices does not and will not produce overnight riches. It is not a get rich quick scheme.
Staying the course and following a reasonable dividend growth plan will very likely produce favorable returns over long periods of time.