The Market is High, is it Time to Invest More?

time

photo credit: If time doesn’t exist, then you’ve never been late in your life. Think about that. lassedesignen/Shutterstock

Do you time your investments ?

 

After such an important rally on the stock market, we have come to the point of asking ourselves as an investor if the party is about the end. We read more and more articles about the next bubble to burst in front of us. The FED has printed too much money, the Chinese market is headed directly into a wall and the European Central Bank has started to mimic the FED and found their own money printer.

Has the stock rally been created from artificially low interest rates and easy access to money or is there a real economy churning behind all this?

Is the stock market is about to collapse?

Or are we going to go through an unprecedented bull market?

 

There is no need to answer all these questions

There is definitely an answer to all these questions and more. In fact, you definitely have your own opinion as I have mine. However, we will only be able to test our answers in a few years when we look back at the charts and say “see! I told ya! It was obvious!”. But trying to time the market and being right about everything that is going to happen in the next 6 months, next year, 6 years is like playing with magic; it happens in the movies but doesn’t quite do well in reality. However, there is something that is a lot more easier to predict and that will keep you happy at night: dividend payments.

 

Dividend Growth Investing prevents you from timing the market

The idea of investing in dividend growth paying companies is the point of buying and holding for a very long period of time, shares of a group of companies that will reward you with quarterly payments no matter what is the weather outside. In general, long term dividend growth companies are less affected by market crashes than the overall market. For example, I’ve pulled out 6 companies that I hold and that meet my 7 investing principles and compared them to the S&P 500 from August 1st 2008 till 5 years later (August 1st 2013):

DM1

Source: Ycharts

 

As you can see, beside Lockheed Martin (LMT), all companies performed better than the S&P 500 5 years after the crash. Also, only one company, Union Pacific (UNP), did worst than the S&P 500 during this period. I could have cherry picked all dividend growth stocks that performed better, but I wanted to pick among my own dividend portfolio (I didn’t hold all these back in 2008, but they are all part of my portfolio now).

I can hear you saying already: “what’s the matter? DivMonk wants to prove us that he can cherry pick stocks that did better during a market crash? Anybody can do this”. You are right to think that. But that’s not what I want to show you. The important graph is the following one:

DM2

Source: Ycharts

The point is that during the market crisis, these companies didn’t only keep distributing their dividend payments, they increased them year after year. This means that while your portfolio recovered from the crisis somewhere between 2012 and 2013, you kept earning your quarterly payments. By the time your portfolio healed fully, your dividend growth portfolio is likely paying 1.5 times the dividend than it used to 5 years ago. You have here a great example of how the power of compounding income can help you weather any market crisis without affecting your investment goals.

Now, imagine if you select strong dividend growth companies and wait 15, 20, 25 years. Your portfolio will go through several storms but you will always earn more money year after year thanks to the ever increasing dividend payments.

 

If you invest by following a simple but effective set of dividend growth rules, you will successfully meet your investing goals.

 

Disclaimer: I’m long JNJ, MMM, KO, LMT, UNP

Should You Buy McDonald’s Now…  Or Wait?  

 

This is a guest contribution from Ben Reynolds at Sure Dividend.  Sure Dividend simplifies the process of dividend growth investing with The 8 Rules of Dividend Investing.

In August of 2015 McDonald’s (MCD) stock traded for a low of $85/share.  The company is now trading for around $128/share.

McDonald’s stock is up around 50% since its August lows.  Has the company’s recent stock price moves made the company a stronger buy, or should you sell McDonald’s now to lock in gains?

McDonald’s Competitive Advantage

McDonald’s has paid increasing dividends for 39 consecutive years.  The company’s long dividend streak makes McDonald’s a Dividend Aristocrat.  There are currently only 50 Dividend Aristocrats – stocks with 25+ years of consecutive dividend increases.

The company’s long dividend streak speaks to its strong competitive advantage.  A business simply cannot pay increasing dividends for so long without having a strong competitive advantage.

McDonald’s competitive advantage comes primarily from three factors:

  • Well-known brand
  • Industry leading size and scale
  • Capital efficient franchise business model

The golden arches are recognized globally.  McDonald’s continues to build its brand with sizeable advertising expenditures.  McDonald’s regularly spends around $900 million a year on advertising.

MCD Advertising

McDonald’s is much larger than its competition.  This give the company a size and scale advantage.  McDonald’s has a market cap of $116 billion.  The 2nd largest restaurant in the world – Yum! Brands (YUM) – has a market cap of $36 billion.

The company’s massive size relative to its peers allows it to buy commodity food products from suppliers at the lowest possible price.  McDonald’s has historically offered extremely affordable “value menu” and “dollar menu” offerings.

McDonald’s has more than 35,000 locations in over 100 countries.  In Europe, North America, and increasingly Asia, McDonald’s is very easy to find.

The franchise business model allows McDonald’s to grow quickly.  Only about 20% of McDonald’s locations are company operated.  The remaining 80% are operated by entrepreneurs who pay to use the McDonald name and products.  Franchising minimizes the cost of opening a store for McDonald’s and spreads risk to the franchise owner rather than McDonald’s corporation.  It results in a highly capital efficient business that is easy to scale.

McDonald’s is an excellent business…  But is it priced to buy?

McDonald’s Valuation

McDonald’s average price-to-earnings ratio since 2000 is 16.1.  The company is currently trading for a price-to-earnings ratio of 26.6.

McDonald’s stock would have to fall by around 40% to reach its historical average price-to-earnings range.

Of course this doesn’t mean the company’s share price is about to fall 40% – that is very unlikely.

For a company to trade far above its historical average price-to-earnings ratio it must have better growth prospects than it did in the past.

This does not appear to be the case with McDonald’s over the long run.  With that said, short-term results have been very impressive.  Relevant financial information from the company’s latest quarter is shown below:

  • Comparable store sales up 5.0%
  • Earnings-per-share growth of 16.0%
  • Constant-currency earnings-per-share growth of 26.0%

These are the type of numbers that do command a premium price-to-earnings multiple.  Growth at this rapid rate will not persist over the long-run for McDonald’s.

McDonald’s has compounded its earnings-per-share at 8.5% a year over the last 15 years.  This is a very respectable growth rate – especially considering the company paid out around 50% of its earnings as dividends over this period.

If McDonald’s continues to grow at 8.5% a year and continues to pay its dividend (current yield of 2.8%) shareholders can expect total returns of around 11.3% a year going forward.

This is greater than the S&P 500’s long-term historical average return of around 9% a year.  An argument could be made that McDonald’s commands a price-to-earnings ratio greater than the S&P 500.

The historical average price-to-earnings ratio of the S&P 500 is 15.6.  It is currently at 22.6.  The stock market needs to fall by about 31% to fall in line with its historical price-to-earnings average.

Based on these numbers it appears that McDonald’s is not terribly overvalued.  It is trading at a premium to the S&P 500 – but that should be expected for an excellent business.

McDonald’s:  Buy, Hold, or Sell?

But just because a business is not extremely overvalued does not make it a buy.

While McDonald’s isn’t excessively overvalued, it is very likely trading above fair value.  I would put the company’s stock into the ‘somewhat overvalued’ category.

Intelligent investors wait to purchase high quality businesses until they trade at fair or better prices.  Here’s a quote from Warren Buffett on the matter:

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

McDonald’s may sell inexpensive burgers, but the price of its stock is anything but marked down.

I am currently long McDonald’s.  While the company is a bit overvalued, I don’t believe it is a sell at current prices either.  The company will very likely continue growing per-share value through:

  • Share repurchases
  • Comparable store sales growth
  • Continued store expansion internationally

This growth will bring about continued dividend increases.  I don’t want to ‘cash out’ the dividend income my McDonald’s investment brings.

Selling the company’s stock now would incur capital gains taxes (in taxable accounts).  Investors should deduct this lost tax money from any investment they make with funds from a sale.  Allowing money that would be paid out in taxes to compound is one of the advantages of long-term investing.

McDonald’s is not so absurdly overvalued that it should be sold.  For investors who currently own McDonald’s, the stock is a hold.

In summary, McDonald’s is:

  • A hold at current prices
  • Probably somewhat overvalued
  • Will very likely continue growing its dividend far into the future

 

Dividend Monk’s Note:

Back in April of 2015, I’ve reviewed MCD with a similar approach. I determined the fair market value at $98 considering a 5.5% dividend growth rate. If I adjust the numbers today and consider a 5% dividend growth rate for the first 10 years and then 6% for the years after, I get a higher value, but still, MCD is overvalued:

 

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $3.56
Enter Expected Dividend Growth Rate Years 1-10: 5.00%
Enter Expected Terminal Dividend Growth Rate: 6.00%
Enter Discount Rate: 9.00%

 

Calculated Intrinsic Value OUTPUT 15-Cell Matrix
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $207.54 $138.84 $104.47
10% Premium $190.24 $127.27 $95.76
Intrinsic Value $172.95 $115.70 $87.06
10% Discount $155.65 $104.13 $78.35
20% Discount $138.36 $92.56 $69.65

 

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

Delivering a New YUM! – What’s in it for Dividend Investors?

 

Summary:

In 2016 YUM! Brands will spin-off its Chinese division into YUM! China for the benefits of investors.

The New YUM! will rely on a very strong cash flow generation business model with 96% of its restaurants operated by franchisees.

Since the transformation is not yet completed, there is still a buying opportunity that has presented itself.

DSR Quick Stats

Sector: Consumer Cyclical – Restaurants

5 Year Revenue Growth: 2.93%

5 Year EPS Growth: 3.63%

5 Year Dividend Growth: 13.94%

Current Dividend Yield: 2.19%

What Makes YUM! Brands (YUM!) a Good Business?

In three words, you can resume what YUM! Brands is… Tacos, Chicken, Pizza:

yum1

Source: YUM! website

YUM! Brands operates the brands of Kentucky Fried Chicken, Taco Bell, and Pizza Hut, with over 42,500 restaurants in over 125 countries. The company was spun off from Pepsico in 1997, and maintains a partnership with that company. Ironically, the company now plans to spin-off its Chinese division by the end of 2016. At the moment, this is like saying goodbye to 52% of its revenues, but will also leave lots of problems behind in exchange for a perpetually increasing dividend (more on this plan later).

Although not the largest in terms of revenue, YUM! Brands is the largest restaurant operator in the world in terms of the number of locations. YUM wants to positioned its company as a pure franchise play after the transformation with 96% of its restaurants operated by franchisees. The best part of franchise business models is their ability to generate a constant cash flow for investors.

Ratios

Price to Earnings: 27.25
Price to Free Cash Flow: 27.89
Price to Book: 35.69
Return on Equity: 85.53%

Revenue

yum2

Revenue Graph from Ycharts

As the number of restaurants in China skyrocketed from 1,792 in 2005 to 3,906 in 2010 and then over 7,000 by the end of 2015, the currency impact and recent bad press events in China (2014 and 2015) has hit their revenue growth.

After the spin-off, revenues are expected to grow in a more stable and predictable way as the company will sell the Chinese volatile operations in exchange for a 3% licence fee to give YUM! China the exclusive right to operate KFC, Pizza Hut and soon Taco Bell. The search for low-volatility revenues is the first reason to spin-off the Chinese restaurants.

How YUM! fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

yum3

Source: Ycharts

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple; when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing other than a constant cash flow to offer its investors. However, high yield hardly come with dividend growth and this is what I am seeking most.

yum4

Source: data from Ycharts.

When I created my portfolios at DividendStocksRock back in 2013, the company yield wasn’t interesting enough for a company in the consumer cyclical industry. You can find many other higher yielding company in this sector. However, by looking at the constant dividend growth trend and the recent push of the yield over 2%, I started to look into the company a bit more. YUM meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

My second investing principle relates to dividend growth as being the most important metrics of all. It not only proves management’s trust in the company’s future but is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenues. Who doesn’t want to own a company that shows rising revenues and earnings?

Since the company started to pay dividends only in 2004, the company can’t have a 50 year dividend history. However, in 2015, YUM! has achieved its 11th consecutive year with double digit dividend growth.  This is quite impressive for any type of company. This is the kind of statistic that makes you understand why you can’t ignore a low dividend yield payer, right? There is no question that YUM meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what has happened with a company. As investors, we are more concerned about the future than the past. this is why it is important to find companies that will be able to sustain their dividend growth.

yum5

Source: data from Ycharts.

Being able to propulse your dividend payment into double digits year after year doesn’t mean you will be able to maintain it. Interesting enough, the company has been able to maintain a relatively stable payout ratio over the years. Even better, the payout ratio is around 56% and the cash payout ratio is at 62%. Therefore, the cash flow generation is able to maintain such strong dividend growth in the future. It will become even easier to plan after the spin-off completion at the end of 2016. YUM meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

YUM! Shows an impressive number of restaurants spread among three distinct brands. The business is the global leader in chicken, pizza and mexican style restaurants in terms of number of restaurants. This gives it a unique economic moat that is very hard to cross.

The new YUM! Business model will be solely based on a franchise model which enables predictable and continuously increasing cash flow generation. The number of Chinese restaurants will continue to grow at a very fast pace, following the growth of the middle-class. This will lead to ever bigger franchising fees without having the problem to deal with Chinese market volatility. For these two reasons, YUM meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings put aside. There is some valuation work to be done. In order to achieve this task, I will start by looking at how the stock market has valued the stock over the past 10 years by looking at its PE ratio:

yum6

Source: data from Ycharts.

YUM seems to have generated much hype recently as the company used to trade around a 20 PE ratio for the majority of the past 10 years. Recently, it has gone up to 45 and it is now down to 27. Obviously, the best moment to buy YUM would have been at the beginning of 2016 since the stock is now up close to 9% ytd. Does it mean it’s too late to join the party? Let’s use the dividend discount model (DDM) to see if the company is trading at a fair value.

In order to do so, I will use a 10% dividend growth rate for the first 10 years. This seems quite generous, but if you consider the company has increased its payment in the double digit range for the past 11 years and they are about to create even more cash flow, it seems almost too low. Keep in mind the 5 year average dividend increase is 13% at the moment. After the first 10 year period, I expect the company to drift to a more conservative level of 7% growth rate. Since the company is evolving in a cyclical market, I can’t use a 9% discount rate. I would rather play conservative and use a 10% discount rate. After all, the stock is trading at a PE ratio of 27.25.

 

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.84
Enter Expected Dividend Growth Rate Years 1-10: 10.00%
Enter Expected Terminal Dividend Growth Rate: 7.00%
Enter Discount Rate: 10.00%

 

Here are the results of my calculations:

 

Calculated Intrinsic Value OUTPUT 15-Cell Matrix
Discount Rate (Horizontal)
Margin of Safety 9.00% 10.00% 11.00%
20% Premium $152.65 $100.83 $74.97
10% Premium $139.93 $92.43 $68.72
Intrinsic Value $127.21 $84.03 $62.47
10% Discount $114.49 $75.62 $56.23
20% Discount $101.77 $67.22 $49.98

 

Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

As you can see, even by being conservative with my assumptions, I still get a 5% discount on the current price. There will also be some speculation in regards to what is coming next. I think there will be more cash flow generated leading to a higher dividend growth rate in the first 10 years. In any case, YUM meets my 5th investing principle.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found one of the biggest investor struggles is to know when to buy and when to sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by the fact that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchased shares of a company  are no longer valid, I sell and never look back.

Investment thesis

I think the investment thesis is pretty obvious by now. The company is moving towards a stable, growing and low volatility free cash flow generation stream business model. Plus, YUM will benefit from a stronger economy in the US in the upcoming years and will also earn increasing franchise licence fees from its Chinese spin-off without having to deal with its volatility. An investment in YUM at the moment is also a play on the success of the future spin-off.

Risks

The first risk I see is that the transaction doesn’t create the impact management wants us to believe. The Chinese stock market volatility might not help the elaboration of a successful spin-off and investors may be left behind.

The second risk is more related to the overall business as there is much important competition in the fast food industry. We see how McDonald’s (MCD) is struggling to find growth vectors over the past few years. YUM is no different in this sector where the switching cost for customers is near zero.

The investment thesis is strong enough to claim that YUM meets my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Having both segments helps me to categorize my investments into a “conservative” or “core” section and a “growth” section. I then know exactly what to expect from it; a steady dividend payment or higher fluctuation with a great growth potential.

 

Considering the new YUM!, we can expect YUM to be part of a strong core dividend portfolio. Since the stock price is already trading at high multiples, I don’t expect to see it go through the roof in the upcoming years. However, its steadily increasing dividend is a good argument for any income seeking investor. YUM is a core holding.

Final Thoughts on YUM! – Buy, Hold or Sell?

I must admit that I’ve been somewhat seduced by YUM’s impressive dividend growth rate over the past 11 years. However, keep in mind that the new YUM! will be different and we don’t know exactly how this will reflect on the dividend payment. At the moment, I think YUM is an interesting play for more courageous investors that are willing to invest in the future cash flow generating machine this company will become.

Disclaimer: I do not hold YUM! in my DividendStocksRock portfolios.

Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.