Waiting For A Collapse; Collecting Dividends In Good Times Or Bad

| About: McDonald's Corporation (MCD)

As I detailed in my last article, the impact of the severe bank stock dividend cuts in 2009 wouldn't have been that big of a deal for the average dividend growth investor. The underlying tenet was that reasonable diversification and growing dividends could make up for the drastic dividend slashes experienced in the financial sector. Of course the dividend recovery of many of the bank stocks in 2011 greatly enhanced this example, but it remains that one could have had a near worst case dividend scenario for 10% of their portfolio and they would still be making more money in just 3 years' time or less. So we now have the confidence to continually contribute today, even if an inevitable down market comes sooner rather than later. But is there value in waiting around for the next collapse?

As a dividend growth investor, your focus is to find the opportunities that are most likely to generate the greatest amount of adjusted future income during you "dividend spend" phase in life. In doing so, you know that there is a trade-off between a higher yield or higher dividend growth. Now you can't control the dividend growth bit (unless you land a board of directors gig) but you can make hopefully understated assumptions moving forward. For example, perhaps you forecast that McDonald's (NYSE:MCD) can grow their dividend by 8% a year moving forward for the next 5 years. This seems reasonable given the detail that this would indicate a 5th year dividend payment of $4.50, while they made over $5 per share last year and that McDonald's "remains committed to returning all of their free cash flow to shareholders over the long-term via dividends and share repurchases." In fact, for the dividend growth investor in MCD, hopefully they are able to grow their payout by a rate much faster than 8%. Consequently, it likely would not be prudent to assume a 27% dividend growth rate moving forward even though this is precisely what McDonald's averaged over the last decade. You can't control dividend growth, but you can make reasonable assumptions about it.

Current yield, in contrast, is something that you do control. Now granted you're likely never going to be able to find Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG) or Johnson & Johnson (NYSE:JNJ) with a 10% yield. But you could have bought say Walgreen (WAG) at a 3.7% yield in the last two months instead of at today's 3.1% yield. Moving forward that might be a significant difference. If you had invested $5,000 in WAG at the 3.7% yield instead of the 3.1% yield, you would receive $30 more in dividends during the first year. Advancing into the future, the person with the 3.7% yield will always outpace the person with the 3.1% yield, as their corresponding dividends will grow at the same rate forever. Over a 5-year period, the difference accumulates to a nominal $176 difference.

We all know that we want a high yield and a high dividend growth rate to compound the greatest future income results. The problem is that there's no sure fire way to determine if Walgreen's at 3.7%, Target (NYSE:TGT) at 2.2% or AT&T (NYSE:T) at 6% would provide you more income in 20-40 years. Even if you decide on Walgreen or AT&T, one would have to wait around for their yields to come back to these quoted levels. But that's exactly our job. Incidentally, Warren Buffett has a philosophical view on this matter:

"You do things when the opportunities come along. I have had periods in my life when I have had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing."

What I am currently having trouble with is balancing the tradeoff between buying say MCD today, or waiting for a specific price point. Granted my only option isn't just MCD, but I would at least suggest that my bounds are limited, if only somewhat, by my overall goal. I'm not against buying an assortment of other companies, but your "margin of error" for these companies must be greater. For example, I bought shares of Walgreen at a 3.7% yield, but I am not adding to them today at a 3.1% yield. On the other hand, I would likely be buying shares of Coca-Cola if it had either a 3.7% or 3.1% yield. Unfortunately, the wonderful companies don't go on sale as often as we would like.

Sometimes a hypothetical walk-through can firm up your investing thesis. Let's compare a purchase of McDonald's today, $91.34 at the time of writing, to two alternatives. We'll stick with investing $5,000 but instead of investing today, allow us to assume that you wake up tomorrow and the price of MCD is $85! Or for that matter, you wake up tomorrow and the price is $95! How much difference do these unlikely swings actually make?

Invested Price Shares Year 1 Year 2 Year 3 Year 4 Year 5 Tot Yrs 1-5
$5,000 $91.34 54.74053 $153.27 $165.54 $178.78 $193.08 $208.53 $953.93
$5,000 $95.00 52.63158 $147.37 $159.16 $171.89 $185.64 $200.49 $917.18
$5,000 $85.00 58.82353 $164.71 $177.88 $192.11 $207.48 $224.08 $1,025.09
Click to enlarge

Note that this begins with the current $2.80 dividend and grows this payout by 8% a year. In reality, a dividend increase is likely forthcoming for McDonald's and we don't know the dividend growth rate moving forward, but for illustrative purposes the assumptions work just fine. We see that in the first year, our best case scenario returns almost $165 in annual income, while the worst case scenario turns in just $147 in income. To be sure $18 is nothing to sneeze at (at least cover your nose if you're at a decently priced $18 dinner) but really the difference doesn't seem that measurable. On $5,000 that's only 0.36%, or likely slightly more than you would pay your broker to execute the trades round trip. And it follows that we don't cease from investing just because we have to pay fees to our brokers. Likewise, if we can't find a better alternative, perhaps there's merit in the argument that one's invest-able funds (those above and beyond short-term needs) should likely be invested rather than sitting on the sidelines, regardless on one's strategy.

Over the long-term, we see similar results. If you grow the annual payouts by 5% for the years 5-20, we find annual payouts of $416.81, $433.51 and $465.85 for the respective worse to best case scenarios. Assuming an unrealistic zero volatility inflation rate of 3% each year, we find a difference of just $28 in the 20th year anual income in the terms of today's purchasing power between the best and worst case scenarios.

Of course the likelihood of MCD gravitating to $85 or $95 tomorrow is overwhelmingly unlikely. Thus allow us to make more reasonable considerations. Over time, as long as MCD continues grow and increase profits, it's likely that the share price will eventually follow. But next year, who knows what might happen. Let's use the same numbers, but instead assume that they occur 1-year from now instead of on the unrealistic tomorrow.

Invested Price Shares Year 1 Year 2 Year 3 Year 4 Year 5 Tot Yrs 1-5
$5,000 $91.34 54.74053 $153.27 $165.54 $178.78 $193.08 $208.53 $953.93
$5,000 $95.00 52.63158 $0.00 $159.16 $171.89 $185.64 $200.49 $769.81
$5,000 $85.00 58.82353 $0.00 $177.88 $192.11 $207.48 $224.08 $860.38
$5,000 $105.00 47.61905 $0.00 $144.00 $155.52 $167.96 $181.40 $696.50
$5,000 $75.00 66.66667 $0.00 $201.60 $217.73 $235.15 $253.96 $975.10
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Here we assume that you either buy the MCD shares at today's price, or else allow the money to sit interest free for one year and then purchase the shares. Sure there would be some interest, but if it's in a broker's sweep account it's essentially negligible anyway. In addition, I included two more possibilities: a $105 share price and a $75 share price. Given, one has a legitimate argument against purchasing shares at $105 next year if you weren't willing to buy them at $91 today, but it's just an illustration. Further, time value of money calculations would be needed, but because the income flows are of the same quality, their nominal value counterparts are illustratively fine as well. We see that buying today provides a 5-year nominal income that is almost $94 greater than if you could buy the shares at $85 in one year's time. In fact it would take 11 years of waiting for the $85 price in one year to pay off, nominally. Additionally, I find it compelling that waiting a year for even a $75 price, only allows for a $22 nominal dividend gain over a 5-year time period. The breakeven on buying today versus buying in one year is around $77. Think about that, if you want to have a higher dividend income from MCD over the next 5 years by waiting a year for the price to come down, you need the price to drop nearly 16% over the next year. Admittedly this is well within the realm of possibility; but given that over time the price is likely to track upward rather than downward it at least seems less likely than not.

There are a variety of realizations that need to be known. First, reinvesting dividends were not incorporated, but would play an integral role going forward. Next, much like having a higher dividend growth rate, buying at a lower price guarantees that eventually you will receive more income in the future. The question is whether this trade-off of time vs. income pays off in 6 years or 66 years. Additionally, one could complicate things a bit by adding varying probabilities to the underlying assumptions. But as stated, and now reiterated, I was designing a practical application that might help you develop a thought process when considering whether or not you should wait for a given security to decline in price. In reality we are not forced into making the decision: "ok should I buy MCD today or should I wait until next year?" Instead it's more along the lines of: "should I buy MCD today or in future, or should I consider any one of my thousands of applicable choices." In any event, even if investing now turns out to be the wrong decision relative to the stock price in a year or 5 years, I would take comfort in knowing that the income provided is likely going to be greater than sitting on cash over the long-term.

Disclosure: I am long MCD, T, PEP, KO, PG, TGT, JNJ, WAG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.