With the backdrop of a complete economic meltdown avoided for now, it appears as though investors have begun to pile into the inflationary camp, as evidenced by the recent rally in gold, 52% above its 52 low low, as of 12/4/09.  Yet much of the investment world continues to debate whether or not the economy is in for a prolonged period of inflation or deflation. 

Investors need not take sides to make handsome returns in the coming decade.  My Paid-To-Wait^TM investment strategy embraces corporations with the following attributes:

1.     competitive advantages

2.     healthy balance sheets

3.     and above average (but more importantly, growing) dividend yields

Companies that possess the above attractive characteristics should reward shareholders in either inflationary or deflationary periods. 

McDonald’s Is One Such Holding

Excuse the pun, but as recently as mid-September, McDonald’s (MCD) yield offered a mouthwatering 4%.  The world no longer seems to care about its economic resilience.  As of 12/4/09, (MCD) has underperformed the S&P by 24 percentage points this year.  Instead, the massive rally since March ’09 has been led by low quality companies.

Many people know that McDonald’s possesses one of the world’s most valuable brands (6^th according to Interbrand). (MCD) possesses one of the best inflation hedges around and trades at a healthy discount to the market’s P/E multiple as measured by forward earnings estimates.

What Makes (MCD) So Attractive AT This Time?

A CLASSIC (BUT UNDERAPPRECIATED) INFLATION HEDGE

1.     Franchise Agreements.  In addition to featuring an attractive dividend yield (at 3.6%, 70% more than the market), the real secret lies in the company’s relationships with the franchisees who operate over 80% of the chain’s locations.  More than two thirds of the company’s operating profits arise from an annuity-like stream of rent and royalties based upon franchisee revenue, which is based on dollar volume.

2.     Land Baron.  By owning 45% of the land and 70% of the buildings it occupies (or securing long-term leases on both), McDonald’s has contractually entitled itself to more than $23 billion of cash flows through future minimum rent payments under its existing franchise agreements alone.  The result is free cash flow that can be used to increase the dividend, repurchase shares, pay down debt, and reinvest in the business to the extent profitable growth opportunities arise.

3.     International Exposure.  McDonalds has the most globally diversified restaurant operation on the planet relative to its closest competitors, with more than two-thirds of its revenue and over half of its operating profit coming from locations outside the US.  Thus a weaker dollar results in higher reported sales when international revenue is translated back into US dollars, helping investors offset debasement in the US currency.  

4.     Remaining Inflation Protection.  Unlike many business models, McDonalds also benefits from rapid inventory turnover, ability to adjust menu prices and cost controls, and substantial property holdings (many of which are fixed costs and party financed by debt made less expensive by inflation).

WHY IS THIS A PAID TO WAIT^TM HOLDING?

In addition to serving as an attractive inflation hedge, we demonstrate below why longer-term investors can reasonably expect to earn a double-digit annual return owning McDonald’s, in sharp contrast to the uncertain return from owning gold.  Gold possesses a severe opportunity cost, as gold doesn’t throw off income or grow like stocks while tying up your money.

We derive our minimum 10% return estimate as a function of (1) dividend and (2) earnings per share growth without counting on any (3) P/E multiple expansion.

(1) DIVIDEND

McDonald’s has paid a dividend for 33 consecutive years since 1976.  At $2.20 per share this represents at 3.6% yield.  McDonald’s payout ratio is 52%, leaving room for future growth.  It offers the highest yield of its publicly traded competitors. (MCD) boasts the highest restaurant credit rating (cash flow from operations covered an amazing 59% of its debt load last year).

(2) EPS GROWTH = SALES GROWTH + MARGIN EXPANSION + BUYBACKS

Revenue Growth. According to NPD Group, Inc., fast food hamburger restaurant sales should grow 4% over the next five years.  For those who believe (MCD) can continue to capture share, Technomic estimates each 0.1% gain of share in the QSR industry is worth $56.3 million of annual sales.  Substantial growth opportunities remain outside the established major markets.  Within China, for instance, there are more than four times as many people as in the US, yet only two restaurants for every million people (versus 60 in the US).

Margin Expansion.  Factoring in lower food and packaging raw material costs, the move to refranchise more company-owned restaurants, and lower interest expense, there should be a modest amount of margin expansion resulting in operating profit growth at least 1-2% faster than its 4% revenue growth.  Hence we assume 5-6% operating profit growth, conservative even against management’s own 6-7% estimate. 

Buybacks.  Factoring in share repurchases of 2% (below actual sharecount reductions of 4% in 2008 and 3% in 2007) on top of its 5-6% operating profit growth would result in EPS growth of 7-8%. 

(3) VALUATION           

We are not betting on P/E expansion – if realized, that would certainly be gravy!  But we want to make sure that our 10-12% fundamental economic return (7-8% EPS growth plus 3.6% dividend) is achievable, which means we must not expect multiple expansion (or be hurt by contraction).

Today’s valuation appears reasonable.  The stock’s P/E of 15.9X trailing earnings is less than the S&P at 16.1X and is the lowest for (MCD) in over a decade.  Its forward earnings yield of 7.2% is well above the S&P yield (6.4%) and the 10-year treasury yield (3.48)%.

Investing lesson:

Taking the unpopular view is how to make money.  In fact, a contrarian style of investing is the ONLY method that has proven, over time, to reduce risk and take advantage of mispriced investment opportunities.

There are two key ingredients to most Ponzi schemes:

1.   A “huckster” who offers a too-good-to-be-true investment opportunity.

2.   A willing investor that wants to believe (so I guess they do) that you can get something for nothing.

The two emotions that can wreak havoc on investment success are greed and fear.  Human nature will always allow for the self and promulgated perception that there is such a thing as a “free lunch”.

Over the past decade, insurance companies have offered products to consumers with features such as:

1.   Stock market returns with no stock market risk.

2.   Guaranteed income, even though the annuity value has gone down.

I have been warning the public about the risk posed by “too-good-to-be-true” annuity products for over a decade.  While most “get it”, there is still a minority of the public that do not.  Since the unraveling of the “promises” typically will not unfold until one or both (if married) investors die, mom and dad may go to their graves never knowing that a decision made years earlier may have blown up after their death.

According to the recent Wall Street Journal article “Getting Smart About Annuities”; the total annual internal fees of these complex “multi-promise” annuity products may exceed 4% annually.  My own research of various 200-page prospectuses (that investors fail to read) has concluded the same.  The article goes on to say, “due to the complexity of the contracts, they generally need to be bought through financial advisors”. 

I failed to mention earlier that the commission a so-called “financial advisor” can earn at the point-of-sale on these products can range from 4-15%.

1.   Bernard Madoff offered his illusion of high returns via numerous placement agents across the country that were paid handsome commissions for directing the business to Madoff. 

2.   Insurance companies market their illusion of high returns via agents and brokers who are paid handsome commissions. 

3.   As with Madoff, the vast majority of annuity peddlers can tell you how much in commission they will earn, but are unable to describe how the investment works, both initially and over a long period.

Let’s summarize the key points of these complex annuity products:

1.   Your money can get the return of the stock market, with the safety of a CD.

2.   You can receive a guaranteed income of 4-7% annually, regardless of how the investments you choose perform.

3.   Many agents suggest to the investor that since the insurance company is bearing the risk if the stock market goes down, the investor need not worry about diversification and can go ahead and invest 100% in stocks!

4.   Annual internal fees can exceed 4% annually.

5.   The annuity peddler is paid 4-15% in commission up front at the time of sale.

Another Ponzi Scheme

The insurance companies that market these gimmicky products are in essence running this part of their business like Social Security, which by design, is a Ponzi scheme.  With Social Security, the retirees are paid retirement income not from the capital that has been contributed or grown via the retirees’ lifelong contributions, but instead are paid from the new contributions from current contributors.

As with Madoff, if and when the whistle is ever blown on this game of musical chairs, millions of investors (or their heirs) will be left standing, wondering what happened.

Investing lesson: 

There is no such thing as a free lunch.  Never has been, never will be.

At my firm, Wade Financial Group, we are in the process of “taking some chips off the table” across our various model portfolios based upon the enormous 40-70% bounce off the March market lows.

We manage a “Completion” strategy that serves as a global diversification complement to our U.S. only individual stock model and DCS Combination models.  This strategy has gained 24.8% (net) YTD as of 8/17/09. As comparisons, the S&P 500 is up 10.5% and Foreign (EFA) 20%.  The model is typically approximately 70% U.S. and 30% Foreign, making our results for 2009 far above the benchmarks.

Below are the major components of the strategy and current changes that are being made.  The securities that are being reduced/sold were contrarian picks that were added when the market was much lower in an effort to take advantage of the market upturn that has taken place.

All 2009 YTD performance numbers are as of 8/17/09:

U.S. stock funds/ETFs

• Sold Midcap Growth (VOT): up 21% vs. S&P 500 10.5%
• Added new Consumer Staples ETF position (XLP)

Foreign stock funds/ETF’s

• Foreign Dividend ETF (DWX): Up 39% vs. 20% for EFA index
• Have reduced by 50%
• Added to existing Foreign index based fund (DFIEX) and to a Global fund (SGENX) that is conservately managed

Emerging Markets funds/ETFs: Up 49% ytd vs. 42% EEM index

• Have reduced by 20%

REIT funds/ETFs

• Foreign REIT (WPS): up 32%
• Have reduced by 60%

Commodity funds/ETFs

• Reduced by 25%. 
• Now own three Commodity ETFs (GSC, DBC, PCRIX) vs. one for additional diversification

Investing lessons:

Global diversification still makes sense, but keen attention must be paid to various sectors as they go both “on sale” or become “overpriced”.

Disclosure: Long XLP, DWX, DFIEX, SGENX, WPS, GSC, DBC, PCRIX