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The High And Most Excellent Threefold Path

|Includes: McDonald's Corporation (MCD)

I've owned stock in McDonald's (ticker MCD) for a long while - some of my shares in MCD go back nearly 20 years, and until this year, I have never sold a single share.

Today, MCD has become absurdly expensive (in my view). Yes, the company seems to be growing earnings and rapidly growing shareholder distributions and buybacks, but from what I can see, much of this growth is funded by issuing debt. MCD now holds a 75% debt to assets ratio, which is far higher than in the past. The debt is high enough now that the company has very little wiggle room to allow things to go wrong. With dropping revenues and rising expenses, I believe that there is at least some chance that things could, in fact, go wrong. I don't see that the stock price is reasonable enough to compensate me for taking that risk.

But at the moment, nothing has gone wrong, and as the stock price has been bid up to stratospheric levels. When I look at the average earnings over the past 4 years, I see that the stock trades at a nearly impossible PE ratio of 29, and an earnings yield of merely 3% - which isn't much higher than a risk-free US Treasury. Obviously, Mcdonald's earnings are far riskier and volatile than interest on a US Treasury, so the market clearly expects grandiose things out of this company - which may or may not come to pass. I always just have to ask myself: am I being compensated for that risk with a fair stock price, or not?

I have created a spreadsheet to show how I evaluate one investment alternative over another. In fact, I have a quick formula that I like to use - this may be interesting to some readers.

Here is how it works:

First, I take the average earnings over the past 4 or five years, and divide that by the stock price to derive the earnings yield. I express that number as a decimal - so in the case of McDonald's, the earnings yield is .03.

Second, I calculate the rate at which the company has grown it's shareholder equity per share. In the case of McDonald's, the company has actually reduced shareholder equity to a negative number (which I see as a red flag). This row is NA for McDonald's.

Third, I determine the average dividend growth rate over the past 4 or 5 years. For MCD stock, that's 4%.

Forth, I put in the dividend yield. MCD has an impressive dividend yield of 2.53% (just shy of the company's earnings yield).

Fifth, I determine the company's debt to asset ratio - in the case of MCD, that's 75%. This company borrows a dramatic amount relative to the value of it's assets. Fair enough, the company is attempting to boost it's return on assets by shedding assets (which we see with other companies like Reynold's or Philip Morris). But where some investors see efficiency, I see risk. Truss up the balance sheet in as many ribbons and bows and pretty flowers as you like, but in THIS investor's view, borrowing money is bad and risky, plain and simple. Having assets and money is good - you can't tell me otherwise because I'm pig-headed and stubborn about this sort of thing.

The final step is that I add up all of these decimals described above (that's one through four) and then discount the result by company's debt to asset ratio. I get a result of .0243 but since I find it easier to work with whole numbers, I multiply that by 100. The final composite valuation score I get is 2.43. That number is meaningless on it's own, but gives me a baseline to compare OTHER companies I might rather own.

Those of you who follow the Cash Flow Growth portfolio know that I have a penchant for exchanging expensive, low yielding blue chip stocks that I own for other blue chip stocks that are cheaper and (typically) higher yielding. In fact, in my more transcendental moments, perhaps you've heard me speak of "The The High and Most Excellent Threefold Path." The way of the Threefold Path is not a means by which Shaolin monks master the esoteric arts of Kung Fu, nor is it the means by which Zen Budhists achieve enlightenment. The High and Most Excellent Threefold Path concerns the three basic rules of growing cash flow through investments: (1) own dividend growth companies, (2) reinvest dividends, and (3) sell expensive stocks and buying cheaper stocks.

But what is "expensive", Grand Master Pancake? Answer: a low composite valuation score calculated as shown on the High and Most Excellent Spreadsheet.

Insert here: sound of gong ringing.

Yesterday, I found three solid alternatives to MCD, all of which I bought some shares in earlier this year: CSCO, QCOM and T. Each of these has a far higher composite valuation score and, taken together, substantially higher current dividend yields.

This amounts to sort of two-for-one special: I can buy better valued stocks of equally well established blue chip stocks, and get a modest bump in my dividend income as well. Insert here: sound of gong ringing.

And so, using this methodology, I sold off nearly 45% of our entire MCD holding yesterday, and put the proceeds into equal tranches of T, CSCO and QCOM.

And today, appropriately enough, I celebrated by taking a trip to the Buddhist Gardens located roughly an hour outside of Lisbon in the heart of wine country. You really would never believe such places even exist in Portugal (and if you found them, you'd still be left with the question of WHY they exist).

There are so many times that we find peculiar gems and oddities around this country. It's delightful and unexpected - two words I could use to describe Portugal as a whole.

The Buddhist gardens, as it happens, are part of the Quinta da Bacalhoa vineyard. I've seen Bacalhoa wine in the grocery store countless times, but never tried it. The reason why is because the spelling is suspiciously close to Bacalhao - Portuguese for "cod fish", often of the dried, salted and stinking variety. Drink of class of dried cod scented effluvium? Ehhhhh.... no thanks. But today, we were guests of friends who know the owner, and when presented with various of the quinta's wines to taste I really had no choice. I was expecting it to taste like fish sauce (great on Pad Thai, not so great on it's own in a wine glass).

I was wrong. I was astoundingly wrong. The Quinta Da Bacalhao white wine was absolutely exceptional. One of the best we've had in Portugal. My wife and I took one sip, turned and stared at one another in utter shock and disbelief, and then promptly bought an entire case. You can find bottles at 12 euros apiece at the Quinta da Bacalhoa (the same bottles cost 14 to 16 in Lisbon), and so it's well worth the trip out to visit the vineyard and it's collection oddities and curiousities.

Disclosure: I am/we are long MCD, QCOM, T, CSCO.

Additional disclosure: This is not investment advice and I am not an investment advisor.