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.
But…
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 Corporation (NYSE:MCD) 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:
