The next selection for the Inflation-Protected Income Growth Portfolio is fast food giant McDonald's (NYSE:MCD). By far the largest quick-serve restaurant around, the company has a strong foundation, healthy balance sheet, decent valuation, and solid prospects for the future.
When combined with a dividend that has risen every year since the company started paying them in 1976, McDonald's is a world-class company that deserves a spot in this portfolio.
Why it's worth owning in the IPIG Portfolio
To earn a spot in the portfolio, a company has to pass a series of tests related to its dividends, its balance sheet and valuation, and how it fits from a portfolio diversification perspective.
- Payment: McDonald's dividend currently sits at $3.08 a share, a yield of about 3.4% based on Friday's closing price.
- Growth history: Since initiating dividends in 1976, every year's payment has been higher than the previous year's. In December 2012, it boosted the payment by 10%, from $0.70 to $0.77 per quarter.
- Reason to believe the growth can continue: With a payout ratio of 53%, the company retains nearly half of its earnings to invest for future growth. That reasonable payout ratio also gives the company flexibility to maintain its payment if that anticipated growth doesn't materialize as quickly as hoped.
Balance sheet and valuation:
- Balance sheet: A debt-to-equity ratio just below 1.0 indicates that McDonald's does use debt, but it hasn't overleveraged itself to the point where a near-term financial hiccup would derail it.
Valuation: The company easily passes a valuation test pioneered by none other than Benjamin Graham, the founder of value investing. That said, Graham's equation does take interest rates into account, and today's low rates make stock values seem cheaper than they would be in a more normal rate environment. Still, even dialing rates back up to more "normal" levels, McDonald's would still look decently priced.
The previous picks for the portfolio have included:
- An industrial conglomerate.
- A generic-pharmaceutical powerhouse.
- A provider of staple foods.
- An auto parts distributor.
- A safety equipment provider.
- A high-tech (software) titan.
- A toy maker.
- An electric utility.
- A shipping company.
- A pipeline giant (though this one might actually get away).
- A drugstore.
- A semiconductor superstar.
- A 2-for-1 railroad special.
Like fellow IPIG portfolio pick J.M. Smucker (NYSE:SJM) McDonald's is in the business of feeding people, and both offer a fairly decent cup of coffee, which means it's not perfect from a diversification perspective. Still, it's different enough, given that J.M. Smucker is known for make-it-yourself in-home meals while McDonald's cooks food for dine-in, carryout, or drive-through.
It's largely because of the need to respect diversification that McDonald's was selected over fellow food purveyor General Mills (NYSE:GIS). The overlap between Smucker and General Mills was too big to justify owning a full position in each. For instance, Smucker has Pillsubry, and General Mills has Betty Crocker. Smucker owns Red River cereal, while General Mills owns Cheerios. Smucker has Hungry Jack, while General Mills has Bisquick. It's all part of the balancing act needed to manage across risks in investing.
What are the risks?
Of course, no investment is without risk. In the case of McDonald's, its size may soon start working against it. When you're the largest in your industry, you need to invest all that much more cold, hard cash to see meaningful growth on a percentage basis. McDonald's has tried to solve that issue in the past by moving past the Golden Arches and into other brands.
McDonald's once owned Chipotle (NYSE:CMG), for instance. And while Chipotle stock has been on a tear because it has much more room to grow than its former parent, it currently doesn't pay a dividend and thus wasn't considered for this dividend-oriented portfolio.
On a similar note, another risk you face when you're the biggest in your industry is that your rivals are frequently looking for ways to catch you. Burger King (UNKNOWN:BKW.DL) is the world's second largest hamburger chain and can often be found near McDonald's stores. The joke I heard growing up near McDonald's headquarters was that McDonald's spent a lot of money and effort on choosing the perfect sites for its restaurants, while Burger King simply figured the best spot was right next door.
There's often a lot to be said for buying the No. 2 company in an industry rather than the leader, since that second-place business had more room to grow. From an investment perspective, however, McDonald's is available at a cheaper valuation, has a higher dividend yield, and has a lighter debt burden relative to its size than Burger King, making it a better overall fit for the IPIG portfolio.
What comes next?
When the Fool's disclosure policy allows, I plan to buy McDonald's stock for the Inflation-Protected Income Growth portfolio, as long as it remains below $95 a share. I expect to invest around $1,500, a 5% allocation in the portfolio, with 30% of the portfolio still remaining in cash. Watch my article feed for details of the next pick, coming soon.