17 new stocks make our Safest Dividend Yields Model Portfolio this month, which was made available to members on March 20, 2020.
Recap from February’s Picks
Our Safest Dividend Yields Model Portfolio underperformed the S&P 500 from February 20, 2020 through March 18, 2020. The Model Portfolio fell 41.1% on a price return basis and 40.8% on a total return basis. The S&P 500 fell 28.8% on a price return and total return basis. The best performing large cap stock was up 7%, and the best performing small cap stock was down 27%. Overall, seven out of the 16 Safest Dividend Yield stocks outperformed the S&P 500 and Russell 2000 from February 20, 2020 through March 18, 2020.
Only our research utilizes the superior data and earnings adjustments featured by the HBS & MIT Sloan paper, "Core Earnings: New Data and Evidence.” This Model Portfolio leverages our Robo-Analyst technology, which scales our forensic accounting expertise (featured in Barron’s) across thousands of stocks.
This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating, have positive free cash flow and economic earnings, and offer a dividend yield greater than 3%. Companies with strong free cash flow provide higher quality and safer dividend yields because we know they have the cash to support the dividend. We think this portfolio provides a uniquely well-screened group of stocks that can help clients outperform.
Featured Stock for March: McDonald's Corporation (MCD: $162/share)
McDonald's Corporation (MCD), is the featured stock in March’s Safest Dividend Yields Model Portfolio.
We first featured MCD in November 2012 and more recently made the stock a Long Idea in November 2019. The stock has underperformed the S&P 500 since both reports were published, but given its strong fundamentals, MCD remains undervalued.
MCD has grown net operating profit after-tax (NOPAT) by 8% compounded annually since 2015 and by 4% compounded annually over the past decade. The firm’s NOPAT margin increased from 21% in 2015 to 35% in 2019 while return on invested capital (ROIC) improved from 12% to 16% over the same period. Most importantly, MCD’s economic earnings, the true cash flows of the business, have grown from $3.8 billion in 2015 to $5.5 billion in 2019, or 10% compounded annually.
Figure 1: MCD’s Economic Earnings Since 2015
Sources: New Constructs, LLC and company filings
Cash Flow Supports Dividend Payments
MCD has increased its dividend for 43 consecutive years and the company recently noted it will not be making changes to its dividend, going so far as calling it a “priority.” MCD increased its annual dividend from $3.44/share in 2015 to $4.73/share in 2019, or 8% compounded annually. The current quarterly dividend, when annualized, equals $5.00/share. MCD’s dividend payment has been supported by the firm’s strong free cash flow (FCF). MCD has generated $27.8 billion (25% of current market cap) in FCF while paying $16.2 billion in dividends since 2015, per Figure 2.
Figure 2: MCD’s FCF Vs. Dividends Since 2015
Sources: New Constructs, LLC and company filings
Companies with strong FCF provide higher quality dividend yields because we know the firm has the cash to support its dividend. On the other hand, dividends from companies with low or negative FCF cannot be trusted as much because the company may not be able to sustain paying dividends.
MCD is Undervalued
At its current price of $162/share, MCD has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects MCD’s NOPAT to permanently decline by 20%. This expectation seems overly pessimistic given that MCD has grown NOPAT by 4% compounded annually over the past decade and 6% compounded annually over the past two decades.
Even if MCD’s NOPAT margin falls to 34% (compared to 35% in 2019) and it grows NOPAT by just 2% compounded annually for the next decade, the stock is worth $240/share today – a 48% upside. See the math behind this reverse DCF scenario.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings as shown in the Harvard Business School and MIT Sloan paper, "Core Earnings: New Data and Evidence”.
Below are specifics on the adjustments we make based on Robo-Analyst findings in McDonald's Corporation’s 2019 10-K:
Balance Sheet: we made $21.5 billion of adjustments to calculate invested capital with a net increase of $13.5 billion. The most notable adjustment was $12.2 billion (28% of reported net assets) related to operating leases. See all adjustments to MCD’s balance sheet here.
Valuation: we made $51.2 billion of adjustments with a net effect of decreasing shareholder value by $50.3 billion. Apart from total debt, which includes the operating leases noted above, one of the most notable adjustments to shareholder value was $477 million in underfunded pensions. This adjustment represents <1% of MCD’s market value. See all adjustments to MCD’s valuation here.
This article originally published on March 25, 2020.
Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.
 Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.