Saturday, August 28, 2010

Chubb and McDonald's Suggest Leadership for Next Bull Move in Stocks

On a week in which both gold and silver had strong price move, one might think that stock leadership might come from miners. Not so. While intermediate to long term Treasuries continued their price surge (lower yields) the first four trading days of the week, one of the only two Dow 30 stocks to rise in price during 2008 set yet another all-time price high today. That is McDonald's. It is the only Dow 30 stock to have hit an all-time high since the bear market officially began early in 2008. If one believes as I do that central banks and governments will pull out all the anti-deflation stops and err in policy to be soft on inflation, just as the Bank of England is currently doing (0.5% policy rate with 3+% inflation rates) and Ben Bernanke did in 2006-8 (and I believe is doing again), then one wants exposure to nominal growth as well as organic growth.

Well, Mickey D can benefit from price decreases and it is gaining market share globally. Business is good for MCD.

While I have not done a formal statistical analysis, I have been watching MCD for well over a year in relation to the 10-year Treasury yield. The two have tended to track each other. Thus when stocks were rally sharply in 2009 and Treasury yields were surging upwards, MCD dropped or at best stagnated in price when the whole market was rallying. So here are my thoughts on this stock at its current price around the all-time high set yesterday of $74.

Dividends are expected to be $2.45/share in 2011. (The board may announce a dividend increase soon.) At today's price, that would give shareholders about a 3.3% yield. The 10-year is around 2.60. Let us say that the 10-year yield backs up to 3.0% on average for all of 2011. If MCD trades at a yield equal to the 10 year as has been the case a number of times in 2009 and 2010, that would allow about a 9% price appreciation in addition to the dividend. If at any time in 2011 MCD trades at a 2.6% yield, one is looking at about a 30% total return.

What is the downside?

Of course, it is unlimited. But on a 15-year basis, I think it is reasonable to expect that MCD raises its dividend at least 5% annually. This would mean a doubling of dividends from 3% to a terminal dividend of 6% if the stock price is unchanged. Let us say that the average dividend yield would then be 4.5% at year 7/8 of this 15-year horizon. One can go out 7 years on the Treasury yield curve and get 2% back on one's money yearly.

Between the two choices, I'll take McDonald's for long-term capital I can afford to lose. And given operational trends and price increases that are galloping along in fast-growing countries such as Brazil, where MCD is doing very well; India; and China. McDonald's is financially flexible in a way Uncle Sam isn't, having just received some accolades for a yuan-denominated bond issue.

Now, I am not a professional stock analyst. I haven't eaten at a McDonald's in decades. I tried their espresso drinks last year and hated them (as did two other people who taste-tested them with me). I'm a vegetarian cardiologist who thinks America would have been better off from a public health standpoint without than with McDonald's. But I also think America would be better off without trillion-plus dollar federal deficits or Americans and "allies" chasing Afghans around their own country. But I have to live in the real world, and at least MCD has added some sops to health, and the head of McDonald's India is also a vegetarian.

But I have digressed. I am going with technical chart strength, strong operational results, steady dividend growth, global presence, and the like. If the 10-year returns to 4%, I expect MCD stock price to drop, but that would likely be in association with price increases/economic growth, so faster dividend growth and stronger earnings may await.

If you doubt that it is a market of stocks vs. a stock market, look at the charts of MCD vs. JPM (strong bank) and BAC or C (weak banks). Rising earnings/rising dividends and all-time high stock prices for MCD. Sliced dividends and variable earnings of uncertain quality for the financials = failing stock charts.

However, not all financials are created equal. The boring insurer Chubb (CB) also set a 12-month high yesterday. Its stock chart over the past 2 years is gently upsloping. It retires substantial amounts of stock, sells only slightly above tangible book value (which may be understated due to the bull market in its assets, which are almost entirely bonds), raises the dividend regularly, and has rising earnings estimates, and has stellar financial strength ratings from S&P. The stock is near its May 2007 high (I ignore the bizarre up-move into the $60s during the meltdown in fall 2008 as it might have been due to takeover speculation) and the various moving averages show that it is picking up strength on an accelerated basis.

Thus, even someone such as myself who believes that the general stock market remains overpriced, I am able to find specific boring companies such as the two listed above that meet my criteria for sleep-well-at-night on price declines plus reasonable valuation, strong chart action, no hype by the Street, and rising dividends.

If things break properly, these two stocks could provide 10% total returns year after year even if the general stock averages fail to keep up with consumer price increases (0r less likely decreases).

Lest one think I am bubbling over with enthusiasm for these assets, there is a more mature and safer asset that has no operational issues, cannot disappoint the Street with insufficient earnings gains or a smaller-than-expected dividend increase, and that remains out-of-favor with the mainstream media yet has a picture-perfect bull market chart that looks like a bull market that just might turn into a bubble that could expand for a while before it bursts. That asset is gold. Its compound annual return over long periods of time proves that compared to other financial assets, it is in no bubble. It remains my favorite asset on risk-reward considerations, but it is good to see that as discussed above, stock buyers are quietly rewarding well-run diverse companies.

If only the authorities in Washington were paying heed.

Copyright (C) Long Lake LLC 2010

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