Whenever I purchase a stake in a company my plan going in is always to hold for the long term. Essentially I want to treat my positions as if I owned the whole business and avoid the temptation to trade in and out of positions depending on Mr. Market's moods.
However, sometimes it seems right to make some sales. The reason for this sale, well position trim really, was four-fold. (1) I wanted to have some cash on the sidelines, (2) the position represented ~7.5% of my portfolio, (3) the valuation seems quite rich at the current price level and (4) I have concerns regarding some decisions made by management. Add those 4 together and you get a position that's ripe to be trimmed back a bit.
I first started purchasing shares of McDonald's (MCD) back in 2011 when I was very early on in my investing journey. Since then the position has done remarkably well for me with a 15.7% IRR through Friday's close. I'll detail my concerns later, but first let's look at the numbers.
On June 25th I sold 25 shares of McDonald's for $206.15 per share. After commissions the net proceeds came to $5,148.80. Not bad considering the cost basis on those shares was $2,210.66 representing net profits of $2,938.14 excluding dividends. From capital appreciation alone these shares delivered a 133% gain.
This position trim reduced my forward 12-month dividends by $116. However, I still have a relatively sizable stake in McDonald's and given my desire to have some cash on the sideline I'm content with making this move despite the tax consequences.
This reduced my stake in McDonald's to 59.906 shares with a current market value of $12,440.08 that currently represents ~5.6% of my portfolio. My position in McDonald's is still scheduled to provide $277.96 in dividends barring any future increases.
Reasons for the Trim
As I mentioned earlier part of this decision was just due to McDonald's size in my portfolio as well as my desire to have some cash. Of course if I felt that McDonald's shares were cheap right now that would have changed the calculus on this decision and I would have just held on.
To me it appears that market participants have bid up McDonald's share price too far and that the disconnect between the value of the business and the share price is too great.
I recently went through a full analysis of McDonald's on Seeking Alpha and determined that the fair value is ~$150 per share give or take. However, at a share price of $207 that's ~38% overvaluation.
Based on dividend yield theory the current yield of 2.23% has shares overvalued by ~29% compared to the 5 year moving average of 2.88%.
Adding to the overvaluation thesis is that I don't expect McDonald's to return to its rapid growth days. Given that analysts expect McDonald's to generate 6.7% per year earnings growth for the next 5 years that puts the shares trading at a 20.6x P/E multiple of FY 2022 earnings. What?!?!?!?
On valuation concerns alone I think the decision makes sense. But when you add the over valuation to my issues with some decisions that management has made I think it validates my choice even further.
My preference is for the companies that I own to use their cash flow first to reinvest in the business, second to pay and grow the dividend payment to shareholders, and lastly if there's excess cash for it to be returned via share buybacks. Unfortunately McDonald's has far outspent the cash flow generated by the business to the tune of $31.1 B over the last 10 years.
Here's the breakdown of the cash returned to shareholders based on how I prefer for cash to be used. As you can see between McDonald's has been overspending to return cash to shareholders with the primary catalyst being outside funded, i.e. debt, share repurchases. To make matters worse debt has been the primary funding choice for share repurchases with ~71% of every dollar spent on buybacks being funded with debt, asset sales or cash on the balance sheet.
That's led to a deteriorating balance sheet that now sees McDonald's carry a negative net worth.
At the end of FY 2018 McDonald's would have needed 7.4 years of 2018's free cash flow to completely pay off the debt and 32.0 year of 2018's free cash flow after the dividend. So long story short I believe that the debt on McDonald's balance sheet is here to stay introducing risk into the equation that I feel is unnecessary.
For FY 2018 McDonald's had a FCF interest coverage ratio of 4.3 so the debt is still serviceable. However, I believe they've stretched the balance sheet quite thin and should interest rates rise when McDonald's has to rollover the debt that could put a huge burden on the cash flow leading to lower dividend growth and in a worst case scenario a dividend cut. Although I believe that lower dividend growth is the most likely outcome.
I've already put some of these proceeds back to work and combining that with some massive dividend increases from the bank stocks at the end of June my forward 12-month dividends have already eclipsed their previous high reached after Medtronic's increase last month. I'll detail the purchase that I made in the coming days.
The forward 12-month dividends for my FI Portfolio currently sit at $7,025.20.
What do you think about my trim of McDonald's? Have you trimmed a position due to its size in your portfolio? What about due to valuation or balance sheet concerns? Let me know in the comments below.