Fixed income can play an important role in retirement planning and diversification, although to me the current bond bubble looks like another accident waiting to happen. With yields of 3% on ten-year UK gilts and 2.5% on US Treasuries, investors are just not being rewarded sufficiently to compensate for the future dangers of higher default, inflation and interest rates.
Worse still, this madness is spilling over into other asset classes, with income seekers piling into dividend stocks that they perceive as being reliable – especially those corporations that are paying higher yields on their equity than on their debt. The upshot is that many large caps now also look expensive.
Take McDonald’s. The group has a chunky dividend payout ratio of 50% of earnings, which has helped catapult the shares to near all-time highs. At $74, McDonald’s trades on sizzling p/e ratios of 16.5 and 15.2 respectively for this year and next, while only paying a 3% yield. Yet the rich valuation is not the only worry. Another is McDonald’s exposure to a downturn, despite its value offering. Although the fast-food giant operates 32,000 restaurants worldwide, more than 75% are owned by third parties.
Turkey of the week: McDonald’s Corp (NYSE: MCD), rated a BUY by Stifel Nicolaus
Under these deals, the franchisees pay for cooking equipment, signs, seating and interiors, while McDonald’s owns the land and buildings. This leverage is great during booms, but when times get harder profits get hammered, especially as many overheads – such as rents, utilities and salaries – are fixed.
The bulls argue that in a more austere climate people who wish to eat out will trade down to cheaper alternatives. This is true in the early stages of a recession, but the beneficial effects wear off as there are only so many Happy Meals that families are prepared to eat.
McDonald’s raw material costs, especially wheat, energy and ingredients, have been rising. With limited scope to pass on input inflation without losing sales, I suspect the 30% earnings before interest, tax and amortisation (EBITA) margins will come under threat. So with disposable incomes shrinking, I reckon that even value-orientated behemoths, such as McDonald’s, will suffer in this crowded market. I’d rate the stock on a ten-times EBITA multiple (assuming margins of 27%). After adjusting for the $8.9bn debt burden, it delivers an intrinsic worth of $52 a share.
Recommendation: SELL at $75.70
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments