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Taking Profits: Selling an "Aristocrat," Buying a "Dog of the Dow"

It may seem counterintuitive, but we just sold one of our top-performing Dividend Aristocrats, and we used the proceeds to buy a “Dog of the Dow” that is currently hated by the market. And as contrarians, we wouldn’t have it any other way.

Sold: McDonald's (MCD), Yield: 2.5%

We just sold our shares of McDonalds (MCD). We don’t believe McDonalds is in jeopardy of an imminent collapse, or anything like that. In fact, we believe McDonalds will continue to be profitable, its dividend will continue to steadily grow (it won’t lose its dividend aristocrat status), and its price will trade even higher over the long-term (note: dividend aristocrats are S&P 500 stocks that have increased their dividend payouts for 25 consecutive years). However, given the great run that the stock has recently had, and its high valuation, we have decided to replace MCD. And in true contrarian fashion, we’ve replaced it with shares of IBM, a stock that continues to be hated by the market.

Regarding McDonalds, we’ve owned the shares in our Blue Harbinger Disciplined Growth portfolio since July of 2015, and performance has been great, as shown in the following chart.

And note, the chart is “price-return” only (i.e. the return is even better if you count McDonalds above average dividend).

For your consideration, here is what we wrote about McDonald’s back in July of 2015 when we purchased the shares:

“McDonald’s earnings have declined recently due in large part to supplier issues in China, an unfavorable lower court ruling that resulted in a large increase to foreign tax reserves, the strong US dollar’s negative impact on non-US operations, and a brand that seems to be in decline.  However, the company continues to deliver enormous amounts of free cash flow, new management is pursuing significant top and bottom line improvements, and the stock’s recent declines are overdone.”

Basically, McDonald’s was a contrarian pick back in 2015, and the position has worked out quite well for us. Specifically, the market seems to have forgotten about the negatives back in 2015, and the relatively new CEO, Easterbrook, has delivered with menu improvements and sales promotions. Not to mention the recently weak US dollar has helped with international profits.

And now, we have sold our MCD shares (for a very nice gain) to pursue another contrarian opportunity, IBM. To be clear, we already own IBM shares in our Blue Harbinger Income Equity strategy, and now we are adding shares to our Disciplined Growth strategy as well (for reference, we now own McDonalds in none of our investment portfolios).

Bought: International Business Machines (IBM), Yield: 3.9%

So what is so great about IBM? Two things. One, it is enormously profitable (+$11.9 billion net income in 2016). And two, the market hates it. In fact, because of IBM’s recent price declines and its big dividend yield, it is one of the Dogs of the Dow.

Note: The Dogs of the Dow strategy proposes that an investor annually select for investment the ten Dow Jones Industrial Average (DJIA) stocks whose dividend is the highest fraction of their price. According to Wikipedia: Proponents of the Dogs of the Dow strategy argue that blue-chip companies do not alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company; the stock price, in contrast, fluctuates through the business cycle. This should mean that companies with a high yield, with a high dividend relative to stock price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low-yield companies.

For your reference, the following table shows the recent performance of the 30 Dow Jones stocks.

And for further consideration, here are the ranges for several valuation metrics over the last 5 years.

McDonald’s is currently at the top of its 5-year valuation range, while IBM is slightly more reasonably priced, particularly with regards to price to cash flow (IBM continues to be a cash generation machine).

But besides only the valuation metrics, we like IBM because we believe the market is so caught up with the negative narrative surrounding IBM (such continuing revenue declines quarter after quarter for years) that investors are overlooking what is really happening. Specifically, IBM’s huge backlog of legacy business (+$119 billion) is slowly rolling off the books. However, it’s rolling off slowly, and IBM will continue to be hugely profitable for many years based solely on legacy business. And more importantly, IBM’s growth initiatives (analytics and big data, for example) are growing, and they are in a growing industry. And eventually, the growth will be greater than the declines, and IBM’s huge profits will start growing again. However, as Warren Buffett says “if you wait for the robins, spring will be over.” As contrarians, we like IBM now. For your consideration, we wrote about IBM recently in this report (see #8):

10 Attractive High-Yield Blue Chips For Contrarians

Also we wrote about IBM in detail back in 2015, the last time it was getting to cheap, in this report:

Stop Hating IBM: It's Enormously Profitable

We will be updating our composite Blue Harbinger Holdings List soon, but we wanted to get the news of these new trades to you right away.

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