Year End 2010 Viewpoint

Volume 11 Issue 4

Helping You Navigate in an Uncertain Investment World

Inside this issue: Yield on Cost 2

Ten Year Stock Market 4

Yield on Cost Table 5

McDividends! 6

Bond Market Outlook 7

Speaking of Dividends 8

Dividend Outlook 8

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Belleville, Illinois 62223 Phone: (618) 397-1002

mark@deschaineandcompany.com marnie@deschaineandcompany.com

Maryville Office Jason Loyd

(618) 288-2200 jason@deschaineandcompany.com

Highland Office Matt Powers

(618) 654-6262 matt@deschaineandcompany.com

We’re on the Web at: www.deschaineandcompany.com

Deschaine & Company, L.L.C. A REGISTERED INVESTMENT ADVISOR

Annual Returns 2009

US MARKETS 28.5

GLOBAL EX-US 40.6

DEV MRKTS EX-US 38.1

EMERGING MRKTS 88.1

CORE BONDS 4.6

LT COMMODITY 18.3 Source: Morningstar Q4 2009 Market Commentary

Market Summary 2009

Year End 2010 ViewpointYear End 2010 ViewpointYear End 2010 Viewpoint A Hodge-Podge of Stuff, From a Hodge-Podge Kind of Year

W ITHOUT A DOUBT, in our mind at least, the two top stories of 2010 were the extension of

the “Bush” tax cuts by the lame duck session of Con-gress in late December and the stock market hitting a two year high, also in late December. You may quibble with our assessment of what con-stitutes the two top stories for 2010, but we’re sticking with our choices. Like Time Magazine’s “Person of the Year,” each Decem-ber, we’ve got to write about some-thing from the previous year, and we chose the tax cut extension and the stock market reaching a new high for the most obvious of rea-sons; it’s fresh on our minds. Now granted, they’re important stories too, but when we began our review of the year gone by in search of meaning in what transpired in 2010, we stopped about mid-December. The rest of the year was largely a blur so we went with what was most readily on our mind. Oh sure there are plenty of other notable events during the year such as the election, (where the Repub-licans took back the House and made major gains in the U.S. Senate and governors and state houses, etc.) and Ben Bernanke, (remember him?) getting reap-pointed as head of the Fed, the New Orleans Saints beating the Colts in Super Bowl, ah what, one thou-sand, two hundred and seventeen-something (at this point does it really matter?) The Saint’s Super bowl win was significant for two reasons; well for one, we’re talking the Saints after all, and two it guaranteed a good year for the stock market, and stocks delivered going up 15% on the S&P 500 index for the year. The Saint’s win foretelling an up year for stocks is based on the renowned “Super Bowl Predictor” This renowned theory suggests that whenever a member of the origi-nal NFL wins the super bowl, the stock market goes up that year. Just so you know, we’ve never put much stock in such foolishness, but we root for the NFC

champion each year in the Super Bowl nonetheless. As the year moved into April, the stock market closed above 11,000 for the first time since the debt crisis hit full force in 2008. Shortly thereafter, the Feds and the SEC charged Goldman Sachs with fraud which

sent the stock market down sharply. What shocked us most about the fraud charges was that we thought Goldman was the government. Just when you thought things might settle in for a bit, the top pops off a BP oil well in the Gulf of Mexico and millions of gallons of crude oil spill into the Gulf before the compa-ny can get it capped. While every-one was fixated on a camera shot of an oil leak a mile deep in the Gulf,

half of Europe was about to go belly up under the weight of too much debt. Thankfully, just in the nick of time, all the Euro countries got together, passed around the collective government hat to help dig themselves out of their financial hole and agreed not to foreclose on one another, putting off the financial col-lapse of the European state for another year. Less than a month later, in October, the Chileans showed the rest of the world how to dig out of a real hole, as they managed—miraculously—to extricate 33 miners from a hole two miles deep. The miners had been stuck there since the mine collapsed 69 days earli-er. From there the election happened, cotton prices hit their highest level since reconstruction and gold closed above $1,400 an ounce. Which brings us back full cir-cle to our two top stories for 2010: Congress passing the tax bill and the Dow closing at 11,577.

Taxes and Stocks What’s eerie about our two top stories is they are inex-orably linked. That is to say, we seriously doubt the stock market would’ve closed the year above 11,500 had the tax bill not passed. But then with the stock

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EIP 2010 Score Card

Equity Returns 23.0%

Total Return 17.6%

Income Growth Rate 13.8%

*Annualized returns since Dec 31, 2000

S&P 500 15.1%

2010 Incept*

12.3%

8.7%

12.3%

1.4%

We would like to take this opportunity to thank our clients for making 2010 a record year for Deschaine & Company. Thank you!

Page 2

VIEW FROM THE FRONT SEAT by Mark J. Deschaine

Yield on Cost:: How Dividend Growth Grows Your Money

WE REFER TO THE TERM “YIELD ON COST,” regularly on the-se pages which has prompted many folks to ask: what exactly is “yield on cost?” The definition of “yield on cost” is simple: it’s a stock’s cur-rent annual dividend divided by whatever you paid for the stock, or your “cost.” For example, if you own a stock that pays $1.00 a share in annual dividends and you bought it for $10.00 a share in 2000, your “yield on cost” would be 10%. The $1.00 dividend divided by your $10.00 cost equals a 10% “yield on cost.” Have I managed to over use the “quotation marks yet?” Again, that’s nice and all, but why should you care? You should care because the objective of investing is to earn as high a rate of return on your money as possible. One of the best ways we know to do that is to buy stocks that grow their dividend over time so that as time goes on, you’re earning more money on the amount of capital you’ve invested in the stock. If a company raises its dividend consistently, even at a modest rate of say 5% a year, over time the increase in return from a growing dividend will make a huge differ-ence in the eventual outcome of your investment portfolio. Let me show you how . . . “Yield on Cost”—the Concept at Work If you buy a stock that has a dividend yield of 5% at the time you bought it and the company grows its dividend by 8% a year, in a relatively short 25 years, the stock will be yielding a healthy 34.24% on your original purchase price. If your stock pays a $1.00 dividend in year one and the dividend grows at 8% a year, by year 25 the company would be paying you an annual dividend of $6.85 a share. (See the handy dividend yield on table nearby.) If you paid $20 a share for the stock when you originally purchased it (again repre-senting an initial yield of 5%) then your “yield on cost” in year 25 would be 34.24%. The yield on cost is calculated by dividing the $6.85 annual dividend by your $20 cost. Put it another way, by the time year 25 rolls around you’re earning 34.24% on your original $20 investment. And that goes for each and every year the company pays you the $6.85 a share dividend. Needless to say, at a 34.24% annual return, your money grows quite nicely and quite quickly, more than doubling every three years. The two important variables in the yield on cost equation are the stock’s yield at the time you buy the stock and the company’s subse-quent dividend growth rate. The higher the yield at the time you purchase the stock and the faster the dividend grows over time, the higher your “yield on cost” eventually grows to be. As the dividend grows obviously so does your income and your “yield on cost.” And that’s exactly what we’re shooting for.

As I enumerated a moment ago, if your initial yield is 5%, and the divi-dend grows at 8% a year, by year 25, your investment is yielding a healthy 31.7% on your initial cost. If you’re lucky enough to find a stock yielding 10% at your initial purchase (they are

rare, but they’re out there from time to time as prices fluctuate) and the company grows its dividend 8% a year, by year 25 you’re earning a whopping 68.5% on your cost. I said, “whopping” because I think earning 68% a year on any investment justifies using the word “whopping.” Finding Dividend Growth Stocks Not as hard as it would seem Believe it or not, finding a company or group of companies for a portfolio that raise their dividend consistently isn’t as hard as it seems. Actually, it’s relatively easy. But then to be fair, it’s easy for us because we’ve already identified a couple of hun-dred companies that have a solid history of raising their dividends. For my purposes here, I selected 10 stocks from our Equity Income Portfolio, more or less at random. I say more or less at random because all I did was go down our list and select the first 10 stocks that I thought most folks would recognize. I really only used one criteria. I select-ed companies that I knew were well-known and established in 1985. The reason I wanted stocks that were well-known in 1985 was because I wanted to be able to calculate performance going back 25 years. I also wanted the companies to be well-known because I wanted to show that it is not that difficult to find an acceptable group of high-yield, dividend growth companies. None of these com-panies would have require an unreasonable amount of research to find or verify. For the most

part, they were all lying around in plain sight. At the same time, I wanted to show how relatively simple, yet powerful, the concept of dividend growth and reinvestment is to growing your wealth and income and achieving excellent long-term investment results. Without further ado, the ten companies I selected are: Abbott Labs, Altria Group, AT&T, Colgate Palmolive, Coca Cola, Cono-coPhillips, Consolidate Edison, Johnson & Johnson, McDonald’s Corp, and Procter & Gamble. I expect most of you will be familiar with most, if not all of the companies selected. I think it’s fair to say that the companies I selected, while

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Year End 2010 Viewpoint

1 $ 1.08 5.40%

2 $ 1.17 5.83%

3 $ 1.26 6.30%

4 $ 1.36 6.80%

5 $ 1.47 7.35%

6 $ 1.59 7.93%

7 $ 1.71 8.57%

8 $ 1.85 9.25%

9 $ 2.00 10.00%

10 $ 2.16 10.79%

11 $ 2.33 11.66%

12 $ 2.52 12.59%

13 $ 2.72 13.60%

14 $ 2.94 14.69%

15 $ 3.17 15.86%

16 $ 3.43 17.13%

17 $ 3.70 18.50%

18 $ 4.00 19.98%

19 $ 4.32 21.58%

20 $ 4.66 23.30%

21 $ 5.03 25.17%

22 $ 5.44 27.18%

23 $ 5.87 29.36%

24 $ 6.34 31.71%

25 $ 6.85 34.24%

Yield On Cost Table Initial Yield: 5.0%,

Beginning Dividend $1:00 Annual Dividend Growth Rate: 8%

all certainly fine and upstanding companies, they aren’t going to get the average investor’s heart rate jumping with excite-ment. I mean; Colgate Palmol-ive, Procter & Gamble, AT&T, Consolidated Edison, Cono-coPhillips. Well, you get the idea. But that’s kind of the point. It doesn’t take flashy, high octane, super-sexy growth companies to do well at investing in stocks. In other words, you don’t have to get lucky and buy Mi-crosoft or Google at their initial public offering to grow your wealth and gener-ate a nice healthy flow of dividend in-come to provide a comfortable retire-ment. All it takes is the combination of a decent dividend yield, a decent annual dividend growth rate and a modicum of time and discipline reinvesting your divi-dends to let it all percolate and before you know it, you’ve got yourself a highly efficient compounding machine that’ll consistently build your wealth and in-come for years to come. From there, about all you would’ve had to do was sign up for each company’s automatic dividend reinvestment pro-gram and hang on for 25 years while you watched these fine companies raise their dividends collectively by al-most 10% a year compound-ing your money into a sizable nest egg. To really turbo-charge your returns, all you had to do was consistently and regu-larly throw more money at them. Shown above is the yield on cost table for the ten stocks go-ing back to 1985 and some other rele-vant investment returns and data. So, how did our 10 stocks do? I ran three scenarios to show the results for the 10 stocks since 1985.

Scenario one: a one-time $1,000 in-vestment in each of the ten stocks at year end 1985. Total investment $10,000. Spend the dividend income. Scenario two: same as one but instead of spending the dividends, we reinvested all the dividend income. Scenario three: reinvest all dividend income plus invest an additional $250 in each stock at the end of each quarter for a total additional investment of $10,000 each year over 25 years. Total investment in sce-nario three: $260,000. I also ran the same three scenarios for the Vanguard S&P 500 Index Fund as a proxy for the stock market to give us some idea of how our 10 stock portfo-lio did compared to the overall stock market over the last 25 years.

So, how did we do? The summary table above shows the results. In scenar-io one, a single $1,000 invested in each of the ten stocks on December 31, 1985 would have grown to $147,741 by year end 2010. That works out to a 15.87%

compounded annual return. Pretty out-standing at least on a rate of return basis. The portfo-lio would have generated a total of $48,315 in divi-dends that we would have spent along the way. Compare that to the Vanguard’s S&P 500 index fund which would have grown to only $50,378 and

would have generated $18,435 in total dividends over the 25 year period. Under scenario two where we rein-vested all of our dividends, you would’ve more than doubled the outcome for the portfolio. By reinvesting all the dividend income, the portfolio would’ve grown to $297,858, generated a total of $86,909 in dividends and would be generating $12,107 in annual dividends today. However, those numbers pale in comparison to the portfolio value of $1,814,583, total dividends of $463,957 and annual dividend income of $72,604 the portfolio would be throwing off to-day had you reinvested all the dividends and thrown in an additional $250 a quar-ter into each stock. Doing the same thing with Vanguard’s S&P index fund would be worth $849,944, generated

total dividends of $193,738 over the last 25 years and would be producing a modest $14,152 in annual dividends, or a measly 1.94% current dividend yield. You might be wonder-ing why the annual com-pounded total return number goes down under each scenar-io even though it’s over the same 25 year time period. That’s because scenario one is

a one time investment that compounds over the twenty five year period, while the other two scenarios involve reinvest-ing dividends and or new cash that may or may not have been invested at the best time in the stock market cycle.

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Deschaine & Company, L.L.C. Page 3

10 Stock Sample Measuring Yield on Cost Yield On Cost

Company Ticker

Current Dollar

Dividend Current

Yield

Dollar Dividend

1985

25 Year Dividend Growth Year 5 Year 10 Year 15 Year 20 Year 25

Abbott Labs ABT $1.76 3.8% $0.08 12.82% 5.1% 5.4% 12.4% 26.3% 76.9%

Clorox CLX 2.20 9.1% 0.16 10.63% 4.3% 7.9% 21.6% 39.4% 72.4%

ConocoPhillips COP 2.20 3.5% 0.48 6.11% 4.8% 11.1% 21.5% 34.5% 82.7%

Consolidated Edison ED 2.38 3.7% 1.20 2.78% 6.1% 9.6% 15.6% 29.4% 53.6%

Johnson & Johnson JNJ 2.16 4.5% 0.08 14.09% 3.4% 4.2% 11.1% 29.2% 109.1%

Coca Cola KO 1.76 2.8% 0.12 11.22% 7.0% 5.1% 8.8% 30.4% 82.2%

McDonalds MCD 2.44 3.8% 0.05 16.57% 5.2% 5.6% 8.7% 28.0% 77.0%

Altria Group, Inc. MO 1.52 1.9% 0.13 15.86% 14.1% 24.9% 46.5% 93.3% 563.0%

Procter & Gamble PG 1.93 3.1% 0.16 10.30% 3.8% 6.2% 12.7% 27.2% 79.3%

AT&T T 1.68 5.9% 0.49 5.04% 8.9% 5.6% 10.7% 26.9% 69.7%

Totals 4.2% 9.92% 6.5% 8.9% 17.5% 38.0% 126.6%

Data source: Morningstar

Current Income

Market Value

Total Dividend Income Rec

Annual Comp TR

Yield on Cost

Current Yield

Scenario 1 $ 5,474 $ 147,741 $ 48,825 15.87% 54.36% 4.06%

Scenario 2 $ 12,107 $ 297,858 $ 86,909 14.58% 14.04% 4.53%

Scenario 3 $ 72,604 $ 1,814,583 $ 463,957 12.90% 11.23% 4.60%

Vanguard S&P 500 Index Fund 1985 to 2010 (Ticker VFINX) Scenario 1 $ 855 $ 50,378 $ 18,435 10.88% 8.55% 1.91%

Scenario 2 $ 1,728 $ 102,989 $ 29,721 9.77% 4.50% 1.93%

Scenario 3 $ 14,152 $ 849,944 $ 193,738 7.84% 7.33% 1.94%

10 Stock Hypothetical Portfolio 1985 to 2010 Results

Page 4 Year End 2010 Viewpoint

Dow - 34.52% 87.20% - 52.98% 74.70%

S&P - 45.51% 95.08% - 56.24% 84.03%

NQ - 71.99% 146.13% - 53.88% 105.04%

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

$1.10

$1.20

$1.30

Dec‐99 Dec‐00 Dec‐01 Dec‐02 Dec‐03 Dec‐04 Dec‐05 Dec‐06 Dec‐07 Dec‐08 Dec‐09 Dec‐10

Chart 1: Stock Market still below 1999 levels The Dow Jones, S&P 500 Index and The NASDQ Composite Index: December 31, 1999 to December 31, 2011)

Stock Market Returns Since 1999 Dow Jones .70

S&P 500 - 14.40

NASDAQ - 34.281

So while compounding under scenarios two and three grow our portfolios and our dividend income greatly, we earn a slightly lower overall percentage annual rate of return because of the timing of investing and reinvesting the cash flows. (i.e. through regular invest-ing sometimes we buy when prices are high and therefore don’t al-ways earn the maximum rate of return.) Note our money pile grows quite nicely from regular reinvesting nonetheless. The lesson from this exercise is that basket of stocks with a rela-tively modest dividend yield of a little more than 4%, but with a dividend growth rate of more than 9% annually can compound into a quite a nice nest egg while doing so with very little fuss and without sweating the daily gyrations in the stock market. Now that sounds like a plan to help insure your financial and mental health.

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market reaching new interim highs since the real all-time high reached in October 2007, there must be more going on than an extension of a “temporary” tax cut for another two years. And there was, it’s called earnings growth. While the economy was doing the best it could to pull itself off the mat, most of corporate America was trimming the fat and getting its prof-itability and cranking its cash flow house in high gear. As a result, most of corporate America, at least the part that makes up the publically traded stock market, showed huge gains in profits and has been piling up mountains of cash. Giving at least some economic justification for the current level of stock prices Apple is leading the way in cash accumulation and market valuation. The company currently sports more than $50 billion in cash on its balance sheet and is expected to generate an additional $20 billion in excess cash this year. Apple’s current cash total exceeds the total market value of all but 36 of the stocks in the S&P 500 index. On the one hand, it speaks well of manage-ment’s ability to grow sales at such a high rate of profitably to produce such excess cash. Bravo to Steven Jobs and his team for such a stellar perfor-mance over most of the last decade. And the stock market agrees which is why Apple’s stock is trad-ing over $340 a share giving it a market cap of $320 billion. That makes it the second largest com-

pany by cap size on the New York Stock Exchange. On the other hand with interest rates near zero, (see page 7) $70 billion in cash is one gigantic asset that isn’t remotely earning its keep for share-holders. While Apple gets an A+ for creating shareholder wealth over the last decade, share price is up 45% per year since 2001 (compared to the S&P 500 which is up a mere 1.41% over the same period) unless it does something productive to maximize the return on its growing mountain of cash, it’s liable to get an F from shareholders going forward. Fueling the cash controversy, Apple hasn’t indicated what it plans to do with the cash but management doesn’t seem all that interested in giving it back to shareholders anytime soon. So far, company executives, including the ailing Steve Jobs, have offered only vague, dismissive comments about the need to remain flexible and conservative. Given the uncertain economic environment, we would generally concur with management’s call for caution when it comes to spending and reinvesting capital. However, not to the extent of holding many times the amount of cash than the company can possibly utilize efficiently or while earning such a low rate of return on the money. Bernstein Research analyst Toni Sacconaghi hammered home on the cash issue in a report on Apple issued late last summer. In it he calculated that Apple could pay out a 4% dividend, buy back $20 billion in stock and still add $10 billion to its

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Page 5 Deschaine & Company, L.L.C.

cash pile this year. Even a $15 billion acquisi-tion of a company like Netflix Inc., could be easily financed, leaving room for a big buy back and a dividend. “I think Apple’s cash position is beyond the point of being rational,” says Mr. Sacconaghi. If anything, Mr. Jobs, Apple’s CEO, sur-prise leave of absence, announced on Tuesday, January 18, 2011, only heightens the tension over Apple’s cash management approach. Ap-ple’s stock dropped the day they announced Jobs’ leave of absence. That’s partly because the market still views Apple purely as a growth stock, making its share price more volatile. Adding a dividend would put the stock in the hands of a wider base of shareholders with some seeking income which would help stabilize the shareholder base. While it’s hard to argue with Apple’s stellar shareholder performance over the last ten years, the fact is shareholders are owners of the company right next to Ste-ve Jobs and the management of the com-pany and are entitled to any cash the com-pany can’t justify retaining. Just as with McDonald’s in 2002 (see page 6) where management came to the realization that its growth prospects were running low, if Apple’s piling up cash at such a prodigious rate; maybe it’s time to distribute some of it to sharehold-ers in the form of a dividend. It may seem almost foolish to suggest that Apple may be running out of growth opportunities, but if the company can’t efficiently utilize all of the cash it generates, it’s time to consider paying some of it to sharehold-ers. Ideally in the form of a regular quar-terly cash dividend. And, just as McDonald’s sharehold-ers have found out since 2002, paying a growing dividend can drive shareholder returns just as well, if not better, than using the cash internally to grow the company. Indeed, if the company can’t efficiently use the cash, there’s no better place to put it then in the hands of shareholders. In most cases, all the shareholders are going to do is turn right around and buy more shares with the cash, further cementing their long-term relationship with the company to everyone’s benefit.

Cash is the Problem As the Apple example indicates, we think the challenges for investors going forward is to see that company managers don’t waste or poorly

allocate the company’s growing cash horde. Many financially strong companies don't pay a dividend but most should. Robert Maltbie, managing director of Singular Research opined that a change in dividend policy for many com-panies would revive investment flows into equities. He states: “A shareholder revolt may be in order to make them behave like the ma-ture slow-growth mega-caps that they really are.” The directors of such companies “must be prevented from chasing old dreams of glory and wasting their cash hoards of billions on childish and usually fruitless mergers and ac-quisitions that do not increase shareholder value over the long term.” Ah, Amen to that!

Selling Government Motors IPO Reduces Treasury’s Stake in GM to 33%. The overhauling of General Motors continued apace last year after GM launched its initial public offering of common stock in November. Actually, can it be called an initial public offer-ing? After all, GM actually went public for the first time around 1920. The government went out of its way to extol its investment acumen by boasting of having made a “profit” on the sale of 359 mil-lion shares of GM common at the offering price or $13.5 billion, reducing its ownership stake from 60.8% to about 33% in the process.

The government’s claim of making a prof-it for taxpayers on the “investment” of our tax dollars, while technically true, is disingenuous to say the least to the former equity and bond holders who were wiped out to the tune of more than $70 billion when the government forced the company into a pre-packaged bank-ruptcy. This kind of “creative accounting” of gains and losses would land most CEOs in the slammer. But hey, it’s our friendly federal gov-ernment, so what are we going to do? Treasury Department Automotive Task Force chief Ron Bloom declined to comment on the IPO and how soon the government might divest its remaining 33% interest in GM. His

office continues to monitor the U.S. tax-payer “investment” in the automaker, at arm’s length. In an IPO-day press conference GM chief financial officer Chris Liddell summed up the progress GM has made in the 16 months since the company exit-ed bankruptcy. We used to be a $100 billion finance company with a small car company attached. Thanks to the Section 363, that problem is now behind the com-pany. No kidding, the old GM did little more over the past three decades than pile up debt and UAW liabilities. The company struggled to make a profit building cars while saddled with $100 billion in related liabilities. Most quar-ters, profits or losses depended on the fortunes of the company’s finance arm General Motors Acceptance Corp., as company management paid little atten-tion to the car business. Bankruptcy cut GM debt to almost nothing allowing it to make money on a much lower level of car production. Being able to make a profit after having the government unceremo-niously wipe out $70 billion in debt over the short run really isn’t that big of a

deal. The real test will be if they can make the kind of cars that people will buy in large enough volume to rake in huge profits at the peak of the next automobile cycle. Long time Viewpoint readers might re-member that we called for a possible GM bank-ruptcy in first quarter of 2005, never anticipat-ing the government would be the one to invest in the car business. Alternatively, at the time, we suggested there were ample assets in the company to motivate the private equity crowd to gang up on the company and divvy up the pieces at a tidy profit. We didn’t think they’d

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Initial Yield Year 5 Year 10 Year 15 Year 20 Year 25

1.0% 1.5% 2.2% 3.2% 4.7% 6.8%

2.0% 2.9% 4.3% 6.3% 9.3% 13.7%

3.0% 4.4% 6.5% 9.5% 14.0% 20.5%

4.0% 5.9% 8.6% 12.7% 18.6% 27.4%

5.0% 7.3% 10.8% 15.9% 23.3% 34.2%

6.0% 8.8% 13.0% 19.0% 28.0% 41.1%

7.0% 10.3% 15.1% 22.2% 32.6% 47.9%

8.0% 11.8% 17.3% 25.4% 37.3% 54.8%

9.0% 13.2% 19.4% 28.5% 41.9% 61.6%

10.0% 14.7% 21.6% 31.7% 46.6% 68.5%

Yield on Cost with an 8% Annual Dividend Growth Rate

The table above demonstrates the power of “yield on cost” calcula-tions based on various yields at initial purchase and using a divi-dend growth rate of 8%. The table shows how a growing dividend earns you a higher yield on cost over time as a dividend grows. Here’s how to read the table. Pick an initial yield, say 1.0%. Now move across the table from left to right. In year five, a stock you bought with an initial yield of 1% that grows it dividend at 8% a year will be yielding 1.5% in year five; 2.2% in year 10; 3.2% in year 15; and so on. By year 25, even a stock that starts out with a very modest 1% dividend yield at initial purchase will be yielding a respectable 6.8% your original investment or “yield on cost” by year 25. Thus the power of a growing dividend. Look what a stock yielding 5% that grows it dividend will pay you in year 25: how does 34.2% sound?

Deschaine & Company, L.L.C. Page 6

McDividends! We’re lovin’ it! By Jason M. Loyd

Vice President & Portfolio Manager

I F YOU’VE BEEN A LONG-TERM inves-tor in McDonald’s stock, chances are

you’re as happy as a little kid tearing into a Happy Meal. Since the two McDonald brothers (Richard “Dick” and Maurice “Mac”) kicked things off flip-ping burgers in their drive-up restau-rant in 1940, McDonald’s has methodi-cally grown (mostly at the helm of ham-burger tycoon Ray Kroc) to be the world’s largest restaurant chain. With over 32,000 locations serving 60 million cus-tomers a day, you’d be hard pressed to find anyone in the developed world that doesn’t recognize the golden arches. Under brilliant management, McDon-ald’s Corporation has been dishing out divi-dends as efficiently as their hamburgers. Moreover, they have raised their dividend every year since they started paying them in 1976. To put the com-pany’s dividend payout history into perspec-tive; for folks that bought 100 shares back when the com-pany went public in 1965, it would’ve cost them a hefty $2,250. However, simply holding these 100 shares and reinvesting all dividends would have grown their total shares to well over 75,000. At the year-end share price of $76.76 a share that equates to roughly $5.7 in million market value, and about $183,000 in annual dividend income. Not bad for a $2,250 investment. Management refocuses in 2002 Since 2002, management has taken an even more aggressive, pro-shareholder approach to their management of the business. For starters, they recognized the company had reached a point where aggressively building new stores and

spending capital pushing top line sales was beginning to show diminishing re-turns to shareholders, so they set out to return more of the company’s cash to shareholdings by increasing dividends. Over the last eight years they’ve more than doubled the company’s dividend payout ratio. As a result, since 2002 the dividends have increased from a rela-tively modest 24 cents a share to over $2.44 per share as the payout ratio was systematically increased from 18% of net income to about 50%. Over the same period, earnings per share grew from $.70 in 2002, (a rare off year for the company) to $4.59 a share in 2010. Who says a company can’t grow earnings if they pay out a big chunk of cash in divi-dends at the same time? McDonald’s management has to be commended be-

cause it took a lot for them to change a business model that’s worked extraordi-narily well for over 30 years to head in an almost completely different direction.

Instead of focusing on top line growth, they’ve been focused on improving the bottom-line (or profitability) and cash flow growth. So how has the new dividend pay-out policy worked out for shareholders? Well consider that from 1985 through 2001 MCD provided shareholders with a total return of 12.65%. Certainly noth-

ing to be ashamed of, but when you compare it to Vanguard S&P 500 index fund (ticker VFINX) which was up 13.83% over the same period, the re-turns suddenly look almost mediocre. Since 2002, and their new shareholder focused dividend and cash flow manage-ment policies, however, MCD is up 24.61% compounded annually compared to 6.65% for the VFINX. And this is a nice reminder for us—patience is required for exponential compounding to really take effect. As the stock market goes through its typi-cal daily gyrations it’s very easy to be-come short sighted and glued to the fluctuating market values of our portfo-lios. We shout with joy one quarter or gasp in fear the next. From our experi-ence, such short-term focus on market

fluctuations almost always leads investors to do precisely the wrong thing at exactly the wrong time. As investors with one eye on dividend growth, we seek to leverage the power of compounding by reinvesting a grow-ing dividend over the long-term. To do so successfully, we need to keep in mind that time is the key ingredient for success. McDonald’s has a

long and solid history of providing op-portunities for shareholders to com-pound our money, and given all the fac-

tors we analyze, we expect the golden arches will continue to do what it has done over the last 40 years which is to grow profits and increase their dividend, at double digit annual rates, all to the benefit of us shareholders.

Here is your compounding quiz of the quarter: How tall would a piece of paper be if you could fold it 50 times? Hint, it doubles in size on eve-ry fold. Answer: 95 Million Miles (About the distance from the Earth to the Sun)

* Data source, Morningstar

Period EPS

Growth Annual

Dividend GR Stock Price

Change Pay Out

Ratio

1985-2002 4.7% 9.1% 9.4% 18.0%

2003-2010 26.5% 33.6% 21.56% 49.2%

McDonalds Stock Performance 1985‐2010* 

$2.26

$2.05

$1.63

$1.50

$1.00

$0.67

$0.55

$0.40

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$0.50

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$5.00

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McDonald’s Earnings & Dividend Growth 1985 to 2010

McDonald’s management commits to increasing dividend payouts to

shareholders in 2002

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BOND MARKET REVIEW & OUTLOOK 2011 Once Again: Caveat Emptor

“Bond & Bond Fund Buyers Beware!” “Probably the biggest lesson of the last ten years for the bond market is to never underestimate the Federal Reserve’s power (or determination) to

hold interest rates artificially low.” VIEWPOINT Bond Market

Review & Outlook January 2010

T HE QUOTE ABOVE IS THE OPENING line from last year’s year-end VIEW-

POINT Bond Market Review & Outlook. When we went back and reviewed our interest rate forecast, it was painfully obvious to us, as it should be to you too by now, that we haven’t exactly been on the mark on our outlook for interest rates. As we also noted last year: “When we launched the asset management business in the fall of 1999, one of the primary in-vestment assumptions we made at the time was that low interest rates posed a sizable risk to bond investors.” Again quoting from last year’s VIEWPOINT, “Given the relatively low level for interest rates in 2000, we made what we thought was a reasonable assump-tion in expecting that interest rates were equally likely to go up as go down.” First, we figured if interest rates

went down, the modest commitment to bonds we had in client accounts at the time would benefit from higher prices—albeit only modestly. On the other hand, if interest rates spiked, like they had several times in the recent past, any bonds (or bond funds) with a maturity longer than ten years were likely to get hammered enough to cause potential capital losses ranging from 25 to 40%, depending on the maturity and quality of the individual bond or bond fund. As we also noted last year, our bond strategy at the time was to take a very conservative approach to any invest-ment in bonds by staying very short in maturity, (oh, and always buy high quality merchandise). Essentially, take a wait and see attitude toward interest rates and the direction of the bond market. Client assets not committed to stocks were invested in money market funds, certifi-cates of deposits and short-term bonds. First, the idea was to minimize any po-tential capital losses when interest rates rose. Second, to be in a position to bene-fit from said rising interest rates as money market funds were able to roll maturing assets into higher yielding securities. Well, here we are one year later and we’re still waiting for interest rates to rise. But then in defense of our interest rate forecasting record these last ten years, no one else we know has done any better job of calling for a reversal of

interest rates or for that matter, in fore-seeing the extraordinary economic cir-cumstances we find ourselves in today. For the record, we never predicted when interest rates would actually rise. We would never be so foolish to actual-ly predict something that could be measured so succinctly and held against us. We just know rates will eventual have to go up as history and economic reality so clearly suggests. With the 90-day Treasury Bill rate (denoted in red in the chart above) hovering near zero, we think we’re on solid ground when we suggest they have to go up from here—eventually. Do we know when exactly, of course not, but then as our interest rate forecast record of the last ten years clearly indicates, we’ve never known. We’re just trying to point out the potential financial hazards to bond in-vestors when interest rates finally do, well, rise? Don’t Fight the Fed An old investment adage says “never fight the Fed,” which means never un-derestimate the Federal Reserve’s abil-ity to manipulate interest rates in the short term. Or, as the last ten years shows, in the intermediate, and or the long term. Still, with interests near zero, buying or holding long-term bonds or long-term bond funds right now is probably the riskiest thing an investor can do.

Page 7 Year End 2010 Viewpoint

Yes, eventually this is the next “Bubble” The area in Gray is inflation With interest rates at record lows the next logical

major move is UP! All that has to happen for an investor to lose big in bonds is for interest rates to rise to their 50-year

average. Ouch!

Chart 5: 10-Year Treasury Yield 3-Month Treasury Bill Yield

50 year average 10-year Treasury Rate

Page 8 Deschaine & Company, L.L.C.

have the guts to dismantle an American icon purely for profit, so we didn’t see it happening. Whether or not GM will turn out to be a good investment may take years to find out. But given the historical fact that the auto in-dustry started out with about 3,000 domestic auto makers in 1910 and is now down to three shaky car makers, we’re betting that even with virtually no debt, GM’s long-term prospects are shaky at best.

Speaking of Dividends Savoring a Super Year By Shirly A. Lazo Barron’s January 10, 2011 “Dividend Investors hit the trifecta in 2010”. That’s how Standard & Poor’s senior index analyst, Howard Silverblatt, pithily summed up the year that was. “Dividend increases were up 45% (from the 2009 level), decreases declined 82% and, best of all, the forward indicated dividend rate (based on a company’s latest stated payout) increased over 8%, implying a much better year for dividend income in 2011,” Silverblatt declared. On a dollar basis, companies added $26.5 billion to dividends in 2010 after paying $42.4 billion less in 2009. As encouraging as these results are, there’s room for improvement. “The best way to think of dividend income is as your salary,” advises Silverblatt. “The good news is that you got an 8%-plus pay raise in 2010, and 2011 could bring a 9% hike. The bad news is that

you’re still making 18.5% less than you made in 2008.” Silverblatt argues that dividends won’t return to their 2007-2008 levels until 2013 and then only “if the economy cooperates.” Here’s how the fourth quarter of 2010 stacked up: Of the approximately 7,000 public-ly owned corporations that S&P surveys, 696 enriched dividends, declared a bonus payout or resumed disbursements. That was 44% more than the 484 that did so in 2009’s last three months. Only 28 companies cut or omitted their payments, 62% below the year earlier. For all of 2010, favorable dividend actions jumped to 1,729 from 1,191 in 2009. Negative moves came in at just 145. In 2009, a distress-ing 804 cut or eliminated their payouts. Silverblatt maintains that conditions are ripe for higher dividends. For one thing, com-panies have a lot of cash; the 375 largest U.S. companies in the S&P 500 are sitting on $902.4 billion, according to a preliminary estimate, a record sum that’s 10% above the 2009 total. Corporate America also is producing robust profits and strong cash flow. What’s more, payouts remain low, even though investors are hungry for income, and many companies, eager to show that they are in recovery mode, would actually like to boost them. Silverblatt adds that “large-caps might be the initial aggressors in 2011, given that 75% of them already pay a dividend, compared with less than 40% for the rest of the U.S. market.”

Dividend Outlook for 2011 For all the reasons Silverblatt enunciated above, we remain bullish on the outlook of dividends and dividend growth in 2011 and

beyond. As Silverblatt noted, U.S companies sport record cash balances. In addition, they’re generating record levels of cash flow from a lean and mean operating structure. Of course, the price of a strong balance sheet and lots of liquidity is a dismal jobs market, as companies have aggressively cut staff in order to build cash flow and cash balances. Now they’re reluc-tant to hire new employees in the face of slow overall economic growth. Thus, this is the difficult trade-off every business manager must make in difficult economic times. Reduce em-ployees and related overhead or risk running out of capital. In the current economic and tight credit environment most company man-agers have opted to cut staff first and ask ques-tions later. We suspect companies have taken such a conservative approach to the management of personnel and their balance sheets because borrowing money in today’s credit environ-ment is difficult, to say the least. Many banks are simply not lending money to anyone but their very best customers, so many less credit worthy companies have no choice but to build up their cash balances and fund the business through internally generated cash flow. With economic growth well below typical recovery growth rates, we don’t see companies changing their current approach to managing their busi-ness and cash until they see a sustainable in-crease in revenues. That suggests employment isn’t likely to improve anytime soon. Everyone at Deschaine & Company wants to wish you and yours a happy, healthy and prosperous new year. MJD

(Continued from page 5)

PUBLISHER: MARK J. DESCHAINE EDITOR: JOHN H. DESCHAINE CONTRIBUTING EDITOR: TOM O’HARA STAFF CONTRIBUTORS: MATT POWERS, JASON LOYD COPY EDITOR: MARNIE E. DESCHAINE TECHNICAL ADVISOR: Joseph M. Deschaine. VIEWPOINT is a comple-mentary publication of Deschaine & Company, L.L.C. a registered investment advisor in Belleville, Illinois. This information has been prepared from sources deemed reliable, but its accuracy is not guaranteed. It should not be assumed that any securities discussed will be profitable or will equal past performance, or is it an offer to buy or sell any security mentioned. Deschaine & Company and/or one or more of its clients, employees, family or friends may have a position in the securities discussed herein. © 2011. All rights reserved. Reproduction of this publication is strictly forbidden without written consent from Deschaine & Company. This issue was published on January 25, 2010. If you would like to receive a complementary copy each quarterly, simply send us your address and the preferred method of delivery: snail-mail or email, to: 128 South Fairway Drive, Belleville, IL 62223. Or email us at mark@deschaineandcompany.com and we would be happy to add you to one of our mailing or email list.

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