What do you do when one of your investments has rapid success? Do you sell it for a quick gain hoping to buy it back later? Anytime you buy or sell you have to make a decision, and with every decision comes another chance of being wrong. Large jumps in stock prices are tempting, but they put investors at a crossroads. You have to decide if your goal is to make money... or to create wealth.
In this month's episode, Greg outlines the best way to execute the dividend growth strategy, and specifically, how to stay disciplined when things go well. He dives into Williams-Sonoma, a specialty retailer with a nearly flawless balance sheet that has rallied almost 45% in just a couple of months. It has proven to be a lucrative opportunity, but it poses unexpected challenges to the individual investor. Using 4 different scenarios, he walks through why selling early might put some cash in your pocket but is counteractive to building wealth.
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This is Greg Denewiler and you are listening to another episode of The Dividend Mailbox, a podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks and make each year's check larger than the last.
Welcome to the August episode of The Dividend Mailbox. A lot has happened in the last few months, the markets have been volatile. Of course, they always are most of the time. And we've had a lot of uncertainty. Of course, for the last 100 years, there's always been uncertainty. But when we're in the world of dividends we have more stability, which is part of the whole reason for this podcast. We look at growing dividends, we look at sustainable dividend growth, and we look at the mindset that it takes to invest in a growing dividend portfolio.
So this episode, since we have had some volatility in the market, (you know at one time was down about 25%), and some of these stocks have been more volatile than the market: what if you got lucky enough and bought right at the bottom and you now are sitting on a position that you purchased just a few months ago? And let's just say it's up 50%? You know, what do you do now? Do you sell it and think that I might be able to buy it back cheaper because we are far from being through this whole situation? Do you just ignore it? Do you look at a chance hopefully maybe that you can buy more or just add to your position as it goes higher? How do you execute this strategy and make it work for you long term? If you haven't listened to last month's episode, I really would recommend that you go back and listen to the Ronald Read story because a big part of the answer is right there. But in dealing with reality and the emotions of having some success and having a little bit of luck- how do you deal with it? How do you keep yourself on track? That's what I want to hit on in this episode.
I think the best way to do it is to look at what's the best way to help you know whether you're actually executing the strategy or not and owning growing dividends in your portfolio. And the best way I can answer that question is, we track the dividends. We look at when we're getting dividend increases. We look at the income as it comes in. And the big thing is, each quarter we want dividend income that's growing annually. As I've said many times, maybe too many, we want each year's dividend income to be higher than the last. The best way to do that is just looking at your income as it's coming in every month, see the dividends hitting and go back and look and see when the last dividend increase was. So right there, you see, whether you're really executing the strategy, and you actually see it as it is working out. You want to see one every fourth quarter, is the ideal situation, so, it's an annual increase. Sometimes it’ll stretch it out a little bit longer, but if you get to four quarters and you don't see another dividend increase, it's probably a good time to start looking at the situation to see what's going on there, what the outlook is. Is the stock still going to be on track for dividend growth? The great thing about doing that is it totally takes your attention and your vision off what market prices are doing, towards what the income is doing in the portfolio. And it helps you keep from being seduced by just prices and what they're doing in the marketplace, which you really can't control.
Now, another thing that we haven't really mentioned in the past, or if I did it was just very briefly, is we don't really use dividend mutual funds. Well, we really don't use dividend mutual funds at all. There are mutual funds out there that try to do the same concept, but the problem is, unlike an ETF that pays out all of its income, the dividend mutual funds really have a lot of flexibility as to what they pay, when they pay out, the timing of it. It's really hard to see “well am I really growing my income year to year.” The fund may be 15% a year. But underneath you don't really know whether the dividend income is growing 3%, 5%, 6%. It may look like it's growing 10 or 15% a year, but they're paying things out that may not necessarily all just be dividends. It may include some capital gains and may include dividends. And at some point there is some discretion for fund managers. They don't have to pay out everything, so you're just not quite sure exactly what you're getting at the time. So that is one of the big reasons why we don't use dividend mutual funds. And it's not to say that they're bad and they don't work. They may even be more profitable over time depending on the manager and what strategy they use; if they tilted more towards growth or they are just good managers. But the point is, we're tracking income growth, and that's our major definition of success.
So in regards to execution and tracking dividend growth, execution is a broad term. If you've listened to the episode a few months ago, where I interviewed Simeon Hyman from ProShares (he is their lead strategist), the interview basically was regarding the ProShares aristocrat dividend fund, otherwise known as NOBL. And while I was interviewing him, I had briefly mentioned we had purchased Williams-Sonoma. I didn't really go into it and we haven't brought it up since. This is one of those situations that I'm going to bring out not to tell you how great we are, but this is really more of just kind of a learning experience- how to help look at things to keep your mindset in place and how to keep your portfolio on track long term. Because we bought William-Sonoma at $108 and it was only down there really for a few days. The stock had sold off fairly dramatically due to a negative report from both Target and Walmart, so the entire retail space got hit pretty hard. It came up as just a great value proposition with the dividend growth story. Lo and behold, now it hit $156 today, so in a very short period of time, (roughly two months), we're up almost 50% on the stock and we've already got one dividend. So, what do you do? The market has had a pretty good rebound and the stock has done much better than the market. Do you sell part of it? What's our strategy as far as exiting, or just how do we execute? And that's really going to point us back to: should we even be looking at the fact that stock has gone up? Does that matter at this point? Well, again, I also want to remind you, that if you've listened to this podcast at all, you know about Clorox. I'm not going to touch on Clorox except to say that it as of yet is not the success story that William-Sonoma is. For every one of them that does really good, you've got some you need to be patient with.
So I'll go over some of the highlights of why we took a position and William-Sonoma. This is actually one of those stocks that almost checked all the boxes, you don't see these very often. Besides the fact that it's retail, and normally I'm not a big fan of retail unless it's a big broad base like Target, or Walmart, where you don't have the cyclicality or fad situation like a lot of the clothing brands, Williams-Sonoma has been around for decades. They're a big brand name. They also own Pottery Barn, but the William-Sonoma name is cookware. It's got a reputation of being very high quality. When people get married, they tend a lot of times they will use William-Sonoma on their wedding registries because people love getting the stuff and it looks good in the kitchen. So, it's a great brand name. It's not a fad. It's been around for multiple decades. And not only that, but 20 years ago, the revenue was $1.6 billion. Now it's $8.3 billion. It's up 400%. You've got some real growth there. 20 years ago, they didn't pay a dividend. 10 years ago, the dividend was 58 cents, and now it's up to $3.12. So, the dividend has been growing by 16% a year for the last 10 years, which is way above our 6% benchmark. So, they’ve really been ramping up the dividend. And they've done all this with, currently, they have no debt. I went back and looked going all the way back to 1999. Basically, they have done zero acquisitions. It's all been organic growth they have virtually no goodwill on the balance sheet. From a profitability standpoint, gross margins are above 40% which is really good for retail. Again, they have no debt. Their shares outstanding 10 years ago was 102 million shares and now they're down to 68. They've been buying stock back relatively aggressively. Raising dividend, buying stock back- a lot of times I'm not a huge fan of stock repurchases, but in this case, you got to stock trading and 10 times earnings and their return on invested capital is up to 25%. And that's the five-year median. If you look lately, the three-year median is 33% return on capital. It's almost like that number is so high. I'm just going to go with 25%, but that just tells you how well managed has come to you know, it's cheap. And in this case, they're doing you a big favor by both paying a dividend and buying stock back. So, you've got a very well-managed business. As soon as the stock market looks like it's not quite as fearful with the whole inflation scenario, and “are we in a recession, are we going to go into one, which can hurt retail… but just as a little side note, go back and look at how William Sonoma did back in 2008, and I think it will surprise you. The stock, I'm not going to say is recession resistant, but it does well even in a weak economy. They've transitioned 50% plus over to the internet, they're not as physical store dependent as they used to be, so, it's just a great company. And the stock has rebounded, so what do you do? Well, this is one thing that I have to throw out. What's more important to you: is your goal to make money or is it to create wealth?
If it's just to make money, if you sell part of this position right now, it's pretty hard to say you've gone wrong because even if it goes higher, you still got part of the position. If it goes lower, you can buy it back. If it’s to create wealth, it's a different mindset. Let's just look at a few scenarios here with Williams-Sonoma.
It has 8.4 billion in revenue right now, the revenue 20 years ago was 1.6 billion, and 10 years ago was 3.6 billion. The stock has earnings of $15. That is up from five years ago of $3.30. They did have a little bit of a bump from the whole situation where people were staying home so they put a little bit more emphasis on improving their lifestyle at home. William-Sonoma benefited from that. That's calmed down some, but if you look at the earnings estimates for the next few years next year, it's $15.75, 2025 it’s $16.67. So, it looks like they're going to maintain most of that. Well, they're going to maintain all of it and still grow a little bit at the minimum.
So, let's look at scenario number one. And scenario number one we're going to call nothing grows except that at the end of 10 years, they pay out 30% of their earnings. Now in each one of these scenarios, the dividend starts at $3.12, which is where it is currently. So at $3.12, in 10 years, the dividend will have grown to $4.50 if they pay out 30% of that $15 on the 10th year. So if you add up the dividends for the 10-year period, you've got a total of $37. Now everything else is the same, the stock is still $150. So, you divide the $37 by 10 years and you get roughly a two and a half percent yield. Now that doesn't include any compounding, but we're going to just leave that number the way it is because if you bought a 10-year treasury, you've got the same compounding, so we'll just net it out at zero. So, it's roughly equivalent to a Treasury 10 year Treasury but slightly below.
Well, let's look at scenario number two. Here, we're going to assume that everything stays the same except that the dividend does grow by 6% a year. If you've listened to very many of these podcasts, you know what the line is, but if you haven't, the line is basically what the dividend growth rate has been for the S&P 500 for the last 100 years, and it's 6% a year. So if we use the growth rate of 6% for the dividend of Williams-Sonoma for the next 10 years, the dividend ends up on the 10th year at $5.27. We've gotten a total of roughly $41 of dividends. Slightly higher than the nothing grows scenario. And now our 10-year yield is up to 2.7%. But we're still assuming that the stock is valued at the same level of $150. Both of these scenarios are pretty conservative. And we're really expecting not much of anything happening with the company, which has not been the case in the past. This has been a real grower as far as both revenue growth, dividend growth, and earnings growth. They're really somewhat negative assumptions.
But if we get to the third scenario, we're going to call that the buyback scenario. And again, being very conservative, we're going to assume that the net income does not grow at all. And right now they're earning about 1.1 billion. If you have the $1.1 billion of net income, however, over the 10-year period, you buy back 25% of their shares with their free cash flow. I have to note, in the past 10 years, they have bought back about 33% of their shares. So even this is a little bit of a conservative estimate. Well, the share count will have dropped by 25% which will be 51 million. And now you're dividing that same 1.1 billion of net income by fewer shares. So, you end up with $22 of earnings. And if you take a 30% payout on that $22 of earnings, basically the normal payout ratio for the last 10 years, then you've got a dividend now that's grown all the way up to $6.70. So over that 10-year period, you've earned a total of $45 in dividends. But here's a couple of assumptions that we're going to make. If those earnings are up to $22. We're going to assume the P E ratio is still 10, meaning that for every $1 of earnings, the market is willing to pay $10 for it. So at $22 of earnings, the stock will have grown to $220 as far as what will be its current market price. So there, not only have we earned $45 of dividends, but we've also earned $70 on the stock price; total return of $115. So, our 10-year yield has jumped up to seven and a half percent.
Well, now we're going to go to scenario number four. This is the total return scenario and we really get our cake and our icing too. Now, first of all, I'm going to have 3% earnings growth. 3% seems very realistic, and it's way below the last 10 years’ growth rate of 22% a year. And then we're going to make one more assumption that they continue to buy back shares also. And we're going to use the same 25% share repurchase rate. That gets us back down to just like the last scenario, they'll have about 51 million shares outstanding, if that's the case. Here's where the big leverage comes in and the compounding effect and how dividend growth can really pay off. So, now the net income will have grown to 1.5 billion in 10 years. Not a big number, but it's 3% growth in earnings. So, the 1.5 billion divided by that lower share count down to 51 million. Now you've got $30 earnings, at a 30% payout, and you have a $9 dividend over the 10-year period. We just basically average that out, you've earned a total of $53 in dividends. But we're going to make one more assumption. Now if you've got a company that's grown from $15 to $30 in earnings in 10 years, the odds are that the market is going to evaluate that a little differently, and they're going to put a higher premium on it. We're just going to assume that the PE is now 15, which is, the market is paying $15 for every $1 of earnings. So, you take $30 times 15, now the stock price has grown all the way to $450. You add in the extra $53 of dividends and you have a total ending value at that point of $500, between the stock and the dividends that you've received. So you've got a gain of $350 on your original $150 investment of what it's worth right now. Over a 10-year period, that's a 230% gain. So, you've got a pretty dramatic success story here. We haven't even gotten into the fact that 3% earnings growth is relatively conservative, and with those kinds of earnings, and no long-term debt. If you have a balance sheet, that's that conservative, it's quite possible they're going to be able to buy back more shares, and earnings grow faster.
William-Sonoma has the capability or the possibility of really being a huge winner. The company has performed much better than in those scenarios in the past. But it's a retail stock right now. With the threat of a recession, they're just not willing to pay much for the earnings right now. But that's where you get the opportunity to get into a situation like this at a much more reasonable price. If you go back a year or two, the stock has been up in the low to hundreds, so the market has valued it in the past much higher than they're currently valuing. But this is the dividend growth story playing out. You want a whole portfolio of these kinds of situations and usually, you don't get one it's quite this good. Is there a guarantee that you're going to hit the cake and the icing scenario? There never is. But if you have several of these, the odds are that you hit one of them, starts to go up dramatically. I think it'll compete with any portfolio out there with very few exceptions of these really high-growth techs or more venture capital type stories, but I don't think you really give up anything.
So where does that leave us? Executing the strategy, you don't give something up just because it's moved. And price is a very seductive thing. It tends to get you to start to think well, maybe I should protect part of that profit. But what I hope you take away from this is don't let price seduce you. Take a look at what you still think that dividend can grow by. If the potential dividend growth outweighs the short-term gain that you have achieved, why do you want to interrupt that? And one of the reasons why we brought this up and a big piece of why what this podcast is about is: what happens when things really work well? I mean, how do you manage this strategy for the long term? When we first bought it, we had a pretty much a margin of safety on every one of these four scenarios. And now the margin of safety is much less obviously because the stock is up. But on the fourth scenario, the upside on William-Sonoma is fairly dramatic even from this price. Because of that, there just really isn't a reason to sell it. And if the stock does drop back off again, I don't think you should look at it as Oh, I had a chance to make some quick money and I could turn around and rebuy it or redeploy the money. It’s more of an issue that we didn't take a full position on it initially. So, it gives us a chance to buy more or even reinvest some of the dividends that may have accumulated depending on how long it takes before it drops back off again. Every investor has some bias and one of our biases is if something moves really fast, we start to step back and say well, maybe we should take another look. Really what we're after here is before we want to start making another commitment to the stock at this price is to relook at our scenario and maybe we just underestimated it from when we first started to buy it. We may decide to add to it at this point, but at the moment, we'll see how things develop. You know, one of the things you have to keep in mind is every time you sell something or buy something, it's a decision. Every time you make a decision, it's just giving you another chance to be wrong. So, when you find a company that's well managed, it's allocating capital well, that looks really to the shareholder’s best interest, you really want to try to hang on to it as long as you can. You can ask yourself, are you trying to make money, or are you trying to build wealth? And I hope that helps you in looking at how you actually execute the dividend growth strategy. If you don't know how to do it yourself, some of these ETFs are designed to do it and NOBL is one of them. And if you want an individual stock portfolio, we are investment advisors and this is what we do. We’d love to talk to you. So I hope you enjoyed this episode and I look forward to next month's
if you enjoy today's podcast, please leave us a review. Follow us on LinkedIn, Instagram, and Facebook. If you would like more information regarding dividend growth or just our style of investing, go to growmydollar.com. There you will find some of our previous podcasts and also our monthly newsletter. If you have any questions or anything to add regarding today's podcast, email firstname.lastname@example.org. Past performance does not guarantee future results. Each investor should consider whether a strategy is right for them and all the risk involved. Dividend stocks are volatile and can lose money.