The Dividend Mailbox

Strategic Dividend Growth Exits: What to Consider

March 15, 2024 Greg Denewiler Season 1 Episode 33
The Dividend Mailbox
Strategic Dividend Growth Exits: What to Consider
Show Notes Transcript

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In most cases, holding quality stocks for the long term tends to play out in favor of the investor. However, if a company’s prospects change, there are situations where exiting a position can be warranted. 

In this episode of The Dividend Mailbox, Greg outlines our decision-making process behind selling off a portion of our IBM position. What started as a turnaround play transformed into a potential value trap. Using IBM as an illustration, Greg provides insight into the complexities of owning dividend growth investments and taking advantage of opportunities to exit positions that don't meet your expectations. 

Plus, get a sneak peek into next month's episode featuring a success story with Williams Sonoma, highlighting the potential rewards of high-conviction investments in the dividend growth landscape.

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This is Greg Denewiler, and you're listening to another episode of the Dividend Mailbox, a monthly 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 episode 33 of the Dividend Mailbox. Today we're going to look at a position that we sold recently. One of the reasons why I want to do that is because we have had some questions from listeners regarding, “Okay, when do you decide to sell something? What does it look like? Is there a formula for it?” So, I thought this would be a great time because last week we just sold part of one of our positions; it was in IBM. We decided to cut it back for reasons that we're going to go into, and I think it'll give you a little bit of clarity because this is a position that hasn't performed as well as we'd liked, but we did have a very positive return on it. I'll let you listen to more of the podcast to find out. Then at the conclusion, I'm going to give you a little teaser of why you're probably going to want to listen to next month's podcast. This is going to be a situation that is completely opposite. It's worked really well, in fact, beyond our expectations. So now what? 



So, before we go into the IBM situation, — one thing that I need to make sure is clear — we do not have a specific formula of, “Okay, this has happened, so it triggers an event:  we sell something, or we buy something.” It's always case by case. The reason why I say that is you will get a sense in IBM of why we decided to back off of it. The stock has been performing relatively well recently, but can we get a dividend that's going to grow and double in the next 10 years? That's the heart of what we do. But then you look at Emerson which we've looked at in the past. All these stories can have hiccups. Intel, we've talked about that one, where they cut the dividend. We decided to sell it out of the model portfolio, but we didn't sell it anywhere else because we thought there was just good value there. So, it's just case by case. There's no specific price limit that we're looking for, like if a stock doubles in 12 months, we're going to sell it or sell part of it. It just all comes back to: we want dividend growth. As long as it's there, likely we're going to either stay in it or if it's something we're looking at and we think it's reasonably priced, then we're going to look at buying it. We try not to let the market judge what we're doing, whether we think the market's expensive or not. The market from time to time is always going to give you an opportunity. Each company has its own economy, so to speak. Sometimes they'll have disappointments, and they'll give you a chance to create a position, or if it's positive, maybe give you a chance to get out of it. But the bottom line is, it's not whether the stock goes up or down. It's about our confidence in how we're going to generate our returns going forward and to give you the dividend growth that we just keep preaching about.


So, I will start with why we originally got into IBM, and it goes back to 2015. This is a company that's been around for more than half a century, and it's been a company that has reinvented itself a few times. So, they have a track record of going in and changing their business plan and moving in a different direction. They used to be much more of an equipment-focused business. They used to be heavy in mainframes. They still do a little bit of that; infrastructure is only about 25%. Most of their business now is in software and consulting. Last episode, when we compared IBM to Exxon back in the 70s, 80s, there was a period where IBM was one of the stocks that you wanted to own. As we showed in the last episode, they had some pretty strong growth. But how much do you pay for that growth? 

When you consider yourself a value investor, one of the challenges is, “Okay, what do you pay for growth?” In our case, we're, we're buying dividend growth. Well, if it's a high-quality company and they're growing predictably, or they're showing strong earnings growth, which translates into strong dividend growth, a lot of times the price will reflect that. We're constantly trying to find something that we think long term is just a great story and it's a sustainable growth story, but yet they've hit a headwind, something isn't going quite right, and that creates a buying opportunity. 

So, we'd gotten to 2015 and the company was starting to stumble a little bit again. Earnings had peaked out, the year before, at a little over $15 a share. In 2015 they declined to $13.60. Because the company was showing some signs of starting to struggle a little bit, the stock had declined from a high of $216 a share in 2013, to now, it had dropped into the mid one hundreds. IBM was a big dividend payer; they had a really strong track record of raising their dividends back then. To give you an example, in 2010, they paid $2.50 for a dividend, and by the time we got to 2015, only 5 years later, they had doubled it, and the dividend was at $5. So, we started looking at this, and at $140 a share with a $5 dividend, it was a 3.5% yield. So, there you go. You've got a nice income. You've got a strong dividend growth track record, and you have earnings that are still attractive, but they had leveled off and started to decline a little bit, but the company was still generating a lot of cash flow. And this is one of the things that gave me enough confidence to stay in it for as long as we have, they've always been able to maintain some level of profitability. Even in 2015, the return on invested capital was 16%. It was holding up fairly well, but it had come down a little bit from the high teens. The 10-year average for their net profit margins was around 15-16%. So what we decided was, we can move into the position, we're going to get an attractive dividend, the dividend is going to pay us to hold it while we wait for it to turn around. Usually, this is not a hard and fast rule, but we're trying to find some catalyst where we're going to get a turnaround in the next few years, and the dividend just carries you through that period. Usually, when you're in some form of a turnaround, or I'll even call it a reversion to the mean, you've got a higher dividend than normal because the stock is cheaper. Even if they don't double it in five years and it takes ten years, we'll be in great shape with this thing. So that's why we originally got into IBM. 



Well, here we are at the beginning of 2024 and we have owned this company for nine years. We have yet to really see a turnaround. So being that there was great value there, but the turnaround was taking way longer than we were hoping for, this one was becoming a higher and higher risk of being a value trap. 

As IBM tried to reinvent the company or at least move some pieces around, they sold several things off, and they've acquired some new businesses. One of the things they did, after we bought it, was they bought Red Hat to get into more of a growth cloud computing space. Just the numbers on the surface, they're getting better. The margins are good. Now they've got sales growth that's coming back into the equation. But then when you look at the core profitability of the business, you have a return on invested capital— which is a piece of what we put a lot of weight into— it's actually below 10% now. When you look at these other numbers and they're fairly strong, if you pay too much or you pay substantial goodwill, which is what they did for Red Hat, then it just really dilutes your overall return on capital. Long term it does have an impact on shareholder returns. 

However, IBM was building a story of AI before it was popular. Years ago, they came out with Watson, which was sort of a version of AI where they could take a lot of data, crunch it, and get some meaningful interpretation out of it. They were way ahead of the curve. The problem was they never got it in a really strong commercial model where they could monetize it, but now they are continuing to develop that space and they are one of the big plays in quantum computing. As you're well aware, for any company that really has any footprint in AI right now, the stocks are just— it's the place to be. So consequently, IBM in the last several months has been on that train. The stock for years was hanging around between really $160 and $120 going back and forth depending on what the latest earnings announcement was and what their outlook was. But it really hadn't gone anywhere for years. So, we got to about three or four months ago and their last earnings announcement was a surprise on the upside and them having an AI footprint, the stock started to move. Back in December, the stock was in the $160 range and has climbed all the way up to almost $200 a share. Well, last week, we sold off half the position at $197. If an account had less than $5,000 in it, we sold the entire position. As of today, the stock has backed off slightly, but now I want to go through, “Okay, why did we decide to sell it?” Because maybe the turnaround is really just getting started, and what you had hoped was going to happen, maybe it's actually starting to happen now. Well, I don't think at this point the risk is worth staying in it, in the full position that we had. 

First of all, revenue was at $99 billion 10 years ago. Right now, it's at $62 billion, and in the last five years, it's declined from $77 billion to $62 billion. In 2021 they had $57 billion of revenue so it has started to climb a little bit, but the bottom line is the revenue has declined fairly significantly in the last 10 years. 

Earnings, 10 years ago, were not quite $15 a share. Currently, they're at $9.55. So, they've been in a steady decline. 5 years ago they were $12.81, and in 2021 they were $9.97. Earnings currently have plateaued, but they have stopped declining which is a positive. 

Here's where you start to get into an issue, IBM's P/E for the last 10 years. This is just kind of a back-of-the-envelope average; it's traded around 12 times earnings. This stock has always been, or for the last several years, the stock has been cheap, which is one of the reasons why we continued to hold it. But now with current earnings that are expected to be this year at $9, the stock is trading at 23 times earnings. So, the valuation of this thing has gone up substantially. 

But here's another problem that we look at and where there's risk in this thing, and that is 10 years ago, the debt was $32 billion. Now it's up to $48 billion. I just told you revenue has declined from $99 to $62 billion. They've sold off or revenue has declined because of decreasing sales fairly substantially, but debt has gone up. So that's a little bit of a red flag of when they're going to be able to start paying down debt. 

If you look at the return on invested capital, I told you when we got into it, it was in the mid-teens. But then in 2017, it had declined into the high single digits, which is where it has stayed. It's had a few temporary blips up, but currently, the return on invested capital is 7.5%. So that in itself doesn't meet our hurdle. We really like to see 10% or higher. 

Well, here's the challenge that we now face. In our original position, we started buying it at around $140. With the $5 dividend, it was a 3. 4% dividend yield. So, we like to see a strong income. They did raise the dividend every year, but when you're having financial difficulties, what companies will do is they'll only raise it by a penny or two, and that's what had started to happen with IBM in the last few years. So, we're already starting to question, “Well, are we going to get the dividend growth that we want?”

So, we're going to reference the 10-year dividend model. If this is the first episode you're listening to, I would encourage you to go back and listen to some of the earlier ones. It's really the core of what we do that guides us going forward. 

If you do our simple 10-year model where we look at dividends, right now they're $6.64 for 2024. If you take 7% dividend growth and you start at $6.64 this year, out in 2033, dividends have got to grow up to $12.21. Well, that's double. While a double in the dividend over 10 years is our target, to do that we have to have earnings growth too. If you have a 70% payout ratio, kind of the top of what I would call the sustainable range, they've got to get earnings up to $17.50. If you want a 50% payout ratio, which is probably more of a predictable and sustainable number, and that's going to give you a little bit more confidence, you have to get earnings all the way up to $25 a share. Well, that, I mean, IBM right now, we know it fairly well, but as far as technology, exactly what they're doing and what the outlook is. They're really at the beginning stages of a turnaround to where it's starting to take hold, so they just don't have the growth yet. We just don't have the confidence that they're going to get there. 

Going back to the debt levels, a somewhat substantial part of that debt increase came from, if you go back to 2007, over the space of 10 years, they bought back about 35% of their outstanding stock. For these guys to get to $25 of earnings in the next decade, you've got the challenge of they've got this debt outstanding. As it rolls over, they're going to have higher debt costs. They really, I'm not going to say can't, but I doubt you're going to see them put much more debt on. It does start to limit the options that you have as far as growing the earnings and dividends. Virtually all of their dividend growth now is going to have to come from just organic earnings growth. They don't really have the flexibility to buy back stock. They don't have the flexibility really to just raise the dividend from borrowing with the high debt levels. It's hard for them to go out and buy other businesses to help stimulate growth. That gets back into the whole dilution effect, we've talked about that in several podcasts in the past, but IBM is down to one core thing now, and that's organic growth. There's nothing wrong with that, but we need a higher level than what it's showing right now. 

So, therefore, we decided that since the stock had made a pretty dramatic move up to almost $200, earnings really haven't moved that much, revenue hasn't moved that much yet, and there's still a lot of work to be done at IBM — the payout ratio is relatively high. They don't have a lot of margin of error to where things turned down again for them, there is the possibility of a dividend cut. This is one of the reasons why our confidence level in this thing is not what it was when we first bought it. But they do have a turnaround and it is looking better than it did, which is partly why we still own half of it. 

Another point that makes it a little easier to sell half the position is it's not hard to go out and find another company to replace the dividend that we're giving up with IBM. Now, because of the price increase here recently, it's up in the low 3% range. It's not that difficult to go out and find another 3% dividend payer where we have higher degrees of confidence that we're going to get the dividend growth. 

So, I hope this kind of gives you an idea of some of the thought processes that we go through. The thing about investing is there's no secret formula, there's no magic bullet. You have to look at this stuff and assess what the probability is and you have to realize that you're always going to make mistakes, but here's the great thing about a growing dividend strategy. Even if it stops growing like you would like it to and the stock doesn't even perform... I'm going to give you a personal example. We paid $140 for it. Well, that alone is only about a 40% gain over eight years. That's not the best return in the world, but when you add dividends into it, it takes the total return up to about 80%. So, it almost doubles it and that is without looking at any compounding at all with all the dividends that I've received on it. The dividend income has been a little bit more than a third of what the original cost of the stock was. 

Just as one final note, if you had reinvested all the dividends into the stock, looking at Ycharts going back to October of 2015, you'd have a total return in IBM of 112%. However, that's in relation to the SP500, which is up 190%. So it has lagged. But I have to tell you, one point you have to remember is when you're running a portfolio — this is evident when you look at Venture Capital, this is the world they live in. They'll go out and make ten investments. They only expect one of them to just hit it out of the park. Roughly, they expect five of them to be plus or minus reasonably well. They expect a few total dogs, or actually, a few total write-offs. In the world that we live in, it's not to that extreme, but it's the same concept. IBM is one of our, probably what I'm going to call the bottom five, where we had somewhat average returns. But if we're able to achieve that with part of their portfolio, and I can still double my money in roughly nine years, that's not too bad of a position to be setting in, because you only need one or two really good ones. It's all about cash flow, and even an investment that doesn't do that well, you've got the cash flow coming out of it, and you reallocate that, so you just continue to open up options. 



I hope one of the takeaways that you get from this IBM illustration is that they're all individual situations, but the overall driving force behind it is, do we think going forward that we can continue to get the 7% dividend growth? Is the return expectation still there? And just to remind you, the 7% number that we target is slightly higher than what the S&P 500 grows its dividend by, which is a little over 6% a year. Another part of what we're doing is we're looking for slightly higher yields than what the overall market pays. 7% is our minimum hurdle rate but we are actually hoping to get more. Our model portfolio has done better than that, but if we start looking for much higher dividend growth, then you're also entering into a world of less predictability and you're going to have a higher fail rate. Risk and reward are not linear. That is the core of the whole modern portfolio theory and the efficient market theory that you go through in the MBA program or CFA program. So, for us, it's a sweet spot. It just helps create a situation where we're more likely to meet our goal instead of having some of these higher-risk situations. 



So now that we're finished with IBM, next month unless something dramatic comes up that we feel would be a much more relevant podcast, we're going to talk about Williams Sonoma. The stock has more than doubled in about a year and a half, and not only that, but the dividend is growing. Last year I believe it was 15%. They just bumped it again 26% this year, and the thing that's amazing about this story is they have a lot of room to run. It's 10-year dividend growth compacted into a year and a half is going to let you see how this can play out and this is where you start to create wealth. Not just because the stock's up 160% but what's going on underneath it. In all of our previous episodes, we've looked at some of the positions that we've sold or that we were looking at where we were getting nervous on that one but it's starting to improve, everything has been more on the I'm going to call it disappointing side where they haven't performed as we would hope. But if you're constantly trying to create a foundation or an environment where you're looking for sustainable growth, you're going to just hit a few that do well. When we look at Williams Sonoma, now we're coming at it from a completely different angle: “Hey, this thing has worked really well. So now what do we do with it?”



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Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.