Cash (Flow) Is King

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Between immediate information on the Internet and minute-by-minute stock quotes at your fingertips, investors appear to be more infatuated with price appreciation than anything else. In contrast, prior to the 1990s, investors primarily focused on earning returns through a cash flow of dividends. Even though there has undoubtedly been a shift from cash-focused investing to a market fixated on price performance, cash flows play a critical role in assessing company valuation.

In this episode, Greg examines wisdom from "The Ownership Dividend: The Coming Paradigm Shift in the US Stock Market." Through several excerpts, he exposes how important dividends are to the structure of the market, investor goals, and company valuation. In the second half of the episode, Greg looks at Williams-Sonoma which has appreciated 200% since we first bought it two years ago. He analyzes whether its recent outperformance should warrant selling it to lock in gains.

EDIT: In the episode, Greg comments that our Williams Sonoma position has appreciated 300%, however, it has only appreciated 200%. The stock prices were given, so simple calculations could identify this error. 

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Transcript

Greg 00:11

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 34 of The Dividend Mailbox. And today we're going to first touch on a book that I recently read, The Ownership Dividend. There were some great points as far as why dividends are important in the markets in general and why dividends are important or should be important to investors. And then we're going to look at and kind of continue the topic that we went into some depth in episode 33, the last one. We've looked at sales in the past from the angle of, “Well, they're not working very well, so at what point do you pull the trigger?” Today we're going to come at it from a different angle, and this time we're going to look at one that has done well, Williams Sonoma. We're going to examine, okay, since it's up almost three times what we paid for it, should we be selling it right now? 

So now let's start by looking at some concepts that I think really put dividend investing in a great perspective. The name of the book is The Ownership Dividend, The Coming Paradigm Shift in the U.S. Stock Market by Daniel Peris. And Daniel Peris is actually a fund manager for Federated Hermes. He runs the U.S. Strategic Value Dividend Fund. He's been the lead manager for 17 years, so he's been in this space for quite a while. And one of the things that he does in his book is point out how relevant dividends were in the past. He goes back into some interesting history going back centuries, and dividends have always been a key point of the market. They've been a key point of stock returns, and up until the beginning of the 90s, dividends were one of the key factors of why investors invested in a stock. They wanted the cash return, that's how you get a return on your investment. 

It was almost the opposite of where we are now, where people don't really care about them. In the last several decades, we've really transitioned into more of a market that's been driven by just price performance. This is part of what Daniel Peris goes through — part of that just may be because of the internet, access to immediate information, infatuation with price movements from day to day, and the whole advent of mobile apps. But we've lost sight of what is really important, and he makes a prediction that we will return to a more cash-based system. He goes through his explanations of why he thinks that is true. It's just a really great reminder of dividends do matter; they've mattered for a long time until just recently. 

So, to take an excerpt, the comment that he makes is: “In contrast, the successful business owner is focused on the continuation of current and future cash flows, not a discovery of the stock by other investors. It's more about the actual business than the stock market's view of the matter. Dividend investing is simply different.” The point that he really tries to bring home in this book is that these are businesses, they're not stock quotes. By focusing on them as businesses, you automatically have to look at the cashflow that these businesses produce. The fact that seems to be lost on investors is that because they're minority shareholders and they just own a few shares of a stock, a extremely small percentage, they forget that they actually do own part of the company. If you did own an entire company— if you just won the Powerball and you go out and buy an entire company— you're going to look at it a little differently. The very first thing you're going to do is look at, okay, how much is company XYZ going to pay me every year? In fact, you're probably going to look at the cash flow on a quarterly, or monthly basis. What I'm pretty sure you're not going to do is look on your phone and say, “Hmm, I wonder what somebody else will pay me for XYZ tomorrow. I paid a billion. Oh, you mean they're going to pay me $1.1 billion tomorrow? Well, I guess I better sell it.” That's just not the way it works when you look at these things as real businesses. 

So, then he takes another quote from Peter Bernstein, and it's basically: “Since profits are less reliably measured than dividends, the behavior of the latter alone is worth noting. With the best of intentions, the earnings that accountants and managers report with such precision are nothing more than estimates, with built in vulnerabilities. Nobody knows how to measure true earnings. Everybody knows the precise amount of a dividend.” And here, if you study accounting at all, you immediately know that earnings are totally a guess because you can could choose how fast you want to depreciate something. You can depreciate something for tax reasons. You could potentially defer income or you have choices of when you actually show income. Another huge factor, especially in the tech sector where you have huge discretion, is are stock options actually an expense, or are they not? That's been a big topic that Warren Buffett has been on. The fact that they should be taken out of earnings as employee expenses but, they're taken off the balance sheet. So as investors, you just have to remember that accounting is not a science, it's an art. Daniel's comment is that dividends are a perfect number because it's down to the cent of what the cash that's actually paid, and it's what you receive. And it's a great way to just measure the success of a business. 

And then he goes on to make a point about the value of an asset is directly linked to the present value of what you, the minority shareholder can expect to get from it in cash over time. Well, here's where we get into a lot of controversy, because a lot of the latest big winners in the stock market don't pay a dividend. Some of them have no real expectations of paying anything in the near future, but yet investors are willing to pay a huge premium for it. Well, here's where I'd like to go into a great example that makes it a little easier to understand and that's just looking at real estate. If you're an investor in real estate and you go out and buy a piece of land, you're either going to look at the cashflow from that land by what is planted on it and what it produces, or if you're going to graze an animal on it, what you could sell that animal for, which then produces a profit for your landholding. Or you're looking at that land from a pure standpoint of, okay, I'm going to take this piece of land and I'm going to develop it, or I'm going to hold it for five years because I think maybe a city is growing, or that you can potentially sell it to somebody who is going to develop it and turn it into a cash producing asset. If you buy a rental house, you're buying it purely for the income. If you're trying to flip a piece of property where it needs to be totally renovated, you're not going to value that property at zero because it currently is not producing any income. You are going to value it based on how much money you think you're going to have to put into it to get it back to being rentable and then what that rental income is going to be. The point is everything is driven ultimately off the cash that that investment pays. So, when we get into the stock market, it seems like everything changes because investors just tend to want to look at what somebody else is going to pay them tomorrow. But in the end, everything ultimately should be driven off of cash flow. Well, here's one extreme example, or not extreme, but one of the more common ones is Warren Buffett is known for saying that he's never going to pay a dividend because he can reinvest earnings at a better rate than you can. I think, you know, most people would agree it's probably true. However, virtually everything he buys is cash flow generating and he wants that cash flow to be able to go out and reinvest and do something else. One of his points is, well, if you want an income, just sell one share. But the problem there is that you're totally driven by whatever the market price dictates. So it may be up one quarter, it may be down the next day, the stock may be out of favor for a while, not performing well, and you're forced to sell something when it's not the ideal time to do it. The great thing about dividend income is, you get paid in cash, period. That cash flow is predictable. If a company has a growing income stream, which is what this whole podcast is about, then you have a pretty good guess of what your income is going to be for the year and you can predict it with a reasonable amount of certainty of what you're going to earn next year. If the stock market drops 25% in 2025, your income may grow if you have a dividend portfolio. But if you're in a growth portfolio, you have no idea what Apple, Netflix, or any of these high-growth stocks may or may not be doing. Tesla has been a huge winner. It's been a great story stock; we all know Elon Musk. He's done a phenomenal job at being able to talk his game and stay true to his story, I have to give him credit for that. Tesla is going to be a little bit of an extreme example but the all-time high in Tesla is $414 a share. Now if you've owned it for the last decade you've had a phenomenal return off of it. But if you're counting on part of that to finance your lifestyle, well, the stock currently is down in $170s. So, it has declined by more than 50%. That's not exactly a situation where you want to be — selling something that if you really believe in it long-term, you don't want to be selling it at $170 something if you think it's going to go back to $400 in the next several years. What you would much rather do is just spend the income that it spins out, which is what ultimately anybody buys an asset for. Otherwise, you're really in the world of speculation. And one of the great ways of thinking about investing versus speculation is: do you want to own the economy over time or do you just want to gamble that the price of something is going to change tomorrow and hopefully it's more than what you paid? There's nothing wrong with speculation, but don't confuse that with investing. 

So, I'd like to kind of end the overview of The Ownership Dividend book by an interesting concept that he brings out, and actually, it's another comment from Peter Bernstein. It's a great idea to kind of think about: “If companies were forced to pay out 100 percent of their free cash flow above operating needs, and then forced to go to the capital markets for new capital, would their behavior change?” Then he goes on and says, “Would there be empire building or unnecessary diversification? Yes, we trust management. Yes, they are good at their jobs. But no, we don't give them a blank check all the time. The dividend forces them to have to make some decisions even more rigorously than they might otherwise wish to.” It's just kind of common sense. If a company is trying to maintain its dividend and try and grow it over time, it tends to instill a little bit more discipline and it tends to change their focus somewhat. It at least makes them pay more attention when they do go out and make an acquisition of how much they pay for it. And are they really going to get the return that's going to drive the business cash flow going forward? 

So as we transition over to an actual pick that we've made in the past, I just want to go back and say that I think this book is reading— it is a little more technical than just a normal investment book. He does go through some, you know, modern portfolio theory. How academia has looked at dividends in the past, and how they value them. But it is a great book to read if you want a little deeper dive into dividends. The point that I think he does a really good job of making is these are businesses and you buy a business to earn the cash flow. In his opinion, he thinks we're going to turn back to a dividend climate here in the next decade or so. 

So now we're going to transition into one of our picks and the reason why we're going to go through this is because in the past when we've looked at why we sell something, it's usually always been on the negative side. But now we're going to look at one that has done extremely well. If you go back to episode 14 in August of 2022, we went into a fair amount of detail about why we thought Williams Sonoma was a great long-term dividend growth story. We bought it at $108 and now the stock is trading— I have to make a note it takes a while for us to edit the podcast and actually get it out — but at the moment it's $308. So, the stock has gone up three times what we paid for it and it's been in less than two years. So, for one, I want to make the note of, “Well, okay, should we sell it? Why are we not selling it or why would maybe we possibly sell it?” And the other piece is, I think, this is a great snapshot of how dividend growth investing plays out over time, but here we get to look at it in a much shorter time frame. We've had a decade, actually more than a decade, of dividend growth, price appreciation, and total return of what we would hope to get, and we've got it condensed into less than two years. 

What I'm going to do is give you just a quick overview of why we bought it. It had an over 3% dividend yield at the time. The payout ratio was very low, it was in the 20% area, so they were paying out a very small part of their earnings and cash flow. The stock was trading at about a 12% free cash flow yield to the current market price. They had no debt. They have very little CapEx. They had transitioned to the internet, and about half of their sales were coming from their website. They had a really high return on invested capital, it was up around 40% percent plus. They have no goodwill or very small amount of goodwill. So, they pretty much have grown totally organically. They don't really have an Amazon threat because they're their own brand, they do their own in-house design. I mean, it was just a great story. When we first purchased it, the quarterly dividend was $0.78 cents. Well, the dividend has grown to $1.13. It's already up 45%. We look for a minimum growth rate of the dividend of 7.2% per year, which means it'll double in 10 years. We're on track to do that here in the next three years, possibly even less, but I'll touch on that here in a little bit. One of the things that Williams Sonoma has been doing aggressively is buying back stock. So not only have you gotten a really aggressive dividend raise, in 2019 shares were at 80 million, and now they're down to 64 million. So they're spending their cash flow. The total shareholder return for Williams Sonoma has just been extremely attractive. I'm going to define shareholder return as adding both the dividend yield and then adding the amount of stock they buy back, and most people also throw in debt, but since William Sonoma didn't have any debt, this isn't relevant. The last several years it's pushed as high as 8%. 

Now, if you remember, and this is a lesson that we all need to constantly remind ourselves of, we only took a third position when we bought this. And you might ask, well, if it clicked all the boxes and it was so cheap, why in the world did you do that? Well, here's where it comes from. The challenge of not paying attention to the headlines and just looking at what the business does and forgetting about the day-to-day price. Back in 2022, there was a lot of talk about a recession. Here we are buying a retail stock and if we're going to go into a recession, retail stocks almost by definition go down. So, we figured we'll start buying it and we'll continue to buy it as it goes down. Well, we all know now there was no recession in 2023. We thought we were going to be able to buy it at a cheaper price, so we held back. And I have to say another thing that bothered us a little bit when we first bought the stock is we could not figure out why management didn't own a much larger piece from an insider standpoint. They didn't own much of it and it just didn't seem to make sense. With the success that this company has had and how well the stock has performed, even before we bought it, you know, why don't they own more of it? It just seemed to be a haunting question. 

So, what has happened? The company has held earnings. They've held their profit margins. They've done a really good job of hanging on to the business that really exploded in the pandemic back in 2020. So, what has happened? The market's built more confidence in the Williams Sonoma story. So, it's gone from a P. E. of 8 to a market multiple of 20. What we've had is no earnings growth and great dividend growth because of all the free cash flow that was there, yet the market has valued this thing three times higher. Now, I mean, that is the power of a story changing over time and what consistent cash flow management and disciplined management can do for you. Normally, this takes years to develop.

So now we're in a situation where the dividend has grown by 45%, the stock's up 300%, um, why don't we sell it and move on, because the dividend yield now is down to about 1.5%. We can definitely earn more somewhere else, right out of the gate. Well, let me just go back and review. One of the things we do is we take a 10-year dividend growth model. It's very simple. We take the dividend today, if we grow up by 7% a year, what's that dividend going to be 10 years from now? Do we have a reasonable expectation that the company can earn enough to cover that in a predictable dividend payout scenario? Well, in the case of Williams Sonoma, the dividend is $4.52 right now. If they grow that dividend by 12%, which is way above our normal rate, in 2033, the dividend is going to be $12.53. As I mentioned in the past, they have very low CapEx, they have no debt, so if they're earning $15 a share right now, could pay out $12 today. That is not even a financial strain for them because it's all coming out of free cash flow. Well, that's not going to happen. However, the earnings estimates in 2027 are $17. So, if they just get to $17 in the next 10 years, a $12 dividend is very realistic. And here's where you get into where this compounding can really turn into some great returns. If they continue to buy back some shares, the 64 million share count could easily go down to 50 million, so that alone will push up earnings. It will actually mean that the dividend rate can stay the same, but it's actually less cash to the company that they have to pay out because they don't have as many shares as they're paying dividends to. If the stock has a terminal yield of 2.3% ten years from now, and they're paying out $12.53 at that point, the stock has a 10-year total return potential of a little over a 100%. So even at this price, the stock has some upside. It's just a really well-run company. So, we're not selling it right now. We're not going to put any more new money in it, but we still think it's a situation that we're willing to hold. And that's what we're doing. 

But that leads to an interesting question: “Okay, what would make you sell it?” One of the things that will really bother me is if they go out and they make a substantial acquisition, which could dilute their returns and really change the equation. Another thing that would be a factor is, there is a point where price does matter. If this stock goes up too much more, and I'm going to say, if we get our 10-year return model down into the potentially 75% range, we may start to think about taking off a piece of it or if we had some other ideas where we needed capital, this one potentially would become a sale candidate. So that would imply if the stock goes up another 25%, if this stock gets close to $400, we're probably going to consider selling it, but, you know, we'll see if it gets there. Another thing I think is noteworthy that you've got to be careful with, in this case, they have been disciplined, they've been buying back stock. But if they continue to spend the kind of money on buybacks that they were in the last several years, I don't view that as a positive because now you're buying back stock at a PE of 20. You're not buying it when it's cheap. 

I'm going to throw you a curve ball here, because, actually, in our mind, where we own a great company, the longer we own it, really the better off we are. And in this case, where the stock has done so well in such a short period of time, it really would have been better if the stock had not done as well as it has. And you're wondering, “Okay, how in the world can you possibly say that?” It's a whole lot better to buy stock back at $150 a share than it is to buy it back at $300. Basically, you're buying back twice the number of shares. That juices your return down the road. If we hold this thing for another 10 years, our return going forward is not going to be as good as what we had originally projected when the stock was $108 because we had a more aggressive model of buying back stock. And now that's just not going to play out because they can't buy back as much now. Even if this stock continues to work, we would have made more money or we will make more money if it had moved slower. So, that will become a little bit of a red flag, and we'll just see what happens here in the next several quarters, and how they allocate capital. 

So, I hope just from the standpoint of Williams Sonoma, it's really all about how a company manages its cash flow, and do the returns justify holding it, because this is what you ultimately hope for. Now we've got several avenues that have opened up. You could sell part of it, and let's just say that the rest of our dividends don't move at all, or we don't get the dividend growth that we were hoping, we could turn around and go buy a 3% dividend payer. We could double the income that we're producing off of this. You know, to be honest here, if we would have bought an entire position, we probably would be selling off at least a small piece of it right now just to diversify and to move somewhere else. 

So as we conclude this episode, I hope you have a little bit better clarity as far as why dividends are important, they can really drive stock prices. And as an advisor and having been around for quite a while now, one of the things that occasionally I hear is that, well, the stock market is just gambling. One of the things that I've learned, and I wish I learned this much earlier in my career is, okay, well, if you want to call the U S economy gambling, that's fine. But, in my book, it determines the fact that you can go out and you can find employment, you can buy a house, you can buy a car, you can finance a lifestyle. These are coming from companies. The bottom line is a company produces profits, they pay their employees, and then they have investors. And if you look at it from an investing standpoint, they're producing a cash flow. That's the only reason why you want to own it. And I don't think investing in a great cash flow story is luck. If you're really going to focus on a sustainable dividend growth story, you really can't just look at a stock and say, “Oh, 3% dividend. It's a good name. I think I'll buy it and walk away and forget about it.” There's definitely some expertise to it. People define dividend stories as a relatively boring space, but I can't stress enough— And I think I probably do this in almost every podcast— these things are growth stories because they have to be in order to get dividend growth. Well, occasionally you're going to hit an Apple computer. They had a 3% dividend at one time. Microsoft, Accenture, another big winner. You know, here we have Williams Sonoma up. Now you're not going to get these all the time, but it only takes one or two to really help add to your return. When you have a management that is showing discipline and showing the priority of trying to create shareholder wealth, you really want to own that for as long as you can. 

If you enjoyed today's podcast, please leave us a review and subscribe. If you would like more information regarding dividend growth or our investment strategy, please visit growmydollar.com. There you will find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com. 

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.