Some ideas I use for investing. Part 3.

Introduction.

Price matters to me when I am investing. The lower the price the more I invest. To get the best return, I don’t want to be too diversified. I want to have my eggs in a small number of baskets. Lastly, I buy and hold because this reduces the tax penalty of selling/buying stocks.

The Kelly Criterion.

The more I diversify across a wide range of stocks, the more I get the return of the market. To beat the stock market, I need to have an opinion on the price of specific stocks. To maximise my returns, I need to bet more when I am confident in my opinion, and bet less (or not at all) when I am not confident. Mathematically, this betting pattern is described by the Kelly criterion. This is what card counters use when playing blackjack. This is is how Warren Buffett invests. It is true that Berkshire is more diversified now than it was in the past, but Berkshire has a very large percentage of it’s assets in a small number of companies (like Geico, BNSF and, more recently, Apple). Berkshire has outperformed the market in the past – not by copying the market – but by making big bets on companies that massively outperformed the market.

I am still working on better ways to implement this kind of behaviour in buying stocks and I am not yet fully systematic. Take Facebook for example, which I consider good value at $178 per share. When the stock falls below this value (it has) I put a certain percent (say 3%) of my liquid assets in this stock. If the stock falls below 75% of this value – $134 per share, I would put in another 3% – and so on. It is important for me to be disciplined about setting rules and sticking to them. Stock prices jump around and I’m not able to predict whether stocks will go up or down at any given time. This approach is very conservative, so I’m not buying stocks very often.

Note: I also set limits and won’t put more than 10% of liquid assets into one stock (although I won’t sell if a stock appreciates by itself and goes above that threshold). I am considering loosening that.

Buy and Hold.

In the US, I pay capital gains tax (~15% + state tax) on profits when I sell a stock that I have held for more than one year. If I sell in less than one year, I pay ordinary income tax (more than double). Clearly this is a reason to hold for at least one year, although I plan to hold for much longer.

Capital gains tax is paid when I sell a stock after holding for one year. There is a critical mathematical point (well described in Charlie Munger’s Almanac) that as I delay selling, the impact of the tax penalty on my annual return becomes smaller and smaller. Take the example of a stock that grows in value by 10% each year, and pays no dividend. Consider a capital gains tax rate of 15%. If I sell the stock after one year, the capital gains tax will reduce my after tax annual return from 10% down to 8.5%. However, if I hold on to the stock for 30 years, the effect of tax is to take my annual return down from 10% to 9.44% instead. If I held the stock for ever, the effect of the tax would tend towards zero – this is effectively what Berkshire does with most of the major stocks it owns. That is Warren Buffett’s claimed holding period – forever. One last point from Buffett – I think about what stocks I would buy if I could only buy ten over my whole life – that forces me to be selective!

After tax annualised returns assuming 10% annual stock growth and 15% capital gains tax. Spreadsheet here.

Technical note on Berkshire: On the surface, the Berkshire structure looks very inefficient tax-wise. For example, Berkshire owns a large stake in Coca-Cola. Coca-Cola pays corporate tax (22% headline rate) on any profits it makes. Of those profits, it distributes dividends to its shareholders (Berkshire). Berkshire then pays tax on those dividends – so there is a double tax. However, the reality is not as bad than this. Yes, Coca-Cola pays tax on its profits, however, it only redistributes a portion of those profits as dividends – with much of the rest being reinvested in ways that grow the value of the stock. Berkshire may never sell its Coca-Cola stock, so the impact of the tax of selling that stock is largely mitigated. Other Berkshire stock investments (like Apple) spend most of their profits after tax on reinvestment or on stock buybacks – both of which increase the Apple stock price. Again, Berkshire doesn’t get impacted much by a double tax here because they are long term holders of stock. In short, for Berkshire, holding stocks reduces the disadvantage of being double taxed. For me, holding stocks provides an advantage that reduces the impact of capital gains tax.

Side note on tax policy: I think it is good that capital gains tax is set up in a way that discourages short term holding of shares because I think long-term thinking is healthy for the market.

THE END OF PART 3 AND SOME IDEAS I USE WHEN INVESTING.

Published by Ronan McGovern

CEO at Sandymount Technologies

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