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Strategies & Market Trends : Buffettology -- Ignore unavailable to you. Want to Upgrade?

To: Paul Senior who wrote (779)	12/24/1998 3:51:00 PM
From: Chuzzlewit	Respond to of 4691

Hi Paul, you raised the issue which is at the very heart of the problem with value investing. It is paradoxical in a way because it really isn't investing so much as it is arbitrage. Let's take an example. Suppose that you spot a stock, XYZ, that has a value of $100, but you can buy the stock for $80. You buy today, and lo and behold tomorrow the stock is $100! So you sell because the stock has reached it price target. If you are a value "investor", that's what you do, no? But, if you are a buy and hold type guy, what you are really looking at is growth. You invest because you believe that the company is going to grow its earnings, and the value of the stock will increase right along with it. Okay, so when to sell this gem? Well, taxes play an important role here, because your sale triggers capital gains taxes. I periodically give seminars in investing, and here is an illustration I like to use. Suppose the capital gains tax rate is 28%, and suppose you are looking at a stock that appreciates 20% per annum. Because you are a very lucky value investor you hit your pricetargets in exactly one year. So after taxes the appreciation rate is decreased to 14.4%. Now suppose by contrast I am a buy and hold guy, and I hold a stock for 20 years before selling. To make things equivalent (for the purpose of analysis) let us assume that I net 14.4% per annum after taxes also. The question is what did my pre-tax rate of return need to be to yield 14.4% after taxes. Well, it turns out that my pre-tax rate of return would need to be 17.3%. The reason is that the accrued taxes on my position behave exactly like an interest-free non-recourse loan. That in a nut-shell, is one major argument for a buy and hold philosophy. The second, of course, is the avoidance of transaction costs (much cheaper now then they were before the advent of discount brokers). That part of my answer was easy, but now you come to a much more difficult question. A core holding going through a prolonged period of decline. I suppose it comes down to this: do you believe that the company will turn around, or do you believe that the company will slide into oblivion. My core holdings are all large capitalization that at least have a significant presence in emerging technologies. So it was difficult to believe that companies like T or IBM would simply fall off the map. I believed that they would turn themselves around given enough time. As a matter of fact, I used the period of their long decline to add to my holdings. So my bottom line is this. I sell as rarely as possible, but the sale may be triggered by tax considerations (i.e., offsetting gains and losses), my need for cash (hasn't happened yet, but who knows?), or my belief that the company has entered a terminally declining phase of its life cycle. I hope this helps you in your thinking. You've asked lots of important questions, and I'm sure that I haven't answered them all, but I'm beginning to suffer from writer's cramp. Have a happy and safe holiday, TTFN, CTC