Very good new white paper from Tweedy Browne. In our opinion one of the top five reads is another Tweedy Browne white paper titled What Has Worked Fund In Investing, this new white paper is a close second. Check the full thing out below.
Investing for Higher After-Tax Returns:
Lessons for Tax-Paying Investors from Warren Buffett, Index Funds,
the Best-Performing Stocks over an 18-year Period, and Our Own Experience
TABLE OF CONTENTS
Page Introduction ………………………………………………………………………….. 1
Pre-tax and After-tax Investment Return Arithmetic:
How delaying taxes as long as possible may dramatically increase
your wealth at any given pre-tax rate of return ………………………………… 5
Why Do Professional Money Managers And Investment Analysts
Engage in So Much Buying And Selling? ………………………………………… 11
Quantitative and Qualitative Examination of three of Warren Buffett’s long-term Winners:
GEICO, The Washington Post Company and The Coca Cola Company and two apparent Losers (at least so far):
World Book, Inc. and Berkshire Hathaway’s Shoe Group …………………….. 12
Connoisseurs of Competitive Advantage:
Mimicking the Master: Buffett 101……………………………………………….. 22
Characteristics of the Best and Worst Performing Stocks
in the S&P 500 Index over an 18-Year Period ………………………………….. 26
Earnings Per Share Growth over the 18-Year,
December 31, 1980 – December 31, 1998 Period
for Companies that were in the S&P 500 as of December 31, 1980 …………… 30
Perfect Together: High Returns from Stocks
that Combine Value and Growth; Buy Cheap and Keep ……………………….. 31
The Intrinsic Value of a Growing Business:
How Warren Buffett Values Businesses………………………………………….. 31
When to Sell: A Framework for Tax-Paying Investors;
Thinking and Acting Like an Owner of a Business……………………………… 37
Predicting the Future of Businesses ………………………………………………… 39 Diversification and the Mathematical Magic of Skewness ………………………… 43 Just in case ……………………………………………………………………………. 47 An example of skewness and unplanned, accidental concentration ……………… 48 Our Advice to You……………………………………………………………………. 48
APPENDIX B APPENDIX C
After-Tax Return on Stocks assuming 20% and 15%
Yearly Returns and Various Turnover Rates …………… 50
State Income Tax Rates as of 12/31/98 …………………….. 62 17 Standard Earnings Outlook/Value Questions
Checklist …………………………………………………… 63
Buffett 101: Questions/Checklist Concerning Assessing a Company’s Growth Prospects, Competitive Position
and Economics…………………………………………….. 65
INVESTING FOR HIGHER AFTER-TAX RETURNS:
Lessons for Tax-paying Investors from Warren Buffett,
Index Funds, the Best Performing Stocks over an 18-year Period, and Our Own Experience
This report will describe what we have learned about investing for higher after-tax returns, and our investment strategy for tax-paying investors. The Managing Directors of Tweedy, Browne Company LLC have become increasingly aware of taxes over the last ten years as their own wealth and clients’ wealth has increased. We presently have nearly our entire liquid net worths, approximately $400 million of our own money that has been accumulated over the years, invested in portfolios that are jointly owned with clients, including Tweedy, Browne Global Value Fund and Tweedy, Browne American Value Fund, and in separate portfolios whose equity holdings are similar to the holdings of clients’ portfolios.
Nearly all of our own money, and probably more than 50% of the money that we manage for clients, is subject to income taxes and capital gains taxes. Capital gains taxes only occur when a stock is sold at a gain above cost, and, hence, are somewhat unique in that they are elective: You can decide if and when you want to sell a stock at a gain, and thereby incur capital gains taxes. Alternatively, you can decide to not sell a stock at a gain and, therefore, not pay capital gains taxes. It has been said that “the only sure thing is death and taxes”, but the second part of this statement does not hold true for capital gains taxes.
Our thinking and exploration of the impact and importance of taxes on investment returns has been aided greatly by Warren Buffett, one of the world’s most successful investors, and by John Bogle, former Senior Chairman and Founder of The Vanguard Group of mutual funds. Warren Buffett has at times invested nearly 40% of his net worth in one stock, and owns operating businesses through his holding company, Berkshire Hathaway. Warren Buffett is the epitome of an active investor. John Bogle, on the other hand, advocates passive, do-nothing investing in index funds, which do not have portfolio managers and investment analysts engaged in analyzing individual stocks, and attempting to beat the market. Index funds that mimic the investment performance of the
Standard & Poor’s 500 Index simply buy each and every one of the 500 stocks that are in the S&P 500, and then continue to hold them. Mr. Buffett and Mr. Bogle seem bi-polar in investment approach, but they are completely joined in understanding and advocating the huge advantage of avoidance and deferral of taxes over very long periods of time. Mr. Bogle calls it, “Buy right and hold tight.”
At Tweedy, Browne, we consider index funds to be our biggest, toughest long-term competitor. The S&P 500 outperformed 91% of all surviving equity mutual funds over the
December 31, 1981 – December 31, 1997 16-year period.* Index funds that mimic the S&P 500 probably beat close to 91% of equity mutual funds over this period. Anyone in the investment management business who does not respect the challenge of low-fee index funds that rarely sell stocks and, therefore, rarely realize capital gains, is, as psychologists would say, in denial.
Fortunately, the investment approach that our firm has practiced for more than 25 years has served us and our clients well. We have to admit that we might be a little bit tempted to at least consider investing some of our own money and clients’ money in an index fund if the valuation wasn’t so high: The S&P 500 is now about 35x reported earnings, with no downward adjustment of these reported earnings figures for “one-time, non-recurring writedowns and special charges” that, in fact, seem to be very recurring expenses that would reduce reported earnings if the companies’ accounting practices were more conservative. The S&P 500’s earnings are also not adjusted downward for the hidden expense of large stock options. In addition, the S&P 500 is priced at over 6x tangible book value. Both the price-to-earnings ratio, 35x, and the price-to-book value ratio, 6x, are all-time high valuations. In 1980, the S&P 500 was selling at 9.2x earnings. It seems very unlikely to us that future gains for the S&P 500 from a starting point of 35x earnings in 1999 will come at all close to generating the 16.94% per year gains that occurred over the 18-year period from December 31, 1980 through December 31, 1998 from a starting point in 1980 of 9.2x earnings.
At Tweedy, Browne, we are well aware that our investment management services are not the only show in town, and that we, the Managing Directors, and clients of the firm always have the alternative of investing in a very low-fee index fund that avoids taxes – because stocks are seldom sold. We do not know for sure if the investment approach that we practice will add value above index returns in the future, as it has in the past, but we are hopeful. We only really have control over investment strategy and its implementation, and the future returns will be substantially determined by what other human beings will pay in the future for stocks that we own. We do know for sure that we can invest our own money and clients’ money in stocks that are significantly cheaper in relation to earnings, book value and estimated intrinsic value than the S&P 500. This investment approach, the value approach of getting more for your money, appeals to our common- sense, and has worked well in the past.
At Tweedy, Browne, we continue to seek to earn both pre-tax and after-tax returns in excess of index fund returns for our own money and our clients’ money. This study and report are part of that effort, and represent our first extensive examination of investing for higher after-tax returns, a topic that we believe is extremely important for tax-paying investors.
* This study, which was completed in 2000, used readily available historical data from CDA Investnet’s Cadence Performance Software Group, which is now a division of Weisenberger Group, a provider of information concerning mutual funds.
The S&P 500 Stock Index is an unmanaged index which assumes the reinvestment of dividends and which is generally considered representative of U.S. large capitalization stocks.
In the first section of this report entitled, Pre-Tax and After-Tax Investment Return Arithmetic: How Delaying Taxes As Long As Possible May Dramatically Increase Your Wealth at Any Given Pre-Tax Rate of Return, we will describe the impact of taxes on investment returns.
Then, in the next two sections of this report, we will look backward in time to study the characteristics of stocks that have provided high investment rates of return over very long holding periods. At Tweedy, Browne, we are able to describe the characteristics of a fairly small sample of stocks within our own portfolios that have provided high rates of pre-tax and after-tax return over long holding periods in the past. This report describes our first systematic examination of successful long-run stocks as a category.
The goal of studying highly successful long-term investments of the past is to develop a framework for trying to identify stocks that, hopefully, will have similar characteristics when we buy them, and after we have bought them. As Warren Buffett has said, “The investor of today does not profit from the growth of the past.” As Mr. Buffett has also observed, if this were not the case, the average librarian would be rich from the stock market. We also want to try to avoid stocks that will have the future characteristics of the worst performing stocks of the past. It is always easier to find (or avoid) something if you know what to look for.
First, we will attempt to learn about long-run value stocks from the Master: We will examine five of Warren Buffett’s long-term holdings: Three winners: GEICO, The Washington Post Company, and The Coca-Cola Company, and two apparent losers (at least so far), World Book, Inc. and Berkshire Hathaway’s Shoe Group. These five case studies will focus on what we believe is a key ingredient in successful long-run investing: the qualitative assessment of a company’s future competitive position and economics. Warren Buffett and his partner, Charles Munger, are brilliant analysts of competitive strengths and weaknesses in businesses, and highly discerning in their selection of businesses. We will try to think along with them, and learn. They want huge, sustainable competitive advantages: advantages that will last for decades, if not “forever”.
Then, in the next section, Characteristics of the Best and Worst Performing Stocks in the S&P 500 over an 18 Year Period, we will examine the best and worst performing stocks in the S&P 500 over an 18-year holding period beginning on December 31, 1980 and ending on December 31, 1998.*
Warren Buffett’s method of computing the intrinsic value of a business is described in the section, The Intrinsic Value of a Growing Business: How Warren Buffett Values Businesses.
* This study, which was completed in 1999, used readily available backtesting data from the Zacks and Compustat databases. The availability of historical financial data in a machine readable form determined the length of the study.
We will describe Tweedy, Browne’s framework for selling stocks on behalf of our tax- paying clients in When to Sell: A Framework for Tax-Paying Investors; Thinking and Acting Like an Owner of a Business.
In the section entitled, Predicting the Future of Businesses, this report will also discuss the general difficulty of predicting businesses’ future financial results, and how we handle this inherent problem in managing portfolios at Tweedy, Browne. Our empirical research indicates that future corporate financial success cannot be predicted solely by simple extrapolation of past financial trends. An educated best-guess about the future financial statements and value of a business hinges upon a qualitative assessment of the sustainability of a particular company’s competitive advantage, standing, or “franchise”. In the second section of the report, we will describe how even Warren Buffett has appeared to have misjudged the future prospects of two companies that he has acquired in recent years: World Book, Inc. and Berkshire Hathaway’s Shoe Group. As Samuel Goldwyn said, “Forecasts are difficult to make, especially about the future”.
The next to last section of this report, Diversification and the Mathematical Magic of Skewness, will describe the return-enhancing and risk-reducing advantages of diversification. We will also describe the wonderful mathematics of “skewness” in a diversified portfolio, which effortlessly serves to “cut your losses, and let your profits run”.
In the final section of this report, Our Advice to You, we will provide some advice, which we plan to follow ourselves in managing money at Tweedy, Browne. We hope this report will be useful to you. There can be a very large payoff from even seemingly small improvements in after-tax returns compounded over a long period of time. If this report serves to provide some understanding and long-run perspective, and aids you in your pursuit of higher after-tax returns, then we, at Tweedy, Browne, will have served you well.*
* During the time periods discussed in the article, Tweedy, Browne American Value Fund and Tweedy, Browne Global Value Fund held the following securities mentioned in the article: American Express, Freddie Mac, Wells Fargo, and Nestle. As of December 31, 1998, these securities represented 11.51% and 7.69% of the net assets of Tweedy, Browne American Value Fund and Tweedy, Browne Global Value Fund, respectively, and may not be representative of the Funds’ current or future holdings.
RE-TAX AND AFTER-TAX INVESTMENT RETURN ARITHMETIC:
How delaying taxes as long as possible may dramatically increase your wealth at any given pre- tax rate of return
“Inactivity strikes us as intelligent behavior” – Warren Buffett
In the 1993 Berkshire Hathaway annual report, Warren Buffett, the world’s most successful
investor, provided this example to illustrate the enormous impact of taxes on investment results:
“Through my favorite comic strip, Li’l Abner, I got the chance during my youth to see the benefits of delayed taxes, though I missed the lesson at the time. Making his readers feel superior, Li’l Abner bungled happily, but moronically, through life in Dogpatch. At one point he became infatuated with a New York temptress, Appassionatta van Climax, but despaired of marrying her because he had only a single silver dollar and she was interested solely in millionaires. Dejected, Abner took his problem to Old Man Mose, the font of all knowledge in Dogpatch. Said the sage: “Double your money 20 times and Appassionatta will be yours (1,2,4,8 ….1,048,576).”
My last memory of the strip is Abner entering a roadhouse, dropping his dollar into a slot machine, and hitting a jackpot that spilled money all over the floor. Meticulously following Mose’s advice, Abner picked up two dollars and went off to find his next double. Whereupon I dumped Abner and began reading Ben Graham.
Mose clearly was overrated as a guru: Besides failing to anticipate Abner’s slavish obedience to instructions, he also forgot about taxes. Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $22,370. Indeed, had he kept on both getting his annual doubles and paying a 35% tax on each, he would have needed 71/2 more years to reach the $1 million required to win Appassionatta.
But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 271/2 times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, about $130 million after-tax. For that Appassionatta would have crawled to Dogpatch. Of course, with 271/2 years having passed, how Appassionatta would have looked to a fellow sitting on $130 million is another question..
What this little tale tells us is that tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate.”
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