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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 214655  
Subject: Internal Compounders - Story of 2013? Date: 11/7/2012 12:01 PM
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At the risk of being repetitive, I believe that companies capable of strong internal compounding are almost sure to be favored by Mr. Market once the dust settles on the fiscal cliff and people figure out how valuable the deferred tax liability can be. A couple of examples:

Scenario 1: Top rate taxpayer. Capital gains tax rises from 15% to 23.8% (including the Medicare investment tax). Dividend tax rises from 15% to 43.4% (including the Medicare investment tax. The investor has $100,000 to invest. Company A can compound internally at 10% per year. Company B can earn 10% per year but cannot compound internally and pays a 10% dividend. The investor either purchases $100,000 of Company A and does nothing for ten years or purchases $100,000 of Company B and reinvests his after-tax dividend in new shares. After ten years, the shares are sold. Here are the scenarios:

http://www.rationalwalk.com/wp-content/uploads/2012/11/DivCa...

The $100,000 investment in company A yields $221,443 after tax, a compound annual return of 8.3%. The $100,000 investment in company B yields $173,423 after tax, a compound annual return of 5.7%. That is a huge difference.

Scenario 2: Middle income taxpayer. Repeat Scenario 1 except the capital gains tax rises from 15% to 20% and the dividend tax rises from 15% to 28%. This is what the scenario looks like:

http://www.rationalwalk.com/wp-content/uploads/2012/11/DivCa...

The $100,000 investment in company A yields $227,499 after tax, annualized compound return of 8.6%. The investment in Company B yields $200,423, a compound return of 7.2%. A very significant difference.

I have zero faith in the "efficient market" but even Mr. Market should be able to see this and adjust the valuation of companies capable of internal compounding accordingly. There are not many companies capable of compounding internally and they should be worth a premium in the upcoming tax regime.

Of course, Berkshire is one of the few companies with a demonstrated record of being able to compound internally due to the much derided "conglomerate" model that allows for shifting of capital between subsidiaries in a tax efficient manner. On a smaller scale, Markel is attempting the same model and is likely to achieve a higher internal rate of compounding vs. Berkshire if the attempt succeeds. Despite this, both trade at valuation levels near historic lows.
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Author: hclasvegas Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195604 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/7/2012 12:26 PM
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thanks rational but dont forget state taxes, some live in Cali, combined divs go way above 50 % worst case.

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Author: hclasvegas Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195605 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/7/2012 12:42 PM
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bro, jeff gundlach interview on cnbc , very sharp guy short apple.

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195612 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/7/2012 4:21 PM
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I believe that companies capable of strong internal compounding are
almost sure to be favored by Mr. Market once the dust settles on the
fiscal cliff and people figure out how valuable the deferred tax liability can be.


Personally I don't think the average investor is nearly that sophisticated.
I think it's probably summed up by a comment on the MI board on the same subject...
I look at it this way, would I rather pay 25% tax on a $1.00 dividend and take home $0.75,
or would I rather pay 0% tax on no dividend and take home nothing? I'll take the $0.75 home anyday.


I'm not saying this guy is not incisive, but rather that this is a very typical and in some ways rational response.
If you need income, you will gravitate towards dividends.
If they are lower because of tax, you will be unhappier and poorer, but you won't switch to something else.
You can't simply switch to being someone with a different investment horizon.
We live in a low nominal return world, and we're all learning to live with it.

As a separate issue, I think the grand sweep of enthusiasm and fashion for
things like growth and yield are much larger and less rational than any tax change effects.
I have a US dividend portfolio, and I pay 30% tax on it all.
I'm not particularly happy about that, but it is what it is.

Jim

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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195613 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/7/2012 6:02 PM
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If you need income, you will gravitate towards dividends.

Alternatively, one could adopt the approach you mentioned a while back with Berkshire where a set number of shares are sold on a scheduled basis - dollar cost averaging on the withdrawal side. A "do it yourself" dividend.

I find it hard to believe that there will be only a limited response at the upper income levels to a near tripling of the dividend tax. And to the extent that the high income group controls the vast majority of wealth, it would not be necessary for every Mom & Pop dividend investor to change behavior for there to be a noticeable revaluation of cash cows vs. internal compounders. I guess we'll know soon enough if the tax cliff/grand bargain plays out as I expect it will.

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Author: chk999 Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195614 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/7/2012 6:25 PM
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There's a possible stratagem here. Wait for prices on dividend paying stocks to drop in response to the tax rate change, then buy them in a tax advantaged account. In a taxable account, find good internal compounders that don't pay a dividend and buy and hold them.

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Author: wittgenstein Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195615 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/7/2012 9:17 PM
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The key is actually quite simple, as your post and the one previous imply...a two part solution:

1. Ample capital, which years of investing should have provided.

2. Patience.


They sort of work in tandem. Sure have for WEB.

jz

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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195619 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/8/2012 5:51 AM
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Alternatively, one could adopt the approach you mentioned a while back
with Berkshire where a set number of shares are sold on a scheduled basis
- dollar cost averaging on the withdrawal side. A "do it yourself" dividend.


I know this and you know this, but for 99% of the population at any
wealth level this notion is entirely beyond them both conceptually and procedurally.
They think that only a dividend is income, period.
Plus, they are somewhat right: prices could be very low for many years,
so it's not a reliable way to generate income without wealth destruction.
Would you be feeling good selling shares at today's prices to pay the rent?

Even many otherwise sane and well informed posters at this board seem
to think that a dividend is extra money (and the only possible source
of income), not quite realizing that divs have to come from somewhere.
Every time a dividend is paid the value of the shares goes down, and if it's a
firm with decent ROE the value goes down by more than the amount of the dividend paid.

I find it hard to believe that there will be only a limited response
at the upper income levels to a near tripling of the dividend tax.


I agree with you that there will likely be some reaction. People do respond to incentives.
If there is a tax change, it will affect the planning of some shareholders.
But bear in mind that the dominant fraction of US equities is owned in
tax sheltered accounts and foundations, funds and companies to whom
the change won't apply, and ex-US domiciled companies, funds, and individuals.
Given the other gigantic things that go on in the market it might not
be a big enough effect to spot, like mice dancing between the feet of elephants.

Jim

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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195623 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/8/2012 8:35 AM
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I was just reading about my former home state of California and the new 13.3% top marginal rate. Assuming the continued ability to fully deduct state income taxes paid (questionable) and a return to taxing dividends as ordinary income, a top rate taxpayer in California would be paying nearly 51% in tax (0.434 + (1-0.434)*.133).

To the extent that the dividend represents corporate income already taxed at 35%, the real effective tax on dividends will be over 68%. For each dollar in pre-tax corporate income, the company keeps 65 cents. If that 65 cents is paid out as a dividend, the top rate taxpayer keeps less than 32 cents of the proceeds.

If we do the same exercise for the top rate CA taxpayer under current policy (10.8% CA marginal rate, 15% federal dividend tax rate), the taxpayer's effective marginal rate is 24% and the true rate of taxation on dividends, taking into account corporate tax, is just over 50%. (That's right, under today's regime, a CA top rate payer is already giving up half of the corporation's paid out income to taxes).

Putting aside political views on whether the upcoming tax regime is appropriate or not, it seems overwhelmingly clear that companies lacking reinvestment opportunities have become much less valuable than those with reinvestment opportunities. We'll see if the market agrees or not over the next several months.

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Author: rationalwalk Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195625 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/8/2012 8:50 AM
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Incidentally, the situation could be even worse if companies lacking real reinvestment opportunities (projects with expected returns greater than their cost of capital) push the envelope and pursue value destroying reinvestment in response to higher dividend tax rates. I can easily see that happening. CEOs who are really interested in empire building and growth at any cost could use higher dividend tax rates as an excuse to retain earnings. Even if every dollar of retained earnings only creates fifty cents in market capitalization due to value destruction, the CEOs options will still become more valuable over time and compensation consultants will be able to justify higher pay since the company is "larger". I read many proxy statements and very few seem to penalize managers who pursue value destroying projects with retained earnings. At least not in ways that I can decipher from the dozens of pages of text describing the typical compensation agreements...

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Author: hclasvegas Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 195628 of 214655
Subject: Re: Internal Compounders - Story of 2013? Date: 11/8/2012 9:14 AM
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<< I was just reading about my former home state of California and the new 13.3% top marginal rate. Assuming the continued ability to fully deduct state income taxes paid (questionable) and a return to taxing dividends as ordinary income, a top rate taxpayer in California would be paying nearly 51% in tax (0.434 + (1-0.434)*.133). >>

thank you rational, my kids live in CALI, they just had their first baby. My kid is a lawyer, would you tell her to go back to work full time, to bill 1800 hours yearly , or to bill 1/2 the hours and keep their combined income near 250k ?
How much would they net if she goes back full time , makes the extra 100k, hire a nanny for 30k a year to watch the baby, the commute,total expenses of going to work , gas, dry cleaning, etc ? Does it make sense for her to work full time ?

We will have a lot to talk about next weekend over turkey dinner, i would rather see her bill the 1000 hours or so NOT 1800 hours, and not give the feds and cali the extra 50k in taxes, not to mention how i manage their money at those tax rates, going forward. See why not everyone wants divs under Obama 2012- 2016 ? Take care bud.

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