Saturday, December 09, 2006

Basic to being a good stock picker (Part7)

Another very simple effect that is very seldom seen discussed either by the investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that will work out is that after taxes, you get to keep 13.3% per annum.

In contrast, if you bought the same investment buy had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% - or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you have chose to sit back for long, long stretches in great companies, you can get a huge advantage from nothing except from the way that income taxes work.

Even with a 10% per annum investment, paying a 35% tax at the end gives you 8.3% after taxes as an annual compounded result after 30 years. In contrast, if you pay 35% each year instead of at the end, your annual result goes down to 6.5%. So you add nearly 2% of after-tax return per annum if you only achieve an average return by historical standards from common stock investments in companies with tiny dividend payout ratios.

However, in terms of business mistakes, trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. Terrible mistakes are made from people being overly motivated by tax considerations. Anytime someone offers you a tax shelter from here on in life, shun it.

In fact, anytime anybody offers you anything with a big commission and a 200-page prospectus, don’t buy it. Occasionally, you’ll be wrong if you adopt this rule. But, over a lifetime, you’ll find yourself a long way ahead – and you’ll miss a lot of unhappy experiences that might otherwise reduce you love for your fellow man.

There’re huge advantages for an individual to get into a position where you make a few great investments and just sit back and wait. Firstly, you’re paying less to brokers. You’re listening to less nonsense. And if it works, the governmental tax system gives you an extra 1, 2 or 3 percentage points per annum compounded.

And you think that most of you are going to get that much advantage by hiring investment counselors and paying them 1% to run around, incurring a lot of taxes on your behalf? Lots of luck.

Are there any dangers in this philosophy? Yes, everything in life has dangers. Since it’s so obvious by investing in great companies work, it gets horribly overdone from time to time. In the “Nifty-Fifty” years, everybody could tell which companies were the great ones. So they got bided up to 50, 60 and 70 times earnings – thus the name “Nifty-Fifty.” And just as IBM fell off the wave, other companies did too. Thus, a large investment disaster resulted from too high prices. And you got to be aware of the danger.

So there are risks. Nothing is automatic and easy in life. But if you can find some fairly priced great companies and buy it and sit, that tends to work out very, very well indeed – especially for the individual.

Within the growth stock model, there’s a sub-position: There’re actually business that you will find a few times in a lifetime where any manager could raise the return enormously just by raising the product prices – and yet some of they haven’t done it. So they have huge untapped pricing power that they’re not yet using. That is the ultimate no-brainer.

That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance still stay right up there.

So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies.

And at Berkshire Hathaway, they are the largest shareholder in Coca Cola – which had some untapped pricing power. And it had brilliant management. It was perfect.


Anonymous said...

Hi Berkshire
I'm also a follower (trying) of Ben Graham and Buffett. Have read your blogs and couldn;t agree more with what has been said about value investing.

I was wondering if you use terms like Return on Invested Capital as mentioned by Graham and also use of FCF (Free cash flow) to evaluate companies ?

I also wonder how do you value the stk price of a company ? Based on PER or DCF using FCF ?

It'll be interesting to hear from you. Cheers.