by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Oct. 21, 1998) -- On Monday, Alex mentioned at the end of his report that we can't be capital allocation fascists in our investment analysis and then go off and make rash capital allocation decisions for our own portfolio. We believe that one of the prime value destroyers in a securities portfolio is quick turnover. Not only do you get eaten up by higher taxes, but you also pay for frequent buys at the ask and frequent sells at the bid. That's the spread eating up your returns and it's very real.
We're not fans of this type of activity for long-term investment accounts. We don't have anything against traders at all, it's just not our bag. A key part of not turning over a portfolio, though, is taxes. Let's see what happens to two individuals who start with a $100,000 portfolio. Take a trading type that generates a yearly return of 15% versus a boring low-turnover investor who generates a yearly return of 12% pre-tax.
Each year, the hyperactive trader has to pay 32% of his or her gains to Uncle Sam while the long-term investor defers taxes. At year 20, the boring investor's portfolio will be worth $791,703 after tax. The hyperactive investor's portfolio will be worth $697,641 after tax. You've got to be pretty darned good to generate those returns over the course of 20 years. The boring investor possesses only slightly above-average skills at valuing and selecting companies for investment. Nevertheless, that investor has almost 13 1/2% more money than the other guy at the end of 20 years. Extending the time period involved and the gap grows at an exponential rate yearly.
That's somewhat of a simple way of going about it, though. A more precise matrix is offered in Wharton Professor Jeremy J. Siegel's Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies (p. 120). For a common stock portfolio returning 7.8% per year from capital appreciation and 2% from dividends, short-term tax rates of 31% on both dividends and appreciation, and long-term tax rates of 20% on capital appreciation (the dividend tax rate doesn't change), the portfolio that takes all short-term gains will never reach an after-tax return in excess of 6.9% per year. If capital gains are realized every two years, the after-tax return reaches 7.82%. If every five years, 7.98%. As the gains are realized at the end of each of the following holding periods, the compound annual after-tax returns work out to be:
5 years: 7.98% 10 years: 8.19% 20 years: 8.51% 30 years: 8.71% 40 years: 8.84% 50 years: 8.93%
I personally don't think it's a coincidence that 54 of the general equity mutual funds (I've pulled out sector funds and funds with derivatives and bonds) generating a yearly return of 20% per year over the last five years generally exhibit turnover rates lower than the 77% turnover that the average mutual fund has shown lately.
Fund Turnover ratio (%) American Capital Exchange 0.00 Dreyfus Appreciation 1.23 Papp America-Abroad 4.71 White Oak 7.90 Sequoia Fund 8.00 Kemper-Dreman High Return Equity Fund 10.00 Torray 11.72 Legg Mason Value 12.90 Capital Exchange 14.00 Enterprise Growth 22.28 Reynolds Blue Chip Growth 25.00 Weitz Hickory 29.00 Vanguard Growth 35.00 Wilshire Target Large Co. Growth 43.00 Pacific Horizon Blue Chip Fund - SRF 67.00 Alliance Premier Growth 76.00 Janus 20 123.00 Accessor Growth 131.75 Spectra 133.98 Janus Mercury 157.00The median turnover rate is 18.14%, which is ONE-QUARTER of the average mutual fund turnover rate. The mean turnover rate is 45.7%, only 60% of the mutual fund average. And off the top of my head, I would also say that the asset-weighted average is below the arithmetic average.
It's pretty much common sense not to turn over a portfolio nearly once a year. If you're choosing investments, you're buying companies. Most of the owners of private companies I know have been involved with their businesses for years. It wouldn't occur to them just to sell because times are going well or sell just because they're in the middle of a recession. And if they did do these things, it would occur after heavy introspection and planning. Too often in the stock market, people make snap decisions because of some new incremental piece of information or simply because they can.
Don't get me wrong. If you've made a mistake, you don't have to suffer through holding a stock as some sort of exercise in determining if you're part of the investing Elect. But the point of all of this is to make investments that offer enduring value. That's the point of the Bore portfolio, anyway. We want to make decisions that are not only right this year but that continue to be right for a number of years.
As Peter Lynch pointed out in a talk I attended last Friday night, his best stocks put in their best performance five years down the line from Magellan's purchase of those stocks. We touched on this the other day. The point of the Bore port is to make purchases where the operating results 10 years down the line dwarf the purchase price and where returns on incremental amounts of capital far and away beat the cost of that capital. This doesn't happen by turning over the portfolio every year.
For discussion, as always, please visit the Boring message board.
Stock Change Bid ANDW - 3/8 14.25 CGO +1 3/16 32.19 BGP + 3/16 25.19 CSL - 11/16 40.75 CSCO +3 1/2 57.63 FCH - 13/16 22.13 PNR - 1/8 35.50 TBY + 5/8 6.94
Day Month Year History BORING +1.66% 2.85% -11.99% 10.74% S&P: +0.56% 5.20% 10.25% 72.11% NASDAQ: +2.17% -1.13% 6.65% 60.89% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 57.63 140.55% 2/28/96 400 Borders Gr 11.26 25.19 123.77% 8/13/96 200 Carlisle C 26.32 40.75 54.80% 3/5/97 150 Atlas Air 23.06 32.19 39.59% 4/14/98 100 Pentair 43.74 35.50 -18.84% 5/20/98 400 TCBY Enter 10.05 6.94 -30.94% 11/6/97 200 FelCor Sui 37.59 22.13 -41.14% 1/21/98 200 Andrew Cor 26.09 14.25 -45.38% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 12965.63 $7575.64 2/28/96 400 Borders Gr 4502.49 10075.00 $5572.51 8/13/96 200 Carlisle C 5264.99 8150.00 $2885.01 3/5/97 150 Atlas Air 3458.74 4828.13 $1369.39 4/14/98 100 Pentair 4374.25 3550.00 -$824.25 5/20/98 400 TCBY Enter 4018.00 2775.00 -$1243.00 1/21/98 200 Andrew Cor 5218.00 2850.00 -$2368.00 11/6/97 200 FelCor Sui 7518.00 4425.00 -$3093.00 CASH $5750.59 TOTAL $55369.34