THE CASH-KING PORTFOLIO
by Phil Weiss (firstname.lastname@example.org)
Towaco, NJ (Dec. 9, 1998) -- There are a few big advantages that can be realized by the individual investor who invests in individual stocks rather than mutual funds. To this Fool, the biggest are the ability to determine exactly which stocks you own, the ability to save on expenses (such as commissions, general fund expenses, and the spread between the bid and ask price), and the ability to control when income in the form of capital gains will be recognized.
As a matter of fact, come tax time this year I expect those who have invested in mutual funds via taxable accounts this year will find the experience more painful from a tax perspective than usual. We'll come back to why I think that will be the case in a bit, though. First let's spend a little time on the first two advantages that I mentioned above.
Are there certain companies out there that you don't have any desire to own and/or benefit from? For this Fool there are. For example, I'm not interested in owning any company that sells tobacco products. That means that no matter how undervalued some may feel a company like Philip Morris may be from time-to-time, you won't find me purchasing any Flip Mo stock. I don't like the principal products that the company sells, so I don't want to derive any gains that it may realized from selling those products.
Unless you invest in one of the mutual funds that practices socially responsible investing, it's quite possible that you'll find a stock like Flip Mo in the fund. After all, I've seen it classified as a value stock, a growth stock, and even an income-oriented stock. This is actually another problem that you'll find with mutual fund investing. The definitions of the various types of stocks held by the different mutual funds overlap so much that funds with vastly different stated goals often hold similar stocks.
The next thing I mentioned is the additional costs that one incurs by investing via mutual funds. Let's say that you have $10,000 to invest and that you have four investment choices. The first is to buy 5 stocks using a discount broker that charges a commission of $8 per trade. The others all involve investing in mutual funds with average annual expenses of 1%, 2%, and 3%. Next, let's say that in aggregate the 5 stocks you purchase earn an average annual return of 11% per year over the next 20 years, and that you hold onto these stocks for that entire period -- sounds a lot like Cash-King investing doesn't it? At the end of 20 years, you will have incurred $40 of expenses and will have a portfolio worth about $80,300 -- not too shabby for a $10,000 investment. During this period you will not incur any capital gains taxes at all.
If, instead, you invest your money in the mutual fund with the 1% annual expense ratio, you will pay $6,400 in total expenses over the 20 year period and you will need an annual return of approximately 12.1% to have a portfolio worth $80,300. These figures do not include any potential capital gains taxes that you may have paid over the 20 years.
If you decide to invest your money in the mutual fund that has an annual expense ratio of 2%, you will end up paying $12,800 of annual expenses over the 20-year period. The annual return that you will need to realize from this fund to have a portfolio worth $80,300 is more than 13.2%. Once again I have left capital gains taxes out of this analysis.
Finally, if you invest in the fund that has an annual expense ratio of 3%, you will pay $19,200 of expenses over the 20-year period. You will need to have a return slightly over 14.4% annually to have a portfolio comparable in value to the individual stock portfolio.
The comparison above should at least start to make you think twice about investing via mutual funds. However, we haven't even discussed the taxability of the mutual fund investment vs. the individual stock investment yet. You see, in order to preserve their federal income tax status, mutual funds are required to distribute any realized capital gains to shareholders on an annual basis. Even if you don't receive any distributions from your mutual funds, you're still required to pay taxes on the gains. Over time this can get pretty expensive and lead to lots of inefficiencies.
I expect that this tax problem will be much worse in 1998 than it has been in recent years. You see, when the market was falling in August and September many fund managers expected significant shareholder redemptions, so they sold stocks to raise cash for these anticipated redemptions. Many of them also failed to see the benefits of long-term buy and hold investing, so they sold some of their stocks to preserve some gains as well.
Lo and behold, the market has already returned to its former levels. So, here's an example of what could happen to a mutual fund holder. Say that the fund manager bought shares of ABC Corp in 1996 at $25 per share. Then say that earlier this year the stock hit $80 per share. Since the fund manager still liked the stock, he held and didn't sell at this level. Next thing you know the stock had fallen to $60 per share and the manager sold realizing a gain of $35 per share. This gain must be passed onto the fund holders who would have to pay tax at the long-term capital gains rate of 20%.
The problem, of course, can get even worse than this. Say that after the market started to turn back around, the manager decided once again that he liked ABC Corp., so he bought it back at $70 per share. Let's look at what this means to the individual that holds shares in this mutual fund now. Capital gains taxes are owed as a result of the sale. The funds expenses went up because of the commissions paid on the additional trades, and $10 of appreciation in the stock (from the sale price of $60 to the repurchase price of $70) was lost as well.
Meanwhile, the individual with a long-term focus like we have here in the Cash-King Portfolio held onto this stock the entire time. This person paid no additional commissions, had no capital gains tax liability and no additional trading costs. Looks to me like just one more benefit that can be realized by owning stocks instead of mutual funds.
I'll be back tomorrow night with some thoughts for those who haven't started investing in Cash-King stocks yet and are looking to do so. In the meantime, if you have any questions, please ask them on the Cash-King Strategy Board.
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Day Month Year History C-K +0.26% 3.20% 25.65% 25.65% S&P: +0.18% 1.71% 17.64% 17.64% NASDAQ: +0.77% 5.17% 23.05% 23.05% Cash-King Stocks Rec'd # Security In At Now Change 2/3/98 24 Microsoft 78.27 133.63 70.73% 5/1/98 55.5 Gap Inc. 34.06 49.75 46.07% 2/3/98 22 Pfizer 82.30 116.13 41.10% 2/13/98 22 Intel 84.67 119.19 40.76% 6/23/98 34 Cisco Syst 58.41 80.75 38.25% 8/21/98 44 Schering-P 47.99 55.75 16.16% 2/6/98 56 T. Rowe Pr 33.67 36.69 8.95% 2/27/98 27 Coca-Cola 69.11 67.13 -2.87% 5/26/98 18 AmExpress 104.07 96.63 -7.15% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 64.34 73.94 14.93% 3/12/98 20 Eastman Ko 63.15 72.50 14.81% 3/12/98 15 Chevron 83.34 86.06 3.26% 3/12/98 17 General Mo 72.41 69.06 -4.62% Cash-King Stocks Rec'd # Security In At Value Change 2/3/98 24 Microsoft 1878.45 3207.00 $1328.55 5/1/98 55.5 Gap Inc. 1890.33 2761.13 $870.80 6/23/98 34 Cisco Syst 1985.95 2745.50 $759.55 2/13/98 22 Intel 1862.83 2622.13 $759.30 2/3/98 22 Pfizer 1810.58 2554.75 $744.17 8/21/98 44 Schering-P 2111.7 2453.00 $341.30 2/6/98 56 T. Rowe Pr 1885.70 2054.50 $168.80 2/27/98 27 Coca-Cola 1865.89 1812.38 -$53.52 5/26/98 18 AmExpress 1873.20 1739.25 -$133.95 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 20 Exxon 1286.70 1478.75 $192.05 3/12/98 20 Eastman Ko 1262.95 1450.00 $187.05 3/12/98 15 Chevron 1250.14 1290.94 $40.80 3/12/98 17 General Mo 1230.89 1174.06 -$56.83 CASH $120.62 TOTAL $27