<THE RULE MAKER PORTFOLIO>
Investing and Taxes
By Al Levit
GLENDALE, CA (April 5, 1999) -- Here in Fooldom, we often write about minimizing expenses when investing. Yet we don't spend a lot of time talking about taxes when we write about our portfolios, and in a very real sense the taxes we pay on our investing profits are the biggest expenses of all. Not only that, but next Thursday is April 15, Tax Day, and that makes this an even more appropriate time to think about the role that taxes play in investing. As a result, I'm going to spend a few days discussing taxes this week.
First of all, let me suggest that any Fool smart enough to manage her own investments is also smart enough to do her own taxes. In fact, I know from experience that with computer programs available like TurboTax, TaxCut, and others, it's actually much easier these days to do your taxes than it is to manage your portfolio!
I do my own taxes for three main reasons:
1) It's cheaper to do them myself than to pay someone else to do them for me. Since my return can be fairly complex, the difference in cost is substantial. With my savings, I invest in Foolish Rule Making stocks (of course!), and watch the fruits of my labor compound.
2) My taxes are finished much sooner than if I had someone else do them. After all, I have only have one return to worry about, whereas an accountant would have hundreds.
3) Most importantly, by doing the taxes myself, I have developed an appreciation for the financial events that result in tax savings. Moreover, this has also been a good (although occasionally painful) way to learn just how costly it is to behave in ways that are not tax-efficient. If someone else had done my tax return, I would have been far more likely to make the same mistakes again.
However, I do need to say a word about my qualifications in this area. I am not a CPA, nor do I pretend to be one. When I face a tough tax question, an amateur like me needs help. Fortunately, valuable tax resources are available online, such as The Motley Fool's Tax Area and the Tax Strategy message folder. In addition, there's nothing wrong with taking your return to a pro for a "once-over" after you've completed it. At that point, all you'll need to pay for is professional advice, and that is an area where a human being still has an edge over a computer program.
Years of doing my own taxes have taught me that when it comes to investing, taxes aren't just a once-a-year issue. Really, they're a part of each and every investment decision. The reason is that I want my portfolio to produce the highest return possible after all taxes are paid. Fortunately, this corresponds perfectly with the Motley Fool's buy-and-hold strategy, and especially the Rule Maker decade-long holding strategy.
It's one thing to read those words, but another to actually see them in action. Today, I'll start with a simple example. One of our more volatile stocks has been Intel (Nasdaq: INTC). It's had its ups and downs for us in the 14 months we've owned it, although it's been up more than down as Intel has returned 35% to date versus the S&P's 27%. The "problem" we have with Intel, which as of this writing trades for about $121 per stub, is that we could have sold our shares in the last week of February for about $135.
Did we make a mistake? A lot of investors would say that we did; that we left $14 a share "on the table." Most Fools would probably first say that the price of a stock on any given day is no reason to sell or not to sell. Fools believe that a sell decision should be based on the company's fundamentals and whether or not there is a better use for the money. That's an extremely valid point, and one I believe in, but for today, I want to examine what really would have been gained by selling Intel at $135.
To examine this, I'll pretend that I purchased Intel on the same date and at the same price as the Rule Maker portfolio last year, and then sold the stock for $135 in the last week of February of this year. Here we go.
1) Purchased each share for $84.67 on 2/13/98.
2) Recorded a gain of $50.33 ($135.00 - $84.67) on each share sold.
3) Paid tax of $10.07 per share (20% of $50.33) to the federal government.
4) Paid about $4.50 per share more to the state of California as well (California taxes capital gains as ordinary income).
5) The $4.50 paid to California is deductible on the federal return, thereby reducing my federal taxes by $1.26. Thus, total taxes paid on the sale would be $10.07 + $4.50 - $1.26 = $13.31 per share.
As you can see, my after-tax gain wouldn't be $50.33, but only $50.33 - $13.31 = $37.02. Interestingly enough, most of the $14 that I "left on the table" by not selling in February would have been eaten away in taxes.
There's a lot more to say on this issue, including the fact that taxes have to be paid at some point in the future. Tomorrow, I'll look at the value of putting off taxes by hanging on to your winners.
Question of the Week
Last week's challenge brought forth a wealth of poetry in honor of our Rule Makers. In the process, discussion on our Strategy board doubled as a lesson on the diverse forms of poetry, including several examples of haiku, a sonnet, and even a villanelle. (For the left-brained folks, such as myself, here's a link to a dictionary!) Among the many clever poems, the most Foolish was A Long-Term Rule Maker's Villanelle by "an unemployed terrorist poet," cassandra169. Nice work, Cassandra!
This week, our question moves from the light-hearted to the serious. Recent discussion on our Companies board has been swirling about the issue of whether or not T. Rowe Price (Nasdaq: TROW) is a Rule Maker. The question involves more than T. Rowe's questionable position of dominance within the mutual fund industry. Our friend, Mycroft (who posts under the handle 692738), recently pointed out a disturbing fact from the company's recently-filed 10-K (scroll down to page 32, under Note 4):
"At December 31, 1998, the Company had reserved 36,425,304 shares of its unissued common stock for issuance upon the exercise of stock options..."
Added to the 130 million shares outstanding, this stock option issuance represents 21.8% of the company. This week's question of the week asks for insight and critical thought regarding this thorny issue. Since the discussion began on the Companies board, we'll move our Question of the Week discussion to that board this week. Click here for the detail of the question and this week's award.
Version 2 of the Rule Maker Spreadsheet is now available (links below). You'll notice several changes. First, the new version incorporates last week's changes to the Flowie and Cash-to-Debt Ratio. Second, the sheet can now average the scores of up to three competitors, thereby making the Monopoly Status section more indicative of a company's true position within its industry. Finally, the sales growth criteria has been moved from Financial Location to Financial Direction. The thinking here is that sales growth represents a dynamic situation indicative of a company's direction. Do you agree? Come to the Strategy board and let us know what you think of the changes.
-Matt (TMF Verve)
- Rule Maker Strategy Board
- Rule Maker Companies Board
- Rule Maker Beginners Board
- Rule Maker Spreadsheet (Excel 97, 68k)
- Rule Maker Spreadsheet (Excel 95, 41k)
Stock Change Bid AXP +4 7/16 125.44 CHV +3 13/16 90.63 CSCO +4 1/2 114.44 KO - 7/16 60.50 GPS + 1/2 67.75 EK - 1/8 63.75 XON +2 1/16 72.19 GM +2 1/8 87.56 INTC +6 5/8 127.50 MSFT +2 1/4 94.94 PFE +2 13/16 142.38 SGP + 5/16 55.63 TROW + 13/32 32.38 YHOO +39 3/8 219.13
Day Month Year History R-MAKER +3.99% 4.75% 16.68% 47.63% S&P: +2.12% 2.70% 7.79% 33.36% NASDAQ: +2.67% 3.99% 16.75% 54.88% Rule Maker Stocks Rec'd # Security In At Now Change 2/3/98 48 Microsoft 39.13 94.94 142.59% 5/1/98 55 Gap Inc. 34.37 67.75 97.12% 6/23/98 34 Cisco Syst 58.41 114.44 95.92% 2/17/99 16 Yahoo Inc. 126.31 219.13 73.48% 2/3/98 22 Pfizer 82.30 142.38 73.00% 2/13/98 22 Intel 84.67 127.50 50.58% 5/26/98 18 AmExpress 104.07 125.44 20.54% 8/21/98 44 Schering-P 47.99 55.63 15.90% 2/6/98 56 T. Rowe Pr 33.67 32.38 -3.86% 2/27/98 27 Coca-Cola 69.11 60.50 -12.45% Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 17 General Mo 72.41 87.56 20.93% 3/12/98 20 Exxon 64.34 72.19 12.21% 3/12/98 15 Chevron 83.34 90.63 8.74% 3/12/98 20 Eastman Ko 63.15 63.75 0.95% Rule Maker Stocks Rec'd # Security In At Value Change 2/3/98 48 Microsoft 1878.45 4557.00 $2678.55 6/23/98 34 Cisco Syst 1985.95 3890.88 $1904.93 5/1/98 55 Gap Inc. 1890.33 3726.25 $1835.92 2/17/99 16 Yahoo Inc. 2020.95 3506.00 $1485.05 2/3/98 22 Pfizer 1810.58 3132.25 $1321.67 2/13/98 22 Intel 1862.83 2805.00 $942.17 5/26/98 18 AmExpress 1873.20 2257.88 $384.68 8/21/98 44 Schering-P 2111.7 2447.50 $335.80 2/6/98 56 T. Rowe Pr 1885.70 1813.00 -$72.70 2/27/98 27 Coca-Cola 1865.89 1633.50 -$232.39 Foolish Four Stocks Rec'd # Security In At Value Change 3/12/98 17 General Mo 1230.89 1488.56 $257.67 3/12/98 20 Exxon 1286.70 1443.75 $157.05 3/12/98 15 Chevron 1250.14 1359.38 $109.24 3/12/98 20 Eastman Ko 1262.95 1275.00 $12.05 CASH $185.03 TOTAL $35520.97
Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and
it adds $2,000 in cash (which is soon invested in stocks) every six months.