RULE MAKER PORTFOLIO

<THE RULE MAKER PORTFOLIO>

When to Sell? --
Part 2 of 2

By Phil Weiss and Matt Richey

ALEXANDRIA, VA (August 19, 1999) -- Yesterday's report and today's continuation will soon be included as a "Selling Step" in our steps to Rule Maker investing, which are linked on the right side of this page.

Yesterday, we discussed three reasons to sell based on a company's fundamentals. Tonight, we offer two more reasons, plus a few closing thoughts on a great way to avoid selling altogether -- charitable donations.

Reasons to Sell Based on Portfolio Management


Even if all your Rule Makers are dominating their markets, warding off competitors, and putting out sparkling financial statements, there are still two more reasons you might conceivably sell one of your companies.

4. A much better place to invest your money

There may be times when you discover a great investment candidate, but won't have any additional money to invest. If this happens, it will be necessary to re-evaluate your existing holdings to see if it makes sense to sell one in order to raise the money needed to buy stock in your new finding. This is not a simple decision to make, either. Commissions, expected returns, and capital gains taxes must be considered.

Okay. Let's work through an example here. The facts and assumptions are as follows:

  • Five years ago, you purchased 100 shares of Mulder & Co. (Ticker: FOX) stock at $40 per share, plus a $10 commission, for a total investment of $4,010.
  • Mulder has grown at an average rate of 25% per year during that time and is now worth $12,207.
  • You think that Mulder will only grow at a rate of 15% per year over the next five years.
  • You're excited about your new investment idea, Scully Inc. (Ticker: DANA), which you believe will grow at a 20% rate over the next five years, so you want to sell Mulder and buy Scully.
  • Scully stock is selling for $75 per share.
  • Your commission to buy and sell stock is $10 per trade.

Let's work through the numbers:

  • Your net before tax proceeds from the sale of Mulder will be $12,197 ($12,207 sales price less $10 commission) -- a gain of $8,187 ($12,197 less $4,010 cost basis).
  • You will pay $1,637 of tax ($8,187 gain taxed at 20%) on this gain. This will leave you with $10,550 ($12,197 - $1,637 - $10) to invest in Scully stock.
  • Since Scully is selling for $75 per share, you buy 140 shares of stock for $10,500. This means that your investment in Scully is approximately $1,700 less than the value of Mulder at the time that you sold it.
  • If Mulder grows at an annualized rate of 15% per year over the next five years, your old investment would have been worth $24,553.
  • If Scully grows 20% per year over the next five years ($75 per share to $186 5/8), your total investment will be worth $26,127. This is only 6% more than the Mulder investment would be worth. The value of the Scully investment will not become more than the value of the Mulder investment until sometime approximately four years from now.

If all your assumptions hold true, then it would make sense to sell Mulder to buy Scully. However, if Scully grows at only 18% per year, it will be worth $24,021 in five years. In that case, holding onto your Mulder stock would have been the better decision.

What all this means is that you have to make some best- and worst-case assumptions about each stock when making this decision. Since predicting future investment returns is a precarious science, make sure that you've found a much better place to invest your money if you're considering selling one stock to buy another.

5. Time to rebalance your portfolio

It is not altogether impossible that one Rule Maker stock will substantially outperform all the others in your portfolio. In doing so, that one holding may grow to become a substantial portion of your invested assets. Whether you let your winner continue to run or sell a portion depends largely on your individual tolerance for risk.

On one hand, your biggest winners are likely the best businesses within your portfolio. By letting winners run, your best businesses organically assume the dominant positions within your portfolio. The flip side of this scenario is that whenever a single holding represents an overwhelming percentage (greater than 40%) of your portfolio, your portfolio will inevitably be more volatile.

For more on this issue, check out David Gardner's Rule Breaker Report from last March 24. Also, in considering whether to rebalance, keep in mind the above analysis involving commissions, taxes, and expected returns.

Alternative to Selling: Charitable Donations

Having made it this far, you probably well understand why Philip Fisher and Warren Buffett prefer the joy of buying over the complexities of selling. One of the best ways to avoid selling, avoid the taxman, and make the world a better place is to donate shares as a charitable contribution.

It's a wonderful thing to share our wealth with those less fortunate. If you have invested successfully and accumulated wealth, you may want to donate some of your stocks towards a worthy cause. You can make a charitable donation and take advantage of a great tax-planning technique at the same time.

Say that you want to make a donation to your favorite charity, and figure that you'll sell $5,000 of stock to come up with the money. The stock that you want to sell was bought for $2,000 several years ago, so you'd have to pay $600 in capital gains ($3,000 x 20%) on the sale. This would leave you with only $4,400 to donate. The final result -- you get a $4,400 tax deduction, the charitable organization gets $4,400, and the IRS gets $600.

If you decide to donate stock rather than cash, you can get a tax deduction for the fair market value of the stock, and you don't have to pay any capital gains taxes on the transfer of the stock. If the charitable organization turns around and sells the stock, it doesn't have to pay any taxes on the sale. The final result is that you get a $5,000 tax deduction, the charitable organization gets $5,000 worth of stock, and the IRS gets nothing. Personally, we like this method a lot better -- don't you?

Conclusion

Obviously, we haven't covered every conceivable selling scenario. You may find yourself needing to sell some holdings just to buy that ski boat or vacation home you always wanted. Or, maybe you'll need to cash out of some of your holdings to send junior to one of those ivy-covered institutions. There are countless personal reasons why you might sell a stock.

But hopefully, you'll end up doing more buying and holding, and less selling. As we said in the step on buying (Tuesday's report), the best businesses are few and far between, so once you find these gems, you'll want to hang on tight. One of the more substantial advantages of buy-and-hold investing is the opportunity to defer capital gains taxes into the distant future. Uncle Sam will give you an interest-free loan on this tax obligation as long as you don't sell.

By avoiding the monetary costs of churning your account, you'll be substantially more likely to beat the market. And, less time trading and researching new investments means more time for hiking, barbecues, reading a great book, or whatever floats your boat.


 




Rule Maker Portfolio

8/19/99 Closing Numbers
 Ticker   Company   Dly Pr Chg   Price 
AXP  AMER EXPRESS                 1/4   $138.50
CHV  CHEVRON CORP                 1/16   $94.50
CSCO  CISCO SYSTEMS                -1 1/16   $62.25
DPH  DELPHI AUTOMOTIVE SYSTEMS   -1/4   $18.06
EK  EASTMAN KODAK                9/16   $73.38
GM  GENL MOTORS                  7/16   $63.13
GPS  GAP INC                      -1 5/16   $39.50
INTC  INTEL CORP                   -1 3/16   $77.31
KO  COCA-COLA CO                 -7/16   $58.06
MSFT  MICROSOFT CORP               -1 3/16   $83.81
PFE  PFIZER, INC                  1/2   $35.25
SGP  SCHERING-PLOUGH              5/16   $49.81
TROW  T.ROWE PRICE ASSOC           -3/8   $33.00
XON  EXXON CORP                   -3/8   $81.81
YHOO  YAHOO INC                    -5 7/8   $139.19

  Day Week Month Year
To Date
Since
1/5/98
Annualized
Rule Maker -1.03% -.51% .09% 9.75% 38.39% 22.24%
S&P 500 -.69% -.31% -.39% 7.68% 35.46% 20.63%
S&P 500(DA) -.69% -.30% -.38% 8.19% 37.24% 21.61%
S&P 500(DCA) n/a n/a n/a n/a 22.49% 13.36%
NASDAQ -1.37% -.52% -.65% 19.55% 64.44% 35.99%

 Trade Date   # Shares   Ticker   Cost/Share   Price   LT % Val Chg 
  6/23/98  68CSCO    28.784  $62.25  116.27%
  2/3/98  54MSFT    45.135  $83.81  85.69%
  5/1/98  82GPS    22.708  $39.50  73.95%
  2/13/98  52INTC    46.928  $77.31  64.75%
  5/26/98  18AXP    104.067  $138.50  33.09%
  2/3/98  66PFE    27.433  $35.25  28.50%
  3/12/98  20XON    64.335  $81.81  27.17%
  3/12/98  20EK    63.148  $73.38  16.20%
  3/12/98  15CHV    83.343  $94.50  13.39%
  2/17/99  16YHOO    126.309  $139.19  10.20%
  3/12/98  11DPH    17.190  $18.06  5.08%
  3/12/98  17GM    60.400  $63.13  4.51%
  8/21/98  44SGP    47.993  $49.81  3.79%
  2/3/98  56TROW    33.673  $33.00  -2.00%
  2/27/98  27KO    69.107  $58.06  -15.98%

 Trade Date   # Shares   Ticker   Cost   Value   LT $ Val Ch 
  6/23/98  68CSCO    $1,957.28  $4,233.00  $2,275.72
  2/3/98  54MSFT    $2,437.28  $4,525.88  $2,088.60
  2/13/98  52INTC    $2,440.28  $4,020.25  $1,579.97
  5/1/98  82GPS    $1,862.06  $3,239.00  $1,376.94
  5/26/98  18AXP    $1,873.20  $2,493.00  $619.80
  2/3/98  66PFE    $1,810.58  $2,326.50  $515.93
  3/12/98  20XON    $1,286.70  $1,636.25  $349.55
  2/17/99  16YHOO    $2,020.95  $2,227.00  $206.05
  3/12/98  20EK    $1,262.95  $1,467.50  $204.55
  3/12/98  15CHV    $1,250.14  $1,417.50  $167.36
  8/21/98  44SGP    $2,111.70  $2,191.75  $80.05
  3/12/98  17GM    $1,026.80  $1,073.13  $46.32
  3/12/98  11DPH    $189.09  $198.69  $9.60
  2/3/98  56TROW    $1,885.70  $1,848.00  ($37.70)
  2/27/98  27KO    $1,865.89  $1,567.69  ($298.20)
  Cash: $100.80  
  Total: $34,565.93  


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.