The Rational Walk
Intelligent Investing is not a "Random Walk"

When to Sell a Successful Investment July 20, 2015

“If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” — Philip Fisher

“Those who believe that the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously. ” — Howard Marks

There are many approaches used by value investors to identify investment candidates but the obvious common theme is that one makes purchases only when the offered price is significantly below a conservative estimate of intrinsic value.  In times of significant pessimism, there are often far more investment candidates than one would wish to add to a focused portfolio.  This was the case for a number of years following the 2008-09 financial crisis, not only in retrospect but as a function of the opportunities clearly available at the time.  During such times of abundance, the purchase decisions are mainly a function of which opportunities within an investor’s circle of competence offer the greatest prospective returns with acceptable business risk.  Making such bargain purchases, assuming the availability of the necessary cash and the right mindset, is usually an enjoyable experience.

On the other hand, the decision to sell can frequently be agonizing for various reasons.  If a business unexpectedly deteriorates, one must determine whether the relationship between the lower stock price and lower intrinsic value still justifies ownership.  Numerous psychological pitfalls await investors who must decide whether to sell an unsuccessful investment.  Often times, the best approach is to pull the band-aid off quickly and move on.

The more interesting question, and the subject of this article, is when one should sell a successful investment.  This question is almost certainly timely for most readers as markets reach new highs and signs of investor optimism becomes more and more common.  In retrospect, we know that the pendulum referred to by Howard Marks reached its most pessimistic limit in early 2009 bringing with it the greatest opportunities for success.  We cannot know today where the pendulum is exactly located but it seems to be drifting more toward the optimistic end of the spectrum.  This necessitates careful consideration of when a successful investment has run its course.

Motivations for Selling

There are obviously a number of motivations that would lead an investor to sell a successful investment.  Many of the reasons are somewhat beyond the scope of this article.  It is possible that an investor seeks to raise cash for personal reasons such as increased consumption or purchasing a personal residence.  Such needs may be immediate or on the horizon.  Clearly it is not advisable to hold common stocks, regardless of valuation, if the time horizon for the remaining period of ownership is very short.  In such cases, with cash being necessary, one simply sells the investment, pays the required tax, and moves on.

Aside from time horizon constraints, an investor will often consider selling in order to fund the purchase of another investment.  This is the more interesting scenario for purposes of this article.  When does it make sense to sell a successful investment in order to purchase something that is perceived as “better”?

Assess Prospective Returns

Perhaps it goes without saying, but when tempted to sell a successful investment it is necessary to revisit the valuation again in considerable detail.  It is possible that an advancing stock price is in response to an unexpected positive development that was not considered in the original investment thesis.  Investors are subject to both good and bad luck.  When good luck takes the form of an unexpected positive surprise, it wouldn’t make sense to immediately sell and abort the benefits of that good luck.

Assuming the valuation has been revisited and the investment is indeed trading above a conservative estimate of intrinsic value, it is still important to consider the prospective returns of the investment from its current price level.  For example, a month ago, we posted an article on Markel trading above $800 per share for the first time.  Since that time, the stock has advanced an additional 10 percent and currently trades above the $840 intrinsic value estimate provided in the article.  As no obvious new developments have taken place over the past month, the stock appears to be trading about 5 percent above the intrinsic value estimate.

The intrinsic value estimate was based on requiring a 10 percent annualized prospective return over the next five years.  Although the stock recently traded at $875, it still offers the possibility of 9 percent annualized returns over the next five years, holding all other aspects of the valuation constant.

Consider Tax Consequences

Warren Buffett has often discussed the major benefit Berkshire Hathaway realizes by investing policyholder “float” in securities.  Float represents funds that Berkshire holds in anticipation of payment to policyholders, in some cases in the distant future.  However, Berkshire also benefits from another type of “float” represented by deferred taxes on appreciated securities.  Effectively, Berkshire is able to invest deferred taxes that will eventually be payable to the government.

All investors have the same opportunity to benefit from retaining highly appreciated investments with large deferred tax liabilities.  For example, consider an investor who purchased Markel shares at $400 approximately four years ago.  Of the $875 share price, $400 represents the cost basis and $475 represents embedded capital gains.  The current effective top Federal income tax rate on long term capital gains is 23.6 percent.  Assuming residence in a state without income taxes, the investor would have to pay taxes of around $112 per share leaving him with $763 to invest in new opportunities.  In contrast, holding on to the Markel shares will allow the investor to keep all $875 invested.

Continuing this example, if the investor retains Markel shares at $875 and the share price compounds at 9 percent over the next five years, the ending share price would be $1,346.  At that point, taxes of $223 would be owed on the capital gain (assuming no change in tax rate policy) and cash raised on sale would be $1,123.

If the investor instead sells Markel today and reinvests the $763 proceeds, it will be necessary for the new investment to compound at nearly 10.1 percent to match the after tax proceeds realized by holding on to the Markel investment.  At that rate of return, the new investment will be worth $1,234 in five years.  Of this amount, $471 will represent a capital gain and taxes of $111 will be owed to the government  resulting in net proceeds of $1,123.

(As an aside, one must also overcome transaction costs, both explicit in the form of commissions and implicit in the form of bid-ask spreads.  We have ignored transaction costs for purposes of simplicity.)

The Hurdle May Be High

As we can see from the example, the tax friction associated with selling a successful investment and purchasing a new one can be considerable.  In this case, it would be necessary to find an investment offering a return 1.1 percent higher than Markel in order to make the switch pay off.  Furthermore, one would need to be satisfied that the level of business risk is similar or, better yet, lower.  Markel also could have upside above and beyond the intrinsic value estimate if the company succeeds in emulating Berkshire Hathaway’s business model.

It might still make sense to sell Markel and find another investment if it can be done in a tax exempt or tax deferred account.  In such cases, the tax friction disappears, but the other issues remain.  Ultimately, each investor must make an educated decision when it comes to the question of selling appreciated securities.  It goes without saying that frequent activity on a short term basis is almost always ill advised.  The same is often true in the long run, as Philip Fisher pointed out.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel.  Since publication of the article on Markel on June 18, fifteen percent of the Markel shares held on that date were sold in tax exempt and deferred accounts and invested in Berkshire Hathaway with no plans to sell the remaining Markel shares.  See also general disclaimer.

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Harness Technology to Stay Informed During Earnings Season October 14, 2010

As we move into the height of third quarter earnings season, many investors may feel overwhelmed when it comes to staying on top of earnings announcements for portfolio companies and investment candidates.  Without a solid system for keeping abreast of company filings, it is inevitable that you will either miss a report entirely or only read it several days after it is initially released.  This is particularly true for smaller companies that are not regularly covered by analysts or major newspapers such as The Wall Street Journal.  How can investors confidently stay informed?

We take it as a given that intelligent investors always examine the primary source documents released by companies rather than relying on analyst reports, newspaper articles, and other third party sources.  Public companies are required to file financial information and other material documents with the Securities and Exchange Commission and all of the documentation is available online through the EDGAR system.  In this article, we will discuss an easy way to stay on top of SEC filings using the EDGAR system and Google Reader.

Using the SEC EDGAR Database

During earnings season, most companies will announce quarterly results through a press release that provides management’s summary of the quarter and condensed financial information.  The press release is filed with the SEC as a 8-K Current Report.  At a later point, the company will file a 10-Q report with much more information.  Some smaller companies do not issue press releases and only file the 10-Q.  Investors much keep an eye out for both types of filings.  Fortunately, it is possible to easily automate delivery of such filings.

The image below shows the main company search screen of the EDGAR database.  There are a number of potential options for searches, but we will simply use the ticker symbol for a company that we follow:  Markel Corporation (Ticker:  MKL).  Click on the image for a larger view.

After clicking on the Find Companies button, we are presented with a list of results (click on the image for a larger view):

We are presented with a list of the latest company filings for Markel.  The latest entry is a 13F-HR filing made on August 9 which lists the equity positions held in Markel’s portfolio as of June 30, 2010.  The next entry is the company’s 10-Q report for the second quarter which was filed on August 6.

If we wish to track only 10-Q reports, we can enter “10-Q” in the “Filing Type” text box and hit the search button.  However, if we filter on a specific filing type, we could miss other important information such as 8-K current reports and future 13F-HR filings so we will leave the search results unchanged.  To view the actual filing, click on the “Documents” button and then on the appropriate form.

Using RSS Feeds and Google Reader

While the EDGAR system is a great way to look up company information, it is not practical to look at the database every day for each individual company to see if something new has been posted.  Fortunately, we do not have to constantly check the database because we can create a RSS Feed based on our search criteria.  The image below highlights the RSS Feed icon in the search results area:

After clicking on the RSS Feed link, your browser may allow you to add the feed to a specific RSS Reader or you may be presented with the raw RSS Feed text.  If you are provided with a page allowing you to add the feed to Google Reader, you may do so directly.  If not, copy the RSS Feed URL and save it for use in your RSS Reader of choice. Any RSS Reader will allow you to import a feed if you have the URL for the RSS Feed available.  For example, adding the following URL to any RSS Feed Reader will import the feed for Markel:


Our preferred RSS Feed Reader is Google Reader which allows for a great deal of customization to suit the reader’s needs.  Feeds can be organized into multiple folders, individual items can be “starred” for later reference, and useful statistics are available.  The following image shows the Markel RSS Feed within Google Reader (click on the image for a larger view).

To view the actual filing, simply click on the link that appears in Google Reader (for example, the 13F-HR report can be viewed by clicking on the link shown above).

As you can see, there are numerous other folders that have been set up to categorize industries, portfolio companies, and other types of content such as blogs and networking posts.  Google Reader can manage any content that is available as an RSS Feed.

Once Google Reader, or any other RSS Reader, is set up with the SEC EDGAR feeds for your portfolio companies and candidates, it is simple to check Google Reader once or twice a day to keep abreast of all filings that have been made by company management.  Many companies also offer email notifications and other ways of staying informed but by using RSS feeds, all of this information can be available in one place which greatly increases efficiency and avoids the risk of missing a filing when a flood of earnings reports come in.

So while there are no easy ways to decipher creative accounting, at least you’ll be up to date on the filings!

Disclosure:  No position in Markel Corporation which was just used as an example for the article.

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Individual Investors Abandon Stocks; The ‘Death of Equities’ Redux? July 13, 2010

Business Week Cover

Throughout the 1990s, mutual funds were marketed to individual investors with stellar ten and fifteen year track records made possible by the record bull market of the 1980s and 1990s.  While there were a few notable interruptions, with the 1987 crash being the most obvious, most individual investors learned to “buy the dips” throughout this period.  Most large capitalization companies made significant advances in earnings during these years but the expansion in earnings multiples had the effect of turbo charging returns to investors.  Of course, this all culminated in the bubble of the late 1990s, but small investors remained relatively optimistic for much of the past decade, having been trained to buy the dips for so long.  However, optimism may now be turning to pessimism as small investors abandon stocks in disgust.

With the Dow Jones Industrial Average and S&P 500 both at levels first breached over a decade ago, the “buy the dips” mentality has been dramatically reduced.  A recent article in The Wall Street Journal is somewhat reminiscent of the famous 1979 Business Week cover story entitled “The Death of Equities”.  In the late 1970s, investors had endured well over a decade of stagnation in equity prices.  The Dow Jones Industrial Average first breached the 1,000 level in 1966 but failed to permanently ascend beyond that level until 1982.  The similarities between 1966-1982 and the period we are currently in are obvious and the pattern of investor sentiment turning against stocks may be repeating as well.

Safety in Cash and Bonds?

One major difference between the options available to investors in 1979 versus 2010 is that one could actually obtain decent returns from bonds and cash investments in the late 1970s and early 1980s.  The primary reason for the high level of nominal interest rates during the period was very high inflation, but anyone who purchased long term treasury bonds in the early 1980s ended up with very satisfactory returns due to a combination of the high coupon and significant price appreciation due to the disinflation of the 1980s.

While the disinflation that would take place over the following decade was not obvious to an investor in 1979, the fact is that high coupon treasuries were available as an option to stocks.  Compare the situation to what faces investors today with yields on the ten year treasury near 3 percent and yields on cash equivalents near zero.

One can say that the inflation scenario is vastly different today compared to the late 1970s and this is probably true.  It is folly for investors to attempt to predict interest rates, inflation, and most other macroeconomic trends which is why the best value investors focus on individual stocks.  Still, this does not mean that we cannot make some observations regarding broad asset allocation decisions being made by individual investors such as those profiled in the Wall Street Journal article:

  • An investor buying a ten year treasury note yielding 3 percent today is very unlikely to realize any significant capital appreciation.  The only scenario under which significant capital gains will occur is a Japan style deflationary scenario where ten year yields crash to levels below 2 percent.
  • Any uptick in inflation will result in massive capital losses as the price of treasuries and other bonds decline.  An investor holding bonds to maturity is protected from the price declines in nominal terms, barring the risk of default.  However, in real terms, a relapse of inflation will destroy significant wealth for anyone purchasing long term bonds at today’s yields.
  • Investors buying treasuries today due to fear of additional losses in equities should at least consider other options for generating income with reasonable risks.  The fact that a treasury bond will not result in capital losses in nominal terms if held to maturity does not mean that it is without risk.

Dividend Paying Stocks – An Alternative Approach

There are many alternatives to treasury bonds for conservative investors who wish to generate income while controlling risk.  Many alternatives are far more likely to result in the protection of wealth as measured in real terms compared to a 3 percent ten year treasury.  One such alternative is to purchase I Bonds or Treasury Inflation Protected Securities  (TIPS) which offer a hedge against inflation along with a very modest real return.  However, for this article we will focus on the possibility of using dividend paying stocks as an alternative.

It must be stressed that dividends on common stock are not contractually protected obligations of the company.  The Board of Directors is almost always free to pass common stock dividends at any time.  As a result, investors looking for income must examine a company’s track record over many years, the competitive advantages of the business, and make an assessment regarding future prospects for the dividend.  Simply buying the highest yielding stocks is a recipe for disaster.

With these caveats in mind, we provide a sample of high quality companies with a solid track record of meaningful and rising dividend payouts.  Most of the companies on this list yield over 3 percent, the current yield of the ten year treasury.

Each of the companies listed above are well known, stable, and high quality businesses that have demonstrated an enduring ability to pay dividends on common stock over a long period of time.  Equally important, each of these companies has increased dividends over time, in some cases by very significant amounts. The point is not to make specific recommendations but to illustrate the potential for purchasing dividend paying stocks to produce income.


There are risks associated with any investment strategy and buying dividend paying common stocks is no exception.  Some of the potential risks include:

  • Paying too much attention to the dividend payment without looking at the overall valuation of the company.  Our list above only includes companies where the payout ratio is reasonable and the valuations appear to be more or less “reasonable”.
  • Companies may lose their competitive edge and have difficulty making payments going forward despite a strong track record.
  • Overall stock market valuations may decline precipitously which would reduce the value of the portfolio even if dividend payments are not cut.
  • Changes in tax rates on dividends in the future could cause companies to revisit their dividend policies which could result in slower rates of increase or, far less likely at least for our list, actual cuts in dividend rates in favor of more tax efficient buybacks.  The federal dividend tax rate, currently at 15 percent, will increase substantially starting in 2011 if Congress fails to extend current tax rates.

Balance is Required

The point of this article is not to suggest that investors should abandon all bonds, or even that some government bonds should be included in an income portfolio.  However, it seems unwise for investors to concentrate their entire portfolio in bonds with the hope that abandoning stocks will result in an elimination of investment risk.  Instead, investors should consider maintaining at least part of their income portfolios in strong dividend paying common stocks that have the potential to increase payments over time and offer a degree of inflation protection.

Disclosure and Disclaimer:  No position in the companies listed in the article, all of which are provided only as examples of a potential dividend income strategy.  Consult with your financial advisor to ensure that your portfolio and security selection is appropriately aligned with your personal financial situation.

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Book Review: The Basics of Understanding Financial Statements April 24, 2010

Understanding Financial Statements

In a more perfect world, no high school student would be permitted to graduate without understanding the basics of personal finance.  Required material would include elementary topics such as balancing a checkbook, creating and monitoring a budget, and above all else, the power (and peril) of compound interest.  Part of achieving basic financial literacy should also include a working understanding of accounting and financial statements.

Since the primary goal of such a program would be to provide Americans with basic knowledge, a comprehensive accounting text book may be overkill.  Instead, a basic introductory guide to reading financial statements is needed.  Such a guide would cover the three main financial reports:  Balance Sheet, Income Statement, and Cash Flow Statement.  Mariusz Skonieczny, President of Classic Value Investors has written a concise primer on financial statements that allows the reader to gain a basic understanding of these key financial reports.  The e-book is being offered free of charge to readers who subscribe to the Classic Value Investors Blog.

Mr. Skonieczny is also the author of Why Are We So Clueless about the Stock Market? which we reviewed in December.  The author has a talent for simplifying potentially confusing topics for readers who are new to investing and are looking for basic information that will help to build the foundation for further study of accounting topics.

In some ways, Mr. Skonieczny’s e-book may remind the reader of Benjamin Graham’s classic book The Interpretation of Financial Statements which was discussed in one of the earliest book reviews presented on The Rational Walk. In a concise 120 page book, Ben Graham provided the reader with all of the basics required to navigate a financial statement and the book is still very relevant today, more than 70 years after its initial publication.

Neither of these brief surveys of financial statements are sufficient for an individual who is interested in allocating his own capital, but they are solid starts and highly recommended for new investors.

To receive a copy of The Basics of Understanding Financial Statements, visit the Classic Value Investors blog and enter your name and email to subscribe to the blog.  You will then receive an email with a download link.

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Consider Roth IRA Conversion as Hedge Against Higher Taxes March 28, 2010

Retirement Count Down

Note to Readers:  This article is part of an occasional series on personal finance topics that may be useful for a broader audience than The Rational Walk’s typical focus on value investing.  This is not intended to provide specific tax advice.  Consult with your accountant for solutions specific to your personal finances.

While many of us are still working on our 2009 tax returns, it is never too early to begin planning strategies for the current tax year.  2010 provides an unusual number of opportunities to reposition assets in ways that can minimize taxes for decades to come.  One of the more interesting opportunities involves converting traditional IRA assets into a Roth IRA.

Traditional vs. Roth

Traditional IRAs allow taxpayers to make annual contributions of $5,000 ($6,000 for those over 55) which can be deducted against current year income for lower income taxpayers or those who are not covered by a retirement plan at work.  Assets within a traditional IRA compound on a tax deferred basis until funds are withdrawn in retirement.  At that time, the withdrawals will be taxed at income tax rates prevailing at the time.  In addition, taxpayers are forced to begin withdrawals in the year after reaching 70 1/2 years of age.

Roth IRAs permit annual contributions in the same amount as traditional IRAs for single taxpayers earning less than $105,000 and married taxpayers earning less than $166,000.  Contributions are not deductible against current income.  Roth IRA assets compound on a tax free basis and withdrawals in retirement are tax free.  Unlike traditional IRAs, owners of a Roth IRA are never required to take withdrawals during retirement.

2010 Roth Conversions

A Roth conversion occurs when a taxpayer who owns a traditional IRA re-characterizes all or part of the IRA into a Roth IRA.  The taxpayer would normally owe current year income taxes on the funds that are converted into the Roth.  However, in the future all of the benefits of a Roth IRA will apply.  Prior to 2010, taxpayers earning over $100,000 per year were not permitted to make conversions.  However, in 2010, any taxpayer is permitted to make the conversion.  Even better, the taxes that would normally be owed in 2010 can be paid in two equal installments for the 2011 and 2012 tax years.

In general, tax advisors recommend that taxpayers use funds from outside the traditional IRA in order to pay taxes.  If a taxpayer must use funds from the traditional IRA to pay taxes, the amount lost to taxes will not be available to compound within the Roth IRA.  Furthermore, taxpayers under the age of 59 1/2 will owe a 10 percent penalty on funds that are withdrawn to pay taxes.

Hedging Against Higher Taxes

The opportunity to convert traditional IRA assets into a Roth can provide an opportunity for investors to minimize the long term impact of taxes, particularly since rates appear to be moving toward higher levels in the coming years.  Here are a few potential scenarios where a Roth conversion could reduce long term tax burdens:

  1. Higher income taxpayers may benefit from a 2010 conversion and could choose to pay taxes in 2010 rather than 2011/2012 in order to avoid anticipated higher tax rates after 2010.  While Congress may extend the Bush tax cuts for lower income taxpayers, it is nearly certain that the current 33 percent bracket will revert to 35 percent and the current 35 percent bracket will revert to 39.6 percent starting in 2011.  By converting into a Roth in 2010 and paying taxes at today’s lower rates, higher income taxpayers can avoid paying taxes on traditional IRA distributions at higher rates in the future.
  2. Those who are not in tax brackets that are likely to increase in 2011 can make a conversion in 2010 and strategically spread the income over 2011 and 2012 in a way that avoids being bumped into higher tax brackets.  One danger of making a large conversion is that it can have the effect of temporarily reaching higher tax brackets if done in any one year.  2010 offers the opportunity to spread out the tax burden over two years while also potentially avoiding a temporary move into higher brackets.
  3. Retirees and others in the 15 percent tax bracket can make annual Roth IRA conversions strategically sized to “use up” their 15 percent tax bracket and minimize the required minimum distribution from Traditional IRAs in the long run.  For example, a taxpayer who has income that results in paying taxes at the 15 percent level may not have fully exhausted the bracket with normal income.  A traditional IRA conversion to a Roth could fully exhaust the bracket while falling short of breaching the 25 percent bracket.

The dire fiscal situation of the United States is likely to lead to much higher taxes in the future, particularly on those who are in higher tax brackets.  Recent health care legislation broke precedent by subjecting certain types of investment income to Medicare taxes for higher income taxpayers.  While it appears that retirement plan distributions will not be subject to the Medicare tax, this could change in the future.  Of course, there is always the risk that the government may try to break its pledge to treat Roth IRA distributions as tax free for higher income taxpayers.  However, this seems less likely than moves to tax investment income outside retirement accounts.

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