Lesson 19 - Warren Buffett Books

BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE

LESSON 19: WARREN BUFFETT’S 2ND RULE – LONG TERM PROSPECTS

LESSON OBJECTIVES

Learn how to identify a company with long term prospects.
Understand what Capital Gains Tax is.
Understand the difference between short term gains and long term gains.

LESSON SUMMARY

In this lesson we learn about Warren Buffett’s second rule for picking stocks: “A stock must have long term prospects”. Warren Buffett would always ask himself before buying into a company whether that product or service that is being sold would be used 30 years from now. To illustrate this way of thinking we can consider a company that is producing Apps.

The apps section is shifting very fast, and probably everybody can agree that it is very difficult to predict how that industry looks like in 30 years. It is likely to be different for a good like candy. We ate candy 30 years ago, and there is every reason to believe that we will still buy candy 30 years from now.

While it is hard to predict which industries that will be around in 30 years from now, it is a lot easier to predict which industries that won’t be around. The reasons why we want to invest in a company with long term potential is two-fold.

Sustained Earnings

The first reason is somewhat simple to understand. If there is a demand for your product in at least 30 years as an investor you also know that your stock will keep putting money in your pocket through growth in the company’s equity and through dividend.

Taxes

As an investor you get taxed on your capital gains. A capital gain is the profit you make on a stock. For instance if you buy a stock at $10 and you sell it for $30, you get taxed on the profit of $20. How much you are getting taxed is dependent on your ordinary income tax rate but also whether you have hold on to the stock in shorter or longer time than 12 month, and even a further incentive after 5 years. In other words: The longer the investor waits to cash the profit in, the lower is the capital gains tax.

Using simply math it can be shown how much an investor gain from holding on to the same security for 20 years, compared to a situation where the investor makes the same return, but buys and sells every year –and therefore pay the short term capital gains tax. In the latter example the compounding does not have the same effect. One can think of it as the return being set back every year. The investment that was compounded is simply a lot smaller.

Understanding taxes is one of the more advanced concepts in term of profiting in the stock market, and is one of the “secrets” of Warren Buffett’s successes in stock picking. Now it may be wrong to call it a secret, as he has always been very open to how he is investing. Minimizing taxes is a key concept is starting the “snowball”. If you want to start a snowball like Warren Buffett, the book “The Snowball and the Business of Life” by Alice Schroeder is highly recommendable. This book was the first time Warren Buffett had agreed to cooperate with an author on a biography of his life.

NEW VOCABULARY

Sustained Earnings
This is often referred to as “retained earnings”. A company retaining earnings uses the earnings to buy new income producing assets, thereby growing the business.

Capital Gains
The profit you make from selling a stock that was bought at a lower price. One example of this is if you bought a stock at 10 and sold it at $30 you would pay taxes on the $20 profit. If the tax rate is 15%, you pay $3 in taxes.

Taxes
When making a profit you are required to pay taxes. In stock investing is no different.

LESSON TRANSCRIPT

A stock must have long term prospects. As we look at these four different items up on the screen, let’s go item by item and predict whether these will still be something 30 years from now.

In 30 years from 2012 is 2042. Do you see people still using iPhones? I might sound like attacking apple, but to be quite honest, everyone can agree that the use of an iPhone has no chance of staying in the industry in 30 years from now.

The next item is a candy. It’s pretty obvious that people will still eat candies 30 years from now.

Next are the apps. If your business were making apps, would it still be viable 30 years from now? The programming apps will still be, but whether that specific application, no pun intended, we would never know. It’s almost impossible to predict that.

The last one is an electric fan business. There’s probably a good sign that we’ll still be using fans 30 years from now.

Whenever you buy a company, take in this example of Johnson’s & Johnson’s. Will Johnson’s & Johnson’s still supply medicines 30 years from now? When looking at investing, Apple is an unbelievable company, you’ll probably have a difficult time buying their stocks, because you have no idea if their company will still be the number one selling computer manufacturer 30 years from now.

Why invest in a long term company? Why not in Apple and hold that company for a year and then just sell it after making money? There are 2 main reasons why you want to buy a company and hold it in long term:

Sustained earnings
Taxes

Here’s a good demonstration on why you should buy companies and hold it as long as you can. In 2013, this will be the new capital gains tax bracket (Refer to the video). An example of capital gains is buying a stock for $10 and holding it for 6 months, the stock increasing in value to $20, you selling it and making $10 in profit off of the market of that stock. It’s because you bought it for $10 and sold it for $10 in that 6-month period.

The gain you will be taxed on is what you’ll pay. The amount depends on what income bracket you’re in and how long you held the assets. For 6 months, that’s considered short-term capital gains. If you held it longer than a year, that’s considered long-term capital gains. This is new to 2013 capital gains structure. Anything over 5 years is taxed at a different rate. The longer you hold it, the less you pay in the taxes.

For the said scenario, you made $10$ on a company in a 6 months period depending on what ordinary income tax bracket you’re in. Assume you’re in the lowest ones – 15%. You’ll pay 15% taxes on that gain. If you held that business for over a year, you’re down to 10%. If you held it for over 5 years, you would be in the 8% tax bracket.

Think about if you would hold this company, you’d make $10 in the first 6 months, and the business is continuing to make money. If you’d continue to hold it for a 5-year period, you’d even make more money if it’s a good business. You’d have paid much less than the taxes if you’d go and sell it.

Let’s go ahead and demonstrate how the short-term and the long-term taxes are when you buy and sell and stock quickly. Assume that you had $50,000 and you invested that in a 10% investment. You’d hold that for 20 years. Every year, that investment is growing by 10%. Assume that you sold it at the end of 20 years. You’d pay your taxes and see how much money you would have made.

After one year, your $50,000 would have turned into $55,000. After 2 years, it would have turned to $60,500. You keep going down that chart if you’re not paying any taxes. That business is continuing grow due to the equity and the dividend.

You will pay taxes on dividend on the income for that dividend. As far as the actual growth of the market price, you’re not going pay any taxes on that for 20 years if you would just continue to hold it. Now if you continued to hold that for the rest of your life and you just take the dividends, you won’t have to pay taxes on the market price on that company.

At the 20-year mark, you end up with $336,375. Assume that you sold it right at the 20-year mark and you’re in that highest tax bracket. In the highest tax bracket, you would owe 18% on your taxes after you held that security for 20 years. After the 18% taxes, it goes down to $275,827. The taxes that you would pay would be $60,547. That’s a lot of taxes to pay, but you also made a whole lot of money out of that $50,000 investment, and that’s primarily because of the large 10% yield.

Let’s look at what happens if you’re constantly selling and buying. You would still make that 10% every year. Same exact scenario. Invest $50,000, but in here, go ahead and sell the security right before the one year mark and pay that short term capital gains tax. The person who’s out there doing the trading and buying the company and holds it for 3 months, then sells it, then buys something else. Give this person the benefit of the doubt and say they held it for an entire year right before they sold it.

In this scene, that $50,000 after the first year will turn into $53,020 off that 10% gain. After the first year it would have been $55,000, but you would have paid that 39% tax on that $5,000 gain. What I’m showing you is after that 39.6% tax was paid.

Even though you made 10%, you only had $53,020 after the first year. After the second year it’s $56,222, and so on and so forth until the 20-year mark where you have $161,571. The tax that you would have paid over that entire 20 years was $73,149. Here’s a perfect example of a person who would be investing. This is assuming that it can continue to put their investment in a 10% yield in return every time they trade it.

Let’s compare two examples. A person who bought the company continuing to grow 10% whose investment turned into $275,827 after paying the capital gains tax of $60,547. Another person has the buy-sell-buy-sell-buy-sell strategy and he only has $161,000 in that investment. Both of them were making 10% every year, but there is more than a hundred thousand dollars difference over the time of that single investment. When you look at the taxes that are paid, the taxes that the person paid were actually very similar, but the amount that they have in their bank account is drastically different.

This is Warren Buffett’s second rule – a stock must have long-term prospects. The reason is because he doesn’t have to pay as much as his taxes. He’s avoiding paying that the enormous capital gains tax by not trading it every other month or every few years. He’s holding these companies with the intent to own it for the rest of his life because he’s going to continue to collect the dividend and the market value will continue in increase and you don’t have to pay the taxes on it.

In this lesson, students learned the importance of buying an asset that they can hold for ever. Buy purchasing a company that has long term prospects, the owner (or stock holder) doesn’t have to continually pay capital gains tax. When comparing the capital gains tax of a person that trades in the short term, it becomes very obvious that it’s not advantageous.

By purchasing a company with long term prospects, you’re not only minimizing your capital gains tax, but you also enjoy the sustained earnings through time.

Related Resource: Podcast discussion on Warren Buffett’s Rules to Stock Investing.