Published July 18th, 2016
An investor with $100,000 invested in the market will make $10,000 if the market goes up 10%.
An investor with $1,000,000 invested in the market will make $100,000 if the market goes up 10%.
The more money you have invested, the more you will make (in actual dollar terms) when the market rises. Of course, you also have more to lose.
When you invest in great businesses with strong competitive advantages trading at fair or better prices, you want as much money working for you as possible…
And you want that money working for as long as possible.
“When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”
– Warren Buffett
Buffett’s portfolio is filled with ‘outstanding businesses’. Take a look at Berkshire Hathaway’s (BRK.A) (BRK.B) stock holdings from its 2015 Annual Report:
Cost Versus Market Value
Buffett’s portfolio is filled with high quality blue chip stocks (most of which pay dividends).
In fact, Warren Buffett’s top 4 holdings (which make up 62% of his portfolio) have an average dividend yield of around 3%. You can see all of Buffett’s top dividend stocks here.
Take a look at the cost basis and market value of the 3 Buffett investments below (values in millions):
- Coca-Cola (KO): $1,299 cost versus $17,184 market value
- American Express (AXP): $1,287 cost versus $10,545 market value
- Moody’s Corporation (MCO): $248 cost versus $2,475 market value
Notice anything unusual?
The cost of these stocks is much lower than the market value. It’s unusual for investors to have this big of a discrepancy between cost and value.
Buffett’s Coca-Cola investment is worth 13.2x what he paid for it (and that doesn’t include dividends!). American Express is worth 8.2x the initial investment, and Moody’s is worth 10.0x the initial investment.
You don’t get these type of fantastic results over night:
- Berkshire began buying shares of Moody in 2000
- Berkshire began buying shares of Coca-Cola in 1987
- Buffett began buying shares of American Express in 1964
Capital Gains Taxes
The current long-term capital gains tax is at 20%. For every dollar in profit you realize in your long-term investments, you owe the government $0.20
Buffett famously pays a lower tax rate than his secretary. This is not by accident.
Buffett understands how to minimize his tax bill to maximize the amount of money he has at work compounding for him.
Capital gains taxes are only due when you sell your stock. They aren’t due just because a stock goes up in value.
This means you get to pick when you pay capital gains taxes.
You can sell your stock and take the capital gains ‘hit’ now. You can also hold your stock and keep letting it compound your wealth.
The Buffett Loan
Buffett uses his accrued capital gains as a sort of loan from the government.
If Buffett sold his Coca-Cola shares today, he would owe the government $3.2 billion. That’s a lot of money to pay out.
If Buffett doesn’t sell, he gets to keep that money invested and compounding.
The key point: by not selling, you are in effect getting a loan from the government.
That $3.2 billion Buffett isn’t paying to the government will keep compounding in Coca-Cola year after year. If you think Coca-Cola will generate total returns of around 7% a year going forward, then you are looking at around $220 million in extra growth every year just by not selling.
And each year this amount grows larger… Such is the power of compounding.
The image below shows how the ‘Buffett Loan’ would grow larger year by year, assuming the following:
- 10% growth rate
- $100,000 initial investment
- 30 Year investment
Getting Locked In (In a Good Way)
Buffett’s longest-term holdings have tremendous amounts of ‘Buffett loans’ working for them.
The greater the accrued capital gains, the more impractical it is to sell a holding (that is still compounding wealth).
Using our previous 10% growth rate/$100,000 investment example above, after 30 years an investor would have $328,988 in accrued capital gains tax.
Consider the following additions to the scenario (after 30 years):
- The current investment is expected to continue growing at 10% a year
- The investor projects returns out another 10 years
Under these constraints, what growth rate would compel the investor to sell his current holding, pay the 20% capital gains tax and reinvest?
An investment would have to offer a 12.3% annual growth rate to match his current 10% growth rate after 10 years…
The difference is because the new investment has to ‘make up for’ the capital gains tax that is realized when selling occurs.
Replacements Are Even More Difficult in Reality
The reality is, few businesses can reliably compound investor wealth year after year, decade after decade.
The business that have been able to do this have generated tremendous shareholder wealth. Case-in-point: The performance of the Dividend Kings.
When you do find a high quality business that compounds your wealth year-after-year, it is better to let it keep doing so.
The odds of finding another stock that will do the same are small. Even Buffett does not bat 1.000 when it comes to finding high quality businesses to compound his wealth over the long run.
The odds that another business will be able to sustain a significantly higher rate of return over a long period of time versus an already proven business with an imbedded capital gains tax advantage is fairly low.
For this reason it is better to hold onto your best holdings and continue to let them compound rather than trade them out when you think you have found a better investment.
Assiduity & Do Nothing Investing
“Assiduity is the ability to sit on your ass and do nothing until a great opportunities presents itself”
– Charlie Munger
Once you’ve invested in a great compounding machine, you don’t have much left to do. Activity without purpose is detrimental to total returns.
Practice Do Nothing Investing.
Buy great businesses trading at fair or better prices. Hold these businesses for the long run. Let them work for you. Let them compound your wealth over long time periods.
The truth is, it is difficult to ‘do nothing’. The majority of individual investors like investing. We read about different investment opportunities often (perhaps too often).
It is easy to become distracted and jump from high quality compounding machines to businesses that might do better.
When you are tempted to sell one of your most successful investments, be sure to analyze it from the perspective of the ‘Buffett Loan’, and ask yourself if it still makes sense to sell and buy something else.