Indexing, taxes, dividend growth indexing

[frommi]

I`ve been playing around with numbers the last week and came to realize that i need 14-15% pretax returns with value investing to get the same results as just buy and hold indexing after taxes.

 

15% returns long only, full time invested for me looks like a pretty tough hurdle especially given the risks of underperformance and concentration necessary to reach these goals.

 

Now i am thinking about improving the index returns with equal weighting and a dividend growth approach. I started building a list and have now around 100 companies with a history of increasing dividends every year with an average yield of 3.0% and 9% historical growth. This comes down to 12% returns which is exactly what the original S&P500 companies that built the index in 1957 have returned, so it doesn`t seem to be that wrong.

 

I don`t like buying etf`s for indexing because i am too cheap to pay fees for nothing (and after buying there will be no additional fees with my approach), and there is always the risk that the etf someday will be closed and i lose the tax advantage. And its probably a lot harder to sell the complete portfolio, so psychologically its easier to maintain the approach for me than etf`s.

 

Has somebody else done it that way, or is it just a stupid idea?

[Nelson]

I used to be pretty anti dividend growth investing. I enjoy finding obscure micro-caps, so the thought of buying JNJ or KO doesn't really appeal to me. Value investing is like finding a needle in a haystack. Dividend growth investing is pretty much the opposite.

 

But I've changed my stance, at least sort of. I've been reading a lot of what Scott Hall has been writing about finding these long-term compounders that you can buy now and not worry about for a decade or two. He makes a whole lot of sense. Dividend growth and indexing is just another form of that.

 

If you can generate a little bit of alpha using a passive approach, there's value there. Even if it just frees up time to play video games or read.

[CRHawk]

Frommi,

 

I don't understand where you are getting the " i need 14-15% pretax returns with value investing to get the same results as just buy and hold indexing after taxes."

 

What do you mean?

 

 

[augustabound]

Just curious why the 9% hurdle for dividend growth?

[LC]

I used to be pretty anti dividend growth investing. I enjoy finding obscure micro-caps, so the thought of buying JNJ or KO doesn't really appeal to me. Value investing is like finding a needle in a haystack. Dividend growth investing is pretty much the opposite.

 

But I've changed my stance, at least sort of. I've been reading a lot of what Scott Hall has been writing about finding these long-term compounders that you can buy now and not worry about for a decade or two. He makes a whole lot of sense. Dividend growth and indexing is just another form of that.

 

If you can generate a little bit of alpha using a passive approach, there's value there. Even if it just frees up time to play video games or read.

My vibe these days is to buy large-cap, mostly household name companies without huge valuations (30+ P/E), without massive, regular capital needs (think auto manufacturers, railroads, etc.) and without obsolete business models (think Pitney-Bowes). Set it and forget it.

 

Not a lot of people are going to compound at 26%/year. Not born into the right decade, or have the single-mindedness, or connections, or plain luck. Buy Berkshire, the S&P, or maybe a basket of some quality S&P companies. Sit back, spend your time and effort on family, friends, career, hobbies, etc., and live a balanced and generally happy life.

[orthopa]

I think an argument against value investing can be the poll on the 2015 returns thread. More then half of the people were right around returns fore the market with ~75% who did close to what the market did or worse. I love finding good cheap stocks too but sometimes the boring obvious ones give the best returns. I have read very little about tobacco stocks on this site especially MO which has provided Berkshire type returns or better with dividends reinvested over time.

 

I think many on the site dislike dividend stocks due to the double taxation. I like dividend payers and a year like last year was a perfect year for them.

[Jurgis]

If I had to invest in taxable account, I would have gone forever-hold or indexing long time ago. When you have 20%+ tax cost on gains, outperforming an index after taxes is pretty much impossible without forever-hold or similar.

 

(I probably should have done this in my tax advantaged accounts too. No taxes encourage bad trading behavior unfortunately... :( )

 

To answer frommi: No, haven't tried what you are suggesting. I think ETFs would be simpler/less trouble, but your idea might work.

[frommi]

Frommi,

 

I don't understand where you are getting the " i need 14-15% pretax returns with value investing to get the same results as just buy and hold indexing after taxes."

 

What do you mean?

 

Its all about after tax returns isn`t it? With 15% returns pretax at a 26% tax rate, i get ~11% after tax returns.

 

Here is my spreadsheet: https://docs.google.com/spreadsheets/d/1bA3Nv5YwiYIJ5Vdha1YrN3A_kyhF65N5LZvoskK86-c/edit?usp=sharing

 

Just curious why the 9% hurdle for dividend growth?

 

Its not a hurdle, it was the average growth rate of earnings & dividends over the past 10-20 years. There are utilities and REIT`s with lower growth rates included (but of course with higher yields).

 

If I had to invest in taxable account, I would have gone forever-hold or indexing long time ago. When you have 20%+ tax cost on gains, outperforming an index after taxes is pretty much impossible without forever-hold or similar.

 

(I probably should have done this in my tax advantaged accounts too. No taxes encourage bad trading behavior unfortunately... :( )

 

To answer frommi: No, haven't tried what you are suggesting. I think ETFs would be simpler/less trouble, but your idea might work.

 

There more i know the more i realize that i don`t know anything. The crux with value investing is that you rely on both the market being inefficient and at some time in the future being efficient and you being smart enough to find out when it is and when it isn`t. Since the future is unknown and all the value is in the future, how can anybody be sure about anything?

The dividend growth list has of course hindside and survivorship bias. So how reliable is past dividend growth to estimate future dividend growth?

[james22]

I don`t like buying etf`s for indexing because i am too cheap to pay fees for nothing (and after buying there will be no additional fees with my approach), and there is always the risk that the etf someday will be closed and i lose the tax advantage.

 

Paying a tenth of 1% to track a benchmark seems very, very cheap.

 

Fund: https://personal.vanguard.com/us/funds/snapshot?FundId=5702&FundIntExt=INT

 

ETF: https://personal.vanguard.com/us/funds/snapshot?FundId=0920&FundIntExt=INT

 

[frommi]

I know of these etfs but why pay someone if i can do it myself? 0.1% every year of 1 million are 1000$ per year for nothing. I also want to create barriers to exit for myself and have the psychological benefit of dividend payments hitting the account every day. And if someday in the future vanguard choses to close the etf or increase the ter (see current lawsuit against them) you are screwed and have to pay the taxes and lose all benefits of doing it in the first place.

[Jurgis]

I know of these etfs but why pay someone if i can do it myself? 0.1% every year of 1 million are 1000$ per year for nothing. I also want to create barriers to exit for myself and have the psychological benefit of dividend payments hitting the account every day. And if someday in the future vanguard choses to close the etf or increase the ter (see current lawsuit against them) you are screwed and have to pay the taxes and lose all benefits of doing it in the first place.

 

This might be true, but you have to think about converse too: the cost of your time (and commissions - though they may be low) for the upkeep of your "own etf". Slippage cost if you make mistakes during upkeep. BTW, there might be even tax benefits in ETF vs your own solution.

 

I'm not saying that your own solution won't work. I'm just not sure it will cost less and be better than ETF.

[james22]

I know of these etfs but why pay someone if i can do it myself?

 

You plan to continually rebalance? At no cost?

[frommi]

No, only reinvestment of dividends.

[petec]

Frommi,

 

I have a very similar train of thought.  I love value investing and finding undervalued stuff but I don't have the time (and may not have the skill).

 

I've therefore allocated a portion of my portfolio to something similar to what you describe.  I have two categories of company, and I aggregate them to think of them as two positions, akin to etfs but compiled by me: Global Stapleco, and Centurions.

 

Basic criteria:

1. Must be either staples, producing things I am sure humans will still need in 100 years, or have already lasted for 100 years, suggesting there is something in the DNA of the company that can survive and thrive through every sort of macro.

2. Must produce things that I think humans will buy more of in 50 years, either because there are more humans or humans are richer.

3. Must pay a decent dividend.

4. Must, at purchase, be valued reasonably.

5. Must have strong balance sheets.

 

I do everything I can to fall in love with these stocks so that I don't sell them according to my current macro views.  I intend to hold them for the rest of my life.

 

I don't worry too much about the relative weights between them, keeping them roughly equal.

 

They sit in tax-advantaged accounts so I don't pay tax on the dividends.

 

P

 

EDIT: Perhaps a better way of expressing the criteria is that I want something with a very good chance of giving me a multi-decade return in excess of inflation.  That's a surprisingly hard thing to achieve.

 

[Uccmal]

Frommi,

 

I have a very similar train of thought.  I love value investing and finding undervalued stuff but I don't have the time (and may not have the skill).

 

I've therefore allocated a portion of my portfolio to something similar to what you describe.  I have two categories of company, and I aggregate them to think of them as two positions, akin to etfs but compiled by me: Global Stapleco, and Centurions.

 

Basic criteria:

1. Must be either staples, producing things I am sure humans will still need in 100 years, or have already lasted for 100 years, suggesting there is something in the DNA of the company that can survive and thrive through every sort of macro.

2. Must produce things that I think humans will buy more of in 50 years, either because there are more humans or humans are richer.

3. Must pay a decent dividend.

4. Must, at purchase, be valued reasonably.

5. Must have strong balance sheets.

 

I do everything I can to fall in love with these stocks so that I don't sell them according to my current macro views.  I intend to hold them for the rest of my life.

 

I don't worry too much about the relative weights between them, keeping them roughly equal.

 

They sit in tax-advantaged accounts so I don't pay tax on the dividends.

 

P

 

 

Petec, Can you list them, tx. Al

[Jurgis]

Petec, for how long have you had this portfolio and did you manage to hold everything in it so far?

[petec]

Oh, it's a pretty dull list!

 

Global Stapleco:

KO

PEP

ULVR

DGE

 

Watching:

PG

NESN

 

Would like to add Grupo Nutresa in Colombia but don't have an account that can buy it yet.  Sure there are many more I could consider. 

 

Centurions:

BAS (BASF, the only one I would be buying now, and then only lightly)

MMM

JNJ

 

Watching:

UPS

WFC

GE

AXP

JM (Jardine Matheson)

 

To be honest the "Centurions" idea is pretty new and I am still fleshing out the list.  The idea is to capture companies that have *something* - a culture of innovation, or capital allocation, etc. - that isn't dependant on one person and that has allowed them to thrive for a century.  Just surviving isn't enough.

[handycap5]

I`ve been playing around with numbers the last week and came to realize that i need 14-15% pretax returns with value investing to get the same results as just buy and hold indexing after taxes.

 

 

frommi, can you walk us through your math for the 15%? when i play with numbers, i get only a 75 bps opportunity cost hurdle to get similar results AT (assuming a 10 year hold on the passive index vs. a typical 3 yr hold for the "trade" approach.

 

a few notes:

- there is a good research paper called "is your alpha big enough to cover its taxes? revisted" and the original under same name, which one should read on this subject.

- the big lift from DTL comes many years in the future, not in the first few years. as an example, my "opportunity cost" goes from 75 bps to 290 bps pa once index hold goes from 10 to 50 years. but a lot can change in 50 years. so the decision is (for US payors): 1) realize ST gains (answer is NO!) and 2) hold forever or not. First one is easy. Second is less straightforward. (as a digression, the numbers make it clear that some holdings like KO in BRK have exceedingly low opportunity costs - if you think you can hold them for 50+ years)

- don't know ETFs. for US tax payors, the index mutual funds tax treatment is weird. last time i looked, vanguard's S&P500 mutual fund had an NOL! something with the way they redeem their investors with appreciated stock but realize taxable losses and redeem with cash. so index funds are even more efficient than i originally guessed.

[petec]

Petec, for how long have you had this portfolio and did you manage to hold everything in it so far?

 

I guess I've been building it since 2008/9, but I wouldn't have been able to articulate what I was doing quite so well.  I have been pretty good about only adding, but the last couple of years have been a real test because I'm pretty bearish so I am trapped between:

 

1. these are great companies that will survive whatever is coming and compound healthily, if not rapidly, over time; and

 

2. shouldn't you have the courage of your convictions and sit in cash until you can buy everything cheaper?

 

Largely, I've taken the view that buying and holding works better than market timing, but once or twice I have succumbed to the temptation and sold a part of a holding.

 

It is certainly easier to stick to this strategy when KO is at 12x (when I bought it) than when it is at 20x!

 

I do also have a monster position in FFH to help me sleep at night.

 

The final part of my portfolio is special sits/value picks to keep me interested!

 

P

 

 

 

 

 

 

[frommi]

frommi, can you walk us through your math for the 15%? when i play with numbers, i get only a 75 bps opportunity cost hurdle to get similar results AT (assuming a 10 year hold on the passive index vs. a typical 3 yr hold for the "trade" approach.

 

https://docs.google.com/spreadsheets/d/1bA3Nv5YwiYIJ5Vdha1YrN3A_kyhF65N5LZvoskK86-c/edit?usp=sharing

 

At the bottom there is a timetable. I pay ~26% taxes regardless of holding period and i calculated with a 1 year holding period vs. infinite holding period. If that is realistic is on another paper, and that is maybe the flaw in my thinking. Thanks for the response.

[racemize]

I wrote an essay on this topic, which might be helpful:

 

https://www.dropbox.com/s/uwawteaj86zfz1l/2014-03-25%20Hurdle%20for%20Active%20Investors.pdf?dl=0

[orthopa]

frommi, can you walk us through your math for the 15%? when i play with numbers, i get only a 75 bps opportunity cost hurdle to get similar results AT (assuming a 10 year hold on the passive index vs. a typical 3 yr hold for the "trade" approach.

 

https://docs.google.com/spreadsheets/d/1bA3Nv5YwiYIJ5Vdha1YrN3A_kyhF65N5LZvoskK86-c/edit?usp=sharing

 

At the bottom there is a timetable. I pay ~26% taxes regardless of holding period and i calculated with a 1 year holding period vs. infinite holding period. If that is realistic is on another paper, and that is maybe the flaw in my thinking. Thanks for the response.

 

That dividend income in your spreadsheet in your 60's and up is very enticing and ultimately my goal over time.

[frommi]

Interesting fact: Even though this was a list of 108 companies, the list has outperformed the market by more than 5% over the last 5 weeks. So it looks like even with this amount of companies, diversification doesn`t mean the returns will be similar to the index. The companies with the highest yields outperformed by ~6% up to now.