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Will BRK underperform S&P500 if BRK held S&P 500 as Buffett says?


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In 2019, Buffett answered that BRK intrinsic value will underperform S&P 500 if BRK just held S&P 500.  Looks like he missed accounting for leverage through float, or did he take that into account, and saying taxes will nullify any benefit from float and eat some more? 

 

Charlie answers, "even if we just match the S&P 500, we would be way ahead after taxes... we shouldn't be too disappointed".

 

Buffett continues, "We could have structured differently ... present form ... corporate capital gains tax up to 39%, certainly 35%, and on top of that state income tax..."

 

So, if BRK's investments are going to generate only as good as S&P 500, is it better to just hold S&P 500?  The impact from taxes eats away at any poisitive impact from leverage through float?  Then, why take the risk of holding a single entity that also has insurance risk, instead of holding S&P 500, post Buffett and Munger, unless successors show that they can earn way more then S&P500 to pay for taxes also? 

 

Thoughts? 

 

 

Edited by LearningMachine
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Buffett has said many times that Berkshire wasn't the most efficient tax structure.  However, it was baked in at inception and there is nothing to be done about it.  They do well, anyway.

Berkshire is not a proxy for the S&P 500.  It has a different collection of companies--and management.  So, the issue is whether you trust Berkshire to make better investments than the S&P index, and what you think of their strategy for deploying cash. 

There are a lot of moving parts besides taxation.  Understanding the various types of businesses, market cycles, and your own, as well, are just a few.

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Munger said "There'll be one big advantage for the shareholders that pay taxes. The Berkshire shareholders - even if we just match the S&P we'd be way ahead after taxes".

 

I'm not understanding the mechanism here. Why is this true? If BRK.B matches SPY, and I incur a capital gain on both of them, and I have to pay capital gains tax on both of them, how are the Berkshire shareholders ahead on an after-tax basis?

 

Can someone explain please?

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It doesn't matter. 

 

Why? Because brk almost always sells at a lower multiple. You more frequently and more non correlatively have an opportunity to buy it when it is at a significantly lower multiple. That is the main difference. Therefore, they already "earn" more. This is "why" it's easy. As an aside, absent catastrophe at 

a major pillar, they are more predictable. 

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Posted (edited)
1 hour ago, snowglobe said:

Munger said "There'll be one big advantage for the shareholders that pay taxes. The Berkshire shareholders - even if we just match the S&P we'd be way ahead after taxes".

 

I'm not understanding the mechanism here. Why is this true? If BRK.B matches SPY, and I incur a capital gain on both of them, and I have to pay capital gains tax on both of them, how are the Berkshire shareholders ahead on an after-tax basis?

 

Can someone explain please?

 

That is exactly the crux I am trying to get to here. 

 

If you listen to the video, I think Munger might have meant one of these two things:

  • Interpretation 1: Even if we just match the S&P 500, we'd be way ahead of the S&P 500 after taxes.
  • Interpretation 2: Even if we just match the S&P 500, we'd be way ahead of your current position after taxes. 

 

If you continue listening to Munger later in the video, and try to be consistent with what Buffett said earlier in the video, Munger seems to be saying #2, not #1.  In other words, to be consistent with what Buffett says earlier in the video, if BRK holds S&P 500, BRK would be worse off then holding S&P 500 directly because of taxes, and because leverage through float apparently doesn't help enough to fill the hole created by taxes?  

 

Do folks agree? 

Edited by LearningMachine
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3 hours ago, snowglobe said:

Munger said "There'll be one big advantage for the shareholders that pay taxes. The Berkshire shareholders - even if we just match the S&P we'd be way ahead after taxes".

 

I'm not understanding the mechanism here. Why is this true? If BRK.B matches SPY, and I incur a capital gain on both of them, and I have to pay capital gains tax on both of them, how are the Berkshire shareholders ahead on an after-tax basis?

 

Can someone explain please?

 

Let us say BRK annual average return equals total return of S&P 500 including dividends. S&P 500 fund dividends are taxed every year whereas BRK has no dividends so no taxes are paid by BRK owner during the holding period. Hence BRK investor comes out ahead after taxes. 

Edited by Munger_Disciple
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Is this the argument?:

 

1. BH avoids paying $x/share in tax (presumably because it didn’t sell).  

 

2. Therefore BRK share price is $x/share higher

 

3. Now I sell BRK and pay some “extra” cap gains for the unpaid taxes. Say 15% of $x

 

4. But my brother in law bought SPY instead.  He’s now paying 100% of $x

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Posted (edited)
2 hours ago, Munger_Disciple said:

 

Let us say BRK annual average return equals total return of S&P 500 including dividends. S&P 500 fund dividends are taxed every year whereas BRK has no dividends so no taxes are paid by BRK owner during the holding period. Hence BRK investor comes out ahead after taxes. 

 

@Munger_Disciple, the question someone asked in the video was slightly different, i.e. if BRK held S&P 500.  Buffett mentions in the video that BRK's dividend tax rate is between 10.5 and 13 percent, and capital gains tax rate is now 21% plus state taxes. 

 

What really surprises me in Buffet's and Munger's answers is that they didn't bring up anything regarding benefit of leverage through float by holding S&P 500 inside BRK. 

 

Any thoughts on that from you or anyone else? 

 

I thought Munger had said in the past that people directly buying same stocks as BRK won't get benefit of BRK's leverage through float.  

 

Wondering if they didn't bring up benefit of leverage through float now because benefit of leverage from float will get eaten up by taxes? 

Edited by LearningMachine
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1 hour ago, LearningMachine said:

 

@Munger_Disciple, the question someone asked in the video was slightly different, i.e. if BRK held S&P 500.  Buffett mentions in the video that BRK's dividend tax rate is between 10.5 and 13 percent, and capital gains tax rate is now 21% plus state taxes. 

 

What really surprises me in Buffet's and Munger's answers is that they didn't bring up anything regarding benefit of leverage through float by holding S&P 500 inside BRK. 

 

Any thoughts on that from you or anyone else? 

 

I thought Munger had said in the past that people directly buying same stocks as BRK won't get benefit of BRK's leverage through float.  

 

Wondering if they didn't bring up benefit of leverage through float now because benefit of leverage from float will get eaten up by taxes? 


@LearningMachine Buffett or Munger didn't really answer the question about leverage due to float. Buffett pointed out the double taxation problem (when index is held and sold later by BRK) and Munger pretty much said what I wrote in the earlier post. 

 

BRK's float pretty much equals cash+ST bonds held by BRK, so the long term return roughly equals cash returns, assuming zero cost float. Given that float is roughly 25% of SH equity, I don't think this leverage adds much to BRK performance. At 4% ST treasury rates, it adds roughly 1% pre-tax to BRK which is 0.8% post-tax. 

Edited by Munger_Disciple
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Posted (edited)
3 hours ago, Munger_Disciple said:


@LearningMachine Buffett or Munger didn't really answer the question about leverage due to float. Buffett pointed out the double taxation problem (when index is held and sold later by BRK) and Munger pretty much said what I wrote in the earlier post. 

 

BRK's float pretty much equals cash+ST bonds held by BRK, so the long term return roughly equals cash returns, assuming zero cost float. Given that float is roughly 25% of SH equity, I don't think this leverage adds much to BRK performance. At 4% ST treasury rates, it adds roughly 1% pre-tax to BRK which is 0.8% post-tax. 

 

Thanks @Munger_Disciple for sharing how leverage doesn't add much to BRK's performance.  Now, it begs question whether it would add much to MKL's performance?  If not, maybe buying quality businesses through BRK and MKL is not as great an idea anymore instead of buying them directly? 

Edited by LearningMachine
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3 hours ago, LearningMachine said:

 

Thanks @Munger_Disciple for sharing how leverage doesn't add much to BRK's performance.  Now, it begs question whether it would add much to MKL's performance?  If not, maybe buying quality businesses through BRK and MKL is not as great an idea anymore instead of buying them directly? 

 

You can think and discuss a lot of arguments (asset quality, management, etc) but I would say the main to reasons is a. BRK also owns operating businesses, which constitutes like half or more of its value and b it is still somewhat cheaper than the market, while probably more safer/resilient/etc.

Edited by UK
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I was under the impression they were speaking about the investment portfolio, not the entirety of BRK. Given the size, it will be difficult to have the equity portion of BRK's investments to much better than the index, but with the operating companies, they should, as a whole, do much better, especially in down markets. It is for this reason that I believe BRK is a great defensive stock to hold in these times. Now if they get the opportunity to put, say $80-$100 billion to work in beaten down stocks of great companies, then there is a chance they can do better. Patience is WEB and CM's strongest asset in this regard.

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  • 2 weeks later...
On 10/5/2022 at 4:13 PM, snowglobe said:

Munger said "There'll be one big advantage for the shareholders that pay taxes. The Berkshire shareholders - even if we just match the S&P we'd be way ahead after taxes".

 

I'm not understanding the mechanism here. Why is this true? If BRK.B matches SPY, and I incur a capital gain on both of them, and I have to pay capital gains tax on both of them, how are the Berkshire shareholders ahead on an after-tax basis?

 

Can someone explain please?

To Munger's point, there's a constant tax bill with holding the SP500 index whereas Berkshire is a buy-and-hold-forever.  So buying SP500 and selling after 10 years incurs taxes each year and taxes at year 10 whereas the same scenario for BRK would incur taxes only in year 10.  I'm purposely ignoring dividends which are a wash.  BRK's float leverage would amplify the amount of taxes paid.  That structural difference will add up over longer periods of time (10 years or more).

https://www.businessinsider.com/sp-500-index-constituent-turnover-2015-6?op=1

 

Among other things, Parker points out that the makeup of indexes like the S&P 500 is constantly evolving.

"One of the main items that changes over time in the S&P500 is the actual constituents of the index," Parker writes. "While there has been relatively less turnover lately, with only 3% of the companies changing since 2013, the cumulative effect of adding and subtracting companies is surprisingly substantial. Ten percent of the companies in today's index are different since 2011, 17% are different since 2009, and fully half the companies are different since 1999. Said another way, at least half the companies in the S&P500 today were not in the S&P500 when your average portfolio manager started running a portfolio."

To put it another way, there is a healthy amount of trading going on in the S&P 500.

Parker charted the number of companies that have been added each year since 1965.

"On average, 22 companies, or 4.4%, are added to or removed from the index each year," Parker wrote.

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Tax implications of S&P index ETF, any ETF really, are an important consideration.  If you buy and hold an ETF for 10yrs, you pay tax on annual dividend and capital gain tax on the ultimate sale of ETF 10yrs later.  However, when the S&P re-shuffles its allocations, adds new companies, removes companies - the ETF re-allocates the index fund and that is a tax free transaction.  For example, if Apple's allocation in the S&P is 10%, then there is a re-shuffle, Apple's allocation is reduced to 8%, the holder of the ETF does not pay on the gain of Apple inside the ETF.  I am probably missing some pieces but this is my understanding.  The structural tax advantage of ETF is pretty strong.  Especially vs a Mutual Fund that pays taxes on a shuffle of the allocation.  To that point, Berkshire's tax implications are better compared to a mutual fund rather than an index ETF.  I understand returns can be compared but the tax implications are different all together.  

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On 10/19/2022 at 1:11 PM, longterminvestor said:

Tax implications of S&P index ETF, any ETF really, are an important consideration.  If you buy and hold an ETF for 10yrs, you pay tax on annual dividend and capital gain tax on the ultimate sale of ETF 10yrs later.  However, when the S&P re-shuffles its allocations, adds new companies, removes companies - the ETF re-allocates the index fund and that is a tax free transaction.  For example, if Apple's allocation in the S&P is 10%, then there is a re-shuffle, Apple's allocation is reduced to 8%, the holder of the ETF does not pay on the gain of Apple inside the ETF.  I am probably missing some pieces but this is my understanding.  The structural tax advantage of ETF is pretty strong.  Especially vs a Mutual Fund that pays taxes on a shuffle of the allocation.  To that point, Berkshire's tax implications are better compared to a mutual fund rather than an index ETF.  I understand returns can be compared but the tax implications are different all together.  

Seems like some magical thinking -- somebody pays for lunch and the government gets paid.  ETFs have some tax avoidance workarounds through some creative structures that effectively defer most taxes until sale of the ETF by the holder.

 

The workaround for ETFs is that they can exchange shares amongst themselves without conversion to cash - the taxable event.  Payment is done in delivered shares avoiding taxation.  This helps deal with underlying index churn and securities turnover.  So, that works well in highly liquid markets, but in less liquid markets, and in severe market dislocations, conversion to cash is a reality.  Nobody talks about the black swan case in these typical articles which are thinly disguised marketing pitches.  Some ETFs use leverage and options which invokes different short/long term capital gains taxation.

https://www.jhinvestments.com/viewpoints/etfs/creation-and-redemption-etfs-secret-sauce-explained

 

But, in the end, if there is a capital gain distribution, the ETF investor is still responsible for the cap gain taxes annually.

https://www.fidelity.com/learning-center/investment-products/etf/tax-basics-etfs

Distributions. Both mutual funds and ETFs generally are required to distribute capital gains to investors, which can potentially result in a significant tax cost annually.

 

Dividends. ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a “qualified dividend” and is taxed anywhere from 0% to 20% depending on the investor’s income tax rate. If the dividend was held less than 60 days before the dividend was issued, then the dividend income is taxed at the investor’s ordinary income tax rate. This is similar to how mutual fund dividends are treated.

 

 

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Wouldnt the argument be that Berkshire's ZERO cost float during ZIRP world represented only a tiny marginal advantage versus PE firms who would (1) pay alot more for operating businesses with OPM and (2) access relatively cheap debt (float) externally themselves to acquire them........perhaps moving forward BRK's insurance float becomes a real competitive advantage again...........as costs of capital return to more normals levels and multiples to revert to more normal levels

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51 minutes ago, changegonnacome said:

Wouldnt the argument be that Berkshire's ZERO cost float during ZIRP world represented only a tiny marginal advantage versus PE firms who would (1) pay alot more for operating businesses with OPM and (2) access relatively cheap debt (float) externally themselves to acquire them........perhaps moving forward BRK's insurance float becomes a real competitive advantage again...........as costs of capital return to more normals levels and multiples to revert to more normal levels

Hopefully for a while, though over the long term combined ratios have been strongly correlated to interest rates

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How does Berkshire get taxed on dividends received from its public market investments such as AAPL. Does 50% of dividends received get taxed at the 21% corporate tax rate?

 

Here, it says:

A US corporation generally may deduct 50% of dividends received from other US corporations in determining taxable income. The dividends received deduction (DRD) is increased from 50% to 65% if the recipient of the dividend distribution owns at least 20% but less than 80% of the distributing corporation.

 

https://taxsummaries.pwc.com/united-states/corporate/income-determination#:~:text=Dividend income,80% of the distributing corporation.

 

 

Warren is really fighting an uphill battle, with gigantic positions he can't move in and out of, and a hefty tax bill to fight.

 

 

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29 minutes ago, snowglobe said:

 

Warren is really fighting an uphill battle, with gigantic positions he can't move in and out of, and a hefty tax bill to fight.

 

 

 

Unpack that statement a bit, what is an uphill battle, also...generally positions that are made or allowed to get to be "gigantic" are not positions that Omaha would want to move in and out of...thats why they are "gigantic". They're pretty clear about their preferred holding period. 

 

Hefty tax bill is all relative...from your statement you are saying it would be preferred if he could quickly/nimbly move in and out of large positions? Unless selling for a loss on those positions thats a sure fire way to make sure Uncle Sam doesnt have to wait for his cut...

 

 

 

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