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TIP Academy
LESSON SUMMARY
In this lesson, we learn that Warren Buffett likes to invest with long term-prospects that he identifies by asking if the property of the product is subject to change. If we look at candy for example, it’s highly unlikely that we would consume candy differently or that the product will dramatically change. Compare that to an iPhone. Though it’s a great product, it’s equally highly unlikely that we will consume information and communicate the same way in 30 years. Warren Buffett wants a company with long term prospects that can continue to make a profit in the long run. Aside from the obvious notion that it’s nice for a company to generate profit, the additional reason is capital gains tax. In this lesson, we further learn the following points:
1) What is capital gains tax: If you buy a stock at $10 and sell it for $12, you are taxed on that $2 gain. In investing as with your personal life the biggest expense is typically what you incur and you want to pay as little as possible. If you incur the capital gains tax by selling your stock within one year, you are taxed heavier than if you hold it longer.
2) How to defer capital gains tax: The way to defer capital gains tax is actually quite simple: Don’t sell your stock! This underlines the importance of understanding the next level of Warren Buffett’s second rule. If the company has long term perspectives you’ll find that the stock continuously increases in value and you can defer taxes into infinity. Even if you eventually decide to sell, you’ll find that even at the same tax rate, it’s pays off to defer it as long as possible.
LESSON TRANSCRIPT
LOOKING AT LONG-TERM PROSPECTS
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 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 of why you should buy companies and hold them 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 the 2013 capital gains structure. Anything over 5 years is taxed at a different rate. The longer you hold it, the less you pay in 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.
SHORT-TERM VS LONG-TERM GAINS
Let’s go ahead and demonstrate how the short-term and the long-term taxes are when you buy and sell and the 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 to grow due to the equity and the dividend.
You will pay taxes on dividends on the income for that dividend. As far as the actual growth of the market price, you’re not going to 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 of 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 them for the rest of his life because he’s going to continue to collect the dividend and the market value will continue to 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 forever. By purchasing a company that has long-term prospects, the owner (or stockholder) 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.
LESSON 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.
