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TIP Academy
LESSON SUMMARY
In this lesson, we learn that there are two general reasons why Warren Buffett sells stocks:
1) When a higher return is expected by trading with another asset (considering the capital gains tax): One thing that might be tempting to do is keep trading your stocks when you find a new company that you really like. The problem about this approach is that you have to pay capital gains tax every time you sell a stock with profit. We learned more about capital gains tax in lesson 19 and saw that it was a large expense that required unrealistic stock picking skills. Continuously paying tax on your profit instead of deferring your tax obligation implies that the amount of money that you invest for decreases.
Therefore, when you sell stocks, you should evaluate if the expenses you incur in terms of tax outweigh the higher expected return on the new stock pick.
To fully understand when you should sell stocks, it is recommended to fully understand the calculation of intrinsic value that was taught in lesson 21.
Assume your current holding is called XXX and the new stock you are looking at is called TTT. By following a few simple steps you can determine whether you should sell your stocks or not.
1.1) Calculate the expected annual return for stocks XXX and TTT based on the current market prices and intrinsic values
1.2) Subtract the cost of capital gains tax from stock XXX
1.3) Calculate whether stocks XXX or TTT yield the highest expected annual return based on a given time frame.
2) When the company changes the fundamentals: Another important factor Warren Buffett really looks for when selling his stocks in a company is whether the fundamentals of the business are changing. What that means in practice is whether the first three rules are being broken. As we have learned in lesson 18-20, that would happen in situations where: the company is no longer managed by vigilant leaders, the company no longer has long-term prospects, and where the company is neither stable nor understandable.
One final thing to take away from this lesson is that the process of determining if stocks should be sold or not is actually not as complicated as it may look at the face of it. With a little practice, it becomes fairly easy.
LESSON TRANSCRIPT
Selling stocks is treated as a mystery to many people. Hopefully this lesson will help you easily determine whether you should sell or buy shares.
Buffett knows when and if he should ever sell shares or stocks. Whenever he buys stocks, his mind is set on owning it forever. He doesn’t buy it when it’s low and sell it when high. His intention is to buy low and hold it forever. In some situations, he does need to sell shares, and it revolves around two rules.
WHEN A HIGHER RETURN IS EXPECTED BY TRADING ANOTHER ASSET
When you take into account and conduct that transfer, not only do you account for the capital gains, but you also lose money. However, you must take into account the risk level as you move from one level to another. You will eventually find a reasonable return after gaining the capital gains tax. This entire lesson focuses on determining whether a change is worth the trade or not.
WHEN THE COMPANY CHANGES ITS FUNDAMENTALS
Course 2 unit 3 discussed the 4 rules for buying common shares. If those principles changed after purchasing the shares, it is enough reason to sell those. The company that manages debt well – .5 Debt to Equity and 1.5 current ratio – 2 or 3 years down the road, that’s a very good reason to buy shares regardless of the trading price. It’s changed the way it is operating.
First, figure out how to assess that change in value from one asset to another after accounting for the capital gains tax.
Here’s a generic scene that doesn’t have anything to do with the current market trend: You have one share of Company XXX. The market price is $50 a share, the book value is $48 a share, which is close to the market price, and the expected book value growth is 7% annually. While the dividend is 0, the Debt to equity is .5, the forecast future earnings is same as the last ten years, and the 10-year federal note is 3%. Calculate the intrinsic value to be ______ a share.
The scene discussed above is 3 years ago. If Company XXX’s interests were 3%, how do you calculate the intrinsic value right there and then? You will use the buffettsbooks.com website for the intrinsic value calculator. Go to the calculator tab and come down to intrinsic value and stocks. Based on the information, you don’t have to input anything on the top calculator anymore. Just go straight to the lower calculator. All the numbers needed are already there. The cash is taken out of the business, the dividend is 0, the current book value is $48, and the average percent change of book value per year is 7%. The $48 book value will grow with each year for the next 10 years. Use 3% for the 10-year federal note. Click on calculate to get $70.25. Round it off to $70 a share. Company XXX is trading on the market for $50$ share, but its value is worth $70 a share when compared to a 3% 10-year federal note.
Now, assume that you could go ahead and buy some shares. It’s trading for $50 and it says $70 as you compute it. If you bought 1000 shares of company XXX for $50 each, that is a $50000 investment. You own XXX now.
Warp to 3 years later and see what your investment did. You might want to hold it or buy something else. Usually, companies don’t perform as expected.
You bought company XXX with a market price of $50 three years ago, but now it is $70 a share. That’s how you predicted it, but is it worth that much? Just because a stock is trading in a certain amount doesn’t mean it’s worth its amount. The book value of XXX is the same amount 3 years previously, which is strange especially because it hasn’t paid any dividend. It’s a bad sign. The book value hasn’t grown. The market price should have trended with the book value, but it didn’t. The expected book value right now is at 5%, lower than what you thought it was 3 years ago. The dividend is 0. The debt to equity is much higher than where it was instead of 3.0. That number is not good. You could probably disregard the company and sell it specifically for that reason alone.
Lastly, the forecast for future earnings are constantly getting lower. In the previous scenario when you bought it three years ago, the earnings were consistently constant in the past 10 years. The forecast for the future earnings is decreasing. That alone is enough reason to sell the company.
Should you sell it, trade it, or buy a 10-year federal note? The value of the company today and three years later are completely different values than three years earlier. The 10- year federal note is now at 4.5% from 3%, which puts a different intrinsic value, especially since the market price is different.
As we get back to the intrinsic value calculator, you’ll notice that it’s the same exact process. Take out the cash, 0 dividend, same book value, $70 market price. It has $48 book value. 5% average percent of change. 10 years of duration. 3% 10-year federal note. Click on calculate and it gives an intrinsic value of $50 per share. It drastically changed from where you were three years earlier. On the market, its market price is $70 a share. The intrinsic value is much lower than what the company is actually trading for. It’s not good! When you hold it, you’ll lose money.
Know where to put the money when you sell a stock. Your natural inclination is to immediately put it in 10 years and barely get a better return.
Recap: In 2009 you purchased Company XXX for $50 a share. You thought the intrinsic value was $70, so you bought 1000 shares. Three years later, the market price came up to $70$ a share, but the intrinsic value went down to $50 and you still hold 1000 shares. What should you do with this? Transfer the funds to something else?
Companies are trading for higher premiums. You’re most likely in a bull market when you’re having a problem looking for a good intrinsic value. Despite this, you cross a company called TTT. One share costs $50. The book value is also $48 a share just like company XXX. The expected book value growth is 6% for company TTT. It’s 1% higher than XXX. This also doesn’t pay dividends, but the debt to equity is.5 which is better than XXX. The forecast for the future earning is the same for the last 10 years. It’s a good sign of good debt management.
To compare the intrinsic value of both companies, use the intrinsic value calculator. There are still no dividend payments. The book value is also $48. The percent change is 6%. The years are still 4.5%. Click on calculate and it gives you an intrinsic value of $55. It’s trading for $50, so that’s a good thing! You bought the company lower than what you think it is.
A step-by-step method determines what to do in this kind of situation. Do you continue to hold XXX, sell the shares, pay the capital gains, or purchase company TTT?
- How much return do you expect to do with your current stock if you continued to hold XXX for the next 10 years?
- How much do you invest in the ultimate Stocks after you pay the capital gains tax? Once you know that, you’ll know how much you can buy and you can estimate how much it’ll be. Figure out how many you will have after paying the capital gains tax.
- How much return do you get from the new pick?
Take the money and buy Company TTT and estimate how much it’ll grow in 10 years. Well, just compare numbers 1 and 3 to see which one is better.
Step 1: The return on your current pick. You figure out what the intrinsic value is, but what return do you get if you continue to hold the shares, especially when it’s trading for $70 when you think it’s worth $50 only?
Go back to the intrinsic value calculator. Fill up the numbers – 0 dividend, $48 book value, 5% change, 10 years, and 4.5% 10-year federal note. Hit calculate and it gives an intrinsic value of $50. To figure out how much you think you’d get in 10 years, adjust the 4.5 federal note until your intrinsic value is equal the current market price or close to it. Your current market price is $70, so don’t stop until you hit that. It’s a trial-and-error process. 1% is the correct 10-year federal note to make a market value of $70. When the intrinsic value equals the market price, you’ll get the same return as your input is for the 10-year federal note. 1% is how much you will make if you continue to hold XXX over the next ten years. Annually, you only make 1%! That’s pretty bad! How much would that 1% turn into with your current investment? You have 1000 shares of company XXX, so that’s a total of $70000 right now.
What’s the value in 10 years? Follow the formula:
1000 shares of company XXX
1000 shares at $70 a share = $70000
What will be the value in 10 years?
FV=PV* (1+i) n
PV=$70000
I=1% or.01
FV=70000* (1+.01)10
FV=$77, 323.55 (10 years later)
The money will grow to $77,323.55 when we continue to hold company XXX for 10 years.
Step 2: Pull up what the capital gains tax rate you’re going to be at. For XXX, you made a $20000 gain in 3 years. As you look at the chart in the video, it’s 2013. If you’re reading my book, it uses the numbers from the previous years to 2012. The numbers are a bit different from the book to the video. Those numbers are considered a long term capital gain. A short-term capital gain is less than a year. Long-term is more than a year. The five-year capital gains rate is a bit better – 8% and 18%.
For your scene, it is 10-20% long-term capital gains range depending on your ordinary income tax bracket. Assume you’re in a tax bracket higher than 15%, and the capital gain is 20%. To find out the capital gains tax to pay, take 20% times your gain of $20000. It comes up to be $4 of federal capital gains tax. Once paid, you now only have $66000 left from the original $70000. Since you’re changing assets, we have been paying capital gains tax of $4000. Whatever is left is what you can invest in the next asset.
You’re trying to invest in TTT with $66000. This is important to account for because lots of people see this as an extra percent more by transferring it another company. Yes, but you need to pay the capital gains tax, though.
I’m only doing calculation of the federal capital gains tax. You have to account more money than you would have to pay to the state when you do it for real. These are all considerations when looking at transferring assets from one stock the next. You’re paying all those in federal and state taxes before you do the math on how much it’ll grow.
Step 3: Find out how much the return is once you get the $66000 and buy TTT. To do that, come back to the intrinsic value calculator. The cash is only a tenth of the business, no dividend is being paid, and the book value is still $48. Almost always that’ll be different from your previous pick. It’s just coincidence, but when you’re talking about the average percent change of the book, this is a lot different, because the TTT is higher at 6%. The number of years is still 10. The 10-year federal note is still 4.5%. Hit calculate and you get $55. The current market price is $50. You need to change the 10-year federal note until the intrinsic value equals your market price. Do the trial-and-error. 5.5% is then the correct 10-year federal note.
When you buy TTT at the current market price, you make 5.5% annually in ten years.
Final step is to find out how much of the investment of $66000 turns into if it grows to 5.5% a year. Go back to our basic formula.
Company TTT will grow at 5.5% a year
How many shares can we buy with $66,000?
# Shares purchased = $66.000/$50 per share
# Shares purchased = 1,320 shares
FV=PV* (1+i) n
PV=$66000
I=5. 5% air. 055
FV=66000* (1+.01)10
FV=$112, 737 (10 years later)
The money will grow to $112,737 when we continue to hold company TTT for 10 years.
Recap: If you continued to hold XXX for ten years, your market value will be $77,323.55. After you calculated, you traded it to TTT. The future market value would grow to $112,737 in the same time period. This is a $53,413 decision! The wise decision is to sell XXX and use the remaining money to buy TTT.
