The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Feb. 14, 1997)

We're approaching the time of the year when all investors start thinking about (and undoubtedly moaning about) taxes. But too many investors let tax fears rather than realities guide their investing decisions.

For example, many investors believe they're better off avoiding taxes by holding stocks forever rather than paying capital gains taxes every year or so when updating their holdings. But as I've written on many occasions, this is very rarely true because holding a group of stocks for many years (or an index fund) means you get stocks going up and down through many cycles and it's very hard to achieve much more than 15% or so in the long run.

The savings one achieves in deferring taxes doesn't make up for the opportunity cost one forfeits in not updating to better stocks periodically. This really becomes apparent when an investor has held a stock so long that the fear of the deferred tax bite prevents him from ever selling it, locking in mediocre returns rather than paying the tax and moving on.

But a similar fear of the dreaded short-term capital gains tax grips many investors. One of the best long-term strategies around, of course, is the Dow Approach, with a history of returns around the 23% level. After accounting for the maximum long-term tax rate of 28%, that represents an after-tax return of 16.56%.

But if you're in a high tax bracket, your capital gains taxes can go as high as 39.6% on short-term gains. But what really matters, of course, is the return free and clear of taxes. So what does it take to get the same after-tax return as the Dow Approach if you're paying short-term gains taxes? To achieve 16.56% at the higher rate, your pre-tax return must be 27.42%. With many of the more aggressive growth strategies, that's not at all an unreasonable goal over the long haul.

Now, of course, if the Formula90 returns of 35% hold up over many years, that raises the bar quite a bit. (I'll be detailing the Formula90 approach again in the near future, or you can read about it in the archives of these reports.) At the maximum 28% long-term rate, the Formula90 approach would have recorded after-tax returns of 25.20% over the last decade. To achieve that same rate at the higher tax rate (39.6%), you'd have to record 41.72% in pre-tax returns. That's right on the decade-long return for the Unemotional Growth approach.

The key, then, is to compare the truly important numbers -- after-tax returns -- to see what fits you the best. Don't be afraid of short-term gains if by being more aggressive, even though you pay a higher tax rate, you're ultimately keeping more after funding Uncle Sam. I hate giving tax money away, too, but if I get to keep more in the long run by paying more out on short-term capital gains, who's the loser?

Of course, if the tax laws change, all bets are off until we see the new rules.

Monthly Growth Screens
     (Jan. 3 to present)
24.05%  Relative Strength  
19.15%  YPEG Potential  
10.44%  Low Price/Sales  
  8.08%  S&P 500 Index  
  4.29%  Investing for Growth  
 -4.93%  EPS Plus RS  
 -8.36%  Unemotional Growth  

Annual Value Screens
     (Jan. 1 to present)
  8.39%  Dow Jones Ind Avg  
  7.69%  Dogs of the Dow  
  6.20%  Beating the S&P  
  4.21%  Dow Combo  
  2.83%  Unemotional Value  
  2.83%  Beating the Dow  
  0.58%  Foolish Four