The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Aug. 19, 1997)

Does the new long-term capital gains tax rate really mean that much for Dow Approach investors? You bet it does. Let's look at a hypothetical scenario to show the differences between the old tax structure and the new 18-month rate.

If we start from an assumption of a 20% annualized gain (which is lower than the Foolish Four has achieved since 1971), that equates to a return of 31.45% for an 18-month period. We don't yet have confirmation of the returns for the Dow Approach on an 18-month cycle, but based on Lawrence Pratt's research concerning optimal holding periods for all of the Dow stocks (see my August 4 Foolish Four column), it seems that we may actually increase our annualized returns by extending the holding period to 18 months. But for this simplified comparison, let's assume the 20% rate is constant, regardless of whether one holds 12 or 18 months.

With a 12-month holding period, the capital gains tax is capped at a rate of 28%. If we pay the full 28% tax on all gains each year, a $25,000 original portfolio would grow to $1.4 million after 30 years (after all taxes).

By extending the holding period to 18 months, even though the return remains constant, we get a 29% cut in the tax rate, from 28% down to 20%. Let's take the same $25,000 at an annualized growth rate of 20% (or 31.45% every 18 months) and then take out taxes at a 20% rate every 18 months. In addition to cutting trading costs by one-third because the holding period is extended, the lower tax rate proves a huge boon to the bottom-line after-tax growth.

Instead of $1.4 million, the original $25,000 investment would grow to more than $2.2 million over the same 30 years. That's nearly $810,000 more (or 57%) in your pocket as a result of this tax cut. And that's assuming the growth rate stays the same. If, in fact, we find that an 18-month holding period fares even better than our old 12-month model, ladle on the gravy!

Stay tuned in the coming weeks as our researchers scurry about to fill in the blanks for a Foolish Four 18-month test, but based on what we know today, extending the holding period to 18 months and getting a 29% tax cut on capital gains should prove a huge advantage for Dow investors in the future.

For those of you using the approach in IRAs, you may even consider extending the holding period to 18 months as well. It won't make a difference in terms of taxes, but the research suggesting that 18 months is the optimal holding period might mean better gains in that tax-deferred account as well -- the best of both worlds.

Monthly Growth Screens
(Jan. 3 to present)
67.54%  Relative Strength  
33.15%  Investing for Growth  
23.80%  S&P 500 Index  
23.05%  YPEG Potential  
18.57%  EPS Plus RS  
15.91%  Low Price/Sales 
14.86%  Unemotional Growth  
 6.17%  Formula 90  

Annual Value Screens
(Jan. 1 to present)
22.79%  Dow Jones Ind Avg  
21.57%  Dogs of the Dow  
18.39%  Dow Combo  
17.57%  Unemotional Value  
17.57%  Beating the Dow  
17.54%  Beating the S&P  
 9.98%  Foolish Four