The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Oct. 29, 1997)

Scroll to the bottom for year-to-date Growth and Value Screen results.

With the success of the Keystone Portfolio approach over the last year, naturally some readers want to know what to expect from it if they choose to use it with a holding period of 18 months to capture the new lower capital gains rate.

My response, of course, is that I don't know. We have such little data so far on this approach, I hesitate to make any predictions. This is one big real-time experiment.

What data I do have from this single-year's beginning hasn't been promising for the extra six months, though. Let's look at some numbers.

The ten-stock Keystone Portfolio I started tracking at the end of June of 1996 gained 48% versus 32% for the S&P 500 Index after its first twelve months. Through yesterday's trading, if the same portfolio of ten stocks were still intact, the total gain for the nearly 16 months would only have risen to 51%. Meanwhile the S&P 500 has climbed to 37%. So the four months since the one-year anniversary have brought very modest additional returns for the aging Keystone holdings.

If we compare that to the gains for the new Keystone Portfolio that I began at the end of June this year, there's a remarkable discrepancy. The new group of ten has already gained 18% in the past four months while the S&P 500 Index has gained only 4%.

So by updating the portfolio after one year instead of waiting for the extra six months, your gains would total 75% instead of 51% (not accounting for taxes).

As for turnover, the two biggest winners from the previous year's portfolio (Intel and Microsoft) were carried over into the new year's group of ten, so those two big gains will be taxed at the lower 18-month rate anyway when they eventually fall out of the portfolio. The other eight stocks, all with lower gains than the two carried over, would be taxed at 28%.

In some cases, the after-tax return may well favor the shorter term cycle. For example, to achieve a 20% return after taxes at the 20% tax rate, you must have a pre-tax return of 25%. To achieve the same return with the 28% tax rate, you must achieve a pre-tax return of 27.78%, a gap of 2.78 percentage points. That gap widens a bit as the after-tax return you're trying to achieve rises.

So if updating every 12 months produces a few more points a year than the 18-month cycle does, in many cases you're better off with the shorter cycle after taxes. And since some of the biggest winners will ultimately get taxed at the lower rate anyway because they'll be in the portfolio in successive years, that gap between what's needed to break even is even narrower.

Now I have no way of knowing if this single example is indicative of what to expect regularly in terms of the difference in performance. I'm only pointing it out as an example where the higher tax rate may still be more attractive if the overall returns remain better on the 12-month cycle. This wouldn't surprise me, however, if it turns out to be the case, even for these large caps. Jim O'Shaughnessy found this to be true with his model that is based partly on Relative Strength. The jury's still out on the Dow Dividend Approaches since their slower cycles may actually favor the 18-month holding period, but for Relative Strength-based strategies, the extra six months may well weaken the returns. Stay tuned; we'll keep watching.

Monthly Growth Screens
(Jan. 3 to present)
79.11%  Relative Strength  
27.94%  Investing for Growth  
24.51%  EPS Plus RS  
22.88%  S&P 500 Index  
15.11%  Formula 90  
12.78%  YPEG Potential  
12.14%  Low Price/Sales  
12.07%  Unemotional Growth  

Annual Value Screens
(Jan. 1 to present)
21.89%  Dow Combo  
20.72%  Unemotional Value  
20.72%  Beating the Dow  
20.63%  Foolish Four  
19.81%  Dogs of the Dow  
19.64%  Beating the S&P  
16.41%  Dow Jones Ind Avg