Wednesday, February 04, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Feb. 4, 1998) -- A number of readers have asked about the new tax laws for 18-month holdings, not only with the high-yield Dow stocks, but also with the growth approaches like Keystone. It's possible the best course will be different for the two types of approaches.

With the high-yield Dow stocks, some research points to a potential gain in raw returns by extending the holding period to 18 or 19 months. TMF Sandy is currently completing his own study on this issue, and in the near future (I won't promise any dates Bob can't meet), we'll have a good long-term comparison of the issue for the Dow Dividend approaches.

Keep in mind, though, that many of the Dow Dividend Approach stocks will stay in the portfolio for more than one year, even using the 12-month cycle. In those cases, of course, you would get the lower capital gains rate anyway. So my suspicion is that there's not going to be much practical difference either way on the Dow stocks. But we'll wait for Bob's research study before we make any definitive judgments.

For stock screens employing relative strength, however, the extra six months are probably not worth the tax savings. While I've only tested a few groups of stocks for this discrepancy, other researchers, including Jim O'Shaughnessy, have tested the differences in 12- and 18-month holding periods. What Jim found is that the returns slacked off enough in the final six months of the 18-month cycle that even after accounting for the lower tax rate, the after-tax returns were better using a 12-month cycle.

My much less scientific sampling pointed in the same direction for stocks selected in past Keystone groups. The turnover rate on Keystone is much higher than the Dow Approach rate, but even in Keystone a stock will occasionally stick around for a second year (especially if you're holding more than five of them). In those cases, of course, you'll get the lower tax rate anyway.

As always, the real test you must consider is the after-tax rate of return to you. Even if you end up paying more in taxes on a 12-month cycle, if it means you end up keeping more in the long run, that's better than saving on your tax bill by accepting lower after-tax profits. Don't hurt your own profits just to prevent Uncle Sam from collecting a few more bucks. If both you and the government get more, it's a pretty good plan. I'm no fan of taxes on investments, but my goal is optimal after-tax returns with a minimum of maintenance, not the lowest possible tax bill.

So, we'll hold off on pronouncing a final judgment on the Dow stocks' optimal holding period, but I haven't seen any evidence to suggest that extending the holding period for relative strength-based screens is a good idea.

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