Author Archives: Scalper1

Tax Loss Harvesting And Wash Sales

Whenever you have significant losses in a taxable account, you should consider tax loss harvesting, selling those losses as a part of tax planning and then buying a placeholder security for 30 days. Capital losses can offset capital gains or can give you a capital loss which you can report on your tax return . Up to $3,000 of losses each year can be taken as a deduction to reduce ordinary income each year. Capital losses, which are not used in one year, can be carried forward indefinitely to be used in future years. The Internal Revenue Service (IRS) prohibits a taxpayer from claiming the loss on their taxes if they buy a substantially identical security within 30 days before or after the sale. Selling Apple (NASDAQ: AAPL ) stock on Monday and buying it back on Friday, for example, triggers the wash sale rules. In that case, the loss which you attempted to realize on Monday must be applied to the cost basis of the stock purchased on Friday, giving you none of the capital loss benefits. As an example, suppose you owned stock with a cost basis of $60 per share and sold it for a loss at $40 per share. The stock starts to move back up and you repurchase it too quickly at $50 per share. Instead of receiving a $20 per share realized capital loss, you would have to assume a cost basis on your new stock of $70 so that you have transferred the loss to your new purchase. Something similar happens when you purchase a stock on Monday and then try to sell an identical position for a loss on Friday. As an example, suppose you owned stock with a cost basis of $60 per share. On Monday, you purchase a similar position at a cost of $40 per share. Then the stock price rises to $50 per share. On Friday, you sell the first position for what is now a $10 per share loss. Instead of receiving a $10 per share realized capital loss, you would have to add that back to the cost basis of the stock purchased on Monday. Monday’s purchase would now have a cost basis of $50 per share and coincidentally be trading at $50 per share. The $10 unrealized gain would be negated by the $10 transferred loss from the wash sale. The computation of wash sale cost basis adjustments can be complex to follow. That being said, the stock of one company is not “substantially identical” to a stock in a different company, regardless of the two companies. However, contracts or options on a stock are considered substantially identical to the stock itself, and preferred stock which is convertible into common stock without any restrictions may also be considered substantially identical. To avoid the wash sale rules while still harvesting the gains, you could just wait the 30 days to buy the security back. However, when a position has a loss can be one of the worst times to miss being invested in it. Assuming it is part of a brilliant investment plan, you would like to realize the loss and still remain invested in it or something very similar to experience any rebound that may occur. There are several ways to remain invested in something which is very similar but not substantially identical. At Schwab, wash sales are computed automatically and cost basis adjusted for securities which have identical symbols. For securities which have different symbols, they assume that such investments are not substantially identical. Early on, we wrote an article on the fund selection choice between the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ) and the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ). Both are good choices and their returns are extremely highly correlated. While the investments are very similar, they are not substantially identical. They follow two different emerging markets indexes. The number of holdings differs by 177 stocks. One invests 14% in South Korea and the other one invests nothing. One expense ratio is over four times that of the other. While the IRS has never issued a ruling, I am comfortable stating that for any of these reasons the two funds are not “substantially identical.” The wash sale rules were written prior to the advent of mutual funds and exchange-traded funds and the IRS has never pursued investors for changing investments which have some overlap of underlying funds. For this reason, it is nice to have two different investments for each sector of your asset allocation. You can sell EEM for a tax loss and buy VWO the same day to remain invested in the sector. Investments which are similar enough to stay invested do not have to be as similar as EEM and VWO. Any fund with a relatively high correlation will help maintain investment returns for the 31-day wash sale waiting period. But what if you prefer one investment selection for a category above all the others? In this case, you have to wait 31 days between your buy and sell. You have two options. First, you could sell the original position for a loss and allow the proceeds to wait for 31 days out of the markets until you can buy back into the identical position. Or second, you can buy more of the position and have twice what you would normally have for 31 days before you sell the original position for a loss. Wash sale rules need to be followed when realizing capital losses for taxes. They can be burdensome to track and monitor when you are trading on your own and are therefore another way an investment advisor can add value to your portfolio management.

Avoiding Cigarette Butts

Too many investors hang their hat on investments that seem “cheap”. Unfortunately, too often something that looks like a bargain turns out to be a cigarette butt from which investors are hoping to take a last puff. As the old adage states, “you get what you pay for,” and that certainly applies to the world of investments. There are endless examples of cheap stocks getting cheaper, or in other words, stocks with low price/earnings ratios going lower. Stocks that appear cheap today, in many cases turn out to be expensive tomorrow because of deteriorating or collapsing profitability. For instance, take Haliburton Company (NYSE: HAL ), an energy services company. Wall Street analysts are forecasting the Houston, Texas based oil services company to achieve 2016 EPS (earnings per share) of $0.32, down -79%. The share price currently stands at $37, so this translates into an eye-popping valuation of 128x P/E ratio, based on 2016 earnings estimates. What has effectively occurred in the HAL example is earnings have declined faster than the share price, which has caused the P/E to go higher. If you were to look at the energy sector overall, the same phenomenon is occurring with the P/E ratio standing at a whopping 97x (at the end of Q1). These inflated P/E ratios are obviously not sustainable, so two scenarios are likely to occur: The price of the P/E (numerator) will decline faster than earnings (denominator) The earnings of the P/E (denominator) will rise faster than the price (numerator) Under either scenario, the current nose-bleed P/E ratio should moderate. Energy companies are doing their best to preserve profitability by cutting expenses as fast as possible, but when the product you are selling plummets about -70% in 18 months (from $100 per barrel to $30), producing profits can be challenging. The Importance of Price (or Lack Thereof) Similarly to the variables an investor would consider in purchasing an apartment building, “price” is supreme. With that said, “price” is not the only important variable. As famed investor Warren Buffett shrewdly notes, the quality of a company can be even more important than the price paid, especially if you are a long-term investor. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” The advantage of identifying and owning a “wonderful company” is the long-term stream of growing earnings. The trajectory of future earnings growth, more than current price, is the key driver of long-term stock performance. Growth investor extraordinaire Peter Lynch summed it up well when he stated, ” People Concentrate too much on the P, but the E really makes the difference.” Albert Einstein identified the power of “compounding” as the 8th Wonder of the World, which when applied to earnings growth of a stock can create phenomenal outperformance – if held long enough. Warren Buffett emphasized the point here: “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” Throw Away Cigarette Butts I have acknowledged the importance of aforementioned price, but your investment portfolio will perform much better, if you throw away the cigarette butts and focus on identifying market leading franchise that can sustain earnings growth. The lower the growth potential, the more important price becomes in the investment question. (see also Magic Quadrant ) Here are the key factors in identifying wining stocks: Market Share Leaders : If you pay peanuts, you usually get monkeys. Paying a premium for the #1 or #2 player in an industry is usually the way to go. Certainly, there is plenty of money to be made by smaller innovative companies that disrupt an industry, so for these exceptions, focus should be placed on share gains – not absolute market share numbers. Proven Management Team : It’s nice to own a great horse (i.e., company), but you need a good jockey as well. There have been plenty of great companies that have been run into the ground by inept managers. Evaluating management’s financial track record along with a history of their strategic decisions will give you an idea what you’re working with. Performance doesn’t happen in a vacuum, so results should be judged relative to the industry and their competitors. There are plenty of incredible managers in the energy sector, even if the falling tide is sinking all ships. Large and/or Growing Markets : Spotting great companies in niche markets may be a fun hobby, but with limited potential for growth, playing in small market sandboxes can be hazardous for your investment health. On the other hand, priority #1, #2, and #3 should be finding market leaders in growth markets or locating disruptive share gainers in large markets. Finding fertile ground on long runways of growth is how investors benefit from the power of compound earnings. Capital Allocation Prowess: Learning the capital allocation skillset can be demanding for executives who climb the corporate ladder from areas like marketing, operations, or engineering. Regrettably, these experiences don’t prepare them for the ultimate responsibility of distributing millions/billions of dollars. In the current low/negative interest rate environment, allocating capital to the highest return areas is more imperative than ever. Cash sitting on the balance sheet earning 0% and losing value to inflation is pure financial destruction. Conservatism is prudent, however, excessive piles of cash and overpaying for acquisitions are big red flags. Managers with a track record of organically investing in their businesses by creating moats for long-term competitive advantage are the leaders we invest in. Many so-called “value” investors solely use price as a crutch. Anyone can print out a list of cheap stocks based on Price-to-Earnings, Enterprise Value/EBITDA, or Price/Cash Flow, but much of the heavy lifting occurs in determining the future trajectory of earnings and cash flows. Taking that last puff from that cheap, value stock cigarette butt may seem temporarily satisfying, but investing into too many value traps may lead you gasping for air and force you to change your stock analysis habits. DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in HAL or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.