Investment QuotesPortfolio ManagementWarren Buffett

Buffett on Taxes (1965 version)

“One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.” – Warren Buffett, 1965 BPL Partnership Letter

I’ve read a few things lately discussing the benefits of designing a “tax-efficient” investment strategy. I’ve said this before, but I think there is a significant misunderstanding on the tax benefits of a low-turnover portfolio, and there is an even larger misunderstanding on the concept of turnover itself.

I’ve commented on portfolio turnover previously—turnover is neither good nor bad. It gets a bad connotation—especially among value investors—because many people think higher turnover (and more investment decisions) leads to hyperactivity and trading—and eventually results in investment mistakes. While this may be true in many cases, investment mistakes are not due to turnover—they’re due to making investment mistakes, plain and simple. I do believe that too many decisions may lead to this result—and I’m a fan of concentration and a relatively small number of stocks in my portfolio. But it is really important to understand—turnover in and of itself is neither good nor bad.

In fact, as I’ve said in a previous post, turnover is one of the key factors of overall portfolio performance. Just like a business (assuming a given level of tax rates, interest rates, and leverage) achieves its return on equity by two main factors—asset turnover and profit margins—so too does the return on equity (or CAGR) of an investment portfolio get determined by these two factors.

But this post is not about turnover, it’s about taxes. I bring this up because often I find investors lamenting the issue of taxes—especially when it comes to capital gains on their investment portfolio.

I have some thoughts on this topic of taxes and turnover, which I’ll share in the next post. I was going to reference a short passage of the 1965 Buffett partnership letter where he addresses this very same issue. But I thought I’d just post a slightly condensed version of the whole passage here, because I think it’s a good concept to think about.

Here are a few passages that I pieced together from the 1965 Buffett commentary on taxes (emphasis mine):

“We have had a chorus of groans this year regarding partners’ tax liabilities. Of course, we also might have had a few if the tax sheet had gone out blank.

“More investment sins are probably committed by otherwise quite intelligent people because of “tax considerations” than from any other cause. “One of my friends—a noted West Coast philosopher—maintains that a majority of life’s errors are caused by forgetting what one is really trying to do.”…

“Let’s get back to the West Coast. What is one really trying to do in the investment world? Not pay the least taxes, although that may be a factor to be considered in achieving the end. Means and end should not be confused, however, and the end is to come away with the largest after-tax rate of compound. Quite obviously if the two courses of action promise equal rates of pre-tax compound and one involves incurring taxes and the other doesn’t, the latter course is superior. However, we find this is rarely the case.

It is extremely improbable that 20 stocks selected from say, 3000 choices are going to prove to be the optimum portfolio both now and a year from now at the entirely different prices (both for the selections and the alternatives prevailing at a later date. If our objective is to produce the maximum after-tax compound rate, we simply have to own the most attractive securities obtainable at current prices. And, with 3,000 rather rapidly shifting variables, this must mean change (hopefully “tax-generating” change).

“It is obvious that the performance of a stock last year or last month is no reason, per se, to either own it or to not own it now. It is obvious that an inability to “get even” in a security that has declined is of no importance. It is obvious that the inner warm glow that results from having held a winner last year is of no importance in making a decision as to whether it belongs in an optimum portfolio this year.

“If gains are involved, changing portfolios involves paying taxes…

“I have a large percentage of pragmatists in the audience so I had better get off that idealistic kick. There are only three ways to avoid ultimately paying the tax: 1) die with the asset—and that’s a little too ultimate for me—even the zealots would have to view this “cure” with mixed emotions; 2) give the asset away—you certainly don’t pay any taxes this way, but of course you don’t pay for any groceries, rent, etc.. either; and 3) lose back the gain—if your mouth waters at this tax-saver, I have to admire you—you certainly have the courage of your convictions.

“So it is going to continue to be the policy of BPL to try to maximize investment gains, not minimize taxes. We will do our level best to create the maximum revenue for the Treasury—at the lowest rates the rules will allow.”

Buffett ends the section with a tongue-in-cheek reference to the “tax-efficient” funds of his day:

Buffett Tax Table

I thought these were interesting comments—especially regarding Buffett discussing “changing portfolios”, i.e. portfolio turnover. A portfolio of stocks one year will almost certainly not be the same optimum portfolio with the same risk/reward the next year. This implies that the portfolio should be more dynamic—always hunting for value.

Buffett doesn’t operate this way now, but it’s by necessity not by choice. There is only so much you can do when your stock portfolio is over $100 billion. But in the partnership days, there was higher turnover, higher taxes, and higher returns.

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6 thoughts on “Buffett on Taxes (1965 version)

  1. Sure; when you’re picking up cigar butts, and you’ve gotten that free puff out of them, there’s no point in holding onto what remains, taxes or no. The opportunity cost from tying up one’s capital in such low-profitability businesses greatly outweighs the cost from the taxes incurred. I am sure, though, that even if one of the cigar butts gave him the free puff in, say, nine months, he’d have held onto it another three months to get long-term capital gains instead of short. (Assuming, of course, that the tax code made that distinction back then.) That’s probably a serious part of what he meant by, “a factor to be considered in achieving the end.”

  2. Great post! My comment, however, is about expressing the hope that you will dedicate a blog entry to analyzing the metric of “P/E forward”: how should it be used, what metrics should contextualize it, how reliable a metric is it?

    Whereas I like to buy undervalued stocks, I am not comfortable with the concept of waiting 3-5 years until a stock “recovers”, so I place some weight on “P/E forward” as an indication of good returns over the shorter horizon of 12-18 months ahead. With that in mind, recently I bought the Brazilian electricity company CIG (ticker), with a P/E fwd of 2.75 (EV/EBIT 4.15 & ROC Greenblatt of 95.24%).

    1. I’d imagine a forward P/E is as accurate as analysts’ estimated future earnings, so best case “not very helpful” and worst case “purposefully deceptive.”

    2. Hi Giselda, The “forward P/E” is really nothing more than a collection of analyst estimates for next year’s earnings. I would put no weight (or maybe very little weight) on what other analysts think about a company I’m looking at. Basically, your job as an investor is to come up with your own “forward P/E”. In other words, you need to try and figure out what the earning power of the business is, and then decide how much that is worth. Determining this earning power is not really a mechanical formula, but it depends on a variety of factors that vary from business to business. There are certain mechanical strategies out there that have shown to be successful (such as buying a diversified basket of low PE stocks or Greenblatt’s magic formula), but I would look at each individual business on its own and try to come up with a value. Hope that helps some…

      1. “The “forward P/E” is really nothing more than a collection of analyst estimates for next year’s earnings.”

        Some companies offer guidance on forward earning projections, in those cases you have management projecting forward earnings. I would give a lot of weight to those, especially if management has proven trustworthy by having a long track record of fairly accurate guidance.

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