Today’s menu

• Does anyone like paying tax?

• Capital gains tax

• Rebalancing the Extraordinary Companies portfolio

• Q&A

Does anyone like paying tax?

Ask around and it’s hard to find someone who likes paying tax.

If you are working person, you’ve felt the pain of income taxes. The first few hours of every work day is you working to pay the government. You only start earning for yourself, close to lunch time.

If you include all the other taxes payable throughout your life, you will quickly realise that more than half of what you earn will be paid in taxes. That means on every working day, you only start earning for yourself in the afternoon.

What to do?

How about using the tax rules to your advantage?

Capital gains tax (CGT)

You cannot avoid most taxes, but investing gives you the ability to choose when to pay some taxes. That can be quite powerful because you can put off paying taxes for decades.

In particularly, I am talking about capital gains tax.

You’ve heard of income tax. That is the tax you pay on your salary and there is no way to avoid it. It is due every year. Actually, it is probably taken from you every month.

Capital gains tax is different. This is the tax payable when you own an asset and sell it at a profit. Think about selling your house or your shares. If things go well, you are able to sell your shares at a higher price than what you paid. The profit is called a capital gain. And of course, the government wants its share of your boodle, so it created capital gains tax.

There are two defining characteristics of capital gains tax:

1. You only have to pay it when you sell an asset. That means you can decide when to pay this tax. If you don’t sell, there’s no tax.

2. You can offset gains with losses. That means if you have an equal gain in one stock and a loss in another stock, they can cancel each other out. That means no tax is payable.

Extraordinary investors have an advantage

The first characteristic of CGT relates to timing.

One of the advantages of being an Extraordinary Investor is that we look to buy companies that we can own for decades to come. That means we can control the timing around capital gains, to a large extent.

Other investors, such as value investors, don’t have the luxury of choice. If they purchase an undervalued stock and it’s price rises to fair value, they have to sell. If not, from there onward, they will obtain substandard returns or risk losing their gains.

Growth investors also have a challenge. They have to sell when growth slows down. If they don’t the earnings multiple at which they can sell will drop. From there onward, risk-adjusted returns can be substandard.

As Extraordinary Investors, we don’t have these problems. The companies we own generate extraordinary returns and we expect them to continue doing that for years to come. So we will get our returns by hanging onto the shares for a long time.

Tax-loss harvesting

The second characteristic of CGT relates to tax-loss harvesting. This is a tax strategy where you sell an investment at a loss to offset the gain on a different investment. Basically, you add the gain and the loss together and hopefully they cancel each other out.

Rebalancing the Extraordinary Companies portfolio

Here’s the Extraordinary Companies portfolio holdings and weights at the moment:

As you know, we are in the process of rebalancing the portfolio weights because Nvidia and Novo Nordisk are disproportionately high.

Novo had a terrible six months and is down. On the other hand, Nvidia is up. That gives us an opportunity to rebalance the portfolio using a tax-loss harvesting strategy.

As luck would have it, the gain from Nvidia and the loss from Novo Nordisk are pretty close in value. Therefore, if we sell them down in proportion, we can neutralise the capital gains tax effects.

This is beneficial, because if we were to only sell Nvidia at a gain, we would be out of pocket for the capital gains tax. In a different tax year, if we separately sold Novo at a loss, the taxman wouldn’t return any taxes to us for the loss. They would merely allow us to roll the loss over to another year.

So a gain has an immediate negative cash flow impact on you. But a loss doesn’t have a positive cash flow impact until some time in future when you have a gain to offset.

Conclusion

You will notice that the whole discussion around the portfolio rebalance has shifted from "are these great investments” to “how do we save taxes”.

Beware, its very easy for the focus to shift from investing to taxes. As an investor, your first consideration is always to make a good investment, even if it means paying more tax.

Paying tax is your badge of honour for being successful.

But in a case like this where the investment decision requires us to rebalance, you can look at secondary considerations (like tax) and optimise for it.

Before you do anything crazy, remember tax rules vary from country-to-country, so speak to your accountant before trying out a strategy.

Q&A

What is your favourite company in the portfolio?

It’s probably a tie between Microsoft and Visa. In software, the entire business world is dependent on Microsoft. Microsoft is the global standard. You can’t function without it.

In payments, Visa is the giant and the world depends on them. This is also true for Mastercard, but they are smaller than Visa. Owned separately, they are each a part of a duopoly but if you own both (like we do), then you own a monopoly.

What is your favourite company, not in the portfolio?

Ferrari. This is probably the world’s most iconic brand and because it is a highly visible brand everyone knows what it is. Little boys have Ferrari posters. Big boys dream of buying one. And everyone takes a look when a Ferrari drives by.

The brand was created from heritage and through Ferrari’s association with Formula 1. That is a competitive advantage which is not replicable by other car companies - at least not in our lifetimes.

If you have any Q&A questions, send them on email.