Year-End Portfolio Prep

In mid-December, I generally take a little time with my portfolio to prepare for the year's end and line myself up for success next year. There are three primary areas I focus on: harvesting losses, rebalancing, and giving. Let’s have a look at each.

Harvesting gold from losses

Every year, there are stocks in my portfolio which went the wrong way and are now below my purchase price, dragging down my returns and putting red on my statements. It’s normal, it happens every year, and you should expect it of at least say, 30% of your stock picks. But there is one thing you can do to make lemonade from the lemons: you can harvest the loss on your taxes.

All that means is selling the negative position. You’ve then “realized” the loss—remember, stock moves are not taxable events until you sell them for a loss or a gain; all your returns are virtual until you sell. That loss will show up on your tax returns and will offset gains you’ve made elsewhere, both from assets sold for a profit and from regular income. So let’s say you have a stock which you bought for $1,000 which is only worth $600. If you sell by the end of the year, you’ll get $600 (minus trading costs), and the $400 you lost on that investment can be subtracted from your taxable income for that year, which reduces your overall tax bill. There’s no downside, and no catch.

There are, however, two limitations to careful of. The first is that you are restricted to a total of $3,000 in losses against your tax bill. Anything you sell beyond that amount of loss will be disallowed from offsetting your gains (but you can see your CPA about forwarding the loss in later years). The second is called the “wash-sale rule.” Basically, if you sell an asset for a loss and then repurchase the same asset or a nearly identical asset within 30 days, the IRS will disallow the loss. So make sure that, if you harvest a loss on a stock you like and intend to repurchase, you wait a month first. Details on tax loss harvesting can be found here and here.

Another useful annual ritual (I actually do this continually through the year) is a rebalancing of the assets you hold to realign your portfolio with your goals and risk tolerance going forward. The idea is to buy or sell equities specifically to reestablish the asset balance you intended to hold (stocks to bonds to gold, or technology to banking to pharmaceuticals). So if during the year you cashed in or sold a few bonds, and you are now theoretically underweighted in bonds, you would buy some to balance the scales. Or if one tech stock in particular rose dramatically this year (AMZN, NFLX), hypothetically you now hold more technology than you intended (and you have categorically more risk from having so much tied up with just one stock). So you would sell some off, or buy another asset to offset the tech you hold. If you’re not a regular buyer (and if you're reading this I hope you’re not a regular trader), and in fact you don’t look at the portfolio terribly often, rebalancing is good practice to ensure proper a comfortable and adequate allocation in your basket of assets. It will also help you to sleep better. Two great articles and some depth about rebalancing can be found here and here. 

Finally, I like to spend some time with my family choosing and giving to charities at the close of each year. When most people give to a non-profit, for the sake of simplicity they write a check or just put the gift amount on a credit card online. But did you know that many non-profits, particularly larger ones with more developed infrastructure and staff, accept gifts of stock directly? 

If you sell a stock during the year which has risen since your purchase, you’ll pay gains taxes on the sale. You can then use the proceeds from that sale to buy another stock, to pay for a trip or your children’s tuition or just to go shopping. If you use those proceeds for charitable giving, you’ve just paid capital gains tax on money you intend to give away, making your gift that much more expensive. You can still write off the dollar value of the charitable gift itself, but only that amount.

charity: water

If instead you give a non-profit an appreciated stock directly, you’ll pay no gains tax (you didn’t sell it, so you never realized the gain) and you can deduct the entire value of that stock from your taxable income. In other words, depending on your gains tax rate, most of us would save 15% right there. The charity gets a larger total amount, albeit in the form of a stock. And they can choose to hold those stock shares for future gains, or sell it themselves and pay no taxes. (For more on 2015 capital gains tax rates, look at this.)

So take a few minutes this weekend to look things over and make sure your assets are where you want them to be before the tax year closes. A little minor tinkering can save money and headaches later, and put you on the right road going into the new year.

Drifting to Fifty | Random unrelated nugget of the week

Don't fret over those sloppy holiday party guests: Mayonnaise spread thick on a wooden table over a condensation ring will absorb the moisture, clearing the ring. But it will happen slowly. 

Don't just do something! Stand there!!

In the summertime when I was a kid my mom would come into the family room and kick me off the TV. “Go outside. Go do something.” When we’re in school we’re told to work hard, get involved, do our homework, be productive. As adults at work we know we have to perform: tackle assignments, manage the team, track all tasks, host the meeting, complete the project, exceed expectations. At the gym. Around the house. In our communities. Constantly, everywhere, it’s all doing. We are never, never, never supposed to just sit there and do nothing.

Which means it’s all terrible training for investing. No wonder most people fail.

A huge percentage of investors—both hobbyist individuals and professional managers—suffer from action bias, which is the need for action over inaction. This is hardly a surprise given what we’re taught in every other aspect of our lives. So they’ll sell a stock when it falls, afraid it will never return or certain they can move the money to something which will only go up. Or they fear a company of which they own shares is overpriced, so they dump it. Or the nation is going to war, or the Federal Reserve is raising interest rates, or they read the future will be in gold, or real estate, or some financial TV loudmouth who is paid to make hyperbolic alarmist calls says to get out. So they sell everything. Which is the worst thing they can do: the stock market always rises—if we wait long enough.

Life is terrible training for investing. 
No wonder most people fail.

Just sitting there and watching your investments go up and down is really difficult.  We think we can do better. We think we can make our money grow faster. We heard a great stock tip, or a new investing concept, or a buddy is building an app and we can be millionaires. We want to do something to decrease our losses or increase our returns or at least protect ourselves from the crazy nauseating roller coaster ride.

But that’s just it. We have to wait. If we try to speed things up we will make mistakes, we will misjudge and risk and over-leverage. Warren Buffet has said “The stock market is a device for transferring money from the impatient to the patient.” He’s right, of course; he’s been investing for over 60 years. If we get impatient, we act. That’s how we’re built, how we’ve trained since birth: doing better means doing more. Which is false when it comes to investing.

To be clear, there is work to be done. But the lion’s share is at the start of the investment, when we are researching and tracking performance and trying to project forward to determine forthcoming success. We monitor not only the company under consideration but the market operates in, the competition it faces, the trends and buying habits of customers stretching into the future.

But once we pull the trigger and buy ownership in that business, we have to sit on our hands. We still keep up, of course: news reports, press releases, earnings and so on. But that’s it, the decision to become owners was already made. Now, we sit there and let the money we invested work for us. It’s not the same as school, or our work. It’s passive.

As my regular readers know, there are only 4 reasons to sell a stock:

1. The value of one company’s stock has grown so much that your portfolio needs to be rebalanced to reduce single-stock risk: I’ve sold off Apple shares close to a dozen times since 1997 in order to reduce the percentage of my portfolio in that one company.
2. The company you own did something that changes the thesis for ownership in the first place: 3D Systems (DDD) massively overestimated the consumer market for 3D printers, and sales have been shockingly bad; Research in Motion (Blackberry, BBRY) completely missed the transition from keyboards to touchscreen technology, and gave up over 60% of its customers in three years (click here).
3. One stock in your portfolio has been bouncing around below your purchase price for awhile, and you decide to sell for a loss in order to offset gains elsewhere in your tax return.
4. You’d rather have the money. 

Day-to-day price gyration—of the company or of the broader market—is not among the reasons. If you sell because you can’t stand watching a good company’s price drop, planning to reallocate the money elsewhere or, worse, to go shopping, you will miss on the gains to come later.

By way of example: I currently one stock in particularly bad shape: I bought GoPro (GPRO) in late July, and it’s down 60%. 

“The stock market is a device for transferring money from the 

impatient to the patient.” – Warren Buffett

Down 60%! you say. Why haven’t you given up on it!? I haven’t sold because, regardless of the market price of the stock, GoPro is an excellent company with something like 80% market share f or small cameras and years of solid profitability. It’s got smart managers and no debt and a great brand. It’s going gangbusters, share price be damned. If the company continues to grow and make money, the shares will come back. I might buy more. Isn’t that be the kind of business you want to own? 

The solution is just about never to jump in and take action. It’s to distract yourself however you can and sit tight. I know some individuals who only check on their holdings weekly, or monthly. I have one friend who only looks at his portfolio when the market is closed, preventing her from a knee-jerk sell order she would later regret. Whatever works for you: constant churn of a stock portfolio will destroy your returns over time. Better plan: go watch the game, learn a new recipe, play with your kids. The future will arrive soon enough.

My 6 Critical Investing Criteria

Nothing more worries individual investors than not knowing what to look for, and choosing the wrong companies to buy. How do I know when a stock is cheap? How do I tell if it will go up (or down) over time? 

But that doesn't work for me. I'm much more interested in what a stock will do tomorrow than in what it did yesterday-- and I don't believe I can learn much about tomorrow based on yesterday. Which means I have to find other ways to value the companies I buy. I need to look at non-financial criteria. I've written about this before. But because it gets so much investor attention and because it seems so difficult to people starting out, I'm going to revisit it here.

Most money managers try to steer an investment portfolio by looking in the rear-view mirror

1. First up, I want a great brand. By that I mean I want a company people have heard of, and one which dominates or nearly dominates an industry. Examples include Netflix and Apple. Sure some people gotta hate because these companies steamroll the competition (respectively: Cable TV/Blockbuster/neighborhood video rentals, and Microsoft/Dell/Gateway/Sony/Nokia/Blackberry...) but that's what makes them such compelling investments. These companies are so strong they redefine their category: it is no longer possible to have a realistic discussion about retail without mentioning Amazon, or about home video without Netflix. They change everything and as consumers we can either get on board or get out of the way. 

2. Second, I like to see a wide moat. Simply put, this is the distance between the business in question and the nearest competitor, which usually indicates the difficulty of the competitor catching up in the next few years. A good example is Starbucks. On the surface Starbucks sells a commodity-- coffee. But what makes them so valuable is they do it with panache: across a massive swath of the globe, at tremendous profit (remember when we thought $3 for a cup of coffee was crazy?) and they do it in their ubiquitous neighborhoody, comfortable, jazz-infused stores. Sure another business can mimic what they do-- and thousands have-- but Starbucks has such a massive head start and with worldwide brand recognition and a well-established level of quality product and service that no one can realistically catch them for years to come. 

Another great example of a wide moat is Visa. Almost regardless of where you travel, time of day, language spoken, or currency used, they take Visa. Even MasterCard can't catch up. And newer methods of payment-- ApplePay, PayPal-- are just alternative ways for most people of using their Visa card (both systems tie into an existing card account), and in any case are many years away from the level of saturation Visa has worldwide. 

3. Next, I'm looking for a business which is in strong growth mode. This one is obvious: a company whose sales are expanding rapidly year over year as they add new stores, or put out new products or services, or buy up their competitors (or kill them). It is nearly impossible to value these businesses financially based upon their past performance because in a lot of cases they're growing too fast for last year's numbers to mean much. For example, a division of Amazon called Amazon Web Services, or AWS, offers cloud computing services to other businesses (Netflix among them). AWS is only a few years old but it's currently growing at something like 80% per year. In time it could be worth more than the company's "traditional" ecommerce business. A number of other, more established technology companies have even abandoned the cloud services industry in the face of Amazon's juggernaut (Hewlett-Packard did that just that last week). Partially as a result, Amazon's stock valuation has increased over 100% in 2015 alone. That's a ride I want to be on. 

4. After that, I want a business with low debt. Typically, manufacturers have higher fixed costs for heavy equipment and materials, so they must borrow more for those items and maintain higher debt levels on their corporate books. By contrast, software companies and online services generally have much less need for serious capital (their highest costs are often their people) so they tend to carry less debt. (An exception to this is Apple, which contracts most of its manufacturing to offshore companies.) Generally speaking, a company with relatively little debt has a lower bar to clear to make a profit, and therefore has a much wider operating margin to work with. As a side benefit, businesses carrying little debt can usually better weather difficult economic climates or other sales downturns. 

Long Term Debt is a line item on any public company's Balance Sheet. This can easily be found on Yahoo! Finance by entering the company's name in the Quote Lookup field. Ideally (but not exclusively), Long Term Debt should total 25% or less of the company's annual revenues, which is available in the same location on Yahoo!, but on the company's Income Statement. 

5. The next has to do with the company's executive leadership. We want smart, transparent, confident leaders who are less interested in Wall Street analysts' quarterly expectations and more interested in long-term growth, product quality and customer service. You can read interviews, listen to conference calls with press, watch them on YouTube: are the executives of your business providing clear direct answers to questions posed? Are they worried about share prices or customer satisfaction? What do they say about competitors, about new technology, about growth plans? Do they come across as a little phony, a little slimy or more genuine and trustworthy? Do you believe them? Like them? 

Financial research and the news are added to my existing customer experience. Together they serve to enrich and deepen my knowledge

The most famous example of straight-talking, trustworthy leadership is Berkshire Hathaway's billionaire leader Warren Buffett. In his annual letters to shareholders, Mr. Buffett comes across as down-to-earth, honest, folksy and even funny. Whatever the business he's describing he tells is like it is, explaining how it works and why it's important as he goes along. Reading his letters is some of the best business education you can find, not to mention a model for others and entertaining to boot. 

6. Finally, I prefer businesses with which I have first hand customer experience. I've found it invaluable: how better to judge a business's performance than by being a consumer of their products and services over time? 

This one is a slightly higher hurdle because most of do business with only a handful of public companies  relative to the thousands worldwide in which we could invest. But in truth there is no shortage of investment opportunities just among those: manufacturers of toothpaste and paper towels, clothing and shoes, electronics and furniture, housing and automobiles, sporting goods and appliances. Makers of entertainment products like books, magazines, music, movies, television, video games. Service companies like utilities and cellular, cable and internet, shopping clubs and online retailers, banks and even brokerages. 

For example, I prefer Under Armour's athletic clothing to Nike's both for fit and durability, and have since I stumbled onto it about 10 years ago. I'm a huge fan of Amazon's Prime service, which is preferable for me rather than shopping around for vacuum filters that fit, or having the right gas grill shipped to my door. Despite living in Seattle my coffee snobbery has never advanced past Starbucks' fresh roasted espresso beans. I generally enjoy Disney's Marvel superhero movies. I've mentioned Netflix and Visa. Also there's LinkedIn and Twitter, IMAX and Zillow, all of which have come up with a great new business concept or revolutionized an everyday process like career networking or house shopping or movie-going.

By being a customer/user (even an unpaying one), I better understand the value proposition these businesses offer and I've already got a finger on their pulse. I notice when quality slides or new services are added, and this information informs my investment decisions. Financial research and the news I read are additional to my existing, ongoing customer experience. Together they work to enrich and deepen my knowledge.

This list of criteria has provided me close to 80% of what I need to know prior to investment-- but you likely will not find all 6 in one company very often. It happens, but those are rare. Look to get several in one stock. I've listed several of them here, but there are probably a couple of hundred if you look hard enough. This method is largely unscientific and non-financial, and therefore is an unconventional way of assessing a stock-- but then being somewhat contrarian is my nature. Some pro stock-pickers and market timers might poke fun at you; they certainly have at me. Generally speaking, however, my returns crush theirs... though I don't think they believe my numbers. A high-class problem if there ever was one. 

Drifting to Fifty | VOLKSWAGEN DECIEPT UPDATE

I've posted previously about Volkswagen's ginormous diesel engine deception and what it means for automakers, car owners, VW employees and much of Germany. But sadly this story is still going, just spiraling downward for the company, its customers, its government, and the pollution levels our planet is already struggling to absorb. 

Not only did VW install an emissions-test cheat device on 11 million 4-cylinder diesel engines sold in almost every country on earth, then lie about it for years to the testing authorities in each nation, unlawfully and irresponsibly permitting discharge of poisonous nitrous oxide (NO2) gasses at up to 40 times legal limits all over the globe. Heck, we knew all of that in September, but that's just the headline. Early this week we learned that the company likely substantially overestimated the mileage numbers and the carbon dioxide (CO2) emissions of many of its gasoline-engined cars as well. And yesterday we learned that most of VW's 6-cylinder diesels (including a Porsche and a number of Audi models), which were previously exempted from the cheat device findings, probably run the same tricky and illegal software. So now it's beginning to look as though every consumer vehicle engine made by Volkswagen in recent years either gets lousy mileage, or spews huge quantities of poisonous NO2, or dumps huge quantities of climate-warming CO2. Or two of the three. 

Oh, and there's this nugget: a new study in Environmental Research Letters shows that the additional pollution resulting from 500,000 U.S. cars which are worse contributors of poisonous NO2 than we thought will prematurely kill about 60 people, even if all the vehicles are fixed by the end of 2016. Which they won't be. And that's just in the U.S: there are another 11 million NO2-spouting VW diesels around the world.

This mess makes Enron look like a pack of unimaginative amateurs. 

And today it came out that our family car, which I had earlier thought escaped the cheat-device indictment, is among those affected. So we're joining our local jurisdiction's class-action lawsuit against Volkswagen. I am bitter and unforgiving. 

Thought you'd want to know.