Wednesday, July 16, 2014

Is What Warren Buffett And Charlie Munger Thought In 1996 Relevant Today?

I was looking at some past Chairman’s Letters from Berkshire Hathaway (penned by Buffett and Munger) and thought you might enjoy some insightful excerpts from the 1996 letter. What was relevant for intelligent investors eighteen years ago remains so today.

On Investment Fees

   “Seriously, costs matter.  For example, equity mutual funds incur corporate expenses - largely payments to the funds' managers - that average about 100 basis points, a levy likely to cut the returns their investors earn by 10% or more over time.  Charlie and I make no promises about Berkshire's results.  We do promise you, however, that virtually all of the gains Berkshire makes will end up with shareholders.  We are here to make money with you, not off you.”

(They are talking about actively managed mutual funds and the current average expense ratio for actively managed funds is about 1.3 percent or 130 basis points. Also worth noting, only 39 percent of active managers beat their benchmarks in 2012. So for the majority of investors in actively managed funds you not only made less than the average index fund investor you paid more for the privilege.)

On Taxes

   “In 1961, President Kennedy said that we should ask not what our country can do for us, but rather ask what we can do for our country.  Last year we decided to give his suggestion a try - and who says it never hurts to ask?  We were told to mail $860 million in income taxes to the U.S. Treasury.”

     “Here's a little perspective on that figure:  If an equal amount had been paid by only 2,000 other taxpayers, the government would have had a balanced budget in 1996 without needing a dime of taxes - income or Social Security or what have you - from any other American.  Berkshire
Shareholders can truly say, ‘I gave at the office.’”

     “Charlie and I believe that large tax payments by Berkshire are entirely fitting.  The contribution we thus make to society's well-being is at most only proportional to its contribution to ours.  Berkshire prospers in America as it would nowhere else.”

(This is not relevant to this blog post but with more U.S. companies changing domicile to foreign countries to avoid paying U.S. corporate taxes – which are the highest – I found Berkshire’s perspective interesting.)

On Common Stock Investments
“Our portfolio shows little change:  We continue to make more money when snoring than when active.”

     “Inactivity strikes us as intelligent behavior.  Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market.  Why, then, should we behave differently with our minority positions in wonderful businesses?  The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries.  In each case you simply want to acquire, at a
sensible price, a business with excellent economics and able, honest management.  Thereafter, you need only monitor whether these qualities are being preserved.”

“Let me add a few thoughts about your own investments.  Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”
     “Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering.  Intelligent investing is not complex, though that is far from saying that it is easy.  What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected":  You don't have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.”

     “To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets.  You may, in fact, be better off knowing nothing of these.  That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects.  In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.”

     “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.  Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock.  You must also resist the temptation to stray from your guidelines:  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.”

(To summarize their thoughts on common stock investments: Buy and hold with a long-term time horizon and unless you really know how to value a business and understand market pricing, buy index funds. I might add that using the services of an accredited advisor to help you reach your future goals and manage expectations with regard to financial planning and portfolio construction may be the best idea of all.)

CBlakely, CFP®             06/2014

Source: BERKSHIRE HATHAWAY INC., Chairman's Letter, 1996

Friday, April 11, 2014

Understanding the AMT

During tax time, using regular IRS rules you start with your gross income, subtract deductions and exemptions and eventually you arrive at your taxable income amount. Sounds simple unless your income is too high and you take too many deductions. Enter the Alternative Minimum Tax.

The Alternative Minimum Tax (AMT) is basically a simple flat tax system, the rate is 26 percent on the first $175,000 of income and 28 percent on anything above. You add up all your income, subtract the few allowable deductions, deduct the AMT exemption - which makes up for all the other forgone deductions - and viola you arrive at your taxable income. When you think about it, it really is much simpler than the current system in place.

But the reality is if you are exposed to the AMT you need to calculate your taxes under both the regular system then back out AMT adjustments and preference items, apply the AMT exemption, careful to note phase outs, and calculate your second tax liability. You end up paying the larger of the two.

When figuring AMT, even though some deductions still stand, including those for mortgage-interest and charitable donations, some key breaks are lost. They include: state and local income taxes and property taxes, child-tax credits and home-equity loan interest.

Everyone who files taxes is obligated to figure out whether they have to pay AMT (see line 45 on the 1040). The worksheet and Form 6251 can be difficult and time consuming which is why a significant majority of AMT payers hire a CPA professional. The first time most people hear about the Alternative Minimum Tax is when they get a letter from the IRS saying that they still owe money. To avoid this, check out "AMT Assistant," an online tool offered by the IRS that helps you determine whether you need to pay the AMT – if you decide to DIY.

There are some AMT planning strategies that should be examined to minimize your tax burden. Michael Kitces a CFP® and blogger who is well respected in the industry, noted in a recent blog post:
Under the regular tax system, good tax planning is relatively straightforward – since tax brackets just rise as income increases, the goal is to defer income when income is high (and the tax brackets will be high), and accelerate income when income is low (e.g., harvest it in the form of capital gains or Roth conversions, to avoid having too much income that drives the client into higher brackets in the future).

With the AMT, though, planning is different. In the case of the AMT, the system is a (relatively) flat tax system with only two brackets of 26% and 28%. Accelerating income isn’t necessarily helpful, and deferring income isn’t necessarily harmful, as the tax rates hardly vary anyway. However, one important nuance of the AMT system is that, as income rises, the large AMT exemption that “everyone” gets is itself phased out. Once the phaseout threshold is reached (at $117,300 for individuals and $156,500 for married couples, indexed annually for inflation), every additional $1 of income also phases out $0.25 of the exemption, which at a 26% - 28% tax rate is actually the equivalent of a 6.5% - 7.0% “surtax”.

As a result, taxpayers who are phasing out their AMT exemption actually face a “bump zone” of tax rates, as their AMT marginal tax rate jumps up to 32.5% and then 35%, before ultimately falling “back” down to 28% once the AMT exemption is fully phased out!

Given this unusual “bump” in marginal tax rates in the middle, AMT tax planning takes on a rather unique approach – simply put, the goal is to “avoid the bump” to the extent possible. If income is low, this means the best approach is to spread out or defer income, stay below the bump zone. However, if income is high, the best approach may actually be to accelerate income to avoid the bump zone in the future, since the top AMT rate remains ‘capped’ at maximum rate of only 28% (and 20% + 3.8% = 23.8% for capital gains at those income levels) once the exemption is phased out.

So as you prepare your taxes (or have then prepared) be on the lookout if your deductions and exemptions under the normal code are close the AMT exemption and also if your adjusted gross income changes significantly due to itemized deductions and exemptions. And as always, when in doubt, contact a certified professional.

CBlakely, CFP®    04/2014

Sources: NY Times, IRS, NerdsEyeView blog