Use access key #2 to skip to page content.

TMFPostOfTheDay (< 20)

Internal Compounders - Story of 2013?



November 08, 2012 – Comments (0) | RELATED TICKERS: BRK-A

Board: Berkshire Hathaway

Author: rationalwalk

At the risk of being repetitive, I believe that companies capable of strong internal compounding are almost sure to be favored by Mr. Market once the dust settles on the fiscal cliff and people figure out how valuable the deferred tax liability can be. A couple of examples:

Scenario 1: Top rate taxpayer. Capital gains tax rises from 15% to 23.8% (including the Medicare investment tax). Dividend tax rises from 15% to 43.4% (including the Medicare investment tax. The investor has $100,000 to invest. Company A can compound internally at 10% per year. Company B can earn 10% per year but cannot compound internally and pays a 10% dividend. The investor either purchases $100,000 of Company A and does nothing for ten years or purchases $100,000 of Company B and reinvests his after-tax dividend in new shares. After ten years, the shares are sold. Here are the scenarios:

The $100,000 investment in company A yields $221,443 after tax, a compound annual return of 8.3%. The $100,000 investment in company B yields $173,423 after tax, a compound annual return of 5.7%. That is a huge difference.

Scenario 2: Middle income taxpayer. Repeat Scenario 1 except the capital gains tax rises from 15% to 20% and the dividend tax rises from 15% to 28%. This is what the scenario looks like:

The $100,000 investment in company A yields $227,499 after tax, annualized compound return of 8.6%. The investment in Company B yields $200,423, a compound return of 7.2%. A very significant difference.

I have zero faith in the "efficient market" but even Mr. Market should be able to see this and adjust the valuation of companies capable of internal compounding accordingly. There are not many companies capable of compounding internally and they should be worth a premium in the upcoming tax regime.

Of course, Berkshire is one of the few companies with a demonstrated record of being able to compound internally due to the much derided "conglomerate" model that allows for shifting of capital between subsidiaries in a tax efficient manner. On a smaller scale, Markel is attempting the same model and is likely to achieve a higher internal rate of compounding vs. Berkshire if the attempt succeeds. Despite this, both trade at valuation levels near historic lows. 

0 Comments – Post Your Own

Featured Broker Partners