One of Charlie Munger's mental models is to always analyze a problem by inverting it. When it comes to stocks, this means looking for reasons why you shouldn't invest in your favorite equities instead of seeking validation from others about what a great investment you made. Since Berkshire Hathaway (BRK.A) (BRK.B) is one of my largest holdings, I make sure to follow Charlie's advice and periodically examine the company from a critical perspective. This is especially relevant today, given that Berkshire's share price hasn't gone anywhere in the past five years. This doesn't matter to me since my position is a relatively recent one, but it's always good to try to figure out if the market knows something that you don't.
One idea that struck me recently is that ever since the Bush capital gains tax cuts were passed, Berkshire immediately became a less attractive investment opportunity for one reason: it's extremely tax-inefficient. Despite its tremendous move towards buying operating businesses instead of shares in publicly traded companies over the past decade, a significant percentage of Berkshire's book value still rests with its equity portfolio. After the Bush tax cuts, even investors in the highest income bracket pay only 15% capital gains tax. Meanwhile, Berkshire still has to pay the standard 35% corporate tax on any realized gains. Talk about a drag on performance! Buffett has always criticized hedge funds for being unable to outperform their benchmarks after charging their clients exorbitant fees, but Berkshire investments carry the biggest fee of all: corporate taxes.
This has to be one of the reasons why Buffett prefers dividend powerhouses like Coca-Cola (KO) and Procter & Gamble (PG): because intercorporate dividends receive a tax exclusion that makes Berkshire's effective tax rate on dividends something in the area of 10-15%, much less than the full 35% tax charged for capital gains, which receive no such exclusion. It's also one of the reasons why Buffett is so hesitant to liquidate his positions, even when they become vastly overvalued. In his 2004 shareholder letter, Buffett pretty much admitted that he may have erred in failing to sell some of his holdings during the great bubble when they were massively overvalued (KO peaked at a P/E over 76 in 2000). However, his mistake may have been much smaller than most people believe. Berkshire equities only incur a capital gains tax when those gains are realized, which means that even if the company's holdings become overvalued, Berkshire's unique tax position means that shareholders may be best served if Buffett hangs tight to his investments.
However, dividends won't protect Berkshire from the tax man forever. Buffett likes to say that his favorite holding period is forever, but the reality of competitive destruction in capitalist markets ensures that that will almost never be the case. After all, one of Buffett's biggest sells in the most recent quarter was Johnson & Johnson (JNJ), where more than 8 million shares were liquidated - clearly he felt that despite its status as a dividend champion, the healthcare giant wasn't a keeper. That's not very surprising since a series of corporate missteps (including massive product recalls) have resulted in essentially flat top and bottom line growth for the company over the past five years.
Another driving force may have been the fact that JNJ, unlike Berkshire's other holdings, hasn't appreciated all that much in the time Berkshire has owned it. As of last year, JNJ's cost basis was $2.75 billion, and it had a market value of $2.78 billion. The government didn't get much revenue from that sale, which may have been why it was so easy for Buffett to make it. When we look at holdings like Coca-Cola, which has a cost basis of $1.3 billion on a market value of $13 billion, and Procter & Gamble, which has a cost basis of $464 million on $4.6 billion, it quickly becomes apparent why Buffett would be hesitant to sell, even when these companies become overvalued.
What does any of this have to do with the Bush tax cuts? Well, the discrepancy, or spread between Berkshire's tax rate and the individual Berkshire investor's tax rate is the hurdle the company must overcome in order for its investments to generate shareholder value. Not only must Berkshire's equity portfolio outperform the S&P 500, it must outperform the index by a margin equal to the difference between its own corporate tax rate and the capital gains tax rate of its shareholders. Otherwise, shareholders would be best served by Berkshire paying out its earnings as a dividend rather than reinvesting them. This spread between the corporate tax rate and the individual tax rate has become much, much larger since the Bush tax cuts. I believe that this is one of the factors that have been keeping Berkshire's share price suppressed over the past few years. However, these tax cuts are due to expire soon. When they do, the spread will narrow, and Berkshire will suddenly become a more attractive investment opportunity, especially for those in the highest income brackets.
This development affects not only Berkshire, but also its largest equity holdings, including KO, PG, and JNJ, so shareholders in these stocks should stay vigilant. These companies will experience the same phenomenon, except in reverse. Ever since the capital gains tax rate was lowered, fans of Buffett's equity portfolio were better served investing in his holdings directly instead of buying Berkshire itself (though of course there were other reasons to buy Berkshire, such as its large collection of operating businesses). However, once these tax cuts expire, Buffett copycats with money tied up in Coke, P&G, etc will find that it's in their best interest to redeploy their capital into Berkshire instead. Considering Buffett's enormous popularity and the legions of copycats he has inspired, there will no doubt be an exodus of funds out of his major equity positions and into Berkshire, though the full extent and impact of this movement cannot be predicted.
Buffett is aware of the tax disadvantage he has been saddled with by incorporating his company. This was not a problem when Berkshire was still young and agile, and Buffett could outperform the market by such vast margins that the extra taxes he had to pay became irrelevant. But things have changed now that Berkshire has become such a juggernaut. Buffett himself admits that returns on investment going forward will not be nearly as good as returns in the past, and he would be satisfied if Berkshire outperformed the S&P by only a few percentage points. Net of taxes, those few extra percentage points may become no outperformance at all. Always mindful of effective capital allocation practices, Buffett has seen this problem coming a long time ago, which is why Berkshire has been redeploying its focus towards acquiring entire operating businesses instead of buying equities. Earnings from wholly-owned subsidiaries don't get hit with a double tax the way equity positions do. When Buffett does buy public companies, he prefers to acquire the entire operation for the same reason, like he did with Burlington and Lubrizol. In any case, I believe that in time, the tax concerns I've raised in this article will become irrelevant as Berkshire eventually transforms into a company made up of almost entirely wholly-owned subsidiaries. Until that day comes, taxes will continue to influence Berkshire's business dynamics in a way that all Berkshire shareholders should be aware of. After all, it was Buffett himself who has always emphasized that investors must be aware of their frictional costs, whether they be taxes, fees, or commissions.