Seeking Alpha

Building A Portfolio Of Zero-Dividend Stocks

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Includes: BRK.A, BRK.B
by: Anson J. Glacy Jr. CFA
Summary

It is possible to construct a zero-dividend portfolio.

A portfolio of zero-dividend stocks can possess advantages over funds.

The key tradeoff surrounds tracking error vs. the tax benefits involved.

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Key Points

A diversified portfolio of zero-dividend stocks can confer significant advantages over mutual funds or exchange-traded funds (ETFs). It has long been an article of faith that investors should focus primarily on investing fundamentals and make tax considerations secondary. Yet, when the aggregate of all taxes inflicted upon capital can approach 100%, a reasonable observer might conclude that the risk posed by taxation exceeds that posed by the capital markets themselves.

Abstract

Using Portfolio Visualizer (an online suite of portfolio analysis tools) I will describe methods for constructing a portfolio of zero-dividend stocks, keeping diversification and tracking error in view. Results show that it is possible to capture more than two-thirds of the S&P 500 (SPX) performance over the past fifteen years using parsimonious subsets of zero-dividend-paying stocks present in the SPX index. Unsurprisingly, Berkshire Hathaway (NYSE:BRK.A)(BRK.B), a diversified holding company with presence in multiple market sectors, forms the core of the strategy.

Introduction

Individual investors seeking to build long-term wealth face many challenges. It has long been an article of faith that such investors should focus primarily on investing fundamentals and make tax considerations secondary. Yet the aggregate of all taxes inflicted upon capital can approach 100%:

  • Corporate income tax the company pays (21%)
  • Individual ordinary income taxes, federal and state (49.3% max in California)
  • Income taxes on up to 85% of Social Security benefits
  • Capital gains taxes (20%)
  • Medicare (IRMAA) tax surcharges
  • The Net Investment Income Tax (3.8%)

This list does not include threatened tax increases that may accompany a change of administration in Washington, D.C. Perhaps a reasonable observer might conclude that the ability to remain fully invested, by minimizing depletion of balances due to taxation, may be a more important investing consideration than issues of asset allocation, rebalancing, trading cost containment et al.

A diversified portfolio of zero-dividend stocks can confer significant tax advantages over mutual funds or exchange-traded funds, above and beyond avoiding fund fees that could reach 1% per annum or more. These tax advantages can include:

  • All distributions receive long-term capital gains tax treatment.
  • Ability to choose timing of distributions, avoiding inconveniently timed dividends.
  • 100% tax-deferred compounding within the portfolio.
  • Unfettered ability to harvest tax losses to offset capital gains and ordinary income.
  • Step-up in cost basis at death.
  • Avoidance of the Net Investment Income Tax (3.8%).
  • Ability to stay within Medicare (IRMAA) income limits.
  • Absence of dividend reinvestment trading costs.

By holding individual zero-dividend stocks, an investor can defer investment taxes indefinitely and regain control of her taxable income. Were the investor to hold mutual funds or exchange-traded funds, she would lose control to the fund manager of the realization of capital gains and losses. More importantly, she would not get to deduct internal fund losses initiated by the fund manager that exceed internal fund gains. Funds with high turnover are especially egregious offenders.

Furthermore, amassing a growing portfolio of capital gains over the long term delivers to heirs a step-up in cost basis at the investor's demise. In other words, a tax rate of 0% on those moneys. She will have adroitly utilized all capital losses, have the original cost basis from the stocks at no tax, leaving nothing but unrealized capital appreciation to heirs at step-up time.

Investor Suitability

The objective of this strategy is to defer the payment of taxes for as long as possible. This necessarily means deferring the realization of capital gains and dividends that would incur taxation. Therefore, the strategy is suitable for individuals using taxable distributions from deferred compensation and tax qualified plans as their primary source of household income.

To the extent such distributions are in excess of household needs, individuals could direct moneys to a Roth (IRA). For example, a married couple taking distributions equal to the 2019 Medicare (IRMAA) income limit ($170,000) would incur a tax rate of 13.8% under the 2017 Tax Cuts and Jobs Act, which expires in 2025. A year-by-year program of partial Roth conversions up to the annual IRMAA limit would be a powerful way to liberate pre-tax dollars at generationally low tax rates.

This strategy avoids the use of mutual funds and exchange-traded funds in order to regain control of realized capital gains and losses from fund managers, letting the investor once again enjoy the full tax benefit of incurred losses. Again, mutual funds and exchange-traded funds cannot pass along net internal losses to shareholders. Individuals adopting a strategy of building and maintaining a portfolio of zero-dividend stocks would have to be adept at managing their tax loss positions. This is not a "set it and forget it" type of investment strategy.

Methods

Portfolio Construction - Part 1

About 80 of the stocks in the SPX do not pay dividends. Nine of these stocks have a recent market cap of greater than $50 billion and at least a fifteen-year track record (from September 2004 to June 2019). These are:

Ticker

Company

Market Cap (000)

June 2017

GOOGL

Alphabet Class A

$682,482,752

AMZN

Amazon Inc.

$479,767,648

BRK.B

Berkshire Hath Hld B

$412,510,016

CELG

Celgene Corp.

$104,871,936

ADBE

Adobe Systems Inc.

$71,934,328

NFLX

Netflix Inc.

$68,106,624

CRM

Salesforce Inc.

$63,038,956

BIIB

Biogen Inc.

$59,881,960

REGN

Regeneron Pharmaceutical

$54,987,008

Source: Data taken from Dividend.com.

Using Portfolio Visualizer's Match Factor Exposure regression tool, the author created parsimonious selections of the nine stocks to see how closely he could mimic the historical performance of the SPX.

# of

Positions

Tickers

R-Squared

1

BRK.B=100.00%

34.3%

2

BRK.B=66.54%, ADBE=33.46%

58.9%

3

BRK.B=54.13%, ADBE=30.59%, CELG=15.28%

64.9%

4

BRK.B ADBE CELG GOOGL

67.8%

5

BRK.B ADBE CELG GOOGL AMZN

69.9%

6

BRK.B ADBE CELG GOOGL AMZN BIIB

70.6%

7

BRK.B ADBE CELG GOOGL AMZN BIIB CRM

71.4%

8

BRK.B ADBE CELG GOOGL AMZN BIIB CRM REGN

71.4%

Source: Author

Unsurprisingly, BRK.B, a diversified holding company with presence in multiple market sectors, forms the core for the portfolio. These results show that a three-stock clone captured about two-thirds of the variation in the SPX. By adding additional zero-dividend stocks with market caps below $50 billion it is possible to achieve a 90% R-squared.

Portfolio Construction - Part 2

Alternatively, one can optimize the nine stocks using prospective return expectations. Using observed betas it's possible to back into CAPM-based return expectations:

ERi = Rf + βi (ERm - Rf), where

ERi = expected return of stock i

Rf = risk-free rate

βi = beta of stock i

ERm = expected return of market

(ERm - Rf) = market risk premium.

Ticker

Observed Beta

September 2004 to June 2019

CAPM Return Expectation

GOOGL

1.02

6.24%

AMZN

1.20

6.99%

BRK.B

0.59

4.45%

CELG

0.88

5.66%

ADBE

1.42

7.91%

NFLX

0.98

6.08%

CRM

1.50

8.24%

BIIB

0.86

5.58%

REGN

1.12

6.66%

Source: PortfolioVisualizer; Author

At June 2019 the implied market risk premium was 4.16% and the assumed risk-free rate was 2.00%.

Maximizing the Sharpe Ratio produces a portfolio with an expected alpha of 13 bp, a Sharpe Ratio of 0.24 and a beta of 1.02. By contrast, using market weights produced an alpha of -3 bp and a Sharpe Ratio of 0.20. Further, giving up 16 bp of return reduced Maximum Drawdown from 37% to 22%.

Ticker

Maximize Sharpe Ratio

Minimize Maximum

Drawdown (@6%)

GOOGL

10.35%

4.66%

AMZN

4.72%

BRK.B

30.20%

35.10%

CELG

11.71%

12.30%

ADBE

27.57%

NFLX

24.00%

CRM

9.62%

BIIB

4.96%

7.67%

REGN

0.88%

16.26%

Source: Author

Potential Pitfalls

Once an investor has achieved satisfactory levels of diversification or index tracking, there are some pitfalls she could face. Companies could start paying dividends. (As of this writing, it appears that CELG will be acquired by Bristol-Myers Squibb (NYSE:BMY), a dividend-payer.) The prospect of BRK.B commencing dividends would be a blow to a parsimonious zero-dividend portfolio strategy, but not a fatal one.

Changes in the tax code cut both ways. For example, Congress eliminating the concept of "qualified" dividends would make the zero-dividend portfolio concept even more compelling. On the other hand, Congress could begin taxing unrealized gains, introduce a wealth tax or eliminate the step-up basis. These would indeed be fatal to the strategy.

Conclusions

It is possible to reap the benefits of a zero-dividend portfolio through a careful selection of individual stocks. BRK.B would form the core of the portfolio due to its size and presence in multiple market sectors. But BRK.B has minimal exposure to energy, healthcare, real estate and commodities, leaving other zero-dividend stocks to "fill in the holes."

But suppose an investor chose BRK.B as her sole taxable holding (and the company committed to maintain its zero-dividend policy) - the investor would thereby be alchemizing the earnings on Berkshire's many businesses into distributions taxed at either the long-term capital gains rate (20%) or 0% to her heirs. BRK.B "captures" about a third of the SPX, so the investor would have to feel comfortable that the prospective tax advantages of making BRK.B her sole holding is worth the tracking error involved. The fact that BRK.B exhibits a beta of 0.59 probably would be an additional compensatory consideration.

References

DeMuth, Phil. High bracket investors should avoid mutual funds and ETFs. Forbes. April 25, 2016.

Ibid. High bracket investors should avoid mutual funds and ETFs - Part Two. Forbes. May 2, 2016.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.