Sector Model

XLE

2.10%


Full Model

Date

Return

Days

PWR

3/9/2015

16.55%

153

CBI

4/2/2015

9.36%

129

MTZ

4/9/2015

14.60%

122

DRQ

5/15/2015

23.49%

86

RES

5/19/2015

18.65%

82

SPN

5/28/2015

27.85%

73

NOV

6/23/2015

19.18%

47

INT

7/7/2015

14.67%

33

AHC

7/28/2015

12.42%

12

FFIC

8/3/2015

1.73%

6

(Since
5/31/2011)


S&P

Annualized

10.93%


Sector Model

Annualized

20.98%


Full Model

Annualized

13.54%


S&P

Total

54.44%


Sector Model

Total

122.15%


Full Model

Total

70.26%


Sector Model

Advantage

10.05%


Full Model

Advantage

2.61%


Previous

2015


S&P

53.06%

0.91%


Sector Model

142.84%

8.52%


Full Model

101.13%

15.35%

Now we come to the time for wondering just what the point
can be when after four years of effort the Full Model has collapsed so
spectacularly that it is nearly as bad as the S&P. To make matters worse, taxes will eat away
any alpha that was left, leaving a simple holding of SPY superior to many hours
of effort.
The Sector Model, of course, continues to tick away without
much care in the world, even after itself losing over 8% so far this year:
An annoying year, but most profitable overall.
And yet, even here there is a problem: the Sector Model
trades short term. With capital gains rates at 43.80%, the NET return rate for
the Sector Model would be 20.98% * (143.8%) = 11.79%.
In other words, you might as well have just held SPY and
forgot about the entire exercise.
That’s what IRAs are designed to solve (and yes, I run this
in an IRA). The delayed capital gains tax is collected at long term rates after
many years of compounded returns.
IRA accounts are fine for these short term versions of the
model. But neither will work for a taxable account.
Nevertheless, there is a factor that can be used to full
advantage if measured correctly: an adaptive long term holding period.
That is, the Full Model has a secondary holding period based
on the collapse of Effective Annualized Capital Gains rates.
Here’s a table to show how that works:
< Year

Annualized Rate

Base Rate

1

43.80%

43.80%

2

11.27%

23.80%

3

7.38%

23.80%

4

5.48%

23.80%

5

4.36%

23.80%

6

3.62%

23.80%

7

3.10%

23.80%

8

2.70%

23.80%

9

2.40%

23.80%

10

2.16%

23.80%

11

1.96%

23.80%

12

1.80%

23.80%

13

1.66%

23.80%

14

1.54%

23.80%

15

1.43%

23.80%

16

1.34%

23.80%

17

1.26%

23.80%

18

1.19%

23.80%

19

1.13%

23.80%

20

1.07%

23.80%

We all know that the short term rate is higher than the long
term rate. What we do NOT usually
calculate is the fact that the effect of a capital gain tax can be greatly
reduced against compound returns if we can hold onto a stock for a number of
years.
This becomes an Effective Tax Rate as seen in the following
chart:
That’s all well and good, if one can pull it off. But who can pick long term outperforming
stocks?
Well, Warren Buffett, for one. He’s not much of a trader. He waits for a stock to create significant long term value and then holds on – often for decades at a time.
Once we reach a holding period of greater than 5 years, the
Effective Tax rate is less than 5%.
I’ve not only tracked the returns of the Full Model from the time I’ve bought and sold each stock – but I’ve also continued to track those sold stocks as if I were still holding them.
The annualized return RATES in the following graph are
calculated in two ways: first without tax, and second with tax.
The top line is the return rate in an IRA account of each
stock since I began tracking live trades on 5/31/2011; all 189 of them.
As time lengthens, the Effective Tax Rate falls closer and
closer to zero, until the taxed account is almost as good as an IRA account.
The ideal holding period for a stock in an IRA account is
about 99 calendar days.
The ideal holding period for a stock in a taxed account is about
1525 days (so far). I’ve not yet found
the maximum point.
Now, this is an interesting graph, since we can see that the
return rate gradually decays from 99 days until a bottom around 886 days.
After that two things happen:
1)
About 10% of the stocks
cease to exist (either through purchase or bankruptcy).
2)
The remaining stocks
recover aggressively.
In Haugen’s studies, “value” companies tend to underperform
“growth” companies for about five years, but the stocks associated with those
companies have been too aggressively discounted.
The market is very accurate in identifying which companies
will do better than others in the next few years, but the market is NOT very
accurate at pricing those discrepancies beyond three years.
Investors tend to hyperbolically discount time as it
fades further into the future. The difference between two and four years is
treated the same as the distance between one and two years.
Logarithmically, those two are equal, but time does not progress logarithmically – it progresses linearly.
Logarithmically, those two are equal, but time does not progress logarithmically – it progresses linearly.
To put this simply, investors will price correctly from one
to two years, but price two to four years as if it were two to three years. I’ve
shown this kind of perception error in the following table.
Reality

Perception

$100.00

1

1

$105.00

2

2

$110.25

3

4

$115.76

4

8

$121.55

5

16

$127.63

The actual “value” of a company after 5 years is discounted
as if it were 16 years in the future. What may seem to be a moderate 5% growth
rate is perceived as if it were closer to 1% because of the logarithmic
perception of time.
This is how value stocks can become growth stocks. Earnings
will begin to surprise and traders will over react in buying the stock as if it
had miraculously made 16 years’ worth of growth in only 5 years.
We are always trying to pull a rabbit out of the hat, but if
Aesop’s Fable is to be believed, we’d be better off trying to pull a tortoise
out of our hat instead.
By the end of this year I will either convert the Full Model
into a long term holding period, or else add a long term version. I haven’t decided yet. But four and a half years of data has
confirmed something that Benjamin Graham argued many decades ago: in the short
term the market is a voting machine; but in the long term it is a weighing
machine. Good companies are worth buying and holding for the long term.
The key is to find out which companies, and for how long.
We aren’t exactly there yet – but we are close enough to
begin the final version of the Full Model – a version that is infinitely
patient, and infinitely scalable.
Tim
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