Sunday, August 3, 2008

The Investment Zoo Chapter 8: A Tale of Three Stocks

In this chapter Jarislowsky lays out his rationale for sticking with premium non-cyclical companies that can reliably grow earnings at around 15% per year. The major reasons include 1) not having to worry about timing market cycles, 2) letting the magic of compounding do its work with your investments and 3) being able to trade far less and delay paying capital taxes.

Jarislowsky does not think capital gain tax is fair because there is no allowance for inflation. The full nominal gain of the investment is taxed even though a big portion is really (as he puts it) an "inflationary mirage". For that reason, he prefers to hold on to investments without selling so that he can maximize the amount invested and collect the dividends on the full investment. If you sell a $100 investment and pay $20 due to taxes, and then reinvest the money, you will only be able to collect dividends on $80 now compared to the $100 before taxes. So paying taxes shrinks your investment funds. This is one of the major reasons he prefers a buy and hold strategy.

He only occasionally invests in cyclical companies. If he does, it will be at or close to market bottoms where he can buy at very cheap prices. The problem with investing in cyclical companies is that they will not appreciate over the long term as well as premium, non-cyclical, 15% earnings growth companies. Therefore, he doesn't think its prudent to adopt a buy and hold strategy with cyclical companies. Rather, he advocates selling a cyclical investment well before the next cycle top so as not to miss the cycle and have to hold onto the stock while it loses money and perhaps cuts dividends. To minimize the capital gain tax on cyclical investments, Jarislowsky recommends using a tax sheltered RRSP account.

With premium non-cyclical high compound growth stocks, Jarislowsky explains that it is not necessary to get out at market tops. Even if your 15%-20% reliable growth stock is overvalued by the same amount, it will make up this ground in the next year. He would rather wait one year then sell and have to pay tax and trading costs just to trim down the investment. Of course, his strategy hinges on finding those premium stocks.

Jarislowsky gives the example of three stocks that he has held for close to 50 years in his portfolio. These three stocks are Reynolds Metals, United Airlines and Abbott Laboratories. He bought Reynolds and United Airlines when they looked like fantastic bets with good growth potential and expanding markets. However, the best investment by far was the rather boring but reliable growth and non-cyclical company Abbott Laboratories. The power of compounding at reliable rates has turned his $2,000 in Abbot to over $1 million, not including dividends. The dividends rose almost every year in the 50 year period.

Reynolds was merged with rival Alcoa and his initial $2,000 was worth $15,000 after the merger. With United, an initial $2,000 would be worth around $47,000 after the acquisition but Jarislowsky had to pay huge capital gains and was left with a substandard annualized return after 35 years invested in the stock.

He advises to be like Warren Buffet who invests in premium, non cyclical reliable growth companies but also admits investing mistakes and takes corrective action. Do not respond to temporary setbacks but if a stock fails to live up to your expectations and reasons for owning it, then admit your mistake and sell.

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