May 2021 IssueLong scroll reading

Chaff from Wheat

By Edward A. Studzinski

“The idea that a nation can tax itself into prosperity is one of the cruelest delusions which has ever befuddled the human mind.”  Winston S. Churchill, speech at the Royal Albert Hall, 21 April 1948

Yesterday I thought this would be a relatively easy piece to write. The Vanguard S&P 500 fund, according to Morningstar, closed out on April 30th with a year-to-date total return of 11.80%. Value had recovered as an investment style. It was now generally outperforming growth. Small-cap value especially was strongly outperforming other asset classes. The world seemed to be reordering in a fashion that was familiar and as expected.

Year-to-date returns, by Morningstar style box (as of 4/30/21)

  Value   Growth
Large 12.10% 10.7 7.5
  21.8 15.1 5.7
Small 28.3 20.6 3.8

But this week we saw the first details of the Biden tax plan. The capital gains tax would be dramatically increased for those with incomes above $400,000 a year. The stepped-up basis upon death would be eliminated, with family businesses at the death of one owner to be taxed as if a sale had taken place (so much for those minority families that had built up businesses that they wanted to keep in the family and pass on to the next generation). The Internal Revenue Code Section 1031 like-kind exchange for commercial real estate would be removed. Higher corporate taxes across the board would be the order of the day, impacting the competitive position of our domestic corporations globally.

While none of this had made it into law yet, it appears that the goal is to achieve a massive redistribution of wealth, not just from the upper classes, but also from the aspiring middle class. Which begs the question as to how one should invest, how one should allocate assets going forward, to maximize after-tax income as well as the preservation of capital from attempts to impede its growth?

The short answer is – I don’t know. Since mid-January, I had been wondering whether a greater allocation to international and emerging market assets was called for, if for no other reason than a relative valuation opportunity. Clearly, the U.S. market, with many blue-chip investments with price-to-earnings ratios in the high 30’s has been looking to be quite pricey on a relative basis. Selectively, international and emerging markets issues in Asia and parts of Europe offered relative attractiveness in terms of valuation. The contrary argument for so doing falls into the area of governance and strong legal protections for investors (referencing the recent and ongoing problems of Credit Suisse).  For me, this is now a work-in-progress, to be picked at over the next several months as we see how regulation and taxation evolve in the United States.

Whither Mutual Funds

In the past, I have highlighted the issue of individual taxes being impacted by the timing of the mutual fund portfolio manager’s decisions on taking capital gains and capital losses in the fund portfolio. I have argued in the past that a flaw in constructing a portfolio of mutual fund investments in non-retirement accounts is the issue of timing of capital gains and losses and the loss of control over that timing. That problem will now be exacerbated going forward. Accordingly, I continue to believe that with rare exceptions, mutual funds should only be owned in tax-exempt accounts by individuals. This issue will require constant monitoring going forward to avoid adverse tax consequences.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.