I have had this pleasure in the past few days. After several weeks of research and hundreds of hours of work, I finally found a stock that seems very attractive to me.
However, even if we find an interesting security, it is still far from certain that we will buy it to add it to our portfolios under management. There are several factors to consider before making this decision. I’ll share a few with you:
- Would adding the security improve the quality and return potential of my portfolio?
This, in my opinion, is the fundamental question to ask when considering the acquisition of a new security in the portfolio. The stock in question should be significantly more attractive than the least attractive stock in the portfolio. If not, better do nothing.
- Does the stock add to portfolio diversification?
In the case of the recently identified stock, the company operates in the same industry as one of our portfolio companies. Considering that our portfolio currently includes 28 stocks, owning two in the same sector becomes an issue in terms of portfolio diversification.
Ideally, a new stock should be from a company operating in an industry that is not in the current portfolio.
- Can the candidate replace an existing stock in the portfolio?
It would have been possible to sell the existing security and allow us to buy the new security; we had considered it.
The catch is that the stock we should have sold has been in the portfolio for several years and has performed strongly since it was acquired, which means significant tax liabilities for many of our clients. For example, I looked at a specific client’s portfolio to get a sense of the tax issue. For this client, the existing security has appreciated by more than 185% of its book value (the security is held in a taxable account); selling it would produce a substantial realized gain tax.
Such unrealized gains and the taxes they entail are not necessarily a reason not to sell an existing security, but they do raise the bar significantly for replacing it with another security. For example, in our assessment of the candidate stock, we determined that it was undervalued by the market by just over 20%. As for the existing stock, we estimate that it is undervalued by almost 10%. Do these yield differences justify a substitution?
Let’s see using a base of $100 for calculation purposes and a marginal tax rate of 50%. Selling the existing security would have yielded after-tax proceeds of nearly $239 ($100 originally invested is now worth $285 [185% appreciation], minus estimated taxes of $46 on the gain of $139 = $239). If we reinvest this sum in the new security and obtain the expected return of 20%, we will find ourselves in one year with a market value of $287 (incidentally, roughly the current value of the existing security). On the other hand, if we keep our shares of the existing security and it achieves the expected return of 10% over the next 12 months, we will end up with a value of $313.
I would add that we must also consider the fact that, in general, we know the company that we have had in our portfolio for several years much better than that of the new coveted company. In terms of risk-taking, it often makes more sense to stay with a stock that you know well than to buy a new, less well-known one.
To conclude, we opted to pass on purchasing the candidate stock. It will be added to our hot watch list for potential purchase in the future.
