Do As Warren Does, Not As Buffett Says

Trying to invest like Warren Buffett has such a long history that numerous columns have been written about how to construct portfolios of companies that the writer posits Warren Buffett would like. Other investors or money managers simply build portfolios of companies in which his Berkshire Hathaway has substantial holdings. Multiple books have been written on how to invest like Buffett. Still, it is always worth reminding, particularly as the subject of tax reform bubbles up in Washington, D.C. once again, that while imitating Warren Buffett can come with large rewards, listening to him is a much less rewarding strategy.

With tax reform talk in the air, discussion will resume about Warren Buffett's well known position that the rich should pay higher taxes (he also favors the estate tax). Yet, it is far more instructive to note that while advocating for higher taxes on the wealthy Buffett has continually done everything in his power as an individual and as a corporate CEO to minimize both his personal taxes and his company's corporate taxes.

Two recent news stories reminded all of us that as year-end tax planning and portfolio rebalancing comes upon us, there is much to copy in what Warren Buffett does. First, there is his repeated tax-advantaged use of appreciated stock holdings. Second, there is his love for dividend-paying stocks.

Buffett's Berkshire Hathaway just announced a purchase of Proctor & Gamble's Duracell battery unit which demonstrates how to effectively avoid taxes on capital gains. Berkshire owns $4.7 billion worth of P&G stock with an apparent cost basis of $336 million. That leaves Berkshire Hathaway facing a potential $1.66 billion corporate tax bill. However, Berkshire plans to give those shares back to P&G in exchange for Duracell along with $1.7 billion in cash that Proctor & Gamble will put in Duracell's bank accounts to make the deal work.

With this structure, Berkshire saves $1.66 billion in taxes and Proctor & Gamble saves on taxes as well because it is essentially buying back stock with an appreciated asset (Duracell) rather than using its own retained (post-tax) earnings. Shareholders of both companies win thanks to their management's shrewd deal making because fewer corporate taxes paid mean more value for shareholders.

Perhaps this deal will remind people that rather than writing a check in response to the many year-end charitable appeals you are about to receive (they have already started to arrive), you can instead give a gift of appreciated stock. It is always a good idea to check with the charity first, ensure they know how to handle such donations properly, and get instructions on how to convey the stock (and get a receipt). In general, however, such donations are simple and straightforward. You probably cannot save $1.66 billion in taxes that way, but you can save something.

Beyond this, do not neglect the opportunity to include appreciated assets in other purchases you make when the other party is agreeable. While such deals may be slightly more complicated, the rewards can be high.

The second lesson to be learned is to invest in dividend-paying stocks. Funnily enough, Buffett has long resisted paying a dividend from Berkshire Hathaway's earnings. However, he has relied heavily on dividends received for much of the returns his stock has generated for shareholders. A good example is Berkshire's holdings in Coca-Cola.

Simply on Berkshire's shares in Coca-Cola, the annual dividends paid appear to equal about half of the cost basis for the position (built up over years, but essentially complete by 1994). Buffett projects, based on the rate that Coke has been increasing its dividend, that in less than ten years Berkshire might be getting annual dividends that exceed the cost of purchasing the stock.
Most investors would be overjoyed to make a 100% return on a stock they purchased. Imagine making a 100% return each and every year.

Historically, dividend paying stocks have either matched the broader market or beat it, depending on exactly where you go to look at the performance (time periods and methods for computing returns vary somewhat). Still, not all dividend-paying stocks are equal. Buffett focuses on strong companies with growing dividends and then holds them for long periods. The evidence certainly points to his strategy being a good one.

While I certainly cannot encourage people to follow what Warren Buffett says (at least when he is talking about raising taxes), there is much to his actual behavior that is worth copying. In particular, smart use of appreciated assets can save you a lot in taxes. In addition, buying and holding high quality, dividend-paying stocks can lead to a healthy stock portfolio, especially in the long run.