The Tax Man And Your Compounding Machine

In an interview with Forbes on January 22nd, 1996, Charlie Munger said, “The objective is to buy a non-dividend paying stock that compounds for thirty years at 15% a year and pay only a single tax of 35% at the end of the period. After taxes this works out to a 13.4% annual rate of return.” The one advantage possessed by companies that pay no dividend, compared to those that do return cash to shareholders, is that they only have to pay one layer of taxation to their owners.

I’ll use as an example one of my favorite companies that pays no dividend at all: Autozone, the country’s largest retailer and distributor when it comes to car replacement parts. Entering 2015, Autozone had 4,836 stores. The company pays no dividend at all, and dedicates a large percentage of its annual profits to reducing its share count outstanding so that the remaining profits only go towards a smaller ownership pool.

Oftentimes, I’m not enamored with stock repurchases because it serves as a substitute for actually taking the risk to innovate and invest in new products, and other-times buyback programs are used to cover up the effects of excessive executive compensation OR only occur when a company is flush with cash during robust economic conditions while the stock is trading at an unusually high valuation.

Autozone is one company that has managed to buy stock year after year, doing so only after the necessary commitments to future growth are made.  The auto-company has increased its share count from 3,483 stores in 2004 to over 5,400 stores coming into 2014. The company grew its profits from $566 million to a little over $1.0 billion during this time frame. That’s not bad, but here’s the kicker: Autozone reduced its share count from 79 million to 31 million over the same time frame. The earnings per share increased from $6.56 in 2004 to $31.57 in 2014 because of the way the significant buyback interacted with the company’s profit growth. It is one of those buy-and-hold for a long time type of stocks that Munger talks about when tax planning becomes a significant part of your focus—after all, if Autozone had been paying out a sizable dividend through the years instead of buying back stock, investors holding the company in a taxable account would have to sacrifice part of their returns each year. Instead, your tax rate is 0% with Autozone until you decide to sell, at which point you’d pay a tax up to 23.8% of your capital gain to Washington.

That’s why you may want to stuff your taxable account with Ross Stores, Disney, Visa, Gilead Sciences, Franklin Resources, Becton Dickinson, and T Rowe Price because those companies either pay no dividend or a negligible dividend, and they are highly useful if you are generating income well above what you presently need to spend and have the objective of minimizing your tax bill.

Among companies that pay out high, growing dividends, it is quite important to find a way to tuck those stocks away into an IRA of some kind. Over a long period of time, the difference between holding Chevron in an IRA and holding Chevron in a taxable account starts to amount to more than a rounding error. For someone that owned Chevron and reinvested in an IRA for the past twenty years, you would have compounded at a rate of 11.6% and turned every $1 invested into $9. If you did the same thing in a taxable account, you turn every $1 into just a bit under $8 over the same time period. The structure of how you hold the assets alone is responsible for the difference between turning $100,000 into $900,000 or turning $100,000 into $790,000.

The portfolio lessons I draw from this? With companies that yield over 3%, and have dividend growth rates above 7%, it’s often best to find a way to fit them into tax-protected IRA accounts because your reinvestment of dividends is permitted to compound undisturbed for years and years. The companies with negligible dividend payouts, meanwhile, only demand modest tax payments as the bulk of profits are retained and used to fund future growth until the day arrives when you find it necessary to sell. People who should ignore what I say are those who plan on using dividends in their 30s, 40s, and 50s, as paying the taxes is often an acceptable tradeoff for the amount of flexibility granted by dividends generated in a taxable account.