Imagine you spent the past thirty-five years of your life working for Colgate-Palmolive. During your time there, you recognized the greatness of the company. You soaked up the history, knowing that the original William Colgate & Company founded on Dutch Street in 1806 to sell soaps and candles had resulted in a business that had been profitable for 87% of the time that the United States America existed. You know that the private owners collected their dividend checks through the War of 1812, the Civil War, and the 1896 introduction of toothpaste in a tube marked the point from which it would never again cut its dividend.
If this Colgate-Palmolive employee started investing $500 per month 35 years ago, and increased his contribution by 6% each year, the net result would be a $33,900,000 portfolio. When you find an excellent company, give it a long time, and constantly supply fresh powder to the position, you get wild results (if Warren Buffett had merely held on to his $4,000,000 Disney position in 1966, and refused to sell it for a 60% gain in 1967, he would presently have $13,500,000,000. He could have spent the past 48 years resting on the laurels of his past work, and he could have become the richest man in Nebraska and one of the fifty richest men in Nebraska by doing nothing except watching his Disney shares compound.)
Often times, people who can trace their employment success to a specific company also find themselves relying on a concentrated investment in that company to explain their success. According to the late Dr. Thomas Stanley’s research on the topic, over 42% of businessmen and businesswomen–almost a majority!–that have over $1 million invested in the stock market have their stock market wealth in just one publicly traded company.
The most rational explanation for this behavior is that investing in company stock has a tangibility factor to it. It’s not just a blip on the screen. You see the offices. You see the employees. You know who the clients or customers are, and can understand how the company makes many. You may get e-mails or read reports from the CEO talking about profit growth. You see the new initiatives unfurl and add to the profit streams. For the same reasons that some people prefer real estate investing–you can actually see the house!–some successful stock market investors find themselves nearing the end of their career having only felt comfortable investing into the company that provided them with a paycheck.
The question, then, is how do you deal with this concentrated position once you are retired and no longer engaging in the sale of your time and labor? A single corporate bankruptcy can financially wipe you out and undo a lifetime of delayed gratification.
There are two principles that should drive your considerations: You should first determine how much money is necessary to maintain your standard of living independent of the concentrated stock position, and your strategy will also depend on whether the investments are in a tax-protected retirement account or not.
The easiest solution for our Colgate employee-investor would be determining that $2,000,000 is the necessary retirement threshold from which you cannot go below and at least that amount of money is available in a retirement account.
In such a circumstance, you would sell $2,000,000 of Colgate in a retirement retirement, diversify it across high-grade corporate and U.S. bonds as well as blue-chip common stocks, and then collect that $80,000 per year. That could compound while you would still have a very significant sum of Colgate dividends to live off.
The question becomes trickier when the Colgate fortune rests in a taxable account, and you have to think about capital gains taxes and losing the benefit of stepped-up cost basis on the investment amount for your heirs at death. After all, a complete sale of the Colgate stock in a taxable account would result in a $8,000,000 tax bill. You don’t build great fortunes by making tax moves like that.
In this circumstance, you would likely want to pursue a derivative short-straddle that protects against the risk of bankruptcy. Essentially, you would determine a minimum amount of money that you’d want available in a worst-case scenario (say, $5,000,000), and then you would borrow money from the bank at rock bottom interest rates to short the stock so that you would end up with $5,000,000 in the event that Colgate-Palmolive’s common stock were to ever crumble into bankruptcy. This plan would currently cost you around $75,000 per year, and would become gradually more expensive over time as Colgate continues to grow.
The ultimate drawback of this plan is that, in 9,999 out of 10,000 real-world scenarios, this plan will leave you with less net worth than you’d have if you merely held onto the Colgate-Palmolive common stock. After all, Colgate grows its profits every year, the products are highly resistant to technological obsolescence, it is breaking into new markets, and this leads to a dividend that has grown every year for over fifty years. The fantastic quality of the business explains why you were able to get rich in the first place!
You would need to think of this as analogous to insurance that is much cheaper (over the short and medium term) than taking the capital gains tax. However, if Colgate continues to compound in line with historical norms, there will come a point fifteen to twenty years out at which it would have been cheaper to sell the stock and take the capital gains hit rather than continuing to short the stock.
The tax planning strategy of Facebook executives generally involves borrowing funds as a way to mitigate against taxes and concentrated positions in Facebook stock. Some have borrowed to actually short against the stock, other have borrowed to use the borrowed funds to live off, and as the valuation of Facebook increases, they borrow more. Other have been able to use their gigantic Facebook net worths to borrow large sums to set up an investment portfolio that provides more income than the payments on the debt and the spread can be used to support the lifestyle.
For instance, our Colgate investor would have no problem borrowing $5,000,000. A collection of oil and energy assets would provide $250,000 in income against $125,000 in expenses and repayments. Instead of taking a tax hit from the sale, you’ve been able to create a sustainable $125,000 annual income stream in addition to the pre-existing Colgate dividends.
Normally, an aversion to borrowing is an important ingredient to riding through the bottoms of economic cycles and having free cash flow available to go on the attack and make new investments. The one time when borrowing late in life makes sense for the ultra-rich is when a disproportionate amount of the wealth is tied up into one stock in a taxable account that you do not want to sell, and such borrowing strategies can provide better protection than incurring a tax bill that will make your heart skip a few beats.