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Strategic Value Investing: Income and Taxes


Your choice of an investing style may be dictated by either your need for income or your tax situation. That's according to the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors."

Authors Stephen Horan, Robert R. Johnson and Thomas Robinson pointed out that investors who need income will want to focus on finding value stocks with high dividend yields, rather than stocks that offer capital appreciation.

In a sense, though, that may pose a false choice. After all, you can create a "homemade" dividend by selling some shares of any of your holdings for cash. That obviates the need for finding dividend stocks, but it also requires discipline and choices of what to sell, and when.

In the end, it will likely be some trade-off between the need for income and the desire to avoid taxes that will dictate your direction. If you own stocks that pay dividends, those dividends will be taxable unless you are in a tax-advantaged plan. Perhaps you don't need the income from the dividends now, but they will be taxed when you receive them if you do not hold them in a tax-protected account (such as a 401(k) or an individual retirement account).

The authors noted that Berkshire Hathaway (NYSE:BRK.A)(BRK.B) does not pay dividends for tax reasons. If it paid you a dividend, which you would simply reinvest, then you would lose a portion of your income or capital to taxes each time you collect one. From Berkshire's perspective, it is more financially efficient for its investors to take a homemade dividend when they need the income.

When income isn't needed, then an investor will usually look for value investments that have capital gains potential and a low- or no-dividend yield. The authors added, "From a pure tax standpoint, that philosophy is an efficient method of accumulating wealth."

Many investors have both taxable and non-taxable accounts, providing them with flexibility in managing their assets. Investors with non-taxable accounts can accumulate wealth by deferring taxes until they make withdrawals. For that reason, a non-taxable account is the optimal place to put dividend-paying stocks. Should investors run out of room in their non-tax account, then their non-dividend or low-dividend stocks have to go into their taxable accounts.

Further, the authors argued that core, long-term stocks could go into a taxable account, while stocks bought for the short term or for trading should go into a non-taxable account. Given that many value investors are long-term investors and plan to hold each of their stocks for years, these holdings could go into a taxable account.

Other value investors, however, buy stocks when they go on sale and sell them when they become overvalued by the market. These should go into a non-taxable account. The authors offered these examples:

  • If you buy Berkshire Hathaway to be a core, long-term holding, you would hold it in a taxable account because the stock does not pay dividends. It is fine for a taxable account because you don't expect to harvest any income or capital gains for a long time to come.

  • On the other hand, perhaps you bought a position in Companhia Siderurgica Nacional (NYSE:SID) because it was undervalued. This would go into your non-taxable account because it pays dividends and you will sell it when the market realizes the stock is undervalued.

They added, "We realize that such a division between taxable and non-taxable accounts cannot always be accommodated. The point of the discussion is to indicate that, when possible, such a distinction helps the investor make their investing more tax efficient."


As the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" prepare us for investing styles in the next section of chapter 13, they have alerted us to the issues of income and taxation.

First, it boils down to buying dividend stocks or buying low to no-dividend stocks. Dividend stocks will generate current income, on which you will need to pay taxes when you receive the dividends. On the other hand, if you buy a stock with low or no dividends (for capital gains), you will be able to defer taxation until you sell some or all the stock.

Second, if you expect to have to pay taxes on dividends or because you don't expect to hold a stock for long, then you should put those securities into a tax-protected account. Again, you will defer taxes. If you have a long-term holding that does not pay a dividend, you can afford to leave it in a taxable account because, again, your taxes will be deferred.

Whatever the case, planning for income and taxation issues should be a consideration in choosing stocks and allocating assets in a portfolio. The types of stocks you choose will play a part in helping you determine which type of stock analysis is most appropriate.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.