Kevin O’Leary…

In my on-going search for increasing my knowledge about all things finance, I recently came across Kevin O’Leary of the Shark Tank fame. More precisely, I came across a quote he made in this video. The statement he made was this: I would never buy a stock that doesn’t pay a dividend. Whatever you think of Kevin O’Leary as a person, it is worth thinking about the statement. This post is about my thinking process and what actions I took w.r.t. my portfolio.

My Capital Appreciation investment

When I started my journey towards Financial Independence in late 2014, I wrote about the design principles behind my Passive Income streams and how I implemented the design. One of the design principles is this: Invest some money in Capital Appreciation (high risk) buckets. I called this bucket the lottery ticket investments. The implementation of this bucket was done via two Vanguard Mutual Funds.

1. Vanguard Tax Managed Capital Appreciation Fund (VTCLX)
2. Vanguard Tax Managed Small Cap Fund (VTMSX)

If you look at the funds, they are excellent in many ways…

• both Morning Star gold rated and tax efficient.
• both minimize dividends and maximize capital gains…hence tax efficiency.
• both have an awesome track record in prior years

But, for the past four months or so, these two funds stood out whenever I did a Cost Basis analysis in my account. Let us consider VTCLX for example. Since 2014 when I started funding my Passive Income Streams, I have accumulated appx $12,000 in my VTCLX account. If I do a Cost Basis analysis i.e. how much money I invested vs how much is the current market value, here are the nos:

• Total Investment: $12, 000
• Today’s Market Value: $12,300
  • All dividends, however small, have been re-invested
  • Includes all capital appreciation
• Excludes any taxes I paid on the dividends

Damn….Kevin O’Leary time again….

Yes. Only $300 total return i.e. a 2.5% total return, even excluding taxes. Similar numbers for VTMSX. This is where Kevin O’Leary’s statement bugged me. In one of the few interviews I watched of him, he said something like: if I am giving my money to a company, I expect a decent return….a return comparable to the risk I took on.

Painful Questions…

So, I asked myself this question: for the risk of investing in funds whose Beta is > 1.0 i.e. funds that are more riskier that the market, I got a 2.5% total return. This is pathetically low in my opinion. But, lets argue that 2 years (2014 to 2016) is a very small investment window. Then comes the scarier question: what kind of return can I expect in the years going forward? Here is why I think this question is scary:

• S&P 500 is at historically high P/E ratio (inflation adjusted p/e)
  •  I.e. room for capital appreciation is pretty low
• Dow Jones Industrial Average is also at historically high P/E ratio (charts)
  • I.e. room for capital appreciation is pretty low
• Nasdaq composite is also at historically high P/E ration (charts)
  • Higher than the 2000 dot-come bubble!
  • I.e. room for capital appreciation is pretty low

For a moderate risk taker like me, the data is showing me that there is not much room for capital appreciation. Note that Google stock went from $550 per stock to $750 per stock from 2014 to 2016, but also note that VTCLX has google stock 🙂 So, it must be that there were many stocks that dragged it down. But, I do not dabble in individual stocks…I prefer the risk diversification and passive nature of mutual funds.

It gets even worse. I plotted a graph of Vanguard Intermediate Term Tax Exempt MUNI fund (VWITX) and an investment here could have easily beat VTCLX over the last two years. So, if we assume that the room for capital appreciation is low, then it looks like I made a very inefficient investment by choosing capital appreciation vs cash flow. Now for the all important question: Why 🙂

Why why why…

I have realized that I missed a fundamental point in my analysis of investing for capital appreciation and passive income streams.

• Achieving capital gains implicitly implies that one must identify an under-valued asset that can multiply its asset value over time.
  • For example, if I had bought Google stock in 2014 at $550 for one stock, I could sell it today at $750 per stock i.e. $200 worth of capital appreciation.
• If every market index (S&P, DJIA, Nasdaq, etc) is at historically high P/E, there is not much room to find value in stocks
  • Vanguard folks are good but they are not magicians hey 🙂
• If finding under-valued assets is the foundation of capital appreciation, then perhaps I should have invested in a product whose primary focus is Value investing.
  • For example, Vanguard Value Index Fund Investor Shares(VIVAX) is one such fund. But, between 2014 to 2016, the appreciation here too is minimal.
  • If experts who sole job is to find value have not been able to do it, then what hope is there for an amateur like me?

So, my fundamental premise for investing for capital appreciation in my taxable account passive income streams was a broken one.

• Note that I am not saying that capital appreciation approach is broken. Maybe VTCLX has accumulated many under performing assets whose value will become apparent after a bust-boom cycle. Or maybe a balanced approach across capital appreciation and current income like in Vanguard Equity Income Fund (VEIPX) is the way to go, but this fund is not tax efficient for folks in the higher tax brackets.
• So, for an investor like me who is in the search for tax-efficient income on the path to financial independence *at this point in my life*, investing in capital appreciation at current high market evaluations does not seem like a wise decision.
• I have a lot of money riding on a total market strategy in my tax-advantaged accounts i.e. there is sufficient skin in the game riding on a capital appreciation strategy. But the time frame for my tax advantaged accounts is more than 20 years i.e. enough time for a boom+bust cycle. But, in my passive income stream bucket, my time frame is appx 10 years and I do not see a place for capital appreciation investing, at current market evaluations.
• If markets take a deep and I see value in VTCLX or VTSMX, I will dive right in….lets see what the future holds.

Portfolio Changes

I cashed out VTCLX and VTSMX (teeny weeny gains) and moved the money across the following buckets

• Vanguard Intermediate Term MUNI fund (VWITX)
  • Federal tax free
  • Tax equivalent yield of appx 5.5% (Vanguard Tax Equivalent Yield calculator)
• Vanguard Dividend Appreciation fund (VDIGX)
  • Qualified dividends i.e. taxes capped at 15%
  • Dividend appreciation potential…a conservative investor’s substitute for capital appreciation 😉