Articles

Two Types of Capital Gains

Whenever I’m invited to talk about investing, I like to begin by asking if anyone has ever lost money in the stock market. A few hands go up. Then I ask if anyone has made money investing, and almost all hands go up. It’s harder to talk about the losses and more fun to celebrate the gains. However, there are two types of gains in investing, and they are easily confused: realized and unrealized gains. It’s especially timely to look at those two concepts now after an exceptionally fast stock market recovery with some market indices reaching again new all-time highs. After a period like this it’s to be expected that both types of gains may appear in many investors’ brokerage accounts.

If you bought a stock at $10, and now it’s $100, you have a $90 unrealized gain on your investment. The minute you sell the stock, it becomes a realized gain and you take possession of that extra $90. But wait! Very likely there will be some taxes due, unless you hold your investment in a tax-advantaged account like an IRA (individual retirement account), for example. If it’s a taxable account, the net gain won’t be $90. Depending on the tax rate, it could be as little as half of that $90, especially if it’s a gain realized in less than 12 months, and you live in a heavily taxed country, state or city. The actual post-sale, after-tax value of our investment may be as little as $55 (with a 50% tax on the $90 gain). It’s a very different amount than the $90 we might have thought we had!

Some strategies, though, can help us keep a larger percentage of our realized gains. As long-term patient investors, we trade less often, and hold our investments much longer. We also often benefit from a more attractive tax rate on long-term gains. It can be as little as half of the rate the account holder would have paid had we realized the gain in under 12 months. In that case, our $100 example would translate to an after-tax gain of $67.5 vs. $45 (with an estimated 25% vs. 50% tax rate in a high tax state or city in the U.S. for a high-income earner[1]) and the total value after-tax would be $77.5 vs. $55. That’s quite a significant difference. It makes us appreciate any tax advantaged accounts like an IRA, where no tax is due after realizing the gains.

Unrealized gains on the other hand, are gains on stocks we’re still holding. There are no capital gains tax consequences yet, and there might be no tax consequences if we never sell our investment, but we are subject to price volatility (the normal movement of stock prices)[2]. At Sicart, we don’t consider volatility itself a risk; the only risk we worry about is a permanent loss of capital. If we bought a stock at $100, but its value is $10, and the market eventually recognizes that, then we have a $90 loss, a permanent loss of capital.

Unfortunately, it has happened before that a 5-year gain of any specific stock (or the entire market for that matter) to disappear in a matter of days, weeks or months. We saw it as recently as March this year, when three years of gains disappeared in three weeks. Let’s say that we bought the stock at $10, and now it’s at $100. We choose not to sell, either because we hope for more growth or don’t want to pay taxes on the realized gain. The concern, though, lies in the possibility of this stock dropping significantly, possibly even back to $10, or even to $0. Our unrealized gain could evaporate quickly. That’s a valid concern that investors might have at the top of a long bull market or after a strong market rally, especially when the memory of the March 2020 crash is still fresh.

We believe that’s where fundamental research and stock analysis become indispensable. If the business in which we bought stock has been growing, and truly earned its performance from $10 to $100 per share, we have less of a reason to worry that our $90 unrealized gains could be gone in a heartbeat. On the other hand, if we know that we are looking at an expensive stock that became very expensive, and then incredibly expensive, we feel sure that it’s a just a matter of time before investors wise up and run the other way. Impossible? During the Internet Bubble, Amazon’s stock dropped from $108 to $8, which prompted Jeff Bezos’ reaction expressed in one single word — “Ouch!” Without a last-minute financing deal that saved the business, Amazon’s name would be recited today with the other dotcom flops: Pets.com, eToys.com, even Flooz.com (the last one sold online currency heavily promoted in TV ads by a major TV celebrity).

We are not suggesting that Amazon may repeat its dramatic drop anytime soon. All the same, the longest-running bull market, and quick market recovery may have blessed many with big unrealized gains. Some of them may be well deserved — but not all of them. For example, on the surface, 2019 was an impressive year. The S&P 500 index rose nearly 29%, its best performance since 2013. But as many analysts, including Goldman Sachs’ David Kostin have pointed out, “Valuation expansion drove nearly all of the S&P 500 return in 2019.” In other words, expensive stocks became even more expensive. Since March the market got back close to previous peak levels, yet corporate profits are falling, and may take a while to recover. We believe the growing disconnect may put some unrealized gains in some immediate danger.

Unrealized gains can eventually become realized gains. We know that realized gains may trigger tax consequences, but let’s not forget that unrealized gains are always at risk of a permanent loss, especially if they are driven by rising stock prices rather than businesses growing their earnings, and truly deserving their higher prices.

As patient disciplined investors managing family fortunes over generations, we at Sicart do our best to manage both types of gains. In the last three years, we have trimmed many of the older long-held positions, gradually replacing them when we find what we believe to be excellent businesses with potential to perform well over the next 3-5 years and beyond. In the last few months, we both took advantage of certain opportunities when the market crashed, and sold some earlier positions that held up in the midst of the market turmoil.

We expect the coming months to offer both buying, and selling opportunities, and successful investing relies not only on the right buying discipline, but also on disciplined and strategic selling.

Happy Investing!

Bogumil Baranowski

Published:  7/16/2020

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

[1]Actual tax rates may differ from this hypothetical example.

[2] Dividends paid on stock holdings are subject to taxation as ordinary income.