Buffett Seldom Sells Winners, So What’s The Deal With Apple and Bank of America?

Summary:

• Warren Buffett has trimmed positions in Apple and Bank of America, and some analysts believe investors should do the same.
• Uncertainty surrounds whether Buffett will continue selling or eventually liquidate his entire position but one should note the different implications of trimming a large position and selling all of it.
• Selling large positions comes with significant taxes and resistance due to long term capital gains, the major factor that must be considered before selling.

Warren Buffett has recently reduced his positions in both Apple (NASDAQ:AAPL) and Bank of America (BAC). What does this mean? Will he continue selling? Is there any chance he will eventually liquidate the entire position? Nobody but Buffett really knows, and he himself may not yet have worked out where his selling will end. What we do know is that selling a meaningful part of a large position is a major pain in the neck and comes with meaningful taxes which will be permanently subtracted from one’s capital. If you decide to sell a big winner you must be highly motivated to do so. What could have motivated Buffett and what can we learn from it?

The Apple Problem As Buffett Must See It

The place to start is with taxes. The tax hit on your capital in itself generates strong resistance to selling stocks like Apple and BAC in which Berkshire Hathaway (BRK.A)(BRK.B) has large long term capital gains. To get an idea of the tax hit multiply the embedded cap gains on the tranche of the stock sold (normally the shares with the highest cost basis) and multiply at the current corporate tax rate which is the same as the 21% corporate tax rate on ordinary earnings. Buffett did most of his buying between Q1 2016 and Q1 2018, a period in which the price of Apple more or less doubled from around $24 per share to around $46 per share. The average of these two numbers suggests a cost basis of around $35 per share, a number which agrees with the cost basis data in Berkshire Annual Reports. Making the reasonable assumption that Buffett sold somewhere over the past two quarters between a low of $169 per Apple share and a high of $216, his long term capital gains were 80-85% of net proceeds, meaning that Berkshire would have to surrender 16-17% of its capital gains to the IRS. That’s permanently lost capital which simply disappears.

That 16-17% surrender to cap gains taxes does not affect the balance sheet, of course, as it is already discounted in valuing the Apple position as it is carried on the books, but in cash terms it means that Buffett can keep only 80-85% of the recaptured cash. If he wishes to invest the cash received from selling Apple it will be only 80-85% of the amount you would have seen for current value in Berkshire Annual Reports (please note that in the past two years Berkshire has not provided this number). This is the basic argument against selling big winners, almost certainly the argument Buffett has made in his private thinking about long term winners such as Coca-Cola (KO), which has provided very little growth over the past two decades but still returns significant dividends to Berkshire (with a present yield of 2.78%). A few years after the 2000 peak Buffett said casually that he perhaps should have sold Coca-Cola at the top, but one could make an educated guess that he deferred action after calculating of his capital gains would have to be surrendered to the IRS. Taking that into account Buffett undoubtedly saw that it might be difficult to find a company on that scale which would perform as well as Coca-Cola.

It thus makes perfect sense that Buffett has always preferred to let his winners ride as long as possible, ideally forever, so only a powerful motivation to sell would likely move him to pull the trigger. The most obvious motivation is the possibility that the corporate capital gains tax rate will be higher in the future. If there has been a recent moment to worry about an increased future tax rate, the present moment is it. The large deficits in recent years – ostensibly the result of government spending to counteract the economic drag of COVID – will sooner or later need to be dealt with, and a Democrat victory in the upcoming election makes it likely that the favored action will start with higher corporate tax rates.

Most individuals are not much concerned about higher tax rates for corporations while an article in the August 25 Wall Street Journal noted that speakers at the recent Democratic Convention frequently referred to corporate leaders as “oligarchs” and “corporate monopolists,” thus setting the stage for an anti-corporation economic policy. The suggested initial increase mentioned by the Democrat candidate has been an increase to 28%. That’s an immediate increase of 33%. The corporate tax rate from 1993 until 2018 was constant at 35%, and a return to that rate, not unlikely in the long run, would represent a 40% increase. Another idea being tossed around by Vice President Harris included taxing unrealized capital gains with the effect that what is now a mere book entry for future capital gains might become a current tax payable in cash. While this might seem unthinkable, particularly considering the complexity of working out the details, one would have said the same thing before an agency producing accounting rules issued Accounting Standards Update 2016-1 requiring that changes in investment value be included in regular quarterly income reports.

Buffett was sharply critical of ASU 2016-1, noting that it created major nuisance while adding no obvious value, but he may also have noticed that it was just one step removed from taxing unrealized gains. Taken together, all of the possible unfavorable tax changes suggest that an astute investor who plays the percentages might choose to do a bit selling now in positions with large embedded capital gains.

So is it simply a matter of taxes?

Apple’s Own Internal Threats And Headwinds

When Buffett began to buy Apple its P/E ratio was under 15. His initial purchases were made when Apple was growing much faster but could be bought on a large scale at a P/E in the middle teens. Even as its price doubled between 2016 and 2018 Apple’s P/E remained well below its present valuation. In early 2018 Buffett stopped buying. For five years he held on to what he had as the price per share continued to go up, growth subsided a bit, and Apple delivered regular small dividends and larger buybacks. It was a strategy similar to the one he had applied to Coca-Cola which saw its P/E fall from its absurd high back in 2000 as it succumbed to slower growth but managed to continue raising its dividend. Ultimately Buffett decided that Coke’s performance was good enough, better in any case than selling and reducing his capital by a large capital gains tax (which at that time, remember, was 35%). He continues to hold KO as it pays a dividend which now provides a roughly 50% yield on cost.

As for Apple, even as its price doubled between 2016 and 2018 Apple’s P/E remained significantly lower than the present 34. Buffett is surely aware that a P/E of 34 makes Apple quite expensive when weighed against its very modest earnings growth in recent years. His initial purchases were made when Apple was growing much faster but could be bought on a large scale at a P/E in the middle teens. Over the past five years Apple appears to have reached a plateau, at least temporarily. Buffett undoubtedly drew upon a lifetime of experience to make some calculations about the next step. While Apple was to some degree defended by the same consumer brand power that defended Coca-Cola. the fast-moving tech industry comes with higher risks. Apple has always been a company with somewhat lumpy growth, getting stuck on a plateau from time to time before taking a leap upward as it reinvents a new or improved version of its business.

Like me, Buffett is not an expert on technology investments. His strength is in weighing the probable outcome of obvious problems. The key word here is probable. For example, Apple is currently beleaguered by problems with China, which is both a manufacturer and a major customer. The problem is that China is no longer dependable as either manufacturer or customer for reasons beyond Apple’s control. Can Apple tiptoe out of China, and should it do so? Can it create the same ideal relationship with India? The answers to these important questions are in the form of large bands of probability. Nobody really has a definitive answer. The same is true with its new products and product improvements. Will they enable Apple to surge ahead as they did in 2016 as Buffett began gradually loading up on Apple stock?

The best analysts present no single answer. Here at Seeking Alpha I have read all Apple articles for the past month or two, written by analysts many of whom are familiar to me and for whom I have great respect. The problem is that there is no consensus on the next phase for Apple. Yet more problematic, the conclusions are pretty much binary, with some saying that Apple is about to have great success across the board with AI and product upgrades while others saying take care, Apple has big problems and Buffett is doing the right thing to dump it. A few note in passing that Apple stock is currently expensive while others say that it is about to have a growth spurt that will take care of the problem of a high price earnings ratio.

From my perspective Buffett’s sales of Apple so far place him somewhere in the middle. If he continues to sell and ultimately exits Berkshire’s entire Apple position I would simply say that slower growth, higher risks, and expensive valuation have made Apple an outright sell. So far his selling, though substantial, hasn’t said anything like that. Taking a deep breath, here is what I think Buffett’s sales of Apple do say:

• Apple stock is very expensive, especially in light of its many uncertainties.
• Apple is not only expensive, but its market cap is a huge $3.5 trillion, making it the largest company in the world by market cap. Perhaps it deserves that market cap, but size of that sort makes it require a huge leap to “move the needle” in its value. Buffett is particularly aware of that problem from the difficulty in outperforming the S&P 500 for Berkshire Hathaway itself simply because of its size.
• Size also makes Apple a problem in maintaining a balance with Berkshire’s portfolio. Failure to resume rapid growth could well cause Apple’s PE to fall by 50% or more just to get back to its 2016 level. It carries too much risk to put that amount at stake if things don’t go well. He certainly must feel that under present uncertainties Apple should not represent 20% or more of Berkshire’s market cap, which it has at times.
• A major Buffett theme of the past couple of years is setting his house in order while he still has time to do it. Apple is a problem calling for his own long experience and keen judgment, and is not a question he wishes to dump on his successors.
• My best bet is that when Buffett is done selling Apple it will still be a major holding, probably #1 in Berkshire’s portfolio. It may indeed get a huge leap from AI and new products. If it turns out that way, Buffett will not have made a mistake. He will simply have factored in the risks and absolute uncertainties and held the risk to Berkshire to a reasonable level.

It will be interesting to see where and if Buffett’s selling of Apple stops. Many analysts make assumptions based on projected implications of Buffett’s selling. It’s minimally premature to do that. Buffett isn’t really an Apple analyst and none of his actions should lead anyone to make that assumption. On the other hand, Buffett has a keen sense of what he knows and what he cannot know, and the actions he has taken thus far with Apple provide a textbook about the way he comes at investing that we have not seen before.

Bank of America: Is It Simply Ditto?

Bank of America certainly shares risk of higher tax rates with Apple but so do all American companies. Its political risk, on the other hand, is probably greater than most other companies. Under the current administration the large banks have powerful enemies and there is evidence that it may get worse if Democrats win again. You could almost see Senator Elizabeth Warren licking her chops as she spoke to the Democratic Convention.

The exact source of left liberal hatred of large banks goes back to the Great Financial Crisis when bank laxity played a major role in the construction of risky Mortgage Back Securities. Stress tests and constraints imposed on bank dividends and buybacks continue to be important continuing punishments and recently Fed Chair Jay Powell called a closed door meeting with bank CEOs to instruct them in what they must do to create more capital. The larger concern that hangs over all major banks is the fear that many bank critics would like to nationalize banks, turning them into something like a utility with limited shareholder returns. A Democratic victory by a large margin might lead anti-bank politicos in that direction.

Bank of America remains in the public mind as a major miscreant in 2008-2009 and despite a promising start over a decade ago CEO Brian Moynihan has failed to live up to his early promise as a future successor to Jamie Dimon as an important bank leader. Little things have been irritating to me as a shareholder including the fact that its buybacks, even when reasonably large, have done less than they should have to reduce the number of shares. Much has gone to replace shares given as bonuses to executives which would otherwise increase the share count. BAC has been much more generous with its upper level executives than with its shareholders although exact numbers for shares handed out to executives are hard to find in its reports.

Buffett and I have similar histories with Bank of America, with Buffett having converted his preferred shares from the 2011 deal to shore up BAC into common shares at a price of $7 each. According to the most recent numbers presented in the Berkshire Annual Report he is up between five and six fold over 13 years, mainly as a result of having bought skillfully. My own position is also up substantially but not brilliantly since buying in 2016. I would love to reduce the size of my BAC position but am reluctant to do so because, yes, capital gains taxes would take a bite. Maybe next year.

Buffett has the same problem, although the current bite of cap gains taxes is similar to that of Apple, with the same risk of rising rates as cited above. Bank of America may also benefit if a series of rate cuts perk up the economy to I am tempted to wait and see if I can sell nearer the old high, taking some of the edge off of taxes. I don’t have a good insight into what Buffett might ultimately do with his Bank of America position although it trades at a much lower P/E than Apple (around 12), has more than double the dividend yield, and despite its political risks doesn’t have specific internal risks which are quite as sharp as those of Apple. BAC is the second largest position for Berkshire, and I’ll be interested to see how far Buffett goes in reducing its size. Again, my bet is that it will ultimately be treated more or less the way Buffett treated Coca-Cola.

Conclusion

Some analysts have suggested that after all these years Buffett has come into possession of a reliable crystal ball and decided to rely on its prediction of a major storm coming in an overpriced market and bringing major economic weakness along with a powerful bear market. I doubt that his thoughts on the market as a whole were a major factor. Even if that were the case it’s unlikely that he made his decision to sell a ton of Apple and Bank of America on that basis. Buffett is very much a believer in fundamentals and his actions have coincided with market events only occasionally and incidentally. While he has written articles in the New York Times saying it’s time to buy, as he did in a New York Times editorial published in 2008, he has never announced that investors should generally get out of the market.

He would likely have preferred to hold both Apple and BAC through ups and downs to a distant vanishing point had not fundamental factors intervened. In selling heavily and rapidly as he did, he may or may not have called the top of a bull market. We’ll have to wait and see on that. Even if it turns out to be a market top it’s likely that Buffett’s sell decision was a coincidence, perhaps based on the simple fact that at market tops many stocks are wildly overpriced.

Let me say briefly that many of my readers will recall that I have written in the past that investors should generally hold on to winners and sell losers, in part because of tax reasons. While I still hold that as a general principle I strongly support Buffett’s rare action in selling two winners and paying the cap gains taxes. Moreover, I plan to write an article, probably my next one, on the case when selling winners may be the right solution as you get older and organize your portfolio for your heirs.

As to actions you might take to align with Buffett’s actions, my suggestion to investors is to not use Buffett’s actions in this case as a reason to sell Apple or Bank of America. What you might do is consider more fundamental reasons he might have wished to reduce these positions, beginning with the risk of higher taxes in the future, taking into account political risks, and taking a hard look at risks particular to the individual company, especially in the case of Apple. Then consider your own portfolio. Your own best estimate of these risks coming to pass should provide a framework for your own decision.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of BAC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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