19. Warren Buffett's 2nd Rule - Understanding Capital Gains Tax Video Lecture | Become an Expert: Value Investing - Business Basics

welcome to course to unit 3 lesson 3
warren buffett's second rule a stock
must have long term prospects where
we'll be talking about capital gains tax
in this lesson we have three lesson
objectives
the first lesson objective is how to
identify a company with long term
prospects the second lesson objective is
understanding what capital gains tax is
and the third lesson objective is what
is the difference between short-term
gains and long-term gains so let's get
started ok so here we are at the second
rule a stock must have long term
prospects so as we look at these four
different items up on the screen
let's go item by item and let's predict
whether this is still going to be
something that we see in 30 years from
now so the year in 30 years from now is
going to be 2040 - so when you envision
the future in 2040 - do you see people
still using iPhones now that might sound
like maybe I'm attacking Apple but to be
quite honest I mean I think everyone can
agree that the use of an iPhone that
there's no chance that that's going to
be the type of phone that we're still
using 30 years from now in the year 2040
- now when you look over at the next
item you see candy and that one is
pretty obvious that we're probably still
going to be eating candy 30 years from
now so let's go down to the next one
when we look at apps so let's say you
had a company or you want to own a
company that only made apps for
smartphones whether it be the Apple
iPhone or a Droid or whatever the case
might be if you were making apps do you
think that that business model would
still be viable thirty years from now I
think the programming aspect of it most
definitely will be viable but whether
that specific application of it no pun
intended
would be not viable it may be but it's
almost impossible to predict that a lot
less likely than the candy I think we
can all agree on that and then the last
one is let's say you own a business that
made fans there's probably a good chance
that we're still going to be using fans
30 years from now so when you look at
these scenarios these
examples that I have here it's not that
we have foresight beyond recognition
we're just really looking at the
application of what something is and
whether we still feel that it's going to
be around and whenever you're buying a
company and you're looking at their
primary product like let's say for
example Johnson & Johnson are we still
going to have medicines I mean that's
really their primary product yeah that's
still going to be around 30 years from
now so when you look at investing you
know Apple is an unbelievable company
I'm recording this video right now on an
Apple computer I love their product but
I would probably have a very difficult
time buying their stock simply because I
have no idea if that company is still
going to be the number one selling
computer manufacturer in 30 years from
now so when we talk about long-term
prospects this is what we're really
talking about and this is the assessment
that you have to do regardless of how
much you might like a product or like a
company so predicting which companies
will be around in 30 years is impossible
but ones that won't be around is a
little bit easier to predict so why do
we want to invest in a long-term company
why don't we want to invest in the Apple
one and hold that company for a year and
then just sell it after we've made our
money and there's two main reasons why
you want to buy a company and hold it in
the long term the first reason is kind
of obvious is because if that company
has sustained earnings and it's going to
keep making money well then it's going
to continue to put money in your pocket
either through dividends or through the
growth of the company and it's equity
the second reason is the one that a lot
of people really don't understand and
it's taxes okay so I'm going to give you
a really good example here to
demonstrate why you really want to buy a
company and hold it for as long as you
possibly can okay so in 2013 this is
going to be our new capital gains tax
bracket if you don't know what capital
gains are if you buy a stock for $10 and
you hold that stock for let's say six
months and the stock increases in value
to $20 and then you would sell it
you just made $10 and profit off of the
the market price of that stock because
you bought it for 10 and you sold it for
20 in that six month period that gain
you're going to be taxed on that $10 and
gain that you just made is what you're
going to pay taxes on now the amount
depends on what income bracket you're in
and how long you held the asset since
you held it for six months that's
considered a short term capital gains if
you hold it longer than a year that's
considered long term capital gains and
this is new to 2013 s capital gains
structure so I'm going to cover that
anything over five years is taxed at a
different rate so the longer we hold it
you can see on the chart there the less
we pay in the taxes now for that
scenario that I described where you made
$10 on a company in a six-month period
depending on what ordinary income tax
bracket you're in let's just assume
you're in the lowest one is 15% so you
would pay 15% taxes on that gain now if
you would have held the business for
over a year you would have been in the
10% tax bracket and if you held it for
over five years you would have been in
the eight percent tax bracket so the
thing you have to think about is if you
would hold this company you would made
ten dollars in the first six months and
the business is continuing to make money
if you would continue to hold it for a
five year period you would have even
made more money if it was a good
business and it continued to make money
and you would have paid much less than
the taxes if if you would go and then
sell it so let's go ahead and
demonstrate how acidic the short term
and this now middle bracket this long
term taxes are for whenever you buy and
quickly sell stock so let's assume that
you had $50,000 and you invested that
$50,000 and a 10% investment now I'm
just using that to make the numbers a
little easier I guess and you're going
to hold that investment for 20 years so
every year that investments growing by
10% and then we're going to assume that
you sell it at the end of 20 years and
you're going to pay your taxes and to
see how much money you would have made
so you can see after one year your
$50,000 would have turned it into
$55,000 and then after two years would
it turn into sixty thousand five hundred
dollars and you keep going down that
chart you're not paying any taxes on any
of
that growth you're not paying any taxes
on and that business is just continuing
to grow and that's due to the equity and
that's also due to the dividends okay
now you will pay taxes on dividends on
the income of those dividends but as far
as the actual growth of the market price
you're not going to pay any taxes on
that for 20 years if you would just
continue to hold it now if you continue
to hold that for the rest of your life
and you just take the dividends you
would never pay any taxes on the on the
market price of that company so whenever
we arrive at the 20 year mark you can
see we end up with three hundred and
thirty six thousand three hundred and
seventy five dollars okay and let's
assume that we sold it right at the
twenty year mark and we're also going to
assume that we're in that highest tax
bracket okay so in the highest tax
bracket we would have eighteen percent
on our taxes after we held that security
for twenty years so after the eighteen
percent taxes that the number that we
came up with goes down to two hundred
and seventy five thousand eight hundred
and twenty-seven dollars and the taxes
that we would pay would be sixty
thousand five hundred and forty seven
dollars so that's a lot you're going to
pay in taxes but you also made a whole
lot of money off of that fifty thousand
dollar investment and that's primarily
because of the large ten percent yield
so let's look what happens if we are
constantly selling and buying but we're
still making that ten percent every year
okay so same exact scenario we're going
to invest fifty thousand dollars but in
this scenario we're going to go ahead
and sell this the security right before
the one-year mark and we're going to pay
that short-term capital gains tax okay
so the person who's out there doing the
day trading the person who buys a
company and holds it for three months
and then sells it and buy something else
that's this is this is the person we're
describing here okay and we're going to
give this person the benefit of the
doubt and say that they held it for an
entire year before they sold it right
before the year before they sold it so
in this scenario that fifty thousand
dollars after the first year is going to
turn into fifty three thousand and
twenty dollars off of a ten percent gain
so whenever I figured this out there is
a little bit more
than what I'm showing you here the the
math after the first year would have
been $55,000 but then you would have
paid that thirty nine percent tax on
that five thousand dollar gain so what
I'm showing you is after that thirty
nine point six percent tax was paid okay
so that even though you made 10% you
only have fifty three thousand twenty
dollars after the first year and then
after the second year you can see it's
fifty-six thousand two hundred and
twenty two dollars and so on and so
forth as you go down clear down to the
twenty year mark where you have a
hundred and sixty one thousand five
hundred and seventy one dollars at the
end and the taxes that you would have
paid over that entire twenty years with
seventy three thousand one hundred and
forty nine dollars so here's a perfect
example of a person who would be
investing this is assuming they can
continue to put their investment into a
10 percent yielding return every time
they trade it okay
so let's compare those two on the Left
we had the person who bought the company
that was continuing to grow a ten
percent so that investment turned into
two hundred and seventy five thousand
eight hundred and twenty seven dollars
after you paid your your capital gains
tax and you paid sixty thousand five
hundred and forty seven dollars and over
on the right you have the buy sell buy
sell buy sell strategy and you only have
a hundred and sixty one thousand dollars
in that investment and both of them were
making 10% every year so you're talking
more than a hundred thousand dollar
difference over the time of that single
investment the irony that I see is that
when you look at the taxes that are paid
the taxes that the person paid were
actually very similar but the amount
that you have in your bank account is
drastically different so this is Warren
Buffett's second rule that a stock must
have long term prospects and the reason
that he likes the stock to have a long
term prospect is because he doesn't have
to pay as much in his taxes he's
avoiding paying that the enormous
capital gains tax by not trading it
every other month or every every few
years he's holding these companies with
the intent to own him for the
of his life because he's going to
continue to collect the dividends and
the market value is just going to
continue to increase and you won't have
to pay the taxes on it so that concludes
our second rule a stock must have long
term prospects any time you find
yourself wanting to buy a company in the
short term and quickly flip it for some
money you're definitely going to want to
think about this rule and how the
acidity of those taxes eats away at your
gains so this concludes course to unit 3
lesson 3 Warren Buffett's second rule
where we talked about a stock must have
long term prospects and we talk
specifically about capital gains tax the
three lesson objectives were how to
identify a company with long term
prospects what is capital gains tax and
what is the difference between short
term gains and long term gains so I hope
you guys learned a lot and I'll see you
guys in the next lesson where we talk
about Warren Buffett's third rule