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Rupert Hargreaves
Rupert Hargreaves
Articles (324)  | Author's Website |

The Benefits of a Capital Gains Dividend

Capital gains dividends may be a more tax-effective way of creating income

I have written about the importance of dividends to investors many times before. To reiterate, dividends are a vital tool for wealth creation over the long term, and there is no substitute. Well, there is no substitute unless you create your own dividends.

Creating your own dividends is not a complex process. Finding a company to invest in that has the traits you need to be able to build a portfolio where you create your own dividends is the hard part.

Create your own dividend

What do I mean when I say “create your own dividend"? Put simply, I’m talking about selling a small percentage of an equity holding every year and taking the sale proceeds as a dividend. This strategy is slightly more complicated than the income boosting strategy of call or put writing that usually is used by investors and traders to create additional income. And to be able to execute the strategy correctly, you need to find and invest in a company that is a compounder with a management team that has a record of prudent capital stewardship.

Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) is the prime example of such a company. Over the past five years, shares of Berkshire Hathaway have returned 93.3%, outperforming the S&P 500 by 8%. Warren Buffett (TradesPortfolio) is possibly one of the world’s most celebrated capital allocators, and this clearly shows in Berkshire’s stock price.

Buffett (TradesPortfolio) has always refused to pay Berkshire’s earnings out to shareholders as dividends, as he believes he can allocate the capital better himself and help investors avoid double taxation. This is a great strategy in many ways. As an investor, if you were offered the choice of taking your profits out of the business and paying tax on the dividend, which itself comes from profits that have already been taxed, or leaving your money with proven capital allocated with no additional tax liability, which would you choose?

Capital gains are usually taxed at a lower rate than income. So for tax planning purposes, if you are offered the choice, it makes sense to take profits as capital gains rather than income and avoid the higher tax liability. After all, investing is all about increasing your wealth. What is the point of trying hard to increase your wealth and navigate the stock market only to pay a large percentage of your hard-earned income to the government via tax?

Another benefit of the “create your own dividend” strategy is the ability to create the payout when it is most suitable for you. If you have no need for the additional income, there is no reason to sell stock. In this situation, you receive a double benefit. As the business does not have to pay out a dividend to investors, the cash is being reinvested at a suitably attractive rate, and you are benefiting from the additional capital gains that may be generated over the period.

The problem is that companies like Berkshire Hathaway are somewhat of an anomaly. Yet they do exist. Markel (NYSE:MKL), Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOGL) and Fairfax Financial (TSX:FFH) are just four great examples.

There is a bigger point to be made here, however. The companies above are all prime examples of excellently run firms, which have proven to be fantastic compounders over the years, run by shrewd managers. These are, in many ways, the perfect businesses. Rather than chasing dividends, investing in such companies would likely generate better returns over the long term.

Conclusion

Overall, the “creating your own dividend” strategy has many merits. Not only will the strategy help you avoid any unwanted tax liabilities but by pursuing this strategy, the number of investments qualifying for your portfolio falls dramatically, and the ones that are left are likely to be some of the best-managed companies around, with a record of achieving outsized returns for investors.

Disclosure: The author owns no stock mentioned in this article.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. Prior to his investing and writing career, Rupert was as a proprietary currency trader. Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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