Selecting and owning individual stocks has lost favor as a way to invest in the best companies in the world. It isn’t trendy and may seem out of date. However, this approach offers benefits that wealthy investors and institutions have enjoyed for decades.
By thinking outside of the box, you can gain exposure to companies that have demonstrated profitability over generations and paid an increasing dividend as you gain the potential to defer or avoid the tax liability of long-term gains. In the current financial services industry, individual stock portfolios have taken a back seat to mutual funds and index products. Working alone or with an advisor, you can add this style of investing in with your IRAs, Roth IRA, and retirement accounts for the opportunity to access tax features and returns that wealthy invested have benefited from for decades.
Why you should own high-quality stocks
High-quality stocks have long reigned supreme in the investment portfolios of retirees, non-profit foundations, and members of the top 1 % while being almost entirely ignored by smaller, less wealthy investors. Wealthy investors have benefited from owning large stable companies because over a long-term period they grow and compound at acceptable rates of return from earnings and dividend growth. Sure, there are periods when the stock values will be down but with dividend reinvestment, dollar cost averaging and the economic power of the company generating positive shareholder value, over the long-term prices generally trend higher.
You may not be in the top 1% of wealthy investors, but you can enjoy tax strategies that these individuals participate in. During your life, you can gift the securities at a current market value with no tax liability. If you die with the individual stocks still in your estate, passing the deferred tax liability to your children using the step-up cost basis. Taxes are not paid as long as you are under the estate tax limits. It's an incredible, long-standing, traditional tax benefit.
Defining high-quality stocks
There is no universal agreement on what, precisely, makes up a high-quality stock. Generally speaking, the companies have an established record of stable earning over several decades that results in uninterrupted dividend payments that increase at a rate faster than inflation. They have strong financial profiles and maintain a competitive advantage by being among the largest companies in terms of capitalization. Size gives them a major competitive advantage which protects market share.
The high-quality stocks I want you to own tend to favor are members of the Standard & Poor 500 index or similar well-known large-cap index. Research reports, news feeds, and public disclosure allow you to follow the businesses and management decisions. If you desire to invest with a social consciousness Environmental, Social, and Governance (ESG) scores are usually available.
How do you build a high-quality stock portfolio?
Screening financial factors and some common sense will be a good start in building a portfolio. The names can also be found in the holdings list of top-notch active large-cap mutual funds. Buy approximately 30 names and then decide if you want to be industry aware or focus on owning the 30 names equal weighted. Both methods of diversification work because you are focusing on the long-term holdings periods. Transaction costs are highest at the time of implementation and during annual tax management trading. But because trading activity is low, transaction costs are not a major consideration in terms of the portfolios total return.
I am a strong supporter of capturing the benefits of various account types. IRAs, Roth IRAs, deferred tax compensation 401(k) and 403(b), and taxable accounts all have benefits that you should be exploiting as you add tax diversification. Multiple accounts will make asset allocation difficult and it's an important risk to control. To do it right, a good asset inventory tool is essential. Selection of best-in-class individual stocks and mutual funds can be a challenge, and it may be a good idea to hire a professional partner with skills in investment research and security selection. This partnership will allow you to have oversight as you monitor results, similar to the way a steward or pension trustee/professional staff member would using institutional processes and investment policy statements.
John Kirby is a Principal and Co-Founder of Laurentide Advisory.
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