Peter Hodson: A tax-loss sell is a guaranteed win
A specialist trader works on the floor of the New York Stock Exchange. Photo by Brendan McDermid/Reuters files Guaranteed investment certificates (GICs) are amongst the only real guarantees in the investment world today. If you invest $100,000 or less, your money is fully guaranteed by the Canada Deposit Insurance Corp. — of course, you might lose purchasing power to inflation, but that’s a topic for another day.
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But don’t worry, we’re not going to talk about boring old GICs. Frankly, we would rather take a chance on the stock market than be bored to death with fixed-income investments. But that’s just us. Others clearly disagree since GICs are suddenly becoming very popular as rates rise and markets fall.
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Instead, we are going to talk about other guarantees, or pseudo-guarantees, in the investment world. They may not be guarantees in the defined sense of the word, but they nonetheless happen with enough regularity to be considered as such.
A tax-loss sell is a guaranteed win (through tax savings): Suppose you have lost $10,000 on a stock this year and are in a 50-per-cent tax bracket. Sure, the loss hurts, but if you sell that stock before year-end, you can write off the loss this year against other gains. The loss can be carried back three years, or carried forward forever. Yes, you have lost $10,000, but you have picked up $2,500 in tax savings, as long as you have some prior — or future — gains.
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Most investors are extremely reluctant to sell stocks for a loss. After all, it’s a final admission of defeat. But we encourage it. The tax saving is a guaranteed win created from a bad situation. Depending on your situation, if you have losses in prior years, you could even get a tax refund from claiming a loss. This can certainly help the pain of the bear market.
Headlines will be very bad at the bottom: Many investors right now are waiting for the market to bottom out. There is lots of cash on the sidelines, investors hate everything and the doom and gloom, despite a few weeks of normalcy in the market, remains prevalent. Sorry, we can’t tell you when the bottom will be. As they say, no one rings a bell at the bottom. But we can guarantee you this: the news will be very bad when the market bottoms.
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Headlines will scream recession, war, lower earnings, inflation, interest rates or whatever. But all the news will be bad on the day the market stops falling. This I can guarantee you. I remember March 2009 well. After a devastating financial crisis, I couldn’t really find a decent piece of news anywhere. I couldn’t find a bullish investor at any conference I attended, or among anyone I spoke to. The world — at least for investors — truly looked to be ending. But then it didn’t.
Declining stocks will get downgrades and lowered targets: I don’t like picking on Bay Street and Wall Street analysts so much, but this is simply too easy: after a company has problems, or its stock declines, analysts will fall all over themselves trying to downgrade the stock — again, after the fact. We see this so much it is almost comical. A stock falls 45 per cent and then the analysts drop their target prices.
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Recommended from Editorial Five winning investments in 2022 and their prospects ahead Five reasons bad news is not always bad news for investors Attendance was high, but spirits were not: Five takeaways from the MoneyShow Let’s look at poor Meta Platforms Inc. Less than a year ago, the average analyst target price was US$405 per share. Now, after a 71 per cent plunge in the stock, the average target price is US$146. After weak results last week, nearly every analyst lowered their targets — again. We get that companies sometimes surprise investors with bad results. But analysts moving their targets lower as stocks decline practically guarantees investors will miss the turn when it occurs. Like the bad news theme above, it usually spells opportunity when everyone hates a stock.
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Article content A lower share price guarantees dilution: A declining stock price for some small companies can be a death spiral. Why? Because the amount of capital a company needs does not change depending on its stock price. Suppose a company needs $10 million to execute its business plan, and its stock is $10 per share. No problem, it needs to sell one million shares to meet its goals. But what happens, in a year like 2022, if its stock declines to $1 per share? It still needs $10 million, so now it needs to sell 10 million shares. More share dilution is guaranteed if the company really needs to raise money.
As a result, many small-cap stocks, once they start dropping, keep dropping. Investors get worried about more and more shares being issued, and some will sell as they anticipate a financing round. This is why looking at a company’s balance sheet and cash flow is so important for investors. Don’t get yourself into a situation where a company needs money at the wrong time, such as when its stock is way down.
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Article content Small caps lead the market higher: We will end on a positive note. This is not quite as strong a guarantee as the four points above, but history is definitely on our side here. In the past 10 recessions, small-cap stocks have led the market out of its slump, outperforming all other categories in the first year following recessions. Ten for 10. We have no doubt this will occur again. That’s because small-cap stocks were hit very hard, very early, in the downturn. Many stocks are down 80 per cent in a year. Yet relative to large-cap stocks, small caps are both cheaper and growing faster.
Historically, small caps are always more expensive than large caps on a price-to-earnings basis, because of their faster growth. But small caps are now back to 2008 levels, at least in terms of relative cheapness to large caps. As scared investors flocked to the so-called safety of large caps, they have left the small companies behind. This can create big opportunities. One day in the future, investors might look back on the small-cap sector and say, “Wow, they were so cheap, why didn’t we buy them?”
Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)
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