TAKE NOTE: COVER STORY
a Focus on stock selection
It’s important to focus on the fundamentals of any company in which you invest. Peters focuses on companies that have pricing power and a sustainable competitive advantage in their respective businesses. Earnings growth is a particular point of emphasis. The majority of growth stocks’ total return tends to come from price appreciation, rather than dividend payouts—an important distinction for tax-efficient investors. While dividends create a tax liability, the unrealized growth from price appreciation has no immediate tax consequences for a buy-and-hold investor. "Having a growth tilt is an important part of being tax-efficient, in the sense that we look to invest in companies that are relatively early in their life cycle," says Peters. "The idea is that they will be plowing profits into additional growth, rather than dividends."
The ideal tax-efficient investment, says Peters, offers the high growth potential of a younger company with the proven business concept of a more mature enterprise. Balancing these two characteristics often lands tax-efficient investors in the territory of mid-cap stocks, which historically have offered returns that are competitive with small-cap stocks with less volatility.
PROFESSIONAL TAX EFFICIENCY
Tax-efficient investing can be a challenge for individual investors given the amount of research and planning required. Investing in a professionally managed tax-efficient mutual fund allows you to leverage the experience of a manager who has the time and resources to manage those investments actively. When evaluating a fund for its tax efficiency, consider its tax efficiency ratio. The ratio indicates how much of pretax returns are passed along to the investor in the form of after-tax returns. For instance, the tax efficiency ratio for T. Rowe Price’s Tax-Efficient Equity Fund is nearly 100%, which reflects the fact that it has made minimal capital gain distributions since its inception in 2000 despite posting competitive returns.
That said, tax-efficient investors do not need to limit investments to the mid-cap universe. An appropriate mix of stocks across the capitalization spectrum can help smooth out volatility while pursuing good long-term returns. Including large-cap stocks in your portfolio also means you can continue to hold shares of winning mid-cap companies even if they grow into large-cap territory. This is the strategy Peters follows in the T. Rowe Price Tax-Efficient Equity Fund. "If we were a mid-cap-only fund, we would have had to sell some of our winning investments once they grew too big," says Peters. "This way, we can keep winners in our portfolio, as well as target some large-cap companies that we think are attractive based on our mandate."
The Benefits of a Loss
Even with careful stock selection, every portfolio will contain investments that lose value. However, stocks that have lost value provide an opportunity to offset the tax liabilities produced by the gains realized in stocks. This advantage holds even in a down market where you may not have any gains to offset: IRS regulations allow you to carry losses forward indefinitely to future years until they are used up.
Harvesting losses requires a measured approach, however. Rather than realizing losses at the end of the year in one major portfolio rearrangement, Peters spreads those decisions over the full year. The reason: Spreading out the sales offers the flexibility to reverse a decision while steering clear of IRS regulations that prohibit realizing a loss on a security and purchasing a substantially identical stock in the next 30 days. "Harvesting losses is not a riskless strategy," says Peters, who cautions that realizing losses isn’t an end in and of itself. Instead, any decisions you make to sell shares must have a purpose in your overall strategy and fit in with your plan. "You have to be careful that your portfolio is where you want it to be after you recognize a loss," he says.
Taxes are an often overlooked expense that can erode a portfolio’s return. While taxes should never be the primary focus of your investment decisions or strategy, they should factor into that strategy as a means of maximizing your after-tax returns. This approach is particularly important for investors in higher tax brackets who are investing in taxable accounts. "When you invest in a taxable account, the way to keep score changes," says Peters. "Instead of concentrating primarily on pretax returns, look at the after-tax returns because that’s what matters to you at the end of the day." By making the right decisions early on, you can enjoy the benefits of a tax-efficient portfolio for years to come.
Current performance may be higher or lower than the quoted past performance, which cannot guarantee future results. Share price, principal value, and return will vary, and you may have a gain or loss when you sell your shares. For the most recent month-end performance, visit troweprice.com/tmc.
The fund’s expense ratio as of 2/28/13 was 0.98%.
Fund holdings are subject to market risk, and share prices may be more volatile than those of a fund focusing on slower-growing or cyclical companies.
Average annual total return figures include changes in principal value, reinvested dividends, and capital gain distributions.