Why did Buffett significantly reduce his holdings in Apple and Bank of America?

Warren Buffett recently significantly reduced his holdings in Apple (AAPL.US) and Bank of America (BAC.US) stocks. Since mid-July, Buffett's Berkshire Hathaway (BRK.A.US) has reduced its Bank of America holdings by nearly 13% through a series of transactions, with accumulated profits reaching $5.4 billion. In addition, Buffett sold over 389 million shares of Apple stock in the second quarter.

For investment giants with large holdings, selling a significant position in key stocks is a very painful process, and it also incurs a substantial amount of taxes, which will be permanently deducted from the capital.

So, since selling a large amount of key holdings is a costly action, why did Buffett significantly reduce his positions?

Possibility of an Increase in U.S. Capital Gains Tax Rate

Let's start with taxes. The capital tax costs were already a hindrance for Berkshire Hathaway to sell Apple and Bank of America stocks. For example, the tax cost of selling stocks for Berkshire Hathaway is calculated by multiplying the embedded upper limit profit of the sold stock portion (usually the stock with the highest cost basis) by the current corporate tax rate (same as the 21% regular profit tax rate).

Most of the Apple stock held by Buffett was purchased between the first quarter of 2016 and the first quarter of 2018. During this period, Apple's stock price rose from around $24 per share to around $46 per share; the average of these two numbers indicates a cost basis of approximately $35 per share, which is consistent with the cost basis data in Berkshire's annual report. Then, reasonably assuming that Buffett sold Apple stock in the past two quarters at prices between $169 and $216 per share, with his long-term capital gains accounting for 80-85% of the net income, this means Berkshire Hathaway would have to pay 16-17% of capital gains to the IRS, resulting in a permanent capital loss.

Paying this 16-17% capital gains as the upper limit gains tax will not affect the balance sheet, as the valuation of Apple stock on the books has already been discounted. However, in terms of cash, this means Buffett can only retain 80%-85% of the cash. If he wants to invest the cash obtained from selling Apple, his investment amount will only be 80-85% of the current value in Berkshire's annual report (please note that this number has not been provided by Berkshire in the past two years).

Furthermore, just like Coca-Cola, which has seen little growth in the past 20 years but still brings in significant dividends (current yield of 2.78%) for Berkshire. A few years after Coca-Cola peaked in 2000, Buffett casually mentioned that he might have sold it when it peaked, but speculations suggest that considering the 35% capital gains that must be paid to the IRS, he delayed the action.

Holding these stocks allows Berkshire Hathaway to gain substantial long-term capital gains, and capital gains tax is a fundamental reason against selling significant holdings. Therefore, Buffett's significant sale of key holdings indicates that only a strong selling motivation could prompt him to pull the trigger The most obvious motivation is that the future capital gains tax rate for US companies may be higher. In recent years, the huge fiscal deficit in the United States—ostensibly the result of government spending offsetting the economic drag of the COVID-19 pandemic—will eventually need to be addressed, possibly starting with an increase in the corporate tax rate.

Most investors are not too concerned about high tax rates for companies, but an article in The Wall Street Journal on August 25th pointed out that at the recent Democratic National Convention in the United States, speakers often referred to corporate leaders as "oligarchs" and "corporate monopolists," laying the groundwork for anti-corporate economic policies.

Another idea proposed by US Vice President and 2024 presidential candidate Harris is to tax unrealized capital gains, which would mean that currently unrealized future capital gains recorded on the books could turn into cash taxes due for the current period. While this may seem unimaginable, especially considering the complexity of drafting the details, the United States has precedents for introducing complex regulations for investment income.

The US institution responsible for setting accounting standards has previously issued a new rule on capital gains, Accounting Standards Update 2016-1, which requires changes in investment value to be included in regular quarterly income reports. Buffett sharply criticized ASU 2016-1, pointing out that it caused a lot of trouble without clear value, but he may also have noticed that taxing unrealized gains is just a step away.

In summary, all possible adverse tax changes suggest that savvy investors may choose to sell some positions with significant unrealized capital gains now.

So, is this just a tax issue?

Not quite.

Threats and Resistance within Apple Itself

When Buffett started buying Apple stock, its P/E ratio was less than 15 times. The growth rate of Apple was much faster when he initially bought the stock. In early 2018, Buffett stopped buying. As of last year, he has been holding the stock for the past five years, and Apple's stock price has continued to rise, but the growth has slowed down. Apple regularly pays small dividends and conducts larger buybacks.

This strategy is similar to the one he adopted for Coca-Cola. Coca-Cola faced a slowdown in growth in 2000, and its P/E ratio fell from absurdly high levels, but it still managed to increase dividends. Eventually, with the improvement in performance of Coca-Cola, Buffett believed that holding on was better than selling and reducing his capital—selling would incur high capital gains taxes. He continued to hold Coca-Cola because it pays dividends, with the current yield being about 50% above cost.

As for Apple, despite its stock price doubling from 2016 to 2018, its P/E ratio is still far below the current 34 times. Buffett certainly realizes that a P/E ratio of 34 times appears quite expensive compared to Apple's very modest profit growth in recent years. Over the past five years, Apple seems to have entered a plateau period. Undoubtedly, Buffett, drawing on his lifetime of experience, made some calculations for the next step and did not increase his holdings of Apple stock in these 5 years. Apple is somewhat protected by the same consumer brand strength as Coca-Cola. The rapidly evolving tech industry comes with higher risks Apple has always been a company with unstable growth. In the process of reshaping new businesses or improving existing ones, it often stagnates before making a leap.

The perennial issue lies in the lack of consensus in the market regarding Apple's next stage. What's more problematic is that the conclusions are almost binary. Some say Apple will achieve great success in artificial intelligence and product upgrades, while others caution that Apple has major issues and Buffett's selling of it is correct. Some point out that Apple's stock price is currently expensive, while others suggest that Apple's stock is about to experience explosive growth, which will address the issue of high P/E ratios.

Buffett's strength lies in weighing the potential consequences of apparent issues. His current selling of Apple shares falls somewhere between these two scenarios. If he continues to sell and eventually exits all of Berkshire's Apple holdings, it is highly likely that it indicates Apple's slowing growth, increasing risks, and overvaluation have led him to completely divest from Apple. So far, although his selling has been substantial, he has not made such a statement. However, Buffett's selling of Apple shares does indicate that Apple's stock is currently relatively expensive, especially considering the many uncertainties surrounding it.

Apple is not only expensive in terms of stock price, but also has a market capitalization of $3.5 trillion, making it the world's largest company by market value, accounting for a significant proportion of the major indices. Perhaps Apple deserves such a market value, but this scale requires a huge leap for it to "change" its value. Buffett is particularly aware of this issue, as Berkshire Hathaway's holdings in Apple make it difficult to outperform the S&P 500 index.

Apple's size also makes it difficult to balance with Berkshire's investment portfolio. If it cannot restore rapid growth, Apple's P/E ratio is likely to drop by 50% or more to return to its 2016 levels. Taking such a risk in the face of unfavorable developments is too great. He certainly feels that, given the current uncertainties, Apple should not account for 20% or more of Berkshire's portfolio value, yet Apple sometimes accounts for 20% or higher.

Over the past few years, a major theme for the 94-year-old Buffett has been to tidy up his investments while he still has time. The issue of Apple requires his own long-term experience and sharp judgment to resolve, and he does not want to pass this problem on to his successor.

The most optimistic speculation is that after Buffett sells Apple, it will still be a major holding of Berkshire, possibly ranking first in Berkshire's investment portfolio. It may indeed make a huge leap from artificial intelligence and new products. If this turns out to be the case, Buffett will not have made a mistake. He considers the risks and absolute uncertainties, and keeps Berkshire's risks at a reasonable level.

Regulatory Risks Faced by Bank of America

Buffett's selling of Bank of America shares certainly involves issues with higher capital gains tax rates. On the other hand, Bank of America faces potentially greater political risks than most other companies. Under the current leadership of the U.S. government, large banks are under immense regulatory pressure, and if the Democratic Party wins again, the situation could worsen The exact source of the Democratic Party's hatred towards big banks can be traced back to the financial crisis, when banks' loose policies played a crucial role in the construction of high-risk mortgage-backed securities (MBS). Stress tests and restrictions on bank dividends and buybacks continue to be important ongoing punishments. Recently, Federal Reserve Chairman Powell held a closed-door meeting with bank CEOs, guiding them on what they must do to create more capital. A larger concern looming over major banks is the fear that many bank critics want to nationalize the banks, turning them into utility companies with limited shareholder returns. If the Democratic Party wins big, it may lead politicians opposed to banks in that direction.

If the Federal Reserve implements a series of interest rate cuts to boost the economy, Bank of America may also benefit. Despite Bank of America's low price-to-earnings ratio (about 12 times) compared to Apple, its dividend yield is more than twice that of Apple, but its political risks are not as specific as Apple's internal risks.

Conclusion

Some analysts believe that Buffett's predictions for the overall market have been very accurate, and his views on the entire market may have driven his significant reduction in holdings, but this is unlikely to be the primary factor behind his massive sell-off. Buffett has great faith in fundamentals, and the more fundamental reason he wants to reduce these positions may be considering higher future taxes and political risks, with specific risks of individual companies also influencing his decisions, especially in the case of Apple