Many individuals have accumulated wealth concentrated in one single stock. Often this is a company they have worked for many years and have watched their wealth grow as the stock has shined. People often become emotionally attached to the stock since it has been the prime determinant of their wealth. This poses a problem for the investor in terms of diversification, lack of liquidity and tax issues. A highly concentrated stock position exposes the individual to significant risk by holding a single company. All I need to say is Enron or Worldcom and you understand what I am talking about. While the additional return for holding the right stock is substantial, significant underperformance to the S&P 500 has been four times more likely when holding a single position. (1)
Reducing concentrated positions can help investors achieve their long term goals. An individual’s spending needs, risk tolerance, tax cost of selling and the volatility of the stock should all be considered when determining the best way to exit the stock and diversify. Decisions on how fast to diversify and pay the taxes can have a profound effect on one’s ability to achieve their long term goals. A 60 year old whose single stock comprises 80% of his investment portfolio must approach this differently than an 70 year old with substantial assets outside his single stock. There are alternatives to simply holding or selling the stock that can help diversify and delay the taxes and we will explore a few of those.
Divesting in stages rather than all at once can be appealing to some individuals. One needs to ask themselves questions such as:
• Can I maintain my current lifestyle if the stock tanks?
• How much volatility am I likely to experience?
• How much is my wealth likely to grow or decline?
Let’s look at two different cases and possible strategies for different investors who both have concentrated stock positions. Both James and Anne worked for the same company and each have $2 million of XYZ stock and are retired and will need income from their investments to supplement other income sources and maintain their lifestyle.
Anne is younger and a little more aggressive. Her goals are ambitious and her wealth is considerably more concentrated than that of James. For both of them their are arguments to divesting of some or all of the XYZ stock. For Anne, it is clear that having 80% of her net worth in one stock is dangerous. Since James has $6 million in other investments, his risk is not as great, but diversifying out of the position would help limit the volatility of his portfolio.
Let’s start with Anne. We will assume that Anne has held this stock for more than a year and her cost basis is $500,000. So an outright sale of the stock would generate a $1.5 million gain or $225,000 in federal taxes at current 15% capital gains tax rate. A good option for Anne would be to consider an equity collar. This is a good hedging strategy that involves the purchase of a put option on the concentrated stock position, plus the sale of a call option. A put option gives the owner the right to sell their stock at a given price in the future(the strike price) so it provides downside protection. The sale of the call option provides premium income that she can use to pay for the purchase of the put option. When you sell a call option you have the obligation to sell your stock at a specific price in the future(the strike price). A “cashless” collar is when the premium income is just enough to cover the cost of the put option resulting in zero outflow. Alternatively, she could opt for a call with a higher premium and have additional income resulting in net cash flow to her. Let’s assume she has 14,000 shares and the stock is trading between $142 and $143. Anne could purchase a 6 month put option on 7000 shares at a strike price of $135 and sell a call on the same amount of shares with a strike price of $145. On the other 7000 shares, she could purchase a 12 month put option at the same $135 and sell a 12 month call option at the same $145. Splitting it up can break up any potential gain that may occur over two years. The put option gives Anne the right to sell her stock at $135 which she will exercise if the price of the stock falls below that before the options expiration. Selling the call option obligates her to sell her stock at $145. So she will be “called” out of the stock if the price goes above $145. This strategy limits the upside while putting a floor and a ceiling on what she will get for her stock. This can be an effective way to get out of the stock and protect her downside while potentially generating some additional income from the call premium. As she diversifies out of the stock, the money is reinvested in a balanced portfolio that will generate the income she needs to grow her wealth and maintain her lifestyle with significantly less risk.
James’ goals are little different and he is more conservative in that his spending to asset ratio is considerably less. James is charitably inclined and wants to leave a legacy in his community but also want to make sure he has sufficient income for his life and for his daughter. An option that may appeal to James is a charitable remainder trust. James could gift his 2 million stock to a trust and the income beneficiaries would be himself and his 55 year old daughter. After
their death, the trust would terminate and the money would go to the charitable beneficiaries that he would like to create an endowment for. Let’s assume his cost basis is also $500,000. By utilizing this strategy, James is able to avoid capital gains tax of $225,000 and he gets a $589,500 income tax deduction resulting in additional tax savings of $230,000. As long as he or his daughter are living they will receive $76,000 annually from the trust. For James, this is like having his cake and eating it too.
In general, the strategies described here are best carried out by a professional financial advisor. It is worth knowing some of the many options available to you when it comes to protecting your wealth so you can make an informed decision about choosing a financial advisor to help you.
(1) “Bernstein Wealth Management Research, The Enviable Dilemma- Concentrated Stock:
Hold, Sell or Hedge, March 2004”
Michelle Mabry is a financial advisor in Hattiesburg, MS. Questions or comments? Check out her GuideVine profile to watch Michelle’s videos and learn more.