Ann: HY22 Investor Presentation, page-69

Kingsley Jones

Jevons Global

Tax-loss selling happens when investors take advantage of the looming tax year-end on the 30th of June to sell some of their losing stocks to offset any realized capital gains. Using our proprietary average cost-of-entry tool, we calculate estimates of the average investor cost basis for all stocks in the S&P/ASX 200. This can be used to surface likely losers.

Please note that this article is focused on the principles governing tax losses in relation to how investors behave. You should consult a registered tax agent for advice on your own personal circumstances since every investor has a unique tax position.

Tax-loss selling and the average cost of entry

In a previous wire, The savvy yabby (or, how I “know” when to adjust iron ore exposures), I explained how one can use estimates of the average price investors paid for their stock to judge their likely sentiment. The underlying idea is pretty simple:

Are investors going to feel good because they have paper profits, or are they going to feel bad because they have paper losses?

During most of the year, this is just a judgment of how they might be feeling.

However, once every tax year the answer to that question, what is the average condition of investor gains or losses in a stock, will have a practical impact.

You cannot make a tax loss if you only have a gain.

If most investors in a stock have paper gains they are unlikely, on average, to be choosing that stock to sell in order to generate tax losses. Of course, in stocks that have widespread losses, we should expect significant tax-loss selling. This leads us to a hidden fundamental:

The purchase price of every share issued by a given company is a real number and the stocks most at risk of tax loss selling are those where on average it is negative.

Across the market, these add up to what I call the fundamentals of sentiment.

Stocks with large unrealized losses, on average, will have poor investor sentiment, and are those most likely to be sold to harvest tax losses at the end of each tax period.

Relationship between annual losses and tax losses

Generally speaking, there is a close correlation between stocks that have fallen a lot over the past year and stocks that are likely candidates for tax-loss selling.

That is mostly right, except for some complications. For instance, there may have been stocks that did very well for many years which have only just had a significant correction. On the other hand, stocks that fell a lot over one year, but which have rallied a lot off lows may no longer have many unrealized losses. The trailing one-year return is simple, but can be skewed.

In this note, I have used the method I described in the earlier article on sentiment to calculate the bottom-up estimate of average cost basis, taking account of stock turnover. You can read the original article linked above, or just follow along here, where we just discuss results.

Our first result is to calculate the estimated average investor profit and loss by taking the closing price on 3-Jun-2022 and dividing that by our estimated cost basis on that date.

To explore the relationship between this number and the trailing one-year return we can look at a scatter plot of one variable versus the other. You can see the relationship is pretty close.

Scatter plot showing the correlation between unrealized profit and loss and one year trailing price return

The fact that these are actually different quantities shows up in the slope of the line. It is not actually one, because the trailing one-year return is based on the price on 3-Jun-2022 versus that one year ago on 3-Jun-2021. If investors typically held stocks for one year, that would be about the same as the average cost of entry. However, the holding periods for stocks vary widely by stock, by investor, and by year. That is why the numbers are different.

However, they are somewhat similar, as you can see.

Estimated tax losses by sector

Since every stock is different, but similar stocks in similar industries experience similar market cycles, we can glean some further information by looking at sectors. The table below compares the two measures of sentiment: one-year trailing price return, and unrealized investor profit.

Aggregated one-year price return compared with aggregated unrealized profit and loss by sector

The sectors given are the ones I use at Jevons Global. They are fairly self-explanatory but you will see complete lists of every current stock in the S&P/ASX 200 later.

For now, look at the boxed numbers by sector. You can see that Resources & Energy has had a banner year. The average cap-weighted one-year price return was 23.44% and our estimated average unrealized investor gain is 24.86%. On the loss side, you can see that the Consumer Wants sector had negative year-on-year price gains, but shows around 6.08% profit.

These analyses help explain how tax-loss selling may appear in places we don't expect. The risk is not as simple as listing those stocks which fell a lot over one year, as we now demonstrate.

Are large annual falls always indicative of tax-loss selling?

Prior to reviewing the stocks we believe are most at risk of further tax-loss selling, it may be helpful to dig a little deeper into the difference between a large annual price fall and the tax issue of whether investors are sitting on large unrealized losses.

As it happens, these are not necessarily as closely correlated as our scatter plot suggests. The reason has to do with the level of liquidity in the marketplace for the stock. The simple fact is that stocks that trade very little tend to have a much slower moving average cost basis.

The math of this can be a little complicated but the idea is actually pretty intuitive.

Imagine a stock that was listed at $1 but traded very little until it reached $10. The average investor would have bought at an average price close to $1. If the stock then plummeted from $10 to $5 it might look like a high conviction candidate for tax loss selling, but most investors have gains around $4.

The moral of the story is that we have to look closely at the rate of turnover. Low turnover stocks with high drawdowns can oftentimes be stocks that are still in profitable territory.

To illustrate, I have picked out a few current examples from our S&P/ASX 200 database.

The chart below is for Reece REH.AX , a plumbing supplies firm. The blue line shows the recent price history using the closing price from the Australian Stock Exchange. The gold line shows an estimate of the average cost basis of investors. This is the same as the price they paid, on average, when buying the stock over time. The number changes on a daily basis.

Reece has low turnover and so has just hit break-even for investors which is the first time in five years

When the blue line is above the gold line, the typical investor is in profit. When it is below, the typical investor is in loss. This is easiest to see if we plot the average unrealized profit and loss at each point in time by dividing the price on a given day by the cost basis on that day.

Reece is estimated as being very close to break even with no more tax losses to take

This second type of chart has just one line which shows the unrealized profit and loss on each day, measured as a percent gain or loss. It changes each day, as the price fluctuates.

Reece saw good conditions during the pandemic lockdown as many homeowners renovated. While it is down 32% over one year, and significantly more from the recent highs, our estimate of the average investor cost basis shows the typical investor as being pretty close to break even. There are few tax losses to take now!

Reece has shown a very good history of positive unrealized gains and is now at break even.

Stocks like Reece are prime candidates to be bought in the new tax year as investors go back to their models, re-do their valuations for the new environment, and judge their entry price.