Larson's Stock Picks for Your Taxable Account

Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax-Wise Investing Week on Morningstar.com, and today we're talking about how to maximize those taxable accounts.

One way to do that is to pick low- or no-yielding stocks for your taxable accounts; it will help save on that tax bill, but you want to pick the right kind of company. Here with to walk us through some of those steps is Morningstar's Paul Larson, he is the editor of Morningstar StockInvestor and an equity strategist.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: One thing that we know right now is that dividends are actually taxed at a pretty low rate, so it's not a horrible thing to have dividend-paying stocks in your taxable account. But there is some uncertainty about that. We know that the dividend tax rates could go up, and if you wanted to be as efficient as possible, you would actually look for stocks that don't pay out income.

But when you're doing that, of course, you want to know, well, what are they going to do with that money? Are they going to actually be able invest it in a way that will help me as a shareholder? So, I asked you to come up with short list of ideas of stocks that we can consider there, and I think there are probably some similarities between the advantages of these companies. Why don't you kick it off with your first stock idea.

Larson: Well, one stock that does not pay a dividend that does look attractive to us is Berkshire Hathaway, led by Warren Buffett, And this is a stock that's trading at only about 1.2 times book value, which is a very attractive price for the quality of the business that you're getting.

Berkshire just recently announced a share buyback about six months ago, and this is really big news for Berkshire because before this point in time, they had basically accumulated all their capital and had not returned any capital whatsoever to common shareholders. I think it's probably only a matter of time before Berkshire initiates a real dividend, but that point is maybe still a little bit down the road.

Stipp: I was going to ask about that. So, it does seem like with the kind of the cash hoard that Buffett has, it's a little bit harder for him to find the kind of opportunities that he would like fund. Would you have liked to have seen a dividend instead of the buyback announced at this point, or do you think this is a natural progression?

Larson: I think this is a natural progression, and clearly Buffett thought that he could do better with the money himself than shareholders can do on their own buying random stocks out in the market.

But you're absolutely right--with the opportunities set continually shrinking as Berkshire continues to grow, again, I think it's only a matter of time before they start to pay it out because as they say, trees don't grow to the sky.

Stipp: The second one, Paul, is in the tech sector, a search engine giant. What's the story behind that and why do you think that’s a good stock to consider right now?

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Larson: Another one, Google, is a company that doesn’t pay out a dividend, and we think it is undervalued right now. Our fair value is $744 versus the stock that’s somewhere around $600. And this is a company that has a wide economic moat, and while it has spent a lot of money on acquisitions, some of those acquisitions have actually done fairly well. They bought Android, and that's becoming a much larger and larger part of the business. Also YouTube was an acquisition. So, while the company has spent money on a lot of different acquisitions, some of those have indeed paid out.

Stipp: So, hopefully, we will see them continue to bear fruit for that company.

The last one is one that we've talked about as having a very powerful economic moat for a while--online auctions. It's eBay. What's the story behind that, and why do you think investors give that one a look?

Larson: Well, our fair value estimate on eBay is $42 versus the stock that’s around $33 or so. So you have a relatively attractive valuation there.

Also when you look some other very simple valuation metrics--the free cash flow yield on eBay is close to a 6%; it's also near 6% for Google, which I think is a very attractive price tag for a company that has a wide economic moat and is still growing at a fairly decent rate. And this is a company that has also added value through holding its cash and buying other companies.

PayPal may even go down as one of the best acquisitions that the company has ever done, and the most recent acquisition, GSI Commerce, is also doing quite well. Even Skype, which is something that got a lot of criticism when they first did it, even that one turned out to be profitable for them in the end.

Stipp: So you want to make sure that if a company is not going to be paying out a dividend that they have good use, good well-returning use, for that money. So it seems like a pretty good track record there.

One other type of company, Paul, that you mentioned that you wanted to talk about, and it might not be one that immediately would occur to investors because they do pay off income, is MLPs. But actually taxable accounts are the place to put MLPs. Why is that?

Larson: Well, the reason that you want to have Master Limited Partnerships in your taxable account, as opposed to your tax-deferred account, is if you own them in a qualified account, you could actually still end up paying taxes on that potential income that you're going to be receiving.

Also these are tax benefited investments, and you want to make sure to capture that benefit. And if you own it in a qualified account, you don’t get the benefit; whereas, if you do own it in the taxable account, you are going to reap that benefit. And the benefit is, the deferral of taxes that you are going to have to pay on that income.

When you own an MLP, you're going to get a stream of income from the partnership distributions, but the actual IRS income amount that you're going to be liable for, is usually going to be very small, if not nothing, for the first couple of years that you own it. So you are basically getting a tax-free income stream.

Now ... those distributions that you get are going to lower your cost basis as time goes on. So Uncle Sam will eventually catch up with you, but you will get that deferral, which is, again, a tax benefit that they wouldn't necessarily get if you owned it in a 401(k) or such.

Stipp: So because of the way these work, and then your cost basis is adjusted, and it’s a different way than maybe a dividend would be paid out, if you did sell it down the road, then you might have a bigger capital gain liability. But if you held on to that stock for a while, potentially you could defer that tax on into the future?

Larson: In fact, you could potentially defer it in perpetuity if you actually die owning the stock. My interpretation of the tax laws is that you would get the stepped up basis at the point of your death for your heirs, and so you would retain that benefit.

Stipp: So actually some tax advantage in the MLP.

I know that MLPs have done pretty well as investors have gone out to seek yield. They do have a few other tax quirks about them that investors should have on their radar. But do you see any MLP opportunities right now as you are looking across the marketplace?

Larson: Sure. One MLP that I happen to like is Energy Transfer Equity, ticker ETE, and this is a MLP that actually owns the general partners of other MLPs. And general partners are attractive because they are levered to the performance of the underlying MLP. So you if you like MLPs in general, you should really like the general partner, and this is one that has rolled up a couple general partners.

It looks undervalued by about 20% here. Even if that fair value estimate doesn’t come to fruition in the near future, we're getting paid nearly a 6% distribution yield while we wait, which is, again, a fairly attractive yield. And the total return here--this is a partnership that is going to continue to grow, probably not over the next couple of quarters because they are in the middle of merging with another company, Southern Union, so that distribution growth is probably on hold for a couple of quarters. But a couple of years from now, I think that the distribution growth is going to continue.

Stipp: And at 6%, I think it's worth a few small tax headaches to deal with the quirks of the MLP, wouldn't you say, in today’s environment?

Larson: Absolutely. MLPs--there are some headaches to owning them, increased tax complexity. But again that high yield makes it worth it, in my opinion.

Stipp: Plus the potential for future growth.

Paul, thanks so much for joining me today and for your ideas for the taxable account.

Larson: Thanks for having me.

Stipp: For Morningstar I’m Jason Stipp, thanks for watching.