Warren Buffett recently significantly reduced his holdings of Apple (AAPL.US) and Bank of America (BAC.US) stocks. Since mid-July, Buffett's Berkshire Hathaway (BRK.A.US) has reduced its holdings of Bank of America shares by nearly 13% through a series of trades, with cumulative profits reaching 5.4 billion US dollars. In addition, Buffett sold over 0.389 billion shares of Apple in the second quarter.

For those investment giants with massive holdings, selling a large number of positions in important holdings is a very painful thing, and it also incurs substantial taxes, which will be permanently deducted from the capital.

So, since large-scale selling of dominant stocks is a costly action, why did Buffett significantly reduce his holdings?

US capital gains tax rates may rise

First, let's talk about taxes. The capital tax cost is already a barrier 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 income of the portion of the sold stocks (usually the highest cost basis stocks) by the current corporate tax rate (which is the same as the standard 21% company profit tax rate).

Most of the Apple stocks held by Buffett were purchased between the first quarter of 2016 and the first quarter of 2018. During this time, 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 Berkshire's annual report data. Then, it is reasonable to assume that Buffett sold Apple stock over the past two quarters at a price ranging from $169 to $216 per share, with his long-term capital gains accounting for 80-85% of the net income, meaning Berkshire will have to pay 16-17% capital gains to the IRS, resulting in permanent capital loss.

Buffett has turned over the upper limit of the 16-17% capital gains to tax, which of course will not affect the balance sheet of assets, because the valuation of Apple stocks 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 use the cash obtained from selling Apple for investment, then his investment amount will only be 80-85% of the current value in the Berkshire Hathaway annual report (please note, Berkshire Hathaway has not provided this number in the past two years).

Furthermore, just like Coca-Cola has hardly grown in the past 20 years, but still brought considerable dividends to Berkshire Hathaway (current yield is 2.78%). A few years after Coca-Cola reached its peak in 2000, Buffett inadvertently said that maybe he should have sold it when Coca-Cola reached its peak, but people speculate that, considering the 35% capital gains that must be paid to the IRS, he delayed taking action.

By holding these stocks, Berkshire Hathaway can obtain a large amount of long-term capital gains, and capital gains tax is a fundamental reason against selling major holdings. So if Buffett sells a large number of holding positions, it indicates that only a strong selling motivation could prompt him to pull the trigger.

The most obvious motivation is that the future U.S. corporate capital gains tax rate may be higher. The massive U.S. fiscal deficit in recent years - apparently a result of offsetting the economic drag of the new crown epidemic by U.S. government expenditure - will sooner or later need to be addressed, possibly starting with an increase in the corporate tax rate.

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

Another idea proposed by U.S. Vice President and 2024 presidential candidate Harris is to tax unrealized capital gains, the effect of which is that unrealized future capital gains recorded on paper may turn into current cash taxes to be paid. Although this seems unimaginable, especially considering the complexity of formulating details, the USA has precedents for introducing complex regulations for investment income.

The U.S. institutions responsible for setting accounting standards have previously issued a new regulation 'Accounting Standards Update 2016-1' regarding capital gains - requiring changes in investment value to be included in quarterly income reports. Buffett sharply criticized ASU 2016-1, pointing out that it caused a lot of trouble without obvious value, but he may also have noticed that the taxation of unrealized gains was only a step away.

In conclusion, all possible adverse tax changes indicate that savvy investors may choose to sell some positions that have a large amount of hidden capital gains now.

So, is this just a tax issue?

Not at all.

The threats and resistance of Apple itself

When Buffett started buying Apple stocks, its pe was less than 15. He initially bought Apple stocks when Apple's growth rate was much faster. In early 2018, Buffett stopped buying. Over the past five years until last year, he has held the stocks, and Apple's stock price has continued to rise, but the growth has slowed down, Apple regularly pays small dividends, and conducts larger-scale buybacks.

This strategy is similar to the one he adopted for Coca-Cola. Coca-Cola suffered from a slowdown in growth in 2000, causing its pe to fall from an absurdly high point, but still managed to continue to increase dividends. In the end, Coca-Cola's performance improved, and Buffett believed that holding was better than selling and reducing his capital in any case - selling would incur a high capital gains tax. He continued to hold Coca-Cola, as it pays dividends, currently yielding about 50% over its cost.

As for Apple, despite its stock price doubling from 2016 to 2018, its pe is still much lower than the current 34 times. Buffett certainly realizes that the 34 times pe seems quite expensive compared to Apple's very modest profit growth in recent years. In the past five years, Apple seems to have entered a plateau. Undoubtedly, Buffett has drawn on his lifelong experience and made some calculations for the next steps, but he did not increase his holding of Apple stocks during this 5 years. Apple, to some extent, is protected by the same consumer brand strength as Coca-Cola. The rapidly growing technology industry comes with higher risks. Apple has always been an unstable growth company, frequently experiencing stagnation in the process of reshaping or improving its businesses, and then making leaps.

The perennial issue is that there is no consensus in the market about Apple's next phase. Even more problematic is that the conclusion is almost binary - some say Apple will achieve great success in artificial intelligence and product upgrades, while others say be careful, Apple has big problems, Buffett's sale is correct. Some people point out that Apple's stock is currently expensive, while others say that Apple's stock is about to experience explosive growth, which will solve the problem of high pe.

Buffett's strength lies in weighing the probable consequences of apparent issues, and his sell-off of Apple currently falls between the two situations. If he continues to sell and eventually exit all of Berkshire's holdings of Apple stocks, it is highly likely to indicate that Apple's slowing growth, increased risks, and overvaluation have led him to completely sell off the Apple stocks. So far, although his sell-off has been substantial, he has not said such words. However, Buffett's sale of Apple stocks does indicate that the stock is currently relatively expensive, especially considering the many uncertainties surrounding it.

Apple Inc. is not only expensive in stock price, but also has a market capitalization of $3.5 trillion, making it the world's largest company by market cap and accounting for a large proportion of the large cap index. Perhaps Apple Inc. deserves such a market cap, but this scale requires a giant leap for it to "change" its value. Warren Buffett is particularly aware of this because Berkshire Hathaway's position in Apple is difficult to outperform the S&P 500 index.

Apple's scale also makes it difficult to balance with Berkshire's investment portfolio. If it cannot restore rapid growth, Apple's pe ratio is likely to fall by 50% or more before returning to the level of 2016. Taking such a big risk with this amount of money is definitely a concern. He definitely thinks that in the current uncertainty, Apple should not account for 20% or more of Berkshire's holdings by market cap, although Apple sometimes accounts for 20% or higher.

In the past few years, one of the main themes for the 94-year-old Buffett is to organize his investments while he still has time. The issue of Apple requires his own long-term experience and sharp judgment to solve, and he doesn't want to leave this problem to his successor.

The most optimistic speculation is that when Buffett sells Apple, it will still be Berkshire's main holding and may rank first in Berkshire's investment portfolio. It may indeed achieve a huge leap from AI and new products. If that turns out to be true, Buffett won't have made a mistake. He takes into account the risks and absolute uncertainties and keeps Berkshire's risk at a reasonable level.

Regulatory risk faced by Bank of America

Buffett's selling of Bank of America certainly has the issue of higher capital gains tax rate risk just like Apple. On the other hand, the political risk for Bank of America may be greater than that for most other companies. Under the leadership of the current US government, big banks face tremendous regulatory pressure, and if the Democratic Party wins again, the situation may become even worse.

The exact source of the Democratic Party's hatred for big banks can be traced back to the financial crisis, when the banks' loose policies played a significant role in the construction of high-risk mortgage-backed securities (MBS). Stress tests and restrictions on bank dividends and buybacks remain important ongoing penalties. 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 bigger concern hanging over the banks is the worry that many banking critics would like to nationalize the banks and turn them into utility companies with limited shareholder returns. If the Democratic Party achieves significant victory, it may lead the politicians against the banks in this direction.

Bank of America may also benefit if the Federal Reserve implements a series of interest rate cuts to boost the economy. Although Bank of America's pe ratio (about 12 times) is much lower than Apple's, its dividend yield is more than twice that of Apple. However, its political risk is not specific like Apple.

Conclusion

Some analysts believe that Buffett's predictions for the entire market have been very accurate, and his views on the overall market may have prompted him to dramatically reduce his holdings, but this is unlikely to be the primary factor for his massive sell-off. Buffett has a strong belief in fundamentals, and the fundamental reason for reducing these positions may be related to considerations of higher future taxes and political risks, as well as specific risks of individual companies, especially the case of Apple.