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Concentrated Stock Positions: What to Consider Thumbnail

Concentrated Stock Positions: What to Consider

Investment Management

Many of our clients are Senior Leaders in large companies that provide a combination of cash-based and stock-based compensation. Most clients in this group spend cash-based compensation and accumulate the stock-based compensation as it vests; the direct result is an ever growing, ever concentrating representation of employer stock as a percent of our clients’ overall investment portfolio.

What is a concentrated risk position?

There are many definitions! Story Capital’s definition is based on what is archetypical of most of our clients when we first meet:

Frequently, our clients’ wealth development stems from a singular source, their ongoing affiliation with their employer which provides both cash-based and stock-based compensation. A concentrated risk position means that held shares of the employer stock plus the “In The Money Value (ITMV)” of vested stock-based compensation can represent 60% to 80% or more of the total investment portfolio.

Regardless of what technical definition one wants to put forth, the archetypical pattern above is recognizable as being a concentration of many kinds of risk. In portfolio allocation terms, the chief risk is a concentrated single-security risk position.

Is Concentration Dangerous? Bad? Something to be avoided?

 

Bill Gates has likely not been heard to complain about his concentrated position in Microsoft. Concentration can lead to tremendous amounts of wealth development! So, a concentrated position is not necessarily dangerous or bad. In fact, Warren Buffett and Charlie Munger have said that real wealth is built through concentration[1].

On the other end of the spectrum, one need only think about WorldCom, Enron, or Arthur Andersen – companies which no longer exist. Or, consider SuperValu (SVU) – an active company. In the decade before it was sold to United Natural Foods in 2018, SuperValu’s stock lost 90% of its value. Companies like these do not have to go out of business to wreak financial havoc on a leader’s wealth. One of the most memorable days of my life as an advisor was having breakfast with a prospective client who was then a Senior Leader of SuperValu when their stock plummeted from $49/share to $9/share in just 18 months and then to $2/share sometime thereafter. This is what this prospective client told us:

“All my grants are underwater and will surely expire out of the money. My Long-Term Incentive Plan (LTIP) is worthless, my held shares have declined in excess of 80%, and there is no hope of receiving a cash bonus. All I am working for is my base salary and, in addition, I must now terminate the employment relationships of my friends and co-workers whom I have mentored for ten or more years.”

Let’s revisit the question: is concentration bad? Dangerous? Something to be avoided? That depends on a client’s unique circumstances and risk makeup. Story Capital simply maintains that concentration is something to quantify, monitor, and manage.

Is reducing concentration risk a tax decision or a risk control decision?

With millions of dollars evaporated, our former SuperValu officer would say diversification would certainly have been a nice risk control decision. We recently made the mistake of asking a wise old accountant friend if a mutual client had room to recognize $675,000 of capital gain to begin diversification of her portfolio. His answer was priceless:

“You know as well as I do: diversification is not a tax issue. It’s a risk issue! For the sake of diversification, YES, she has room to recognize the gain.”

We understand that some professionals will fervently argue that to diversify or to remain concentrated is a tax decision. However, the important question is this: what does the client believe? Ascertaining this, Story will move forward based on the client’s beliefs, not ours.

How do I decide when to diversify?

If diversification is the next step you want to take with your concentrated risk holding, there are several pieces of information that should be known and decisions that should be made before any action is taken. In fact, there is so much to unpack here, that we will delve into each of these decisions in a future blog series entitled “JAWS.” Here are some core considerations:

  • What is the destination for cash emanating from a sale in the concentrated position?
    • An officer must be knowledgeable about, and comfortable with (if not enthusiastic about) where cash from sales of the concentrated position will be invested and why they will be invested as decided. This is essential to properly time stock-to-stock diversification moves.
  • In what kind of account will diversification take place?
    • Diversification within tax-deferred or tax-free accounts is easy because there are zero tax consequences. We must identify where trades will take place.
  • If diversifying a taxable account, how much unrealized gain (or loss) resides in both the concentrated position and whatever diversified holdings comprise the entire taxable portfolio?
    • To create a diversification plan in taxable accounts, one must first rank every held share of employer and non-employer stock held in taxable accounts ranked from the highest to lowest percent of embedded/unrealized gain as a percent of current market value.
  • How is company stock (the concentrated position) performing relative to the broad market?
    • Optimal diversification decisions are not made based on the employer stock hitting a certain price per share. One must monitor the differential between the employer stock price per share relative to the broad market. The greater the differential between concentrated shares and the broad market, the better the diversification opportunity.
    • At Story Capital, we nickname this relative differential “JAWS,” because periods of time for optimal stock-to-stock diversification can sometimes present themselves for only a matter of days or hours. In future blog posts, we will look at General Mills’ stock movement as an insightful example of “JAWS.

Different advisors have different perspectives on their roles and relationship with their clients. Many advisors seem to want to have “all the answers.” At Story, each of our clients are exceptionally intelligent and well-educated decision makers and leaders. We do not attempt to have all the answers, but we do try to ask some very good questions. After all, working out from under a concentrated position is more art than science. Story’s job is not to provide answers; it is to provide perspective, options, and insight so our clients are empowered to make high quality, informed decisions and then live with the consequences of those decisions.

If you have a concentrated wealth position that you want to discuss, give us a call! We may not have an immediate answer, but we do have the experience to ask the right questions.

 

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[1] https://www.valueinvestingworld.com/2016/05/warren-buffett-and-charlie-munger-on.html
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