LET’S CONNECT

The myths and risks of concentrated, single-stock investment positions

Market analysis reveals

the long odds of optimism being rewarded

Events beyond
management control

Reversals are not always the result of poor management decisions; as often, wide-ranging market, regulatory or economic forces are at work.

New products or processes that disrupt existing markets, create new forms of competition, allow new economies of scale, eliminate middlemen, etc.

Changes in U.S. or foreign government tariff or trade policy.

Theft, misappropriations or other illegal activities by employees or executives that siphon resources and expose a business to risk(s).

Since 1980, shares of roughly 40% of the companies listed in the Russell 3000 Index, a listing of the 3,000 largest U.S. companies, suffered serious declines of more than 70% from their peak value; moreover, their recovery was minimal. Eventually, this group lost 60% or more from its peak. Technology, telecom energy and consumer discretionary had the highest loss rates. Some subsectors—biotech (part of healthcare) and metals & mining (part of materials)—had loss rates of more than 50%.1

Moreover, it was not just small, out-of-the-mainstream businesses that fell victim to market forces. Large and well-known companies suffered serious declines and many others disappeared entirely: Beatrice Foods, Borders, Compaq, Enron, General Foods, MCI, RCA and TWA to name but a few.

With perfect hindsight, some of these declines may seem inevitable. But, in all likelihood, each company’s management, board of directors and employees—as well as research analysts, credit rating agencies and vendors—all firmly believed in these businesses’ long-term success.

1 Cembalest, Michael. The Agony & The Ecstasy. Page 4. J.P. Morgan Asset Management, August 2014.


The unexpected

Even established companies experience unexpected, protracted declines. Some recover; others do not. It is impossible to know in advance which will bounce back—and if your company will be one of them. For example, the stock prices of these companies collapsed and have not yet returned to previous levels.

Select U.S. large-cap companies with substantial long-term price decreases from 2002 to March 1, 2013

Source: Bloomberg, Fact Set.
Data as of March 1, 2013. All dates provided are as of month-end. Declines represent total return in investment. Peaks serve as reference points for price declines and may not reflect stocks’ all-time highs. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

Market analysis reveals

the long odds of optimism being rewarded

Since 1980, shares of roughly 40% of the companies listed in the Russell 3000 Index, a listing of the 3,000 largest U.S. companies, suffered serious declines of more than 70% from their peak value; moreover, their recovery was minimal. Eventually, this group lost 60% or more from its peak. Technology, telecom energy and consumer discretionary had the highest loss rates. Some subsectors—biotech (part of healthcare) and metals & mining (part of materials)—had loss rates of more than 50%.1

Moreover, it was not just small, out-of-the-mainstream businesses that fell victim to market forces. Large and well-known companies suffered serious declines and many others disappeared entirely: Beatrice Foods, Borders, Compaq, Enron, General Foods, MCI, RCA and TWA to name but a few.

With perfect hindsight, some of these declines may seem inevitable. But, in all likelihood, each company’s management, board of directors and employees—as well as research analysts, credit rating agencies and vendors—all firmly believed in these businesses’ long-term success.

1 Cembalest, Michael. The Agony & The Ecstasy. Page 4. J.P. Morgan Asset Management, August 2014.


The unexpected

Even established companies experience unexpected, protracted declines. Some recover; others do not. It is impossible to know in advance which will bounce back—and if your company will be one of them. For example, the stock prices of these companies collapsed and have not yet returned to previous levels.

Select U.S. large-cap companies with substantial long-term price decreases from 2002 to March 1, 2013

Source: Bloomberg, Fact Set.
Data as of March 1, 2013. All dates provided are as of month-end. Declines represent total return in investment. Peaks serve as reference points for price declines and may not reflect stocks’ all-time highs. Past performance is no guarantee of future results. It is not possible to invest directly in an index.


Events beyond
management control

Reversals are not always the result of poor management decisions; as often, wide-ranging market, regulatory or economic forces are at work.

New products or processes that disrupt existing markets, create new forms of competition, allow new economies of scale, eliminate middlemen, etc.

Changes in U.S. or foreign government tariff or trade policy.

Theft, misappropriations or other illegal activities by employees or executives that siphon resources and expose a business to risk(s).

Understanding the risks

myth vs. reality

Individuals hold on to concentrated stock positions for many understandable reasons. Some are holding on for the ultimate payday: a run-up in the share price that produces a windfall for themselves and future generations. But many others remain invested because they:

  • Have strong emotional ties to a particular company
  • Want to avoid triggering a tax bill
  • Rely on the dividend income

In the face of compelling research, however, the risks of any of these courses of action may well outweigh the potential for reward.

MYTH 1

This stock is part of my family's heritage. I can never sell it.

REALITY

Your family's heritage may be safer if you diversify.

Selling all or part of a concentrated stock position may feel like a betrayal to an original benefactor.

At a certain point, most businesses—indeed, most industry sectors—come under siege; those reliant on technological innovation are particularly vulnerable. In the face of seismic change, even the best management teams may be unable to steer their company safely to calmer waters.

The elusive chance of long-term success

Since 1980, when the Russell 3000 Index was created, the shares of roughly 40% of the companies in the index suffered a permanent 70%+ decline from their peak value. Clearly, investors with concentrated positions in those stocks would have suffered catastrophic losses.

In contrast, during this same period, only 7% (210 companies) in the index could be termed extreme winners2; that is, those that generated lifetime excess returns significantly higher than average.

Also consider:
  • The Russell 3000 index outperformed the median stock in the index by over 100%
  • Two-thirds of all stocks in the index underperformed the index
  • The absolute return of 40% of all stocks in the index was negative

After further taking into account single-stock volatility, our research found that 74% of all concentrated stockholders would have benefited from some amount of diversification—as the chart below shows.

Source: FactSet, J.P. Morgan Asset Management, data as of August 2014. This analysis combines the risk of catastrophic loss, the risk of underperforming the Russell 3000 Index, and the risk of heightened volatility. (Volatility factors into the selection, with perfect hindsight, of an “optimal” portfolio combining the concentrated position with the Russell 3000 so that the resulting portfolio would have generated the best risk-adjusted return. That portfolio often did not hold high-returning stock if its volatility was too high. Our results show that 6% of the time, the “optimal” portfolio was 100% in the concentrated stock [similar to the 7% extreme winners described above]. In the majority of cases, however, it made sense to own no more than 30% of the concentrated stock.) Taking these three factors into account, this table shows the percentage of cases in each sector where some amount of diversification could have benefited the concentrated position holder by increasing risk-adjusted return, and could have played an important role in sustaining family wealth. For example, in 74% of cases where an investor held a concentrated position in a consumer discretionary stock, some diversification would have resulted in a better outcome (higher wealth); on the other hand, 26% of holders of concentrated consumer discretionary stocks were better off having held on to their positions with no diversification.

2 We define "extreme winners" as companies that generated excess lifetime returns of more than two standard deviations over the mean (roughly the top 2.5%). See: Cembalest, Michael. The Agony & The Ecstasy. Page 6. J.P. Morgan Asset Management, August 2014.

MYTH 2

It’s better to hold the stock than pay taxes on a sale.

REALITY

It’s not the taxes, it’s the volatility.

Many shareholders maintain a concentrated stock position to avoid paying taxes on a sale–believing this approach will have less impact on their wealth.

You would think that not paying taxes—keeping the concentrated position–would result in greater wealth, even over long periods of time, as money used to pay the taxes is not available to grow. However, in the long run, the volatility of a single-stock concentration often outweighs the potential benefits of holding onto it; so often, in fact, that in most cases even after paying taxes you would be better off with a diversified portfolio.

Volatility is the variability of annual returns: Generally, the more your return varies, the less your investment is ultimately worth.

A single stock is very often more volatile than a diversified portfolio; thus, the variability of its returns can actually result in less long-term value if you continue to hold it. In other words, if your portfolio consists solely of a concentrated position, it is likely to experience higher volatility, potentially resulting in lower value than a diversified portfolio.

Of course, not every stock will behave worse than the broader market. However, as our Russell 3000 research revealed in Myth 1, there is significant risk in holding a single stock and not taking any risk-mitigating actions.

The wealth-destroying effects of volatility, especially over long periods of time, often can lead to worse outcomes for a concentrated position than for a broadly diversified portfolio.

In fact, if your diversified portfolio outperforms your concentrated position by an average of about 2.5 percentage points pre-tax annually, and you live for at least seven years after selling the shares, you are likely to have more wealth than if you had held on to the concentrated position—even if you pay the taxes, according to J.P. Morgan.3

Volatility can distort returns

This illustration is provided for informational purposes only and is not intended to represent an actual investment.

3 Cembalest, Michael. The Agony & The Ecstasy. Page 35. J.P. Morgan Asset Management, August 2014.

MYTH 3

I’ll never be able to replace the dividend income.

REALITY

The big picture is more important.

Many investors rely on the steady income that dividend stocks can generate. This is especially true in today’s low rate environment, when it can be more dicult to find desirable rates of return.

While it’s important to protect a steady income stream, focusing solely on a stock’s dividends may be short-sighted—especially if the share price enters a period of decline. Even if the payout remains intact (and it’s a big if), a significant decline in the underlying value of the stock can erode your net worth over time.

Your net worth can decline if your concentrated stock’s price drops–even if your dividend income remains unchanged

As the value of the S&P 500 Index falls, dividend yields increase–even though the absolute dollar value of dividends paid may stay the same. In fact, in periods of significant market stress, dividend payouts may be lower. The result: both your net worth and your income decline.

Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Dividend yield is calculated as the annualized dividend rate divided by price, as provided by Compustat. Returns are cumulative and based on S&P 500 Index price movement only, and do not include the reinvestment of dividends. Past performance is not indicative of future returns. Guide to the Markets—U.S. Data are as of June 30, 2015.


A stock’s yield (expressed as a percentage) can increase if the dividend remains constant–or falls–and its price declines.

Witness the performance of Avon in recent years–one of the big-name companies whose shares have experienced extreme bouts of volatility without ever fully recovering.

In January 2007, Avon traded for around $35 per share and paid an annual dividend of $0.74, a yield of 2.11%. By August 31, 2015, the stock had dropped to $5.19 per share and the dividend had been cut to $0.24. The yield, however, went up: to 4.62% per share—a 119% increase in percentage terms—despite the 85.2% ($29.81) loss in value per share and a reduction in the annual dividend of 68% ($0.50).

AVON

Avon’s slide in its share price has been accompanied by a cut to its annual dividend.

Source: Morningstar, data as of 8/31/15.

A range of strategies

Managing Concentration Risk

An outright sale is not the only way to manage a concentrated position. There are many possible strategies to employ, depending on your own personal circumstances and any legal restrictions or other considerations. Among some strategies you could consider:

Divest all/part of your position4

It can be advantageous to retain a significant percentage of your ownership. Or, it may be wiser to:

SELL AND PAY CAPITAL GAINS TAXES

Reinvest the net proceeds in a diversified portfolio

SELL AND BORROW TO PAY TAXES

Immediately invest the sale proceeds, and repay the loan over a period of time.

STAGGER SALES OVER TIME

Reinvest the proceeds as sales occur; capital gains taxes are paid as sales occur.

SELL THROUGH A 10B5-1 PLAN

Determine the price levels at which you are willing to sell at a future date–and establish an affirmative defense against a charge of insider trading.


Employ a specialized strategy4

Consider using one or more of these techniques:

EXCHANGE FUND5

Transfer appreciated shares in exchange for a partnership interest in a diversified portfolio, typically a combination of real estate interests and equity.5 The exchange is tax-deferred and potentially tax-free, so the full value of your stock is put to work.

CASHLESS COLLAR

Hedge concentration risk: Buying a put option and selling a call option creates a floor and ceiling for the stock price. Often, the premium received for selling the call finances the purchase of the put. This may enable you to borrow more against your position (albeit at a variable rate), providing liquidity.

VARIABLE PREPAID FORWARD CONTRACT

Defer taxes and receive cash up front–albeit at a discount to the current market price–by agreeing to sell the shares at a future date to a counterparty, typically a bank such as J.P. Morgan. Taxes are deferred until the transaction closes, and you participate in appreciation to a predetermined level.

GRANTOR RETAINED ANNUITY TRUST

It may be possible to pass future appreciation to your beneficiaries at little or no gift tax cost as long as your concentrated position appreciates at a rate greater than the Treasury Department’s monthly “hurdle” rate. This is one way to use volatility in your favor.

CHARITABLE LEAD TRUST

Create an income stream that passes to one or more charities of your choice, with any remaining balance passing to you or your selected beneficiaries. There may also be transfer tax benefits, depending on the structure of the trust.

Each strategy has specific timing constraints, counterparty risk and tax consequences. Depending on your circumstances, it may make sense to engage in more than one strategy.

4 Some of these techniques may not be appropriate or available for corporate executives and/or require reporting on Form 4 or 144, or both. Please talk to your Financial Advisor.

5 Only available for qualified purchasers and accredited investors; please talk to your Financial Advisor.

Case studies

benefits of diversifying

CORPORATE EXECUTIVE

Weighing the benefits of diversification against a potential tax bill

Michael, the founder of a public company, and now its chairman and CEO, has amassed a $20 million position in his company: Some shares are “founder’s stock”; others were granted over time. The average basis of his total position is currently about 20% of the market value. Thus, he would have to pay sizeable capital gains if he were to sell.


WORRIED HEIR

Preserving a legacy without putting a steady income at risk

Heidi inherited a block of stock from her father that is now worth $20 million. While the stock has appreciated about 50% in the interim, it has underperformed the broader market—even with the market down-turn of 2008 factored in. The stock, with a yield of 1.75% (paying $.50 per share annually), is Heidi’s sole source of income. Heidi wants to preserve her father’s legacy, but if the stock declines in value as it did in 2008–2009, she fears she may not be able to replace the income.


In summary

start planning now



As with any significant asset, concentrated stock positions require regular review and evaluation.

So let’s have a conversation.

Your J.P. Morgan Securities Financial Advisor, working closely with you and your other advisors, can help you review your concentrated stock position and evaluate a range of diversification strategies that can help you manage your risk.

It’s not a zero sum game

Selling some or all of your stock can help you preserve your family’s wealth and puts the risk of the concentrated position behind you. But a combination of techniques—and potentially holding on to some of your concentrated stock—may help you achieve multiple goals.

Stay focused on the big picture

Focusing on dividends may prove short-sighted if a stock enters a period of decline. Selling some stock, paying capital gains tax and investing in a diversified portfolio may ultimately give you as much or even more income in the years following, without reliance on the performance of a single stock for both your cash flow and your net worth.

Don’t let the tax tail wag the dog

A well-planned strategy–that all at once or over time replaces a concentrated position with a diversified portfolio–can help offset the impact of taxes on your wealth, provided the diversified portfolio performs at least as well as the concentrated position over time. For example, swapping a concentrated position for an interest in a basket of stocks without triggering a taxable event (via an exchange fund) can tax-efficiently diversify your holdings tax efficiently. Establishing a charitable remainder trust can help you honor a benefactor or other individual, and help create a steady income stream for the rest of your life while also providing tax benefits.