Tax loss selling—2012 hit list

Value investing is a hunt for inefficiency. As with other forms of hunting, there can be a seasonal element to the chase. At this time of year, we keep our eye out for a particularly type of inefficiency—one caused by tax loss selling.

Anytime sellers become price insensitive, or merely less sensitive than usual, buyers should be on alert for bargains. In the weeks leading up to the end of financial year, shareholders often choose to sell ‘losers’ to crystallise a capital loss, in order to reduce the tax bill on capital gains made elsewhere. Sometimes, those sellers are too focused on the capital loss and not enough on the value they’re giving up.

There’s also the prospect of irrational ‘window dressing’ by some funds management outfits at this same time of year. Many fundies would rather ditch a problem stock now than report a big loser stock among their fund’s top ten holdings come the end of financial year.

Both influences can lead to irrational sell decisions. Of course, in an efficient market, rational buyers will rush to take advantage and stop share prices falling too sharply. That’s the way it works most of the time, especially with big blue chips stocks in all but the most flighty markets.

The buyers don’t always turn up, however, especially for smaller stocks. Even hindsight can’t make a watertight case here, but it seems likely that tax loss selling explains why RHG Group hit its all time low, of 4.6 cents, on 30 June 2008.

Twelve months ago, we upgraded Challenger Infrastructure Fund—see Challenger Infrastructure’s flaming buy of 30 Jun 11 (Buy – $0.94)—in what looks to have been another case of tax loss selling. Even adjusting for the distribution it dropped in late June, the stock dropped more than 10% in the weeks leading up to 30 June, and put it all back on in a matter of days. The June 2011 stock chart for gold miner Silver Lake Resources is similarly suggestive of tax loss selling.

Agility counts

Those seeking tax loss bargains need to remain nimble and be prepared to act quickly. But opportunity isn't certain. When the sellers are patient and prepared, stock prices tend not to drop precipitously. The prospect for genuine irrationality rises closer to 30 June. You might be lucky to have a few hours to snap up any genuine bargains offered.

Now, however, is a time for preparation in anticipation. Table 1 is a list of stocks that meet two important variables.

Firstly, they’re already cheap enough to warrant a positive recommendation from our analytical team. Secondly, the stock price is down more than 15% from its yearly high, meaning that at least some shareholders are sitting on substantial uncrystallised capital loses. These are the stocks where the temptation for selling will be high.

The list is fairly short this year. But don’t confuse conciseness for a lack of attractiveness.

In the blue chip department, QBE already earns a Buy recommendation and is getting closer to being upgraded to Strong Buy again. With the stock 30% off its yearly high, we may see more selling pressure in the weeks ahead. Same goes for Computershare, Macquarie Group, Origin Energy and Santos. But remember, eager buyers are more likely to stalk these blue chips, and so the price might not be affected much.

Those happy to invest in smaller and more speculative situations will find a larger pool of potential candidates. Recent upgrades Kingrose and Silver Lake make the list, though the fact both are up a fair bit in recent weeks might dampen the selling enthusiasm.

The stock price of another gold miner, Azumah Resources, is down about two-thirds over the past year (a pain that, unfortunately, many members have endured based on our recommendation). The stock looks cheap but remains extremely speculative in nature. It may get cheaper still by 30 June.

Wind farm owner Infigen is down nearly 50% from its yearly high, a pain that fortunately we mostly avoided. It’s a great candidate for irrational tax loss selling. But any further purchasing by the company’s largest shareholder—The Children’s Investment Fund—could nullify the effect. Two small oil companies—the recently upgraded Tap Oil and the longer recommended AWE—are also potential candidates.

(Speculative) pick of the bunch?

Lastly comes alumina producer Alumina, a fairly large company but also a very speculative situation. This analyst has nothing to offer on valuing this particular stock, leaving that job to colleague Gaurav Sodhi—see Alumina: Down then up? of 15 May 12 (Speculative Buy – $0.96). But, for those who are already interested in the stock and aware of its numerous risks, he offers Alumina as a higher probability candidate for irrational selling (if such a sentence can ever make sense).

Alumina is a good candidate for both tax loss selling and window dressing selling, having fallen a whopping 60% from its yearly high. A third selling influence may also come into play, with the stock falling out of the S&P/ASX 50 Index on 15 June (index deletions are another potential source of irrational selling).

Add to that the unsustainability of China’s investment boom, a matter that finally seems to be dawning on the majority of investors, and we have the chance of a buyers’ strike. Irrational selling and an absence of buyers is what creates the real bargains around 30 June.

There are no guarantees of tax loss selling bargains developing. What we can guarantee, though, is that the lion's share of any bargains will go to the prepared. We hope this list helps you. Keep an eye out for time sensitive upgrades in the weeks to follow, if luck happens to fall our way.

Note: The Growth and Income portfolios own a number of the stocks mentioned in this article, refer to the portfolio pages for a full listing.