VARDAMAN VIRTUAL FORESTRY COMPANY

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WHY PPICS® EARN THE HIGHEST RETURN FOR TAXABLE INVESTORS

Jim Vardaman’s Discussion with Leland R. Speed of Jackson, Mississippi

I thank you for considering LA88040MMB, a PPIC now offered for sale, and discussing its investment characteristics as contrasted with those of other assets. I described an article in our July 1998 Green Sheet about the Warren Buffett concept on internal compounding without taxation, and you pointed out that the same big plus applies to 401K plans. Later I calculated the effect of this for two alternatives: 1. purchase of a stock paying 11.22% annually and 2. purchase of LA88040MMB with the same 11.22% return. The key measure of each alternative is the return the investor gets on his capital.

First, I converted all the figures in LA88040MMB’s financial analysis to shares with a constant value of $100, applied a constant annual dividend of 11.22%, and assumed that the investor must pay taxes of 35% on dividends. On 1/1/99 he invests 127.37 shares, receives a dividend of 14.29 shares on 12/31/99, gives up 5.00 shares in taxes, and finally buys 80.39 more shares with the annual payments due. Here’s the calculation for the whole 12-year period:

His outlays are the same as those in LA88040MMB’s cash flow analysis that I gave you. I calculate annual return on invested capital from this stream of $100 shares to be 7.28%, so there must be an error in rounding. Since the dividend is 11.22% and the tax rate is 35%, the return must be 11.22% x .65 = 7.29%.

Now let’s consider what happens if he buys LA88040MMB instead. If he has enough taxable income to make the annual payments, the interest portion of them is deductible. This money does not belong to him, but to the government. If it were not used for this purpose, it would go for taxes. Therefore, he uses its money to make part of the payments and builds his cost basis with the remainder. His harvest income above the cost basis will be a long-term gain subject to a maximum tax of 20%. Here’s the calculation for the whole 12-year period:

Here is the calculation of the positive cash flow in Year 10:

His outlays are once again the same as those in LA88040MMB’s financial analysis. I calculate the annual return on invested capital from this stream of shares to be 12.78%.

So how does a taxable investor earn the highest return from timber investments? 1. Stick to pure timber with predictable growth and no guesses about price increases. 2. Use borrowed money. 3. Make the tax laws work for, not against, him each year. 4. Reduce the percentage take from taxation.

Listed stocks and tracts of timber growing in rural southeastern United States are very different kinds of assets. Decisions about them demand careful consideration of the pluses and minuses of each, the right procedure before all investments. But another strong appeal of PPICs is that they are different. They add a desirable measure of diversification that will likely improve the performance of many, many portfolios. They may never constitute a large share of these portfolios, but they will play a valuable role.