Take Tax Losses Now, Avoid the Year-End Rush

Not every investment works out. Below is a chart of Pediatrix Medical Group (PDX - commentary - Cramer's Take), a provider of HMO services to children, which had a horrific year in 1999 as a result of investigations into its billing practices.

We bought this stock in 1998 at a range from $30 to $40. Allegations of improper billing surfaced in the first quarter of 1999. The stock fell from a high of 65 in February to $18 two months later. It rallied back to $23 in May, then slid gradually to $14 by the end of September. In the fourth quarter, selling accelerated again, cutting the stock's value in half by the end of December. From that low of $7, the stock shot up 30% in the first weeks of the new year. With settlement of the investigations, and some decent earnings reports, the stock is double the year-end low.

This chart is typical of a stock that has the misfortune of being down sharply for the year at the start of the fourth quarter. In that quarter, institutions and individuals search their portfolios for stocks that can be sold at a loss to offset gains on other transactions. The tax year for most mutual funds ends on Oct. 31 (which gives their accountants time to calculate dividend and capital gains distributions by the end of the calendar year). Individuals, of course, have a tax year ending Dec. 31.

So how do we explain the above chart? Since the stock was down 78% by Sept. 30, it was an obvious candidate for sale by institutional holders in October. Individual tax-loss selling continued through November and December. On Jan. 1, selling abated, and the stock rallied.

We had this stock in our private clients' taxable portfolios. We held on to it through the summer because we didn't think the investigations would find anything substantial (as was indeed the conclusion). In anticipation of fourth-quarter tax-loss selling, however, we sold our position in September at around $14 -- not a great price, but certainly better than the $7 to $9 that prevailed for the rest of the year.

In general, we take tax losses by Sept. 30, getting ahead of other sellers, then mostly sit on the cash until Dec.15 when the tax-loss selling abates. (Although individuals can take losses until Dec. 31, by Dec. 15 most investors seem to be focused on holiday parties, not their portfolios.)

This is the time of year when you should be looking for tax losses. Given what a tough year it has been for stocks, you very likely have a couple of stocks down 50% or more. (Something in the Internet group perhaps?) You may think the prospects for these companies look good and that the valuations are quite reasonable, but that doesn't matter. These are the companies that will take another leg down between now and Dec. 31.

If you're running gains so far this year, take the offsetting losses now to neutralize your tax hit. Perhaps taking these losses now will give you a loss for the year. After you've netted your capital losses against your gains, the next $3,000 in losses beyond that can be deducted against ordinary income, reducing your taxes; the remaining losses can be rolled over to offset gains in the future.

As long as you wait more than 30 days (to avoid triggering the wash-sale rule) you can reestablish the position, most likely at a lower price point. If you don't want to wait 30 days, you can do a "sector swap" (for example, sell Excite@Home and buy Yahoo!).

You might also consider scanning the tables of stocks with the worst declines on the year in December; these stocks are candidates for a January pop. But don't wait until December to take your tax losses; you'll probably get the worst price of the year.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. At the time of publication, his firm held stock in Yahoo!, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback at [e-mail].