Sep 17, 2008|
Lessons from Warren Buffett - LIV...
Last week, through the master's 2004 letter to shareholders, we got to learn his views on the rising American trade deficit and its implications in the long run. Let us turn to the letter for the year 2005 and see what investment wisdom he has in store for us therein.
Frictional costs: Self-inflicted wounds
As evident from his previous letters, Warren Buffett has acquired a reputation of being a strong critic of transaction costs or what he calls as the frictional costs in the field of investing. These frictional costs are nothing but the brokerage or investment management fees that investors pay to brokers and money managers. The reasons for the master's abhorrence towards high frictional costs are not difficult to find. Since stock prices are nothing but the aggregate of corporate earnings between now and the day the world would cease to exist, high frictional costs reduce the returns that an investor stands to earn by staying invested in businesses. Infact, thanks to the proliferation of things like hedge funds and private equity, so huge have these frictional costs become that they are threatening to take a very large pie out of the investor's total returns. It is this very trend that the master has come down so heavily upon. In his own unique style, Buffett has given a very good account of how institutions like hedge funds and investment banks, which he calls 'Helpers', have inflicted great damage to investor returns. For the sake of ease of understanding, Buffett has assumed the 100% ownership of all American businesses to lie in the hands of one large family that he has named as 'Gotrocks'.
Let us see what happens to 'Gotrocks' i.e. the owners when the 'Helpers' start to increasingly meddle in their affairs.
The golden words
The master says, "A record portion of the earnings that would go in their entirety to owners - if they all just stayed in their rocking chairs - is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses - and large fixed fees to boot - when the Helpers are dumb or unlucky (or occasionally crooked)."
Buffett further adds, "A sufficient number of arrangements like this - heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so - may make it more accurate to call the family the Hadrocks. Today, in fact, the family's frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one."
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