Frictional Cost

Here are two figures from 1998 on the Fortune 500 companies for you to consider. When you talk about the Fortune 500 companies, you are really talking about America Inc. because companies in this universe account for about 75% of the value of all publicly traded American businesses.

Fortune 500 profits in 1998 = USD334,335,000,000
Market value on March 15, 1999 = $9,907,223,000,000

In the equity market, investors have a habit of wanting to change chairs, or at least getting advice if they should change. When this happens, it cost real money - big money. This is called frictional costs. It is paid for a wide range of items. It could be for the market maker's spread, the sales loads, the management fees, the commissions, the custodial fees, the wrap fess and even subscription to financial publications. Never brush off these expenses off as irrelevances or unimportance. If you were evaluating a piece of investment in real estate, would you not deduct management costs in deriving your return? So in exactly the same way, equity investors must face up to the frictional costs they bear.

If the frictional expense cost a percent of the deal - which is quite possibly on the low side - investors would have paid USD100 million on frictional cost. This expense makes up about a percent on the Fortune 500 market value in 1999.

Perhaps 1% on the whole deal seems to be minute to pay for on a market value of 9.9 trillion. But if you look at what you are paying in frictional cost in relation to the real profit generated by the 500, you will notice it cost almost 1/3 of the whole pie of profit. So it leaves investors with a real profit of $250 million which is slim pickings on the return of their 9.9 trillion investment.

So it links you back to the very basic but yet ignored and forgotten theory - future returns are always affected by current valuations. Investors must always bear in mind - make it cast it on stones - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Surely, in the interim before the party ends, you and I can sell each other stocks at higher and higher prices till the last fool becomes wise. Let's say the Fortune 500 is just one business and that the people in this room each own a piece of it. In this case, we could sit here and sell each other piece at ever-ascending prices. You personally could outsmart the next fool by buying low and selling high. But no money from the business would leave the game when that happened. You'd simply take out what the next fool had put in. When it is driven so high, the day of judgement will come sooner than later. And when it comes, the real money that talks will be what the business has earned over time, not the money that had transacted between the buyers and the sellers. Investors must also inscribe in the thoughts that the absolute most that the owners of a business can get out of a business in aggregate is what the business earns over time.