Sunday, February 8, 2009

Cost of Capital

One of the most famous events to happen on my birthday (May 17th) was the signing of the Buttonwood Agreement in 1792 forming the New York Stock and Exchange Board. Previously exchanges of ownership in companies were handled by auctioneers who added substantial cost to transactions. The initial 24 broker-members agreed to charge each other "one quarter of one percent Commission on the Specie value and that we will give preference to each other in our Negotiations."

So there we are... To get capital at the beginning of America's organized financial system the cost of capital was 0.25%. In the 1980's commissions on stocks were around 2%. But more importantly, what about when you add in all the other costs. If you buy a mutual fund the manager is getting paid out of the expense ratio, the broker is getting a commission, which were above 8% in the 1970's. Today we have 12b-1 marketing fees, and more. So the real question is, on average, how much does it cost today to get $1 from the person who has it to the economically productive purpose the investor/lender intends? In all our advancements from the beginning of our country, how much more efficient (or inefficient) have we become at allocating capital?
To properly reflect this, we must consider ALL costs. Of course there are the outward fees. But if the current environment teaches us anything, a lot of other costs are added that may not have existed in 1792. In 1792 corporate jets, $18 billion in executive bonuses, high society charity dinners from large corporate charitable gifts, and executive suites did not exist.

Warren Buffett has an annual salary of $100,000. He has no stock options, or other incentive bonus that in any way separate him from other Berkshire Hathaway shareholders. The 2007 annual report notes 19 corporate employees at the headquarters in Omaha for this multi-billion dollar organization of 76 businesses. Their financial information fits on one-third of a page in their annual statement and has one footnote (about goodwill). They commit 3 pages to describing how other public companies "juice earnings."

So why is Berkshire Hathaway the exception instead of the rule? As a business owner, this is how I run my business. As the sole shareholder, I benefit from reduced costs. All optional costs are genuinely optional. If I buy something nice for the business, I am unable to use it for more important purposes.