John,
I agree that usually we can expect to see an average of only 5% profit...any
higher and the competition will be attracted. However, that doesn't mean
that we can't expect to see an occasional higher profit when we bring a new
product to market and there is no competition. If I develop a cure for
cancer, and can expect no competition for at least a year, then I will be
able to use that year to make better than 5% profit...and to generate "brand
name recognition". If I charge too much, then competition will be
attracted, and many consumers will jump ship for the cost savings (hence the
popularity of generic drugs vs name brand).
The problem with 5% profit is that in order to make a decent living, one
must have large volume business. I can't live on 5% of $500,000 (=$25,000).
I would need 5% on $1 million to make a decent living (and even then I would
be making less than I would as an Oracle programmer).
So, it is a combination of profit & volume that is important to success.
Low volume means a higher profit is required (and sometimes accepted in the
marketplace).
-Shaun
(on the road)
Monday, November 15, 1999
Re: What Profits?
What Profits?
Folks,
One of the toughest questions I get is "how much of a commission should I
charge" or "what kind of a markup should I take" on some deal in question.
This fellow, who is cited at the bottom, has an interesting analysis. It
repeats what I have said, "competition curbs excessive profits", But do let
me know, if after reading this, the "5%" mentioned in the piece causes you
any concern.
John
The Sum Also Rises
THE DAILY RECKONING
PARIS, FRANCE
MONDAY, 15 NOVEMBER 1999
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In Today's Daily Reckoning:
*** All the major indexes were up
*** Investors still expect impossible returns
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*** A good week for Wall Street. All the major indexes were up a bit. Friday,
the Dow rose a big 173
points. Transports, Utilities...everything was up.
*** But the rise in the indexes continues to mask the fact that most stocks
are still going down.
Though there has been some broadening in the market, there were 186 new highs
last week against 341
new lows. On Friday, despite the big move up, there were only 70 new highs
compared to 120 new lows.
*** Could the market broaden out...and a genuine new Bull take over? Yep,
sure could. But that's not
what happened in 1929, 1973, 1987 or 1990. After a period of divergence, the
indexes fell sharply to
catch up to the broader market. That is what will most likely happen this
time, too.
*** Leading Friday's Wall Street boom were the financial stocks, free at last
from the restrictions
of the Glass- Steagall Act. Investors expect a wave of mergers and
acquisitions that will lift stock
prices. This is, of course, all nonsense. The financial sector is already
extremely competitive. It
will be a rare company that actually makes more money because of a
merger...more on the financial
industry and what it really costs investors...below...
*** The dollar rose Friday. Money is still flowing into the United States.
The euro is edging down
towards 1 for 1 parity with the dollar.
*** Gold fell by $2.80. Still waiting...
*** Credit Suisse First Boston reports that stocks now make up to 60% of
household financial assets.
Households own $7 trillion directly...40% of the entire market. The average
stockholder is 47 years
old...with a household income of $60,000...and assets of $85,000.
*** James Passin reports that Russian stocks have gained 90% this year. But
that still means that the
value of every publicly traded company in Russia, added together, is worth
less than Amazon.com.
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THE SUM ALSO RISES
You don't have to be a politician to lie. Take the financial industry, for
example.
I wrote to you on Friday with Warren Buffett's views on the stock market. But
there was something
else in his "Fortune" article that deserves attention.
In fact, it is staggering.
Much is made of the fact that the stock market is not a zero sum game. Unlike
poker, currencies or
professional wrestling...there doesn't have to be a loser for every winner.
This leads to the
illusion that we can all be winners.
How else to account for the popularity of index funds? Investors must believe
that it is possible for
all investors to make money...just by all being invested in the popular
stocks. Which is exactly what
they do believe. A survey I just read this morning...new ones come out all
the time...found that the
average investor expects a return of 16% per annum for the next 10 years.
They think the entire
market will rise by 16%...not just that they will get lucky and find the few
stocks that will
compound at that rate. New investors, those who have been investing less than
five years, expect
returns of 22.6%.
Buffet points out that "investors as a whole cannot get anything out of their
businesses except what
the businesses earn." Investing is not a zero sum game...but the sum is not
infinite either. It's the
sum of business earnings. As a percentage of GDP, only occasionally have
business profits exceeded 8%
during this century. Usually they are between 4% and 6%...or about 5% on
average. They are unlikely
to go much higher. Businesses compete for profits. High profits draw in
additional investment and
additional competition...which causes the profits to regress to the mean.
As a group, investors can only expect to make what the stocks themselves
make. They are the owners of
businesses. The businesses can expect to earn about 5% profits, after tax.
Investors can, therefore,
expect to earn about 5%, too...some of it in dividends and some in capital
gains.
Yet investors believe that by trading the stocks among themselves...somehow
they become more
valuable. But imagine the whole group of investors as just two people on an
island. They have a
company that makes money by selling beads to passing cruise ships...earning
about 5% profit each
year. They can sell the shares back and forth all they want...but the
business still only produces
the same 5%. "The absolute most that the owners of a business, in aggregate
can get out of it in the
end -- between now and Judgement Day," says Buffett, "is what that business
earns over time."
So, the upside, for the group as a whole, is limited. By profits...and
profits are limited by
competition.
The only way to do better is to beat the averages. And it is to that end,
obviously, that investors
buy and sell shares...and the financial industry -- which rose so mightily on
Friday -- labors day
and night.
Obviously, buying and selling results in some investors doing better than the
market as a whole...and
some doing worse. But what does it do to the whole group of investors? What
does it do the sum, said
to be greater than zero, which elevates investing above, say, shooting craps
as a means of increasing
one's net worth? The financial industry is expensive. It is not for nothing
that houses in the
Hamptons have soared in price...and the yacht industry is in the middle of a
huge boom.
Buffett examines the cost of the financial industry. The "friction costs," he
says, "are for a wide
range of items. There's the market maker's spread, and commissions, and sales
loads, and 12b-1 fees,
and wrap fees, and even subscriptions to financial publications [an
insignificant item in the grand
scheme of things...and well worth the money, of course]. And don't brush off
these expenses as
irrelevancies..."
Readers may point out that competition in the financial industry is driving
down transaction costs.
American Express is taking the lead, offering Free Trades. But there is small
print...you have to
keep an account balance of at least $100,000. Customers with less than
$100,000 but more than $25,000
are allowed to buy stocks without paying a commission...but selling it
requires payment of $14.95.
E*Trade is paying customers to set up an account. Ameritrade is offering a
free trip to Hawaii or
London.
But it still costs the brokerage houses between $8 and $25 to execute a stock
transaction. And
they've got to make money somehow...even in a post-capitalist world. "How do
they charge thee," asks
Buffett, "let me count the ways. Start with transaction costs, including
commissions, the market
maker's take and the spread on underwritten offerings."
How much do all these expenses add up to? Buffett believes investors pay
"well over $100 billion a
year...say $130 billion...to move around those [stocks] or buy advice about
whether they should!"
Meanwhile, extrapolating from Buffett's figures, investors have only about
$450 billion of earnings
to begin with. Subtract the brokers' yachts and limousines, and you're taking
off more than a quarter
of the potential gain. The sum gets a little closer to zero. Take out 2% for
the inflation rate, and
investors can reasonably expect less than 3% of real gain, net of "friction"
expenses.
You're not likely to earn 22%...or even 16%...
..but, as Hemingway put it, isn't it pretty to think so?
Regards from your faithful correspondent in Paris...where I will raise a
glass at one of Papa's
favorite cafes, the nearby Les Deux Maggots, in his memory.
Bill Bonner
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