8
A Penny Saved Is a Dollar Earned
“The really good manager does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ anymore than he wakes up and decides to practice breathing.”
—WARREN BUFFETT1
“What is the most powerful force in the universe?… Compound interest.”
—ALBERT EINSTEIN
“I don’t know what the seven wonders of the world are, but I do know the eighth—compound interest.”
—BARON ROTHSCHILD
SINCE WARREN BUFFETT ASSUMED CONTROL of Berkshire Hathaway the company has paid dividends in just one year; and Buffett quips, “I must have been in the bathroom at the time.”2
Berkshire doesn’t pay dividends, and Buffett doesn’t like them. Why?
Taxes.
When dividends are paid, income is taxed twice. First, the company pays income tax; then the shareholder pays tax on his dividends. A dollar of company profits becomes 65 cents after corporate tax. When paid out in dividends, just 55 cents is left after federal income tax; and if you live in New York or California you end up with just 44 to 45 cents after you have paid state income tax as well.
If a company pays no dividends, the money is taxed only once; and the company can then compound those retained earnings at its return on equity. If it’s a Buffett-style company, it can compound that 65 cents of retained earnings at 15 percent or more per year.
For the shareholder to get the same return on the 44 to 55 cents he has left from his dividend check, he must find a company with a 20 percent return on equity.
Buffett doesn’t like paying dividends because he doesn’t want his shareholders (especially himself) to have their net worth cut by double taxation. He doesn’t want to receive dividends either because he knows he’ll be better off with them left to compound in the businesses he’s already bought.
The Rip Van Winkle Investor
Buffett doesn’t like paying capital gains taxes, either. That’s one reason his favorite holding period is “forever”: capital gains taxes are deferred indefinitely.
In his 1989 Letter to Shareholders, he explained why he likes the “Rip Van Winkle” style of investing:
Imagine that Berkshire had only $1, which we put in a security that doubled by year end and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with $692,000.
The sole reason for this staggering difference in results would be the timing of tax payments. Interestingly, the government would gain from Scenario 2 in exactly the same 27:1 ratio as we—taking in taxes of $356,5000 vs. $13,000—though admittedly, it would have to wait for its money.3
Buffett wants to reduce his tax bill to maximize the annual rate at which his money compounds in value.
The average investor, by contrast, is focused on the profits he hopes to make from his next investment. Buffett wants to “watch his money grow” over the long term. His time horizon isn’t his next investment, it’s the next decade, even two.
One way to increase the speed at which his money compounds is to cut taxes and other transaction costs. Small amounts saved today can have a large effect on your net worth in the long run, thanks to the magic of compound interest. Buffett magnifies that effect by feeding all these savings into his investment system, to increase the rate of compounding.
George Soros thinks exactly the same way. “I am interested in the overall performance of the [Quantum] Fund over the long term,”4 he writes. “If you keep making 30 to 40 percent per annum for 25 years, you make an awful lot of money even if you start with very little. So the amount of money I have amassed is truly awesome.”5 But Soros’s method of neutralizing the drag of taxation is much simpler than Buffett’s: He just incorporated the Quantum Fund in a tax haven, the Netherlands Antilles, so it can compound its profits tax-free. If subject to American taxes, the Quantum Fund’s annual compound rate of return would have fallen from 28.2 percent to under 20 percent. Instead of being number 54 on the Forbes 2004 list of the world’s richest people, with $7 billion, Soros wouldn’t have made the list at all. He wouldn’t have been poor, but would have had “only” around $500 million.
No wonder the Master Investor is focused on his total return. No wonder he takes into account all factors that will either increase or decrease that return.
Shaving Brokerage Fees
Tax isn’t the only transaction cost that can kill your return.
Consider a commodity trader following an actuarial investment approach. For simplicity’s sake, let’s assume that his system produces one winning trade out of every seven he makes (not an unusual situation).
But to keep the math simple, we’ll also make the highly unrealistic assumption of mechanical regularity: each winning trade gives him a profit of 65 percent; and on each losing trade he loses 5 percent. Let’s also say that he can make seven trades every two months—or 42 trades per year—and puts an equal portion of his portfolio into each position (another unrealistic assumption).
If he starts with $7,000 and puts $1,000 into each trade, at the end of two months he has a profit of $650 on one, and losses of $50 on each of the six others. Overall, he has made $350—5 percent.
At the end of the year he has $9,380—an annual of return 34.0 percent.
What’s the simplest way he could increase his return?
Most investors look for some way to increase the profit on their winning trades—or to increase the number of winning trades they can make.
But to do that you have to revise your system.
It is much easier, as the seasoned investor does, to first focus on cutting costs.
Say this trader can cut the brokerage fee or other transaction costs he pays by a mere 5 percent per trade. That reduces each of his losses from $50 to $47.50.
His annual return jumps to 35.9 percent.
“I Like to Pay Lots of Tax”
A successful investor once surprised me by stating: “I like to pay lots of tax.”
Why? Because he only paid lots of tax when he had made lots of money. To quote Vinod Khosla, cofounder of Sun Microsystems: “One correct move is far better than all the tax savings you can do in a lifetime.”6
The tax regime you face should definitely be a factor in your investment strategy. But it’s a mistake to make “Never Pay Taxes” your primary aim. After all, the simplest way of never paying taxes is to have no income or profit at all. Not recommended.
Return on investment is the ultimate measure. Return on investment means the after-tax return. The Master Investor takes into account everything, including taxes and other transaction costs, that will affect his net worth. You should, too.
That’s a nice boost. But taken over ten years this tiny savings of just 5 percent per transaction has an enormous effect on his net worth.
Before the change, his initial $7,000 would have grown to $130,700 in ten years. That’s an annual compound rate of 34 percent—nothing to sneeze at.
But by shaving his loss on each trade through lower commissions, ten years later he has $150,800. The savings alone added $20,100 to his net worth—triple what he started with.
The Master Investor knows that a penny saved can grow into a dollar through the power of compound interest.