A couple of weeks ago, we received a question by email (we always like to receive them,  drop here if you have your own) relating to our long & short trading. The reader has been executing some of our most recent trades and was being hit with a 2.6% annual fee for being short Blue Nile (NILE). He was wondering if those fees were being included in our performance data.  It’s a great question and I should have actually written about this earlier but here it goes. The short answer is NO.

Why Are Fees Not Included In Your Performance?

The most important reason is that those fees are not “significant” and they would be so drastically different from one investor to the other. That being said, I think it’s important for me to explain what those fees are because while it is difficult to publish this data here, it does remain something very important to investors. I will add a link to this post on the page where we publish all of our returns for future reference.

Fees and Revenues Breakdown

The long & short trading that we perform here involves two major types of fees as well as a revenue that you might not realize that you have. Imagine that you perform a trading going Long Apple (AAPL) and Short Blue Nile (NILE). What are the fees involved?

• Execution Costs: Trading stocks will always cost you but the fee depends largely on which broker you use. Some will charge $30 per trade while others will charge much less than $5. It also depends on the number of shares you are buying. Are these costs significant? It all depends not only on your broker but also on the amount you are trading. How significant is a $5 trading fee when you are trading $10,000? It represents 0.20% (5$ for each side, both on the entry and exit). However, if you are paying more in commissions or are trading a much smaller notional, the trading costs can become more significant.
• Borrowing Fees: When you short a stock, you must get a prior borrow of that stock from your broker (in the US those rules are fairly strict). Why? Because if you sell a stock that you do not own, how will you deliver them to the buyer? The answer is that your broker will borrow the shares. Those fees are much more significant. The reader was being charged a 2.8% fee to borrow Blue Nile which is certainly significant. The issue of course is that the borrowing costs will be drastically different from one broker to another. You end up paying the borrow cost until you buy back the shares that you shorted. That can end up costing you between 1-5%. I usually stay away from the most expensive names but a stock like Blue Nile will end up being shorted quite a bit (usually with good reason!).
• Interest on Cash: The other part of that equation is that you receive interest on your cash. Why? Because if you have a $10,000 portfolio and do long & short trades, you will end up with more or less the initial $10,000 in your account (the money cancels itself out in the long & short trades). The hope is that the interest received on that money will be enough to compensate to a large extent for your borrowing fees. Depending on the stocks and the rate that you are receiving that may or may not be the case.

Transparency

It would be very difficult for me to estimate the fees that investors would typically pay on our trading. For that reason, we prefer to present our return “before fees.” We will make sure this is written more explicitly in the future. If I were to estimate the costs, I would say that they should be between 2-3% of your notional at any time which seems reasonable given our current record.

It’s a difficult challenge isn’t it? And no matter who you are and how much money you have to invest, you will run into this situation at some point. Last week, Microsoft (MSFT) announced it was purchasing Skype for $8.5 billion in cash, an aggressive move for the usually conservative Redmond based company. Why? Because by most measures, Microsoft paid a hefty price to purchase Skype. Few have doubts about the possible synergy between Microsoft and Skype or even the Internet phone business that Skype dominates. The entire criticism was based off of one thing; buying an overpriced asset.

Easier To Say Than Do

I would however caution critics to look at the problem that Microsoft was faced with. What do you do if you have tons of cash and, need to generate new business but all deals and possible deals that are being made are being done at expensive, inflated prices? The answer here would obviously be to wait. But for how long? What if you’ve been waiting for a few years now while Google, Apple, Facebook and others continue grabbing assets at increasingly inflated prices? Do you stand on the sidelines? If Microsoft had not purchased Skype, I am convinced that someone else would have paid that price. It can become very challenging to wait. Why? Because at some point, you start to doubt that the deals are actually overpriced. Maybe I’m missing something?

Same Applies To All Bubbles

When house prices, tech stock prices or any other bubble prices kept increasing, many had doubts that the valuations appeared to be exaggerated. Many waited for weeks, months and sometimes even years. At some point however, they often did give up and lost patience.In most cases, they got the worst of both worlds. They got in late so they paid a high price but also ended up enduring the most losses. It’s not an easy problem… it really isn’t.

Buffet Approach

I remember reading Warren Buffet discussing the insurance industry which has a similar problem at times. If competitors are charging premiums that are so little that you consider that matching or beating those prices will end up costing you, what can you do? The choice is either to write some at a loss (although you can always hope that the math was incorrect) or to not do any new business. Buffet has always said he would much prefer the 2nd option which has meant that some of his insurance units got basically no new business for years at a time when pricing became too aggressive. It’s an approach that is much easier said than done of course.

What About You?

I’d love to hear your thoughts on this. Do you blame an executive like Steve Ballmer for possibly overpaying if that was the only way he could use Microsoft’s huge cash  reserves?What would you do if you were about to buy a house but had a gut feeling that was supported by the numbers that prices were overinflated. Would you wait? Could you wait 5 or even 10 years?

It’s no mystery why the rich are getting richer in most places around the world. Our whole system is build on the fact that the middle class pays a huge proportion of the fees. That is a fact and I don’t personally get upset about it. It’s something that will be difficult if not impossible to change for several reasons. Because of that, I personally think the key to reaching the passive income lifestyle is to be very aggressive in the early years. As I wrote a few weeks ago, I’m not talking about being overly aggressive in your investments but rather being aggressive in saving money aside, setting up passive income flows, and building your portfolio as quickly as possible. Why? Because every 100K will become easier to build after the first one is done…

Why The First 100K Is So Difficult

There are many things that make it very difficult to get to that first 100K, here are some of them:

-Debts: Most that are unable to reach that 100K in net assets have trouble because of debts. Some pay interests on credit cards, loans, credit lines, and in many other ways. Paying back debt is a huge challenge and for many becomes an almost impossible task

-Absolute Fees: So many fees are the same no matter how rich or how poor you are such as ATM fees, trading fees, etc. Proportionally, the poor and middle class do not have close to the same amount of money to pay for these fees.

-Taxes: In theory, the rich pay a bigger percentage and thus a much bigger absolute amount of taxes. The reality however is that the middle class pays the largest amount of taxes. When you have some resources and a decent salary, you get hit big time. Why? Because you do not make enough to implement the dozens of possible ways to save a lot on taxes.This will NOT change. I understand how some people can get upset about it but these are facts and they will not change. Why? Because you would need virtually all lobby groups and all governments to sign up and it is not going to happen.

-Investment Opportunities (mutual funds, real estate, etc): The richer you are, the more options you have in terms of investing. How so? If you have $5000 to invest, what are your options? You will generally get a recommendation for a risk free investment, or a mutual fund that will generally have high fees, etc. These are low quality investments. However, who could blame someone for sending you towards those… It’s not like you can invest in real estate, buy in a hedge fund or build your own portfolio, it’s just not possible. The other aspect of it is that as you become richer, you can sustain more risk all things being equal. That will generally yield you better returns.

-Easier to save money: This is not rocket science is it? The more money you make, the easier it becomes to save. The reason? While it’s possible to expand expenses very quickly, generally having higher revenues translates into a higher surplus as well.

-Compound Effect: I don’t think I need to do the math or demonstration here. Saving 100K by age 30 or by age 60 will make a world of difference in the end. Just to give you an idea, 100K by age 30 at a 5% return by year would give you up to $432,000 by age 60. That also means that the rich end up making money even while sleeping.

-Education: No matter where you live, education is expensive. The more money you have, the more likely you are to have a good education. The correlation between education and income or being rich is incredibly high. Sure, there are tons of exceptions, but as a general rule it is very solid.

-The Rich Receive More: For some reason, the rich always get treated better. Become rich and suddenly people will start inviting you for dinner, you will get free drinks, discounts, etc. It’s not always the case but I would say that as a general rule, it’s accurate.

What It All Means?

I think it becomes very clear that gaining a competitive edge as early as possible is critical. In the end, it will make a world of difference. If the rich are becoming richer, then it is critical to jump on the bandwagon as early as possible.

It’s A Race To 100K

The reality is that as I’ve discussed in the past, I think it’s very important to set ourselves objectives, and plans of action to reach them. In this specific case, I think the initial goal should be to reach 100K of net assets as early as possible.

Does It End After That?

Once that is done, you should be able to reach 200K more quickly, the third one even faster, etc. Whatever it takes, I would focus on that. Things will get easier after that first step

Companies such as Microsoft (MSFT), Google (GOOG), Facebook, Apple (AAPL), Netflix (NFLX), and Amazon (AMZN) used to all operate fairly quietly in their own fields without making too much noise. They improved their products, worked on improving the user experience and in the end that translated into funding, revenues and profits. Technology being a “growth” sector, these companies have focused on expanding their offering instead of returning their increasing cash reserves to investors. It’s not that difficult to understand why as technology has completely changed what used to be a simple landscape transforming it into a much more complex universe.

First, let’s take a look at these companies 5 years ago or so , be sure to notice that there are basically no conflicts or competing products:

• Microsoft: Operating System, Software
• Google: Search
• Apple: Computers, Portable Music Players (Ipod)
• Netflix: Movie distribution (DVD)
• Amazon: Ecommerce
• Facebook: Social
• EBay: Auctions

How the world has changed. These days, these companies are increasingly competing on all types of fronts and using their power and influence in order to buy companies, attract the top talent and create their own landscape:

• Mobile Operating Systems: Google’s Android, Apple’s Iphone OS, Microsoft’s Windows Mobile
• Software: Microsoft, Google, Apple
• Movie Rentals: Streaming on Netflix, Amazon, Google’s Youtube, Apple’s Itunes
• Mobile Apps: Google (through its Android store), Apple (control through Itunes), Amazon (Android stores), eBay
• Telecommunications: Microsoft (through its recent Skype purchase), Google (Google voice and Android), Apple (iPhone)
• Social: Facebook remains dominant with Google and Apple doing their best to compete
• Display ads: Google, Facebook, AOL, Yahoo
• Search: Google, Facebook, Microsoft (Bing), Apple (through Itunes), Twitter
• Cloud computing: Microsoft, Google,, Apple, Amazon
• ECommerce: Amazon, eBay, Google (through checkout), Facebook (increasingly thanks to credits, etc)
• Electronic Payments: eBay’s Paypal, Facebook Credits
• Online Music: Apple’s Itunes, Amazon, Google’s music store

So what has changed? I would say thatthe landscape has gotten much more complex and competitive. Perhaps the three remaining dominant companies are Google in search, Apple in music and Facebook in social but even those are not as dominant as what we could see only a few years ago. Is it a good thing for these companies? I think one of the best examples is Netflix. Facing increasing competition from Apple, Amazon and even Google’s YouTube will certainly affect its future growth, pricing power and negotiation power with the studios. Those studios want to avoid losing power like the RIAA did with Apple. All of those factors will directly affect Netflix’s P/E ratio and thus its stock price.  Companies will all try to continue building the equivalent of an Apple world.

It also means that before investing in a company, we must consider the competition and how likely it is to affect short to medium term growth.

What are your thoughts on this more complex tech universe?