Taoyuan Nights

Sometimes, when you’re talking about investing, you use the word ‘friction‘ to describe the costs that are associated with using stockmarkets. For example, if you’re investing in the US, Taiwan, or anywhere else, you must pay a stockbroker money to buy or sell shares, and move money and share ownership around on your behalf. Additionally, you need to pay any trading taxes that are due – these are known as stamp duty. Finally, ever noticed how the ‘buy’ and ’sell’ on shares, currency etc. is different? That’s because some guy makes a living by offering a ‘market’ in the shares – always ready to buy or sell. The spread between buy and sell prices is what allows him to make his living.

Together, we can refer to these charges as friction. Just like air friction slowing an aeroplane, or road friction slowing your car, ‘financial friction’ slows your ability to make money by stealing little tiny chunks of it all the time.

Many people incur other costs on their interactions with the stockmarket beyond these three basic types of friction. You may incur capital gains tax if you make a big profit on the assets you’re buying. If you invest through a mutual fund, then you are paying some salaries for the people who run the fund, and you are also paying for their behaviour on your behalf. If they trade a million times a day, then the frictional costs they’re incurring on your behalf become rather high. If they trade once per year…. well, then they lose their job for ‘not looking busy’ while being paid a huge salary, which is one of the most unpardonable sins in Big Finance. There may even be another frictional cost involved for you, as you buy into the mutual fund or sell back out! Friction, friction, friction! It’s no wonder that the people who run stockmarkets are able to spend half their time driving around in Porsches.

Anyhow. I bought the Taipei Times today and was having a browse when I noticed that the ‘turnover‘ of the Taiwanese stockmarket was 211 billion Taiwanese dollars. Now just 7 years ago, turnover was considerably lower – about 20 times lower – following the Asian financial crisis of the late 90s. So this got me thinking, how much ‘friction’ does that imply in the marketplace these days? How much are people effectively paying each year, simply to rename the ‘owner’ part of the stock certificates, over and over again? What percentage of the Taiwanese economy’s earnings is being pissed away on simply renaming share certificates from Mr Yi to Mr Yang to Mrs Ting every few minutes?

Let’s look at turnover. Turnover represents the ‘dollar value’ of buys and sells on the stockmarket today, so it describes how quickly a particular value of shares is changing hands. Turnover in TAIEX stocks was 211 billion Taiwanese dollars on Friday. That means that in total, if you added up the value of all the shares that were bought and sold, it would come to 211 billion NT dollars.

Now, there are 365*5/7 = around 260 trading days in the year. So if Friday was a typical day, that means that there is 211*260 = 55 trillion NT dollars of turnover in the Taiwanese stockmarket per year.

What’s the size of the Taiwanese stockmarket? I.e. the ‘total price’ if one person was to try and buy every single company at once? The TAIEX has a total market capitalisation of around 21 trillion NT dollars. So from this we see that every single share in the Taiwanese stockmarket is having the name changed on the ownership certificate, every 5 months or so on average (55 trillion of turnover, divided by 21 trillion of actual shares available to be turned over!). Clearly investors here are overwhelmed by the terrifying prospect of long term company ownership!

Next, let’s assume conservatively that the costs of friction come in at around 1% of each trade (combining the costs of buyer and seller). For comparison, in the UK, these charges are usually in a range from 0.75->10% depending on the type of shares being traded. The costs happen on each end of the trade (the buyer and seller both have to pay their brokers and their taxes!). That gives a total cost for ‘friction’ of 0.01 * 55 trillion Taiwanese dollars = 550 billion Taiwanese dollars.

Example: So if you spend 100,000NTD on buying some shares, your frictional charges would add up to about 500NTD for you and 500NTD for the seller. That doesn’t seem unreasonable. Pretty cheap, in fact – you’d hardly notice 500NTD on the top of a 100,000NTD purchase, would you!

Last of all, how much profit are these companies actually making on their owner’s behalf? Correcting these figures for the current index value suggests an average company PER ratio of 14.6 for 2007. Turning that ratio upside down, 1/14.6, tells us that each company is earning $68 of profits per year, for every $1000 that gets invested into its shares, on average.

So we take the market capitalisation (21 trillion Taiwanese dollars), multiply it by 0.068 (earnings ratio), and we get $1428 billion Taiwanese dollars of profit this year, shared between all the major companies in Taiwan. That’s how much all the major companies made, added together.

Holy Friction, Batman! Can you believe it? We just worked out that Taiwanese stockmarket investors are (in aggregate) paying $550 billion NTD each year, out of their companies’ profits of $1428 billion NTD, just to alter the ownership details on the share certificates every few months, from Mr Yi to Mr Yang to Mrs Ting! This ‘changing ownership’ problem is wasting than a third of the company profits!

Example: Imagine you are living in a street with 8 hotpot shops. Every 5 months, the owners decide to sell up their shop and buy their neighbour’s hotpot shop since they think it’s probably doing better than their own. Over time, they all gradually move their ownership of a hotpot business up one side of the street, and back down the other, in a big circle. After a few years, they sit down together to work out how much this silly ‘buying your neighbours business, selling your own’ behaviour is costing them.

Imagine their shock when they find that moving their business up or down the street is costing them more than a third of their annual profits! Instead of making 60k a month on their hotpot stall, because they keep buying their neighbour’s business, and selling their own, they are all making just 40k a month after the costs of transferring ownership around. Do you think these people would keep moving around? Or do you think they would gasp in shock, and then decide that maybe the grass isn’t greener on the other side of the fence and decide to stay in a single business for the next 10-20 years?

The Taipei Times labelled the Taiwanese stockmarket as being red hot in an article they wrote last week. Clearly they are right – the money that is thrown into it is being burnt up – by stupid amounts of frictional costs, caused by swapping ownership around.

If anyone has the turnover, marketcap and PER figures for other regional stockmarkets, please do the calculations and email me – I’d love to know the extent to which friction is burning up the company profits of the markets of Asia just now.