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Warren Buffett explains how taxes, Wall Street greed, and executive ego help him get rich

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Warren Buffett's annual messages to the shareholders of Berkshire Hathaway are always full of interesting observations about the business world. This year he treated us to a brief explanation of how the tax code, the predatory instincts of Wall Street, and the frailties of human nature create an opportunity for him to make money:

At Berkshire, we can — without incurring taxes or much in the way of other costs — move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.

What he's saying is that some businesses are profitable, some businesses are promising. Coal mines, for example, make money. But solar power is exhibiting more potential for growth. There's money to be made in shifting funds from the profitable businesses to the promising ones.

Shifting money from profitable businesses to promising businesses is what financial markets are supposed to do. But, Buffet says, there are three impediments that make it harder to do this — impediments that his company is in a unique position to overcome:

  • Taxes: A profitable company can pay dividends, flushing cash out to its owners. Its owners could then invest their money in promising new businesses. But the government makes the shareholders pay taxes on those dividends. By owning a diverse array of unrelated businesses, Berkshire can simply shift money from the profitable ones to the promising ones without needing to pay taxable dividends. Buffett is known as an advocate of the "Buffett rule" that would make very rich people pay higher tax rates on their dividend and capital gains income. This would be costly for Buffett personally, but improve the outlook for his business.
  • Wall Street: Even without taxes, reallocating capital normally faces the significant problem that Wall Street intermediaries grab lots of the money for themselves. That's the "other costs" that Buffett is talking about. The services of investment bankers, hedge fund managers, and even mutual funds don't come cheaply. Allocating capital is often more lucrative for the people in a position to grab some of the money flying around the room than it is for the people whose money is being thrown. That's why for normal people passive investments are usually best. Buffett can shift money between his different operations without paying middlemen.
  • Ego: This is arguably the biggest one. When profitable companies get interested in investing in new businesses, they tend to want to find related industries. So Microsoft has turned its Windows and Office profits into the XBox, Bing, Windows Phone, and other technology businesses. Buffett says it is more lucrative to invest across the whole range of businesses, without regard to adjacencies or synergies or anything else. Since his company is a pure holding company rather than an effort to actually manage anything, it's easy to be objective and dispassionate.

Of course these structural explanations for Berkshire-Hathaway's success only take you some far. Picking the right investments is still hard. But Buffett's letter is a reminder that his success isn't just skill or luck, it's also based on some big structural factors.