Running Money: A Hedge Fund Honcho Tells Tech Bubble Tales
Thesis: Successful technology investor Andy Kessler shares some valuable lessons in his most recent book Running Money.
Andy Kessler managed a hedge fund from 1996 to 2001 that ranked among the top ten funds in history over a five-year period, in terms of overall return. His fund averaged a ~50% return per year and grew from about $20mm from launch to over $1billion upon closing (which includes additional invested capital). At one point, he turned down $1billion in Saudi Oil money because he wanted to remain faithful to his strategy and not become over extended. Just what was that strategy? Read on...
Before opening a fund, Kessler spent most of his career as a research analyst in the technology sector for Morgan Stanley. That means he made lots of contacts, asked lots of questions, and wrote lots of reports containing investment recommendations. But he found it quite difficult to raise money when he started his fund. In a somewhat self-effacing tone, he remarks that he told prospective funders that his investment thesis was "finding companies with great long-term prospects." Don't we all--seems obvious. But Kessler demonstrates a particularly deep commitment to his philosophy and an incisive intuition when in search of growth.
Dot-Com Craziness and the Need for an "Edge"
Kessler begins by using the story of his fund as a vehicle for relating the fun (and insanity) of the tech boom in Silicon Valley and introducing us to some of its most memorable characters. Kessler provides an account of a host of investment strategies he encountered, ranging from Clark and Doerr's grand slam with Netscape, to the currency arbitrages of the Tiger and Soros funds, to the bond trades of Long Term Capital Management, to the more loony schemes of some of his peers. One investor, for example, claimed to have found a pattern in tech conferences. He went to these conferences, noted the companies presenting to investors, observed their stocks tick up the next 1 - 2 days, then watched them correct back to their previous level the next day. He would long and short the stocks based on this pattern. Similarly, Kessler watched as investment managers interacted with company management at these conferences, gleaned extremely ambiguous insights, then placed a phone calls that resulted in notable changes in the stock price. His point--it's all about an edge. Call it information. And the average Joe and Mary on ETrade don't have a tee-ball kid's chance in hell of hitting one out of Fenway, unless they're lucky. You've got to be plugged in; you've got to know something. So what did Kessler know?
Kessler's Philosophy: Steamships and Microprocessors
Kessler tells the story (and the background leading up to the boom) in parallel with the story of the industrial revolution. He compares steam power technology and its dramatic effect on power availability to the rapid development in computer technology and its effect on knowledge. For instance, he notes how exponential growth in power resources reduced the cost of most labor intensive processes and enabled a host of other key industrial technologies, while noting how the processor has doubled in speed about every 18 months (Moore's law), thus resulting in, for example, the cost of emails declining from a few dollars per email (Carter's presidential campaign), to a few cents per million emails today. Kessler refers to this concept as "scale," and provides several other more nuanced historical comparisons to understand this concept.
Putting It Into Practice: MP3s and the "CFO Closed Door Indicator"
Kessler attempted to find companies that would experience a massive increase in demand as a result of some rapidly scaling phenomenon. For example, you might remember that Napster served as the catalyst for a gluttonous world exchange of mp3s in the late nineties. Investors, of course, wondered how they might monetize this deluge of downloads. Most of them avoided Napster for legal concerns, but eventually other more legitimate services went public, like MP3.com, and investors got on board. Rather than investing in these ludicrously overpriced companies, Kessler put his money in a little-known company, with no competition, producing the $2 laser diodes in CD R/W drives. As the world began burning its MP3s in order to play them on other mediums, Kessler's investment skyrocketed somewhere between 50 and 100x.
To find these companies, Kessler put in some serious work. He conducted interviews tirelessly. He referred to his car as his office as he turned over "every rock in the valley." He typically scheduled interviews with 3 to 5 companies per day. He described various subtle behaviors he became attuned to in his interviews. For example, the "CFO closed door indicator" was one favorite. If a CFO closed the door to his office or conference room, something could be inferred about the state or dynamic of the company. Maybe the CFO didn’t want fellow employees to hear the truth about their company's financial situation, or maybe they knew the truth, and he didn't want them to hear him lying to a prospective investor. Despite interviewing hundreds of companies, Kessler invested in only a few he believed would be winners, or as he called them, 5 or 10-baggers (that is, 5x or 10x expected growth).
Debunking Econ 1: Intellectual Property and the U.S. Trade Deficit
Kessler concludes his book by merging the stories of the industrial revolution and the dot-com era in an economic analysis of the U.S. trade deficit and increasing reliance on intellectual property for growth. He asserts, in a position inconsistent with traditionally accepted economic theory, that the growing U.S. trade deficit is not necessarily detrimental to the U.S. economy. He states that U.S. companies focus on IP, ideas, and innovation and thus achieve superior margins and high growth compared to the rest of the world. The outflow of capital from the trade deficit eventually returns to the United States, he says, because of the attractiveness of U.S. companies with superior returns. This money flows into our stockmarket without the "bean-counting" economists taking note. The result?--a lower cost of capital for U.S. based companies, which means more growth, which means more wealth created for Americans as capital gains.
Even if his analysis is correct, the two flaws I note are 1) foreigners own an increasingly larger stake in U.S. exchange traded securities and 2) the very notion of scale he discusses means that these countries (like China) will eventually match or overtake the United States in IP generation, achieve similar margins, and the U.S. will have neither a competitive advantage in the industrial nor the knowledge based economy. In other words, we can swim upstream for now (i.e. outsource the mundane to the rest of the world), but eventually the other fish, namely asia, will catch up. Just like we did to the European economy a century ago.
What's Next?--You Guessed It
Kessler's book, though it conveys the obvious in some ways, does so in an entertaining and insightful manner. He peels away the ambiguity that often clouds investor judgment and demonstrates how to focus on the essential--growth and scale. In the final pages of his book, Kessler says that he's closed his fund believing that the information cycle has past, but that he'll be back. What's the next big hit? He named a few possibilities, one of them--nanotechnology.
Andy Kessler managed a hedge fund from 1996 to 2001 that ranked among the top ten funds in history over a five-year period, in terms of overall return. His fund averaged a ~50% return per year and grew from about $20mm from launch to over $1billion upon closing (which includes additional invested capital). At one point, he turned down $1billion in Saudi Oil money because he wanted to remain faithful to his strategy and not become over extended. Just what was that strategy? Read on...
Before opening a fund, Kessler spent most of his career as a research analyst in the technology sector for Morgan Stanley. That means he made lots of contacts, asked lots of questions, and wrote lots of reports containing investment recommendations. But he found it quite difficult to raise money when he started his fund. In a somewhat self-effacing tone, he remarks that he told prospective funders that his investment thesis was "finding companies with great long-term prospects." Don't we all--seems obvious. But Kessler demonstrates a particularly deep commitment to his philosophy and an incisive intuition when in search of growth.
Dot-Com Craziness and the Need for an "Edge"
Kessler begins by using the story of his fund as a vehicle for relating the fun (and insanity) of the tech boom in Silicon Valley and introducing us to some of its most memorable characters. Kessler provides an account of a host of investment strategies he encountered, ranging from Clark and Doerr's grand slam with Netscape, to the currency arbitrages of the Tiger and Soros funds, to the bond trades of Long Term Capital Management, to the more loony schemes of some of his peers. One investor, for example, claimed to have found a pattern in tech conferences. He went to these conferences, noted the companies presenting to investors, observed their stocks tick up the next 1 - 2 days, then watched them correct back to their previous level the next day. He would long and short the stocks based on this pattern. Similarly, Kessler watched as investment managers interacted with company management at these conferences, gleaned extremely ambiguous insights, then placed a phone calls that resulted in notable changes in the stock price. His point--it's all about an edge. Call it information. And the average Joe and Mary on ETrade don't have a tee-ball kid's chance in hell of hitting one out of Fenway, unless they're lucky. You've got to be plugged in; you've got to know something. So what did Kessler know?
Kessler's Philosophy: Steamships and Microprocessors
Kessler tells the story (and the background leading up to the boom) in parallel with the story of the industrial revolution. He compares steam power technology and its dramatic effect on power availability to the rapid development in computer technology and its effect on knowledge. For instance, he notes how exponential growth in power resources reduced the cost of most labor intensive processes and enabled a host of other key industrial technologies, while noting how the processor has doubled in speed about every 18 months (Moore's law), thus resulting in, for example, the cost of emails declining from a few dollars per email (Carter's presidential campaign), to a few cents per million emails today. Kessler refers to this concept as "scale," and provides several other more nuanced historical comparisons to understand this concept.
Putting It Into Practice: MP3s and the "CFO Closed Door Indicator"
Kessler attempted to find companies that would experience a massive increase in demand as a result of some rapidly scaling phenomenon. For example, you might remember that Napster served as the catalyst for a gluttonous world exchange of mp3s in the late nineties. Investors, of course, wondered how they might monetize this deluge of downloads. Most of them avoided Napster for legal concerns, but eventually other more legitimate services went public, like MP3.com, and investors got on board. Rather than investing in these ludicrously overpriced companies, Kessler put his money in a little-known company, with no competition, producing the $2 laser diodes in CD R/W drives. As the world began burning its MP3s in order to play them on other mediums, Kessler's investment skyrocketed somewhere between 50 and 100x.
To find these companies, Kessler put in some serious work. He conducted interviews tirelessly. He referred to his car as his office as he turned over "every rock in the valley." He typically scheduled interviews with 3 to 5 companies per day. He described various subtle behaviors he became attuned to in his interviews. For example, the "CFO closed door indicator" was one favorite. If a CFO closed the door to his office or conference room, something could be inferred about the state or dynamic of the company. Maybe the CFO didn’t want fellow employees to hear the truth about their company's financial situation, or maybe they knew the truth, and he didn't want them to hear him lying to a prospective investor. Despite interviewing hundreds of companies, Kessler invested in only a few he believed would be winners, or as he called them, 5 or 10-baggers (that is, 5x or 10x expected growth).
Debunking Econ 1: Intellectual Property and the U.S. Trade Deficit
Kessler concludes his book by merging the stories of the industrial revolution and the dot-com era in an economic analysis of the U.S. trade deficit and increasing reliance on intellectual property for growth. He asserts, in a position inconsistent with traditionally accepted economic theory, that the growing U.S. trade deficit is not necessarily detrimental to the U.S. economy. He states that U.S. companies focus on IP, ideas, and innovation and thus achieve superior margins and high growth compared to the rest of the world. The outflow of capital from the trade deficit eventually returns to the United States, he says, because of the attractiveness of U.S. companies with superior returns. This money flows into our stockmarket without the "bean-counting" economists taking note. The result?--a lower cost of capital for U.S. based companies, which means more growth, which means more wealth created for Americans as capital gains.
Even if his analysis is correct, the two flaws I note are 1) foreigners own an increasingly larger stake in U.S. exchange traded securities and 2) the very notion of scale he discusses means that these countries (like China) will eventually match or overtake the United States in IP generation, achieve similar margins, and the U.S. will have neither a competitive advantage in the industrial nor the knowledge based economy. In other words, we can swim upstream for now (i.e. outsource the mundane to the rest of the world), but eventually the other fish, namely asia, will catch up. Just like we did to the European economy a century ago.
What's Next?--You Guessed It
Kessler's book, though it conveys the obvious in some ways, does so in an entertaining and insightful manner. He peels away the ambiguity that often clouds investor judgment and demonstrates how to focus on the essential--growth and scale. In the final pages of his book, Kessler says that he's closed his fund believing that the information cycle has past, but that he'll be back. What's the next big hit? He named a few possibilities, one of them--nanotechnology.
posted by Clayton at 9:08 PM
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