Kessler
advice: Outtakes
Sept. 17, 2004
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Wall $treet Week with FORTUNE co-anchor Karen Gibbs recently talked
to author and former hedge fund manager Andy Kessler. Portions of their
conversation will appear on the Sept. 17, 2004 program. Here are parts
that won't appear on the air:
KAREN GIBBS: The death of the industrial revolution
also meant the death of a lot of jobs that went overseas, and that's causing
a lot of consternation among the population. What's with outsourcing now?
ANDY KESSLER: Well, whenever you're inside a transition,
it's hard to figure out what's going on, and certainly there are jobs
being lost. But I think there are a lot more high paying jobs being created,
because the difference between an industrial company and an intellectual
property company is the intellectual property companies have high margins.
You know, Microsoft sells an operating system for a hundred bucks, they
keep $99.99. There's no cost to make that, just research and development.
High margin companies can afford to pay high salaries, unlike the industrial
auto manufacturing, chemical manufacturing. So as we have this global
labor arbitrage where the cheap jobs go overseas, over time you're going
to see the standard of living increase in the U.S. as there are more high
paying jobs. It's going to take some time.
GIBBS: These high margin companies, are they all the Intel Pentium chips,
things like that? Or is it even a Starbucks?
KESSLER: Yeah, it's all sorts of companies, because you can find these
slivers of intellectual property. You know, most people just look at a
PC and they think of Hewlett Packard or Dell, and they go, gee, that's
not all that interesting of a business. But open it up, and there's all
sorts of interesting things inside. The same thing with pharmaceuticals
and Starbucks, who sells basically coffee with fancy names on them and
generates high margins. So you can find intellectual property everywhere.
You don't have to make things to make money anymore. You can design them
and have someone else make them and still have huge profits.
GIBBS: I want you to explain, Andy, for us this barrier concept. I'm
thinking more of like government regulation. Is this the theme that you're
talking about?
KESSLER: It could be government regulation. It could be lawsuits, you
know, companies that are involved in, I don't know, asbestos litigation
or something, anything where investors look at it and throw up and say,
gosh, I don't want to even get near that thing. As an investor, you can
go in and say, can this be resolved over time? I like to call it second
derivative investing, where when you're on the side… second derivative
means not change, but how fast change changes.
GIBBS: The rate of change.
KESSLER: Right, the rate of change. So engineers and scientists understand
this, and so ask one of them. But it's like when you're sitting on the
side of a highway and you're looking at cars go by. You can't quite tell
which ones are going 55 and which ones are going 75, unless they're right
next to each other. But if you're in the car driving 55 miles an hour
and someone passes you, you certainly know who's going what speed. And
so what my suggestion is for investors is get in that car. Don't sit on
the sidelines and listen to people on Wall Street saying this is growing
faster than that. You've got to do your own homework. You've got to get
right in that mix and find something where the rate of change is growing,
where something is accelerating, where gravity is taking hold, not just
a slow moving river. And when you find those, those are the stocks where
you get 10X returns, not 18 percent a year or 5 percent a year or whatever the market
is going to grow at here.
There's all sorts of new things that can happen because of scale, because
of things getting cheaper every year, but you have to unlock your imagination
to think out, again to think out that second derivative, not just incremental
change, but big whoosh changes. And doing that and finding little slivers
of intellectual property, I think you can outdo every other investor,
including professional hedge fund managers.
GIBBS: You know, what you said was very interesting, because it flies
in the face of conventional wisdom that companies can make money with
the prices dropping of the things that they're selling. How does that
work?
KESSLER: Well, it is counterintuitive isn't it? I mean most companies
like to raise prices. I mean, I think it was Jack Welch at GE who said
any fool can raise prices to make money, but I want to see a manager who
can lower them and expand the market, and that's really what it is. I
mean back when the PC was invented 20 years ago, there wasn't a very big
market, because for $8,000 you got this ugly amber screen that didn't
do much. But as the 8086 turned into the 386 and then the Pentium and
then the Pentium 4 for cheaper, it's that $1,000 PC and cheaper, all sorts
of new applications opened up. And if you put 100,000 of them in these
regional data centers, you get Google. Now you couldn't have even imagined
Google 10 years ago, because those computers were too expensive. As they
got cheap, the market expanded, the same thing with digital cameras. Digital
cameras five years ago were grainy, ugly photos. Now they're selling 10
mega pixel cameras that are almost better than film. And as the price
gets down, the market expands. As an investor, I want to be ahead of that
trend, finding a couple of interesting companies that own slivers of intellectual
property. If you look hard enough, you can find them.
GIBBS: You were a very successful hedge fund manager running a billion-dollar
fund. You talked to a lot of people. What are the three key pieces of
advice that you would give to serious investors?
KESSLER: So, my three pieces of advice are un-index, second derivative,
and slivers, meaning stay away from index funds, go find stocks yourself.
Maybe that means mutual funds, maybe that means finding hedge fund managers
as hedge funds open up to the general public rather than just wealthy
accredited investors. But don't get suckered into the low fees on index
funds. You're going to be mediocre. Second derivative means find those
barriers. Find the future waterfalls. Don't sit around and be happy with
trends that are happening today, because it changes so fast. Companies
that are doing well today and trends that are happening today, on a dime
they'll flip on you, so you've got to think ahead of everyone else. And
it's so hard to do, but you've got to do it. And then the slivers of intellectual
property means take the lid off of things. If you get something that looks
interesting like a digital camera, take it apart. Go what is this? Who
is this company? Do they make this stuff? Go online. Find everything else
about them, but find protected pieces of intellectual property, because
those are the high margin companies. And again, when the money goes out
to pay for these Bimmers and Sony TVs, it comes back and it's going to
chase those high margin companies, and that's where I want my dollars
to be.
GIBBS: Andy, you just published a book about your experiences running
a hedge fund. What's some of the strangest things that have happened to
you when running a hedge fund?
KESSLER: Well, you know, there's all sorts of strange things, and that's
the thing about the book. It's really a fun and entertaining read. We
then go through and tell you how we got our edge. But one day I was asked
to go look at a music-related company at the San Francisco airport Marriott,
so I show up and I knock on the door, and this very large, long-sideburned,
leather-clad guy answers the door. And I say is this Danny? He says, yeah,
come on in. And basically I was pitched by a CEO Elvis impersonator. Now
it's hard to be serious when someone's pitching you and talking like this
and, you know, well, thank you very much. And thankfully we didn't invest,
but you know when you're a hedge fund investor, you turn over as many
rocks as you can and find interesting things, and that certainly was interesting.
GIBBS: I guess for investors the lesson there is they should be open
to just about anything as well.
KESSLER: That is true.
GIBBS: Andy, thanks again.
KESSLER: Thank you.
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