Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score
by Andy Kessler

Mar 2005

Light on testosterone, heavy on ideas

Running Money is actually two books entwined. One is a narrative of the late great dot-com boom, told from the perspective of a player at the right place and the right time (with the good sense to walk away at the right time also). The other is sort of an informal investment thesis, a collection of controversial and intriguing ideas that hang together and form an actionable set of guidelines.

It's all tied together with a dry (Sahara desert dry) sense of humor and a knack for understatement that made me laugh out loud more than once. (Example: when a sarcastic friend says never buy a stock where the name is a target forecast for the price, Kessler makes a mental note: "avoid NetZero." Another example: "If you buy a stock at $70 and it goes to $200, it's tough to sell, figuring it might go to $300. If you bought at $3, it's a lot easier to sell.")

The title of the book is fairly misleading. Anyone expecting a testosterone-fueled read is bound to be disappointed. Kessler is a cerebral investor, not a hairy chested alpha-male trader, and he makes that abundantly clear (in spite of his zillion-percent-annualized return gained from flipping mp3.com, a sixty second trade worthy of any gunner's respect).

The fact that Kessler's outfit is a hedge fund is largely irrelevant to the book, as he doesn't go short and doesn't get fancy. (In fact he is snickered at by niche-based peers for not doing anything particularly sexy or exotic.) And when all is said and done, his 50%+ average return shows that you don't have to trade like a banshee or be a genius / hero to make a killing. Being in the right place at the right time, and playing it to the hilt, is enough. (Of course, that's also the rub.)

The stories are entertaining. Far better, the ideas are valuable. (You have to take them with a grain of salt, but that should go without saying.) I appreciated Kessler's concept of "waterfalls," giving a mental picture of technology's promise as an investment vehicle. Pressure builds in some area of inefficiency or untapped opportunity, creating a pool of latent opportunity. Finally the barrier breaks, the waterfall bursts forth, and innovation cascades outward—first to the early adapters, then the commercial adapters, and then the general masses. As prices fall dramatically, unit volume increases far more dramatically and, hopefully, exponential profits are created in the process. Kessler highlights Microsoft as one of the greatest (and luckiest) waterfall examples of all time, thanks to the master stroke of tying software to hardware. Every box sold puts another sale in their pocket, and with someone else building the box, they maintain zero replication cost and 99% profit margins. Beautiful.

Kessler also takes us on a tour of the industrial revolution, courtesy of an intellectual exercise spurred by the friendly investor and erstwhile gnome of Zurich "Mr. Zed." After following the progress of the steam engine and the Niagara Falls opportunity in textiles, Kessler transitions from old school to new school with his "margin surplus" theory, which seeks to replace yesterday's manufacturing model with an intellectual property one.

Along the way he points out how IP (intellectual property) and physical manufacturing have been effectively split up for the first time in history, allowing Intel and Microsoft to make 80-99% margins on products bundled with every Sony laptop sold, while Sony itself sees maybe 1% returns after the hassle of buying materials, paying for labor, assembling the boxes, managing inventory and shipping them out.

Thus the United States gets the lion's share of pure profit through intellectual property value-add, whereas Asia (or wherever the assembly occurs) gets traditional manufacturing sized margins (5% or less) on assembly and delivery, but benefits from mass employment and economic growth. Lots o' jobs is Asia's incentive to keep the high margin / low margin deal going (at least until they finally get innovative too, and start outsourcing to North Africa or some such place).

The margin surplus theory is intriguing, and goes far in explaining why our trade deficit may not be as big a deal as some suggest. If Kessler is more or less correct, then a trade deficit is a natural—and even desirable—byproduct of an investment surplus, as the world continues to invest in our high margin IP profit centers, rather than the lower margin process of assembly taking place elsewhere.

The theory doesn't address a few key nitpicks though, such as the frighteningly low rate of consumer saving in the United States... or the tendency we have to spend borrowed money on "stuff" rather than putting it back into productive investment... or the propensity of government to cheerfully run spending off the rails while whistlin' Dixie.

Kessler is confident that the next round of spectacular innovation is likely to occur within the same twenty mile radius as last time, but here I fear he is overly optimistic. Even if margin surplus is more right than wrong, and even if IP invalidates gaping trade deficits and old economic models (two big ifs), America still has rough waters and real challenges ahead. Just because team USA was the innovation powerhouse of the 20th century doesn't mean we can ‘repeat the feat' in round 21.

Edges can be dulled and edges can be lost. If innovation is going to keep saving our bacon from the deficit frying pan, someone needs to tell the politicians who are discouraging immigration (choking off our brain gain), letting trial lawyers run amok, and bleeding entrepreneurs with heightening cycles of tax and spend. With the baby boomer generation retiring and major fiscal battles ahead, this is no time to be complacent. If apathy sets in, innovation won't save us from decline… and the next big waterfalls could easily make a splash elsewhere.