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Running MoneyJohn Mauldin
How might the economic world be turned upside down as we go from a post-industrial society to a world driven by intellectual property? What if manufacturing no longer was the driver for economic well-being because that is not where the profit is? What if the trade deficit was not as large as the numbers suggest? This week we examine a lot of interesting what ifs while we look for the connections between the steam engine and Napster. All these questions and more should provide us with a little food for thought and maybe even some clues about the Next New Thing. I started this week speaking in Bermuda and end up in speaking in San Francisco, writing much of this letter as we fly over the fruited plain and purple mountain majesties. Looking at the scores of mangers and funds at the two investment conferences, one an industry conference for hedge funds and the other the Money Show for retail investors, brings into sharp focus one of the main problems facing investors: where (and how) can we find an edge? If everyone knows about something, if everyone is already there, then how can there be any profit? Because of all this, I spend a lot of my research time trying to figure out what is not common knowledge. While running with the herd is safe most of the time, it is not very rewarding. Today we are going to look at a new book by a guy who definitely does not run with the herd. Indeed, he may be the anti-herd. Andy Kessler has just written Running Money about his days running what was the fourth most successful hedge fund for its time. He and a partner launched a Silicon Valley technology hedge fund in the mid-90's and began selling and taking profits in 1999. He ran all the way up the market, sold at the top, making his investors six times their money. He subtitles the book "Hedge Fund Honchos, Monster Markets and my Hunt for the Big Score." The book, like Kessler himself, is funny and irreverent. His publisher describes him as a brilliant investor, a born raconteur and an overall smart-ass. The Financial Times says this is going to be one of those books like Liar's Poker or Den of Thieves which is required reading for those in the industry. I agree. If you are in the game of running money, you gotta read this one. This should be required reading for brokers and advisors. Besides, it is a lot of fun. The book is really three books. It is an interesting insight into money management. It is a history of technology, Silicon Valley and how to recognize which companies will be the big winners, which will die and which will merely be OK. It is also a thought-provoking essay on how the world may be changing from a post-industrial economy to being driven by intellectual property. I am going to give you an all too quick summary of these themes, which should by no means be considered a meaningful substitute for actually reading the book. Steam Engines and Napster Interspersed between his stories about his hedge fund, Andy gives us three chapters on the development of the steam engine. It is not a history lesson, but an investment lesson. Assume that there was a stock market at the time. Would you want to invest in the Boulton and Watt IPO? They had a 25 year patent for a four horsepower steam engine that broke down almost as much as it ran. It might have gone up at the opening, but there would have been some shaky days as they missed their quarterly numbers. By and large, the engine was used to pump water out of mines and run bellows for iron forges. Not a big industry, but certainly a nice potential business. Somewhere I remember reading that the founder of IBM (Thomas Watson) once said that the world would not need more than five computers. As IBM and others built the monster computers of those early days, they built them for specific, limited focus jobs. As creative as they were, they did not think about what uses to which they might eventually be put. Part of the problem was they did not also see how those giant vacuum tube driven machines might change and evolve. The steam engine was like that. It produced whole new industries that James Watt never dreamed of and was the basis for the Industrial Revolution. Some guy named Cartwright hooked up an engine to a loom. Another inventor named Eli Whitney developed the cotton gin and increased the output of cotton for a day's labor by 50 times. Those two combined events changed everything about the production of clothes. The steam engine created all sorts of new industries. Did you want to invest in a steam ship company, where anybody with access to capital could compete and drive shipping prices and profits down? Or did you want to invest in the company that made the propellers that every steamship bought? Did you want to invest in the players in the "war" or invest in those who made the bullets? Railroads became the internet investment craze of their time. In the beginning, you could build a railroad and get all your money back in shipping fees and tickets within one year. Is there any wonder that investors flocked to get into such a sure fire thing? Railroad stocks were selling for multiples of potential passengers miles, just like Yahoo would sell for multiples of future page views. It's All About Scale Fast forward to last decade. Kessler's fund, Velocity, was investing in a company called Elantec because of laser diode drivers that were integral to making writeable DVDs (and CD drives too.) It was going to take some time for the technology and company to come together, but Kessler was buying stock at $3 to $5 hoping it would go to $10 in a year or so based upon the new technology. And then along came Napster. Now everyone and their kids could download (read steal) music for free and create their own CDs. Instead of maybe 10% of computers having CD-R drives, it went to 80% within six months. Elantec made those $2 laser diode drivers (but with huge margins) which had to be in every one of those 100 million drives that were shipping a year. All of a sudden, a new technology created a demand that no one even suspected a few years earlier. Did anyone make money directly on Napster besides the lawyers and investment bankers, plus a few traders? No, but Elantac soared to $100. Kessler began selling and sold his last shares at over $200. Trade Deficit and Margin Surpluses A company like C-Cube designs a chip in Silicon Valley, emails the design to a "mask" shop in Taiwan, who sends it to a chip plant which makes the wafers. The wafers are sent to Indonesia or Malaysia or some low labor cost country (Taiwan is too expensive!) and cut into chips. The chip costs maybe $5 to make and they sell it for $50 until competition forces it down to $10. Then they redesign it so they can make it for $1 and sell it for $5. And you get to buy DVD players for less than $100. Now, Kessler helps us follow the money. If C-Cube sells the chip to Toshiba, the profit is actually sent to a subsidiary in Barbados, as Uncle Sam would take 35% if they brought it back into the US. Toshiba sells us a DVD player for 5% margins (or less). It shows up as an import, but the profits on the US designed components don't show up as exports. Look at a laptop. It sells for $1000. $200 of that is for an Intel chip (Intel's gross profit is $180) and $100 for Windows XP (Microsoft's gross profit is $99.99!) The margin of those two products is more than the gross margins of all the companies that make the other components combined and of the laptop itself. What drives the ability of companies to create such margins? Intellectual property. And it is not just technology. Think of pharmaceuticals, entertainment and a host of businesses built on the ability to create property based upon something which is at its essence an intellectual construct or process. So while the U.S. is running a trade deficit, Kessler says, we are running a margin surplus. Stock markets only care about profits. Lots of that money that leaves the country comes back in to invest in our high margin companies. I confess, I am now sitting in San Francisco at the Marriott, drinking my Starbucks Venti decaf cream-something-or-the-other. It is just coffee, but I paid $2 for what is in effect intellectual property. You can call it branding, marketing or whatever, but it is a high margin business built around an idea. Admittedly, it is not a room full of Ph.Ds chained to their desks designing chips, but it is a management team creating an idea and a product for which I am willing to part with $2. What is Wealth? Let's look at a few paragraphs from Running Money "In the US, the Industrial Revolution is dead. Kiss it good-bye. Heating, stirring, mixing, stamping, and bolting have all been played out. These are no longer things that make America great. Instead it's, uh, thinking. I know what you're thinking, "Why didn't I think of that?" It's what people who think they are smart call Intellectual Property. This "IP" is the Silicon Valley model. "But how did we get here? The biggest change since World War II is that design and manufacture are no longer linked. Computers and communications moves designs around in nanoseconds, while industrial era factories locate near cheap labor. A computer on a chip, operating system, wireless packet switching networks, these are all highly intelligent properties that come from mind instead of matter. But so is a Nike Swoosh, an anti-intelligent Adam Sandler movie or Baywatch rerun, a pill to stop the runs from eating a Happy Meal, Vanilla Diet Coke and a venti double decaf blended caramel macchiato with a twist at Starbucks. "The 225-year-old Industrial Revolution never did burn out, but merely faded away into a pit of profitlessness. On the flip side, intellectual property is highly profitable, which makes Wall Street squeal with delight. Money would flow uphill, if it had to, to fund these high margin intellectual enterprises. Money sloshes to margin! "The stock market sorts all this stuff out. A stock is nothing more than the current value of a company's future profits. Capital sloshing around seeking its highest return naturally funds highly profitable companies. General Motors days were numbered when Wall Street figure out they couldn't dominate like they did back in 1962. GM should have been creating subsidiaries in Japan rather than trying to keep Japanese imports out of the U.S. Wall Street probably would have provided them all the capital they wanted. "Like the Pink Panther Inspector Clouseau said when told "That's a priceless Steinway baby grand piano" right after he had smashed it with a knight's chalice stuck on his arm: "Nuut anymeure." "Give GM expansion capital? Not anymore. Over time, stock markets are all knowing and very persuasive. It's the stock market that is leading the change to the intellectual property economy we are in today, by canceling the credit cards of companies that don't fit the model. You have to squint to see it happening now, but it will be more and more obvious every day. "...You can be a long term investor, but you have to constantly adjust your sights to the next big thing. We may be in the midst of a long cycle like the British 100-year Industrial boom, but that doesn't mean you can buy and hold and be on the golf course by noon. What startles me is that those that generate wealth in Silicon Valley run at 100 miles per hour. They don't own anything of value, a textile mill or an auto factory. They own a process, the ability to constantly update their products and take advantage of that waterfall, some massive price declines, and then move on to the next one. "[writing about his hedge fund]...The world had changed. The mighty economies of Japan and Korea and Thailand are not taking over. Their output of cars and laptops and VCRs and DVD players and memory chips and computer monitors and sneakers was booming, but something's wrong. They have giant factories with lots of lower wageworkers that wind wire, screw screws, bolt bolts, wrap plastic and stick in a power cords. But that's not what anyone pays for anymore. Their economies achieve full employment, sure, but these countries are not economic powerhouses. Not anymore. "We were investing in companies with no more than 50-100 workers, most of them highly paid programmers and engineers, whose occupational hazard is coming down off a caffeine buzz and an occasional late night Nerf gun injury. Yet even after the market bubble burst in 2000, these companies would still be worth more than Ssangyong, a company a hundred or a thousand times their size. The stock market values small businesses with high margins over big businesses with low margins. Is that good or bad? Should I even care? "Whenever I try to figure out why this is, I keep thinking back and visualizing Mr. Shim [an executive of Ssangyong -- who was forced to sell stock to Kessler for a fraction of its future value only a year later because of company problems -- they sold the intellectual property to fund their old economy company -- John], a walking, talking, and sweating metaphor for how to invest. Something like "We Think, They Sweat." The spoils go to those with high margins. "...You can make intellectual property, but real soon it's worthless. You don't really own anything tangible, just the ability to move it along, kick the can down the road as diplomats like to say. Ask any economist and somewhere in their babble they will tell you that the role of an economy is to increase the standard of living of its participants. Did the boom-bust-boom-bust yo-yo I just lived through do that? I think so, but with lots of change. America doesn't make stuff anymore - we design it. The numbers are fishy, but even after the rocky start in the 1990's, I think this new Think/Sweat thing will create more wealth for more people, not just the U.S. but around the world, than the Industrial Revolution ever did. "The model I keep focusing on has the U.S. designing chips and someone in Taiwan making them for cheap. That sounds like a plan -- but somehow, this means we run trade deficits. Just the word deficit sounds so awful -- no one likes to be called deficient. What is the right model? Maybe we should just manufacture these chips and everything in the U.S.? Aren't all jobs good for the economy and our standard of living?" Mississippi Labor Arbitrage In the early 1800's the Industrial Revolution almost died before it got started. It wasn't from lack of capital or new technology. It was government. It seems that French and German farmers could produce corn and other products more cheaply than the English. So English farmers got Parliament to pass trade tariffs protecting their prices. Workers at factories could not make enough to pay for their bread. Their bosses could not raise their wages because they could not get enough money for their goods because French and German farmers couldn't sell their grain and afford to buy English made clothes. Kessler scores a point in pointing out that the English should have been happy to buy whatever they could from Europe because it gave them money to buy clothes and other industrial products from England. Yes, English farmers would have had to adapt but English laborers would have had higher wages. It is not that much different today. Labor unions want to "protect American jobs." But those jobs are not the future. Buried in the last labor report was the data which showed we are in fact creating higher paying jobs. Not every new job, certainly. But there is job creation going along with the dislocation caused by the shift in our economy. What if California said it was going to put up tariffs on products made in Mississippi, because California jobs are going there because wages are lower? "We are losing jobs because of an unfair labor advantage." We would think California was nuts. But how is that much different than griping about low wages in Asia? The world is changing and it is going to change at an accelerating pace. It will not be easy for many of us to change, but that is what we are going to have to do. If we can keep governments from screwing it up and trade wars from developing (not an easy thing to do), the entire world will see their standard of living increase. On a relative basis, the increase will be much better in Asia than in the US, but 20 years from now we will be better off than we are today. But the transition will not be easy. There will be lots of "dislocation" as global labor prices and increasing productivity mean that traditional manufacturing jobs will be under pressure. Only as we make things with more brain than brawn will we effectively compete. Remember, the United States makes (manufactures) significantly more stuff now than we did only a few years ago. But we are doing it with 3,000,000 less workers. We are working "smarter" but that is small comfort for those who have had to adjust. One further idea I get from Running Money is that it re-enforces my thoughts about investing in index funds. In a slower growth, Muddle Through Economy which will be in transition, there are going to be lots of losers as well as lots of winners. An index fund will expose you to the dogs and drag down overall performance. I believe active management may again become attractive, able to deliver market beating performance, simply by avoiding the dogs. I disagree with Kessler that trade deficits don't matter. They do. But that one disagreement does not alter the fact that this is a great book with plenty of food for thought. I have already read it twice. I bet a lot of you do as well. You can get it for a 32% discount at www.amazon.com. Economists, Houston, Tahoe Baseball and a Quick Joke Just one quick joke from Running Money: "An economist and an investor are helplessly lost on a hike through the peaks and valleys of the Dow and NASDAQ mountain ranges, well, the Rockies. The investor sticks a wet finger in the air to find his direction via the prevailing wind. The economist is studying charts and numbers, GDP growth, trade stats, unemployment data, inflation, hours worked, productivity, meticulously compiled by the Commerce Department, the Bureau of Labor Statistics and Bureau of Economic Analysis. "OK, I've got this figured out," the economist yells out. "You see that big mountain over there?" "Yup," sighs the investor. The economist then proudly announces, "We're on top of that one." I will be in Houston Saturday morning, October 9 speaking at a public forum for investors. I will give you details in later letters. The final details are on the web for Telecosm 2004, hosted by George Gilder and Steve Forbes at Lake Tahoe, Nevada on October 20-21 at www.telecosmconference.com. Telecosm 2004 has a pretty powerful line-up of speakers, especially for those interested in technology. It looks like we will see something unusual in this year as the Rangers are playing meaningful games in late September. Usually we are 25 games back at this time. Because we swept Oakland, we are now two back with ten games to play. This could be one of the more exciting end of the season pennant races as three teams are within two games and will all be playing each other. As many of you know, I have an office actually inside the Ballpark in Arlington, where we can watch the game from my office balcony. I may be "working" late next week, watching a few games out of the office window. At times like these, it seems a few friends show up at the office with an adult beverage in hand. There is hardly anything better than friends and baseball, unless it is friends, baseball and a real pennant race. This week, call up family and/or a friend or two and spend some time doing whatever you like to do. It's what it's all about. Your 'enjoying life with all the changes' analyst,
John Mauldin
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. This information
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