A Wall Street Education

Andy Kessler (Courtesy HarperCollins Publishers)

Andy Kessler, author of "Running Money: Hedge-Fund Honchos, Monster Markets, and My Hunt for the Big Score" was online to discuss his experiences running a hedge fund in Silicon Valley. Kessler also wrote "Wall Street Meat: My Narrow Escape from the Stock Market Grinder."

A transcript follows.

About Kessler: Andy Kessler worked for almost 20 years as a Wall Street research analyst, invetment banker, venture capitalist and hedge fund manager. He has written for the Wall Street Journal's op-ed page, Forbes and Wired.

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Andy Kessler: Welcome. Andy Kessler here. I am happy to take questions on any topic: Wall Street, hedge funds, book publishing, technology, telecom, whatever. I've played around with lots of this stuff and have an opinion or two to pass along.

Don't ask me stock tips, my series 7 test is long expired. There are TV shows that give stock tips.

Anyway, thanks for chatting and fire away.

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McLean, Va.: Hi, Andy, I've read at least one of your books and many of your op-eds.

Question: in your opinion what organizations are most effectively pursuing shareholder rights and corporate governance reform initiatives? Thank you. Joe

Andy Kessler: I'm a fan of markets policing themselves. Actually, the participants in markets policing markets. If you don't like management or their governence, SELL THE STOCK.

When companies realize that their valuations are hurt by their lack of concern for shareholders, they will figure out a way to make the right changes. If they don't, the thing is going to blow up anyway.

Transparency is usually the best cure. I think any regulation that insists on transparency is usually the right regulation. The rest are bogus, a game of what-if? Scammers figure a way around rules, but not real transparency. If you can see it, then you can make an informed decision to buy or sell. That simple, rally.

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Elmira, NY: Will the volatility of energy prices make predicting the path of funds more difficult in the near future? In other words, will all funds start to carry more of the risk normally associated with commodities?

Andy Kessler: I'm not a fan of energy investing. Maybe back in the days of John D. Rockefeller when costs were dropping and new markets were being created. But now it is a suckers game guessing supply and demand. Good luck with that.

I'd rather invest in a dozen smart people in a dark room with fiber internet access who can change how we work, communicate, socialize or engineering new medical devices or drugs, than a way to add 5 MPG to our commute, or how much reserves Chevron really has.

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Arlington, Va.: Loved the names thrown around for various companies -- Trouble-Click; Sink-tomi. What was your favorite?

Andy Kessler: Nick Moore made attending investor conferences bearable.

He was such a cynic, he came up with funny names of companies he figured would blow up soon

My favorite is probably Win-Scar. Or maybe Micro-tragedy. Or is it Liber-eighth...

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Woodbridge, Va.: Andy,

I loved Running Money! Will energy prices send us into a Bear environment?

Andy Kessler: Thrilled you enjoyed the book.

Energy prices are a problem, but they have already sent us in a bear market. The S&P, ex-energy is down this year.

No one really knows what kind of risk premium is in oil prices, but i wouldn't be surprised if it is $20+.

The good news for tech is that it is energy independant. Search technology still advances, wireless components get better, etc.

When the U.S. was a manufacturing economy, energy was a worse problem. Today, as an intellectual property economy, the concern is much less

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Delran, NJ: What is a hedge fund?

Andy Kessler: It used to be that a hedge fund was as simple as owning one stock and shorting another (selling without owning it first) to "hedge" the market.

Today, it is more about how you charge for your services. A hedge fund is an incentive fund, managers charge 1 or 2% of assets as a management fee and then take 20% of all the capital gains.

Whatever it takes to generate gains, long, short, convertible arbitrage, derivatives, etc. My fund would invest in small cap tech stocks as well as private companies we thought could be public soon.

Hedge funds are different than mutual funds, which are usually just long only, so if the market goes down (it does, you know) there is no protection.

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Havelock, NC: Hello Mr. Kessler - semi day trader here. Question is - do funds sometimes run a 'dog with fleas' stock (to help get out of a net long position) and how does this work with the firms you trade through ?? I.e., does Goldman or whoever say we'll get you 50k shares at $8 or do you keep putting orders in? After a day or 2 of running, you can slowly sell everything & the stock eventually ends down, but you have gotten out of the position. Thanks and good luck. HK

Andy Kessler: Depends on the liquidity of the stock. A big enough fund can run up the shares of any stock outside the S&P 500, even some that are in it and big enough. But to think that they can do that and then get out is overly simplistic.

If it is illiquid on the way up, it will also be illiquid on the way down. Sure, some momo funds may see the activity and start buying, but not enough to make a difference. Again, it depends on the market cap, daily volume, liquidity, etc.

As more trading goes to ECNs and matching services, this game ends anyway. YOu think Goldman is finding sellers of those 50K or 500K shares themselves. They are plugged into the same ECNs.

Most firms don't put their capital up any more to provide liquidity. Not for stocks anyway. For funky derivatives, pethaps, because the spreads are wide enough to drive a truck through. But at 5 cents a share, let alone 1/2 a cent per share, there is no value of putting up capital.

What is a semi day trader? Just the mornings. I like the sound of that? Just kidding.

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Washington, D.C.: Hi Mr Kessler,

Would you kindly elaborate on the types of trades or trading strategies that you used as a hedge fund manager? Thanks.

Andy Kessler: We were long only. It was the right time (mid-late '90's) and place (Silicon Valley).

We didn't trade much, our turnover was something like 30% implying 2 1/2 to 3 year holding periods. We were atypical, but i still think you can have a successful hedge fund model with a long term strategy. You just have to be patient.

We liked long term capital gains. Trading and shorting is always short term. You have to earn that much more to beat the taxes on a return basis.

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Alexandria, VA: I am a value-investor interested in starting a limited liability partnership quite similar to Warren Buffett's original business. I am somewhat experienced in that I have been successful at managing the personal equities of a select few close relatives, in addition to my own of course. Now that I want to take a more formal approach, what would be my most important next moves - getting the contracts read by a lawyer, attaining my CFA (I am a currently in a research scientist), compiling my record into a report, etc.?

I sincerely appreciate your advice.

Andy Kessler: legal documents are boiler plate today

a CFA is needed if you want to work at a bank

the important move is experience, and proving out your track record. some investors will take brokerage statements as a record, others don't. it is too easy to have multiple accounts and just throw away the bad ones.

it may take some money, but you can probably start a small fund, manage it, and use the track record to raise more money

be warned, it is HARD (capitalized on purpose)

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Washington, D.C.: You write that wealth comes from constantly taking risks. Can you qualify those risks -- informed, etc?

Andy Kessler: Wealth comes from productivity. That almost always implies taking risk, or at least doing things differently from the status quo.

Look, if we had an economy where we all did each others laundry, there would be no wealth created. But if one person took risk and capital and invented a clothes washer and energy source and a clothes line, well, soon, that person could do it cheaper than anyone else, get all the business, and as importantly, free up others to take their own risk and invent some other productive business, generate profits, reinvest, etc.

And I hate doing laundry.

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Oakton, VA: "I'm a fan of markets policing themselves. Actually, the participants in markets policing markets. If you don't like management or their governence, SELL THE STOCK."

Surely you are not this naive? This may work for sophisticated and institutional investors, but does this work for mom and pop or grandma?

Most individual investors don't get to meet with management, attend investor conferences, or even have access to sell side research.

Having as transparent an investment process protects the little guy.

Andy Kessler: I'm not naive at all. Dumb perhaps, but not naive.

Individual investors can do just fine if the transparancy existed to allow them to make informed decisions. Someone surely knows more about medical devices then the guy at some growth fund who just buys them all.

Regulation almost always backfires. Reg FD, Fair Disclosure, was supposed to help the little guy by making all disclosures as broad as possible. But it turned into Reg ND, for NO DISCLOSURE, because companies are so afraid of saying the wrong thing at the wrong time and getting sued. (See Seibel). So they wait until once per quarter 10-Q disclosures. Last I checked, the stock market is open 5 days a week, sometimes 4. What information do they trade on the other non 10-Q days. Rumor, innuendo, or worse, analyst opinions. Yuch. I'll take disclosure.

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London, Canada: Mr. Kessler,

What would be the best piece of advice you would give someone who is interested in running their own hedge fund?

Andy Kessler: Go get a job in the money management business. At a bank, at a mutual fund, whatever. Even at an existing hedge fund if you can. Get some experience.

Only then can you have the mindset to successfully raise and then run a hedge fund. I said raise, because that is the first huge hurdle, convincing others to give you their hard earned cash. Then the real hard part comes of putting the money to work. Buying a million shares is different than buying 1000 shares. Takes longer. You are stuck with them, etc.

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Washington, D.C.: Mr. Kessler:

As a recent college graduate, I am extremely fascinated by the world of hedge funds, I-banking, Wall Street, etc. My question to you is: how did you get started in your line of work and do you have any advice for a recent college graduate interested in entering this particular area of the labor market? Thank you.

Robert

Andy Kessler: Get an MBA. I don't have one, but then, I got lucky getting a job on Wall Street, snuck in the backdoor.

An MBA is a ticket to the dance. It may be worthless education -wise (although there must be something of value you will learn) but it is a sign plastered to your head that you have gone through the rigor of getting it and some firm will take a chance and hire you. Other than that, a college degree is just too common these days to count.

Once you are admited to the dance, then you can sniff around and find the path to what you really are good at, running money, investment banking, trading, whatever. Easier from the inside and the MBA is necessary. Sad but true.

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Fairfax, VA: Why do you invest?

Is it simply a transaction for you... or do you believe in what you are investing in, creating value, that sort of thing.

Andy Kessler: In general, one invests to generate a return above inflation.

Whenever the Fed prints money, it dilutes all of our savings, so we must invest to stay ahead.

But I prefer to invest in productivity creating businesses. Those 12 folks in a room chugging Jolt and taking Nerf gun battle breaks. These are they folks creating wealth and I am more than happy to provide capital to help them do it (I'd do it myself, but I am tied up doing chats and the like right now)

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Santa Barbara, Calif.: Are hedge funds generally stronger during difficult times such as disasters or war?

Andy Kessler: Not really. Hedge funds are just another set of investors. If there is opportunity, they will find it. Perhaps difficult times and war means the market will be choppy, which they can leverage better than a mutual fund, but that is not always true. The S&P did well in '03 and has been choppy since.

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Burke, Va.: You write about the shift from a manufacturing economy to an intellectual property economy in the U.S. Is the future of this country centered on designing products, or assembling them from components made elsewhere?

Andy Kessler: That is exactly right. Apple designed the iPod in California and has it manufactured in China. For the original ones, they pay $200 and sell them, on average to retail stores, for $265. In other words, they make the most profit from the device, even though they create a $200 trade deficit for each one they sell. The benefit to Apple and the U.S.? Even though they have probably generated $2-3 billion in trade deficits from the iPod, their enterprise value, market capitalization is up by over $20 billion.

Not a bad trade, eh?

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Ithaca, NY: Andy,

Thanks for chatting here today. I've enjoyed both your books tremendously.

It seems that you were somewhat ahead of your time running a fund that included a lot of illiquid investments. I see that more and more today in the hedge fund space (although you weren't hedged, but that's another story). Do you think your LPs understood the illiquidity of your positions? Do you think LPs of other funds that are moving more to illiquid investments understand the ramifications of this trend?

One other question if you have a sec - what can be done to improve the quality of business journalism on the topic of hedge funds? There's a lot of uninformed sensationalism out there. It's like using the terrible accident at Lake George last week to say, "see, boats are unsafe". But of course that accident doesn't say a lot about the safety of the Queen Mary 2, or of your neighbor's jet ski. Yet journalists seem very willing to use the Bayou or LTCM examples and say "see? hedge funds = baaad".

Thanks!

Andy Kessler: Thanks, glad you liked my books. I am in the middle of writing the next one.

Liquidity should be taken into account when measuring the risk of a portfolio. We did some venture investing, luckily, most of them worked. Hedge funds today are doing a lot of private equity investing, which is very illiquid, long time horizon. Good luck with that. Just be aware before you invest how illiquid positions may become, and if you can get out if you want or need to.

As far as the press, there is a, what, $8 trillion mutual fund business under threat from hedge funds. Money will flow to these incentive funds, it is the right way to manage money, with incentives the same as investors vs. mutual funds which just want to grow large. The press loves to sensationalize any missteps, and there are some bad apples running hedge funds, Bayou the latest example.

Every business has a few sleazy types, it just makes the honest players more attractive.

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Anonymous: "companies are so afraid of saying the wrong thing at the wrong time and getting sued."

Before RegFD, guess who all the disclosures were made to? Large Shareholders and Sell Side Analysts.

How long do you think the disclosures trickled down to individual investors?

Reg FD may not be perfect, but it evens out an uneven playing field.

Andy Kessler: I wrote an op-ed a few years ago, you can find it on my website, andykessler.com, that made the case that companies should disclose how they are doing on a daily basis, even hourly basis. Why not? They have that information internally anyway, let me see it too. Hit me with a firehose of information and I can make an informed decision. Even with RegFD, you are getting nothing, just warmed over spin by the company. We all know how accounting can make anything look good for a while, with reserves, and honey pots and cookie jars. Just give me the raw data, all of us the raw data.

Reg AD, All Disclosure.

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washingtonpost.com: andykessler.com

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Homewood, IL: Andy,

Do you think that hedge funds are sort of th e most recent "fad," like venture capital was in the 1990s (except now we're mostly in Greenwich instead of Silicon Valley)?

If so, where do you think the future of banking is headed? More trading strategies by I-banks? Back to the more traditional corporate financing?

If not, why do you feel that hedge funds have long-term staying power?

Andy Kessler: In 1980, mutual funds had $40 million dollars. The rest was in trust departments of banks and in pension funds.

Today, 25 years later, mutual funds have $8 billion plus or minues. The market is up some 10x, so the other 20x is market share shift from banks and pension funds. Pretty cool.

Mutual funds were a better way to manage money.

Now, I think hedge funds will make similar market share gains over the next 20 years. Incentives the same as investors IS the right way to manage money.

Mutual funds do well by getting more assets. That's there only incentive. But, we all know that too much money makes it harder to find great investments, and returns suffer (See Fido Magellan fund).

This is no fad. And Wall Street needs to keep pace to serve this new client. That will drive trading strategies (like ECNs taking over the NYSE.)

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Alexandria, Va: How is the market for stories about Wall Street these day?

Is the public still interested and mesmarized but the wheeling and dealings and high stakes or investing?

Or has the luster and romaticism worn off?

Do you see a movie deal in your future?

Andy Kessler: Have we reached a saturation point for Wall Street stories? I'm not sure.

It was a world that was some what secretive and unknown, plus wild and crazy and whacky, so readers were interested just to see what was behind the curtain.

Fortunately, there will always be interesting characters coming out of it and new things to learn.

The luster will always be there, it's a high stakes game. Romaticism of finance, I get ill thinking about it, but people do love money!

Brad Pitt was tied up, and apparantly too short to play my character.

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Fairfax, Va.: You have a line in your book that you feel guilty borrowing your grandchildren's future away from them. What's it going to take to stop the deficits?

Andy Kessler: Actually, the line is others worried about borrowing their grandchildrens future.

I think that's bunk. Deficits are just economic constructs.

We run trade defecits but because we are a high margin intellectual property economy, we have a margin surplus. All the money that flows out of the country to buy BMWs and Sony TVs comes right back in and buys our bonds and stocks of high margin companies. Microsoft and Google and Intel and Oracle and Genentech. They aren't lofty by accident.

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Pasadena, CA: Andy, do you have any advice for a college student studying math who wants to pursue a career in investment banking/securities trading?

Thanks for the help!

Andy Kessler: As a previous answer, the ticket to the dance is to get an MBA. You could go into the IT department of one of these firms and then try to move, but from what i have seen from the inside, that is pretty hard. Better to come in through the front door and then find what intrigues you.

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Andy Kessler: Thanks for all the great questions, and the feedback as well. Good luck with your investing, I hope this chat helped in even a small way.

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