What would you do if you could get a dozen outstanding professional investors to give you their best ideas? Undoubtedly, you would be overwhelmed with material. John Mauldin got around that problem by asking these top-flight investors to write about their single best idea.
That was the origin of his book, “Just One Thing: Twelve of the World's Best Investors Reveal the One Strategy You Can't Overlook,” published in 2006. The first writer in this collection was Andy Kessler, who became an electrical engineer in 1980 and soon went on to become a semiconductor analyst on Wall Street.
In the mid-1990s, he co-founded Velocity Capital Management, a hedge fund, and converted its original $80 million stake into $1 billion in five years. As we’ll see later, it didn’t hurt that the firm specialized in tech stocks.
Kessler began his chapter by making the case that if you if you’re doing conventional things, your returns will be average at best. He wrote, “The sun is shining bright. Say what you want about the efficient market theory, if everybody knows something, you ain’t gonna make money on it. 'But the widget business is growing nicely,' you tell me. Yeah, so what? We don’t live in a static world. As my baby’s bib reads, 'Spit happens.'”
To pull in big returns, he said, it’s not about being contrarian, it’s about seeing things before others do. More specifically, Kessler was talking about spotting the big trends earlier, getting to know them inside and out, and then acting on them before the crowd can.
For him, the one big trend idea was this:
"Elasticity: lower cost creates its own huge markets."
He found the idea while reading a 1986 article in Electronics magazine. It argued that whenever prices dropped for EPROMs (erasable programmable read-dnly memory), another new device would adopt them or use even more of them. The same magazine had published an article on what became known as Moore’s law about 21 years earlier (Gordon Moore observed in 1965 that the number of transistors doubled roughly every year, then in 1975 reported they were doubling every two years).
As Kessler explained, “Videogames, PCs, modems, each of them would somehow design in more EPROMs, or denser EPROMs, whenever prices collapsed; and at some point, when the cycle turned, even though prices were still low, sales would increase because more EPROMs would be sold. I looked it up, and the word that describes this phenomenon is elasticity.”
He went on, “Elasticity is just the financial explanation of how the industry grows whenever prices of bits or gates or functions drop. The industry magically grows (and stocks eventually go up), and a smart semiconductor analyst would get ahead of this curve.” In a more basic sense, elasticity is the financial truth that when prices go down, demand goes up.
That idea was the simple premise behind the founding of Velocity Capital in 1996, he said, “while semiconductor elasticity was still playing out (and still, no one on the Street really understood it), telecommunications bandwidth would follow the same pattern.”
Over the next several years, semiconductors and chips became cheaper and, as the saying goes, “Everything changed.” The internet was born and a flurry of new products or applications came to market. He noted that as bandwidth became less expensive, new and improved applications kept turning up. Modem speeds went from 14.4 kilobits to 56 kilobits and 1 megabits. Then, there was 10 megabit speed and fiber optic technology.
From an investment standpoint, Kessler reported he and his partner looked at companies and would try to think out or map out elasticity for them. If they couldn’t figure out how a company would scale and benefit from elasticity in the next two to five years, they would strike it off their list.
In retrospect, it was a great idea; Velocity went from less than $100 million to a billion in just five years. When they talked about their idea in 1996, many listeners simply would say, “how cute” or something similarly dismissive. However, by 1999, he said every investor had adopted their mantra.
When Kessler wrote this article in 2006, he said the principle still applied, even though bandwidth prices were “in the gutter” at the time. Proof that he was right came just a year later when Steve Jobs and Apple (AAPL, Financial) introduced the first iPhone.
We know of other examples, from other sectors. McDonald’s (MCD, Financial) created a new family dining industry with its low prices. Discount airlines created what’s now an important subset of the transportation industry with their low and ultra-low prices.
The challenge for investors today is to find companies that are positioned to bring new ideas and products to the market because someone, somewhere is dramatically reducing prices.
The second trend that helped Kessler and Velocity succeed so dramatically was a byproduct of the first: “Intelligence moves out to the edge of the network.”
He said that idea is a saying in Silicon Valley, one that many people live and invest by. These caustic words describe the center of the network, in Kessler’s view:
“Almost every network invented before 1983 is controlled by old analog monopolies—SBC, Comcast, Cingular, Time-Warner Cable, Verizon. Rules are set by government committees. Prices are set by collusion—er, lobbied regulators. Innovation is limited to call waiting and news crawls. The center of the network is sclerotic and milked for the benefit of moguls first and shareholders second. Users are a distant last. These guys love to be regulated, as it freezes technology and innovation and business models in their tracks.”
Meanwhile, on the outer edge, new companies like Skype allowed users to call, from PC to PC, for free, thus undercutting the stodgy center. He wrote, “Cellular companies have barely added features to their basic service, so they keep inventing calling plans to confuse us into paying more. But meanwhile, by opening a browser on my phone and moving packets through a dumb Internet versus “smart” voice network, I can pull up maps and directions.” (Opening a browser on a phone was a very new and unique idea in 2006.)
Conclusion
In chapter one of Mauldin’s book, “Just One Thing,” Kessler wrote about the one big idea that drove the success of his hedge fund in the 1990s.
It was the discovery that new applications for electronic components would be found whenever the price of those components went down. Companies positioned to take advantage of those lower prices or new applications had a solid business model, one that should generate above-average returns.
Kessler also gave us a bonus of sorts: The idea that intelligence moves from the center to the edges of networks. Because intelligence constantly moves to the periphery, that’s where the best new ideas and investments are likely to be found.
Last, but not least, thanks to GuruFocus reader Henry (Chinhoufu), who brought Mauldin’s books to my attention (originally, he pointed me to Mauldin’s book, “Bull’s Eye Investing”).
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Inefficient Market Theory: Measuring the Foolishness of the Crowd
- Inefficient Market Theory: Staying Safe in a Market Bubble
- Inefficient Market Theory: Bargains in a Market-Wide Crisis
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