“Alone, we can do so little; together, we can do so much.”
In the past few Mid-Year Letters and Year-End Letters, we discussed then-current national and global events and the extent to which those events affected the GDS Investments portfolio. We considered the strength and resilience of the American economy and the ability of our economy to withstand political and cultural turmoil unlike anything most of us have seen in our lifetimes. To say that turmoil remains is an understatement, and we could certainly write more on the interactions between political chicanery and long-term outlook for the GDS Investments portfolio.
Here, though, we think it better to step back from further consideration of the economy’s ability to withstand today’s caustic civic discourse. Instead, we discuss here lessons recently learned about different type of strength and resilience... that of family and community.
Most of you know my wife Alicia and our middle-school-age sons Matthew, Sean, and Danny. For the past thirteen years, we developed a tradition of spending a week each summer in Ocean City, New Jersey. Those days on the beach and nights on the boardwalk, sometimes with dear friends and sometimes just the five of us... but always together, are amongst our happiest memories.
This year, we tried something new and planned a short getaway over the 2018 holiday season in the Dominican Republic. All went according to that plan until December 20th when the five of us attempted to board our plane. At that moment, we learned that the plane was overbooked, and that Alicia and Sean would have to take a later-scheduled flight. Even then, we did not know that they would not be able to leave Philadelphia for another three days. All the while, Matthew, Danny, and I were away while Sean and Alicia were at home... unable to join us until we were halfway through our trip.
My oldest and youngest sons and I enjoyed that time, but something was missing. During those few days, I came to realize in a way more acutely than ever before that we are not just five individuals bound together by family ties and each with her or his own direction. Rather, we are a single and coherent unit, which is far more than the sum of its parts.
My recent experiences with family and community leave me with an even greater appreciation for you, my professional community, than I had before. I am truly blessed and humbled by my relationship with each of you. My appreciation for you, and my dedication to you, is stronger than ever, as is my commitment to work together with you to secure your financial health and future.
We begin this 2018 Year-End Letter with the current interest rate environment. At the beginning of Q4 of 2018, the Federal Reserve Bank set a hawkish tone for raises in interest rates throughout 2019 which reflected confidence in the growing strength of the American economy. More recently, though, bond investors signaled significant concern about that strength in the long-term, and economically-sensitive stocks such as housing and automobile manufacturers slid on those concerns. Despite those signals, the Federal Reserve Bank appeared to remain committed to its program of interest rate hikes... a position that contributed greatly to the December sell-off.
Since the beginning of 2019, though, Federal Reserve Chairman Jerome Powell noted his concern with the recent slowdown in the global economy and suggested that the Federal Reserve Bank “can be patient and flexible and wait and see what does evolve.” He also stated that the central bank does not presently believe that its recent program of Quantitative Tightening contributed to market volatility but, in a recent speech, noted that the Federal Reserve would change course in that regard if necessary. As one would expect, equity markets have responded favorably to the central bank’s more dovish tone.
With regard to individual positions, we start with recent and exciting news from biotech leader Celgene Corporation (NASDAQ: CELG). We initiated our position in Celgene in the middle of 2018 and anticipated holding the company well into the future. On January 3, 2019, though, Bristol-Myers Squibb Company (NYSE:BMY) announced that it would acquire Celgene at a price of $50.00 per share as well as one share of Bristol-Myers Squibb Common Stock for each share of Celgene Common Stock. That formula values Celgene at approximately $75B, a 33% premium to the previous day’s closing price.
For various reasons, we are not very willing to own Bristol-Myers Squibb Company when there are other options with superior risk/reward profiles. Accordingly, on the day the merger was announced GDS Investments sold the entirety of its position in Celgene in the mid- to high-$80’s per share.
In the biotech field, we do continue to hold our position in Gilead Sciences, Inc. (NASDAQ: GILD), which recently hired new CEO Daniel O’Day. Mr. O’Day comes to the company from pharmaceutical industry leader Roche Holding AG ADR (OTC RHHBY) and assumes the helm of Gilead at a time when the company is cash rich with an improving pipeline and visibility around late-stage products. Gilead’s price-per-share is at a multi-year low in a cyclical biotech sector that is currently out-of-favor with investors. When that sentiment turns, Gilead could return significant gains.
We also remain fully committed to Metro Bank (OTC: MBNKF). After selling Commerce Bank (which, long-term, returned gains to rival Berkshire Hathaway Inc. Class A (NYSE: BRK.A)) to Toronto-Dominion Bank (NYSE: TD) in 2007, CEO Vernon Hill started Metro Bank 2010 as the first new bank charter in the United Kingdom since 1840. Mr. Hill, known for his determined focus on the customer experience often so lacking at bigger financial institutions, stated that Metro Bank does “everything big banks don’t and [doesn’t do] what big banks do. Our quest is to kill every big bank rule there is and do things differently.”
In the United Kingdom, Metro Bank found a highly concentrated market where just five legacy banks controlled over 80% of funds-on-deposit. Customers did not use those banks because of exceptional service and relationship goodwill but, rather, because of a lack of alternatives. Metro Bank entered into that market with a disruptive business model focused entirely on the customer experience and now has approximately £15B in deposits. While the legacy banks are shrinking their branch footprints, Metro Bank now has sixty-two stores in the United Kingdom with a well-defined path to approximately 200 stores in that market.
GDS Investments recently initiated a position in cloud storage company Box, Inc. (NYSE: BOX) which has developed a significant following among (and customer loyalty from (i.e. a 95% retention rate)) Fortune 500 companies, which are subject to regulatory oversight and have substantial security needs. File sharing for these customers is very intricate and, so far, Box has integrated more than 1,500 applications.
By spending more than $100M on R&D while realizing $609M in FY 2019 revenue, Box is very nicely positioning its near- and medium-term product pipeline. New technologies such as AI and machine learning should further entrench Box’s role as a corporate partner in “Cloud Content Management.”
We continue to hold and add to GDS Investments’ basket of Chinese-based equities. Though recent trade-related tensions between China and the United States have created significant value-oriented opportunities in that market, there is no doubt that China will continue to play a dominant role in global economy throughout the 21st century. In that regard, we hold the following “best of breed” positions:
JD.com (NASDAQ: JD). As we noted in our 2018 Mid-Year Letter, JD.com is very much the e-commerce brand of choice for China’s most affluent customers and we see no reason for that to not continue.
Baidu, Inc. (NASDAQ: BIDU). This company is commonly referred to as the “Google of China.” That moniker, however, understates how innovative and broadly leveraged the company is to other secular themes, which will play out over the next several decades (e.g., self-driving cars, online streaming (such as the company’s iQiyi service with 20M subscribers and 520M users per month), and the burgeoning form of e-commerce known as “online to offline” (O2O) which allows small and medium size “offline” businesses to create online presences and make local deliveries).
BYD Company (OTC: BYDDF). This automobile manufacturer is a longtime position for GDS Investments (and a company in which Berkshire Hathaway Inc. Class A (NYSE: BRK.A) holds a 10% stake) and one which we expect to continue to perform quite well.
Alibaba Group Holding Limited (NYSE: BABA). This market leader ended 2018 down approximately 45% from its 52-week high, which allowed us to add to our holdings. We expect the company to rebound in 2019 and beyond.
GDS Investments remains very bullish in our largest position, QUALCOMM Incorporated (NASDAQ: QCOM). The company has several major growth drivers on the horizon (e.g. 5G rollout and autonomous vehicles), a cash-rich balance sheet, and a management team with a long history of share buybacks at undervalued prices. We do not presently see any reason to change that attitude or move away from Qualcomm in the near- to mid-future given its growth drivers, valuation, and above-market dividend yield of 4.3%.
Followers of GDS Investments will also know that we hold a moderately-sized position in General Electric Company (NYSE: GE). Last year was a challenging one for the company but, as with all value investments, our position is not short-term oriented. We are steadfast in our opinion that this icon of American business is on the right track and are encouraged that the Board of Directors recently hired outsider Larry Culp as the Chief Executive Officer to manage that process.
Mr. Culp ran Danaher Corporation (NYSE: DHR) from 2000 to 2014. While he was there, the company moved away from its industrial roots and into higher growth-higher return businesses while its market capitalization and revenue grew by 500%. That success is likely due to what The Wall Street Journal called “a maniacal commitment to efficiency and constant assessment of business units against eight performance metrics.”
In recent years, while General Electric was acquiring business and diversifying in ways which hurt corporate efficiencies, Danaher was doing the exact opposite. At General Electric, the legacy of those acquisitions is a bloated corporate structure with many overlapping functions. Conversely, though Danaher employs roughly 67,000 people, only 200 of those employees work in corporate operations... the rest are engaged in work that actually produces revenue.
General Electric now has a big opportunity to restructure is Power business while continuing to grow Aviation and Healthcare – two fundamentally strong sectors. In order to raise capital for that opportunity, the company plans to sell a 92M-share stake inBakers Hughes (NYSE: BHGE) while BHGE repurchases 65M Class B common shares from General Electric. The total proceeds of those transactions will be approximately $4B while allowing General Electric to maintain an ownership stake at or above 50% of BHGE.
In our 2018 Mid-Year Letter, we discussed the likelihood that General Electric would spin-off GE Healthcare. That likelihood now appears a certainty, as the company recently filed with the Securities and Exchange Commission documents associated with an Initial Public Offering of GE Healthcare.
Absent some sea-change, GDS Investments will remain with General Electric while the company continues to right itself and reclaim its place in the pantheon of American businesses.
Some of the best 2018 results for your portfolios came from Under Armour Inc Class A (NYSE: UAA) and The Mosaic Company (NYSE: MOS). Under Armour’s stock price bottomed-out at $12.00 per share in late-2017 as sales slowed and inventory piled up. The company reacted aggressively to those difficult conditions by cutting costs and refocusing its product offerings. Domestic sales stabilized in 2018 and, now, the company has a huge opportunity to build-out the brand overseas... markets which now make up just 20% of the company’s $5B in revenues. Despite what could be a bright future for Under Armour, GDS Investments exited the position in late-2018 and earlier this month in order to allocate our gains to companies with even better risk-reward profiles.
The Mosaic Company rallied late in the year after reporting strong Q3 results with revenues growing 48% year-over-year to $3B. The company also raised its full year adjusted EBITDA guidance and paid down $700M in debt a full two years ahead of its initial guidance. We used the gains from exiting this position to purchase more value-priced and less economically-sensitive companies which were under pressure in October and November.
This year is off to a great start for GDS Investments and our value investment philosophy. We are now in the later stage of the market cycle and a time when investors recalculate their growth assumptions downward. That behavior creates an opportunity to purchase well-positioned and well-managed companies at discounted prices.
The drive-up in prices of FAANG stocks and long-duration bonds which resulted from artificially cheap money (QE) and a herd mentality earlier in the cycle is in the early stages of unwinding. Rising rates will force investors to consider how much they are willing to “pay up” for growth and whether they should continue to own companies with low (or negative) free-cash-flow yields. The impact of rising rates on “value” (i.e. high free-cash-flow yielding) companies, of course, will be much less severe. It’s important to note that “value,” as the term is used here, refers to how a particular company is priced in the public markets (its share price) relative to its underlying worth. The term does not refer to the underlying quality of the business.
GDS Investments has always been committed to owning “Best in class” businesses that exhibit the following characteristics – high unleveraged return on capital, industry-leading market share, shareholder-friendly leadership that manages for the long-term, and businesses with enduring moats and/or businesses that are disrupting industries with weakening moats.
Together, we will continue our dogged determination to identify, research, and acquire companies with the best combination of quality and value. Together, we will continue our commitment to you, your families, and your future. Together, GDS Investments and you will accomplish far more than any of us could accomplish alone.
With warm regards,