A July Update for Clients
July 14, 2023
"Deciding what not to do is as important as deciding what to do."
Steve Jobs, co-founder of Apple
The universal question for every investor and every investment is straightforward: is this a good position to take?
It is not so easy a question to answer. Most of us collect information about the asset in question and assess its potential for generating returns according to whatever criteria we use. To that end, we usually identify certain characteristics we actively seek in our investments, creating something of a mental or literal checklist.
That’s a sound approach but perhaps also incomplete. Sometimes, in order to figure out where we want to go, we must also identify characteristics or situations – red flags – to avoid. This is a key part of the investing process that’s also worth understanding.
In our last two letters, we tangentially touched on a characteristic that we at GDS Investments look for in our holdings: positive consumer surplus. Consumer surplus is the difference between what consumers would be willing to pay and what they actually pay. If there’s room to increase prices, that’s a positive consumer surplus.
We have obliquely referenced this idea in previous discussion of Amazon (NASDAQ: AMZN) and Alphabet/Google (NASDAQ: GOOG), two companies with some degree of untapped pricing power thanks to their positive consumer surplus. Consider the Amazon Prime program: for a $139 annual subscription fee, customers get nearly $1,000 in value after all of its benefits and perks are considered. In other words, consumers would likely be willing to pay a lot more than they're currently paying because of how much they’re getting. Amazon has parlayed that surplus into customer goodwill, which in turn translates into customer loyalty and increased sales. The average Amazon Prime member spends $1,400 annually, compared to less than $600 annually for non-Prime members.
This helps to explain why Google and Amazon are the two largest positions in our current portfolio, but it also raises an interesting question: what about negative consumer surplus – a sort of deficit of consumer goodwill – as an example of something to avoid?
Indeed, this situation can serve as a bright red flag signaling potential structural problems and telling us to proceed with caution. Let’s use Verizon (NYSE: VZ) as an illustration. An enormous, well-known entity in the cable and telecom space, Verizon presents a potentially attractive argument. If you’re not a value investor who cares about long-term value, you might not even look much further than its dividend yield of 7.47%. Altogether, it’s a well-established firm maintaining healthy revenues that consistently pays out generous dividends to its investors.
That read presents only a partial picture, however. Today, Verizon’s market position reflects not so much enduring strength as the lingering aftereffects of an earlier era in which they were often the only game in town. However, the way consumers consume media has changed drastically, and the ability of telcos like Verizon to capture and hold onto customers has weakened. They developed a utility or monopoly mindset in the ’80s and ’90s, so when streaming and other marketplace changes took off, they were caught flatfooted.
Worse, Verizon suffers from a lack of consumer surplus that makes it even more difficult to navigate changes in their market and serves as an immediate indicator of potential deeper issues. The 2022 J.D. Power Wireless Purchase Experience study put Verizon in last place when it comes to consumer sentiment in their market: “The study finds that respondents believe they're paying more and receiving less.”
From an investment standpoint, we must ask what companies like Verizon can do in this larger context. Obviously, Verizon is a $150 billion company with tens of thousands of employees. That gives them staying power, but it’s hard to maneuver a company on that scale operationally, culturally, or financially. They pay out around $2.60 per share in dividends, easily more than $10 billion annually, which is not an expense that most CFOs would be willing to cut. They run about $17 to $23 billion in capital expenditures per year with over $140 billion in debt on their balance sheet. In 2022, that translated into $4 billion in interest payments. Meanwhile, its performance has essentially flatlined or even deteriorated. In 2020, its annual revenue was $128.29 billion (which was a decline from 2019). In 2022, it was $136.84 billion. Though that presents a nominal increase, once we account for inflation, that’s functionally another decrease.
In short, the company faces huge fixed costs, with a revenue base that has been largely flat on a nominal level and highly vulnerable in a world where consumers have a lot of different ways to access both content and the last mile, with new market entrants that can price similar services much lower. The lack of customer goodwill exacerbates these structural issues, leaving Verizon and other legacy telcos operating on thin ice with lackluster financial performance creating a significant headwind against their rate of return.
Remember, it is the strength of the business itself that is our main margin of safety as an investor, and a deeper look at Verizon raises doubts about its long-term strength. Look at it this way: paying $5 for a business that’s worth $10 is a great investment, unless that $10 is in the process of slowly falling to $8, $7, $6. That situation offers a very poor margin of safety for the investor. Instead, the value investor wants a business that’s selling for $5 but is inherently worth $10 and is heading to $12 or $15 in coming years.
There are other red flags that we try to avoid when evaluating investments as well; structural problems and a lack of positive consumer surplus aren’t the only issues that give us pause.
Another example is a lack of transparency into how a company is operating and making money.
Consider a relatively new class of entity in the healthcare space: pharmacy benefit managers. These groups work as middlemen between drug manufacturers and end payers. In theory, they use their purchasing power to negotiate lower prices for drugs, and ideally, they serve the interests of consumers. However, they are rarely truly independent operators and usually have relationships that can raise questions about their motives and incentives.
In this case, our reluctance has less to do with poor performance and more to do with the opacity of the industry. We don’t necessarily want exposure to companies that operate in ways that aren’t fully clear and understandable, which opens the potential that they could be making money by exploiting weaknesses in the system or, worse, its customers. We don’t exactly understand what’s happening in this segment of the healthcare market, but that by itself is a reason for us to stay away. Even if the appearance of compromised incentives is misleading, the fact that there could be margins that are being hidden makes us wary of investing. We are not alone in our concern about the absence of transparency in this space.
This also presents us another lesson in what to avoid: as investors, we must also know our limits and resist any temptation to invest outside of them. If we don’t have the expertise or knowledge needed to fully understand a given company or industry – whether it’s because of our own background or just a lack of available information – it’s not a position or market in which we should operate.
Beyond knowledgeability, we all also have to invest in a way that’s psychologically self-aware. Often, individual investors underestimate or don't understand what they're psychologically able to do. For instance, as a value investor, we find good quality business and invest with them for a long period of time, including through downturns. If an investor cannot weather a brief downturn without panicking and selling, they will not optimize this strategy. Investors need to be able to candidly gauge their own strengths and weaknesses as investors.
That is what we at GDS Investments strive to do on your behalf every day. We remain committed to our fundamental investment philosophy. While other firms chase hoped-for returns in pursuit of quick gains or other short-term goals, often despite glaring red flags, we will continue to maintain our long-term perspective by digging deeper and selecting fundamentally healthy companies that showcase indicators of enduring strength.
You may request an updated ADV Part 2 brochure by reaching out to me at any time.
As ever, I remain grateful to you and humbled by your ongoing support.
With warm regards,