A September Update for Clients
September 3, 2023
"An investment in knowledge pays the best interest."
— Benjamin Franklin
As we prepare this letter, the hot temperatures of summer and even more heated economic and financial dramas of the past this year seem to be settling, at least somewhat. In this late summer respite, we at GDS Investments have been more focused on reviewing and pre-qualifying companies than actively engaged in buying or selling. Investing need not always be “exciting” – indeed, more often than not it shouldn’t be – and periods of research and learning are incredibly valuable for their own sake. As Benjamin Franklin would argue, they are perhaps the best investments any investor can make with their time and energy.
To that end, today we are going to address a series of topical and timely questions to better understand the current investing environment.
ESG Investing: Clearly growing in prominence and emphasis for many investors, does it truly make sense to apply environmental, social, and governance standards to investment decisions?
There’s clearly a real hunger in the marketplace to make investments that do double-duty by both earning financial returns and also rewarding companies for pursuing values like sustainability, diversity, and wise governance. Henry Fernandez, chairman and CEO of index and analytics provider MSCI, said on a recent earnings call: “During my recent client trips to Asia, the Middle East, Western Europe, and parts of the U.S., ESG was the most popular topic clients wanted to discuss. For that matter, when the IBM Institute for Business Value recently surveyed corporate executives across 22 industries, 76% of them said ESG is now central to their business strategy."
We at GDS Investments certainly agree with the idea of making principled investments. There are individual companies and even entire industries we eschew due to principled disagreements with what they do or how they do it.
However, we would also advise caution when it comes to following ESG ratings and activities specifically.
First, it’s not necessarily clear what “ESG” even means outside of an abstract commitment. Corporations and investors have settled on a shared acronym but not on a shared definition. As a result, measures of ESG performance might actually be measuring aspects of a company that have nothing to do with our personal values. With so little standardization or shared understanding, how can you be sure ESG claims by a corporation or third-party match what you as an investor actually care about?
Second, ESG has clearly become a marketing tool for many organizations. As Mr. Fernandez says, a healthy majority of corporate executives see ESG as a key component of business strategy. That doesn’t necessarily mean they’ve become saints and angels. It means they’ve learned that they need to package their activities in an ESG wrapper in order to pass muster with investors, employees, and consumers.
Here, I’d draw a comparison with the nutrition labels required to be applied to food products. These can be just as misleading as they are helpful. The specific language and terminology used, how they define a serving size, and so on can actually obfuscate and mislead consumers. So too with ESG.
Consider oil and gas companies. If you read O&G reports, you'd think you're reading the annual report of some environmental nonprofit. Companies naturally want to make themselves look environmentally friendlier and more diverse than they actually are, so how to position and package themselves is something they think about quite a bit. They figure out where consumers are focused, and they repackage their activities and claims around that.
Third, we should beware of sacrificing the good for the perfect. There’s hardly an organization out there that cannot be criticized. Ethical investment is admirable and desirable, but perfectly ethical investing is also impossible, at least in today’s world. This can be an unpopular truth in some quarters, and we don’t make this argument to suggest we shouldn’t try – of course we should! Instead, what it means is approaching these questions with humility and openness rather than hostility and closed-mindedness.
Finally, don’t discount market forces in their ability to differentiate principled from unprincipled companies. Of course, we can all name organizations that we know to behave in unethical ways and still remain major – if not dominant – players in their fields. But they may be more the exception than the rule, and despite outward appearances, they may be in a state of active decline from past highs. For the most part, companies that are grossly inept or negligent from an ESG standpoint will struggle to attract happy employees and/or to grow their customer base.
As a result, the market itself can serve as a corrective force on these issues by redistributing sales from one company to another. Indeed, in many cases ESG can and does serve as a competitive differentiator between businesses. Residential solar power installations rose by 34% from 2021 to 2022. Total fossil fuel production also rose during the same time period – by just 3%. The market has been looking for – and has found and favored – more environmentally conscious alternatives.
To reiterate, principled investing is something we at GDS Investments believe in, engage in, and recommend to others. However, we also advise against blindly accepting the ESG packaging communicated directly from corporations or even from third parties. Decide what matters to you, do your due diligence, and invest accordingly.
Evaluating investment recommendations and inputs: Information gathering systems are often set up against the average investor, blurring the line between genuinely good advice and cleverly disguised marketing. How can the average person really distinguish between exceptional marketing and intelligent thought?
Discerning intelligent thought from exceptional marketing is genuinely very difficult, sometimes even for experienced investors and especially for inexpert ones.
Regardless, the process starts with intellectual honesty. Warren Buffett refers to this idea as the circle of confidence and argues that investors should concentrate in areas where they have the greatest understanding and familiarity. This requires some frank self-understanding, because far too many people think they know more than they actually do. If you’re not intellectually honest with yourself, you run the risk of being persuaded in an unhealthy way.
In other words, if you receive a piece of investing advice from an otherwise trusted source, do you legitimately have the knowledge or competence yourself to evaluate the soundness of that advice? If not, caution is warranted.
From there, it’s key to consider the source of the insight or advice and how they define success. Think of your sketchy uncle trying to persuade you to put money into a business. He’s telling you it’s going to be a money-maker; but does he really believe that, or is he trying to get you to prop up an investment he already knows is in decline and needs your money just to keep afloat, so he doesn’t lose all of his money? (Cryptocurrency anyone?)
Sometimes the advice serves a different purpose entirely. Think about Jim Cramer of CNBC’s Mad Money: in his case, his success is measured not by the returns generated by his investment recommendations but instead by his viewership ratings. In fact, his investment success rate is dubious: a 2013 analysis found that his forecasts were accurate 47% of the time – worse than flipping a coin (though also typical of other big-name financial gurus as well). Though this study is older, there’s no evidence to suggest he changed his methods or outlook after that review. If anything, there are indicators that some skepticism is still merited. His ETF, designed around his forecasts, is shuttering after only six months with meager gains of just 2.2%.
Ultimately, what Cramer sells is not necessarily good stocks to would-be investors but rather eyeballs to advertisers. Even if his ETF has underperformed, his ratings have been going strong for nearly two decades.
Yet he gives every appearance of proffering sound, marketable advice. At that point, we can either give the advice a pass, knowing our own limits and staying away from investments outside of our own area of expertise; or we can find someone else credible and trustworthy.
Alternatively, if the advice is about a specific market segment that’s interesting to you, but where you might struggle to pick individual winners and losers…just get an industry-oriented ETF.
In that case, you’re essentially investing in the industry as a whole, betting that the industry in aggregate is undervalued relative to its actual value, without having to get into the minutiae of picking individual companies. We do that with biotech: it’s an exciting area, but we do not possess the necessary in-house insight into that field to be able pick individual winners and losers. Instead, we own a biotech XBI to keep a foot in that door.
Stock buybacks: With recent negative news coverage – and critical comments from President Biden – are stock buybacks really the terrible decision they’re sometimes portrayed as?
It appears that stock buybacks have become politically controversial. President Biden, for example, has indicated he wants to discourage stock buybacks as a form of capital allocation. In his 2023 State of the Union address, he proposed quadrupling the tax on corporate stock buybacks in order “to encourage long-term investments instead.”
This is something of an empty threat at this time, but it illustrates how many people have come to take a dim view of buybacks. Poorly handled buybacks don’t help their reputation; think of the notorious decision at Bed Bath & Beyond (NASDAQ: BBBY) to spend $11.8 billion repurchasing its own shares. Initially, that led its stock prices to surge 91%; ultimately, it proved disastrous.
However, a buyback is not inherently good or bad; it’s just another option for capital allocation. CEOs and CFOs must deal with a world of options for where to put excess capital. We would expect them to choose the path that offers the best risk adjusted rate of return. A buyback is invariably one of the options they will consider.
In a good situation, we – the investors – buy a business because we think its price is low relative to its real worth. If the company itself thinks the same thing, a stock buyback is sensible. "The fact that I'm considering going out and buying my own stock typically means I, as the management, think my stock is undervalued," Jennifer Koski, a professor of finance at the University of Washington, told NerdWallet.
The buyback then gives us, the remaining investors, a greater slice of the pie. Imagine we have a company worth $100 (using a small number for simplicity’s sake), with ten shares outstanding worth $10 each. Management decides to buy five shares back. The company is still worth $100, but instead of ten shares, there are now only five shares, each worth $20. The value of our investment effectively doubled. It’s an even better situation if the company is growing in value; if its total worth increases to $125, each remaining share effectively goes from $10 to $25.
In other words, if management executes the buyback at prices below fair value, they are doing something extremely accretive for remaining shareholders. Warren Buffett, in his letter to Berkshire Hathaway shareholders earlier this year, emphasized this point: “When the share count goes down, your interest in our many businesses goes up. Every small bit helps if repurchases are made at value-accretive prices [emphasis theirs]. Just as surely, when a company overpays for repurchases, the continuing shareholders lose.”
That last comment is why buybacks aren’t always a good idea. Now imagine the company is in decline and its total worth falls to $50 after the buyback. Remaining shareholders will be disproportionately harmed by the buyback. If you're a corporate CFO and stock is overvalued, it’s actually a better idea to issue more stock. A lot of CFOs don't think this way, however; they prefer to offset stock dilution. And sometimes CFOs just make mistakes. There are CFOs guilty of every financial pitfall we could name.
Smart investors are going to avoid the bad buyback scenarios most of the time anyway. Let’s return to Bed Bath & Beyond. As Declan Gargan, a credit analyst, told CNN: “The company’s stewardship of their capital failed.”
That poor stewardship didn’t necessarily begin with the buyback. We would never have owned Bed Bath & Beyond in the first place, because we would have had judgments about its business even before the buyback came up. The buyback just magnified what was already happening to the business. If we determine that such a business is declining, we will avoid it in the first place.
Making that kind of decision is what we at GDS Investments do every day on your behalf. We remain dedicated to our fundamental investing philosophy: identifying and purchasing assets priced below value and poised for long-term growth and returns. GDS Investments will continue to implement its core investment philosophy and practices so that we are always able to take advantage of under-valuations in the marketplace.
As ever, I remain grateful to you and humbled by your ongoing support.
With warm regards,