Glenn D. Surowiec
- Apr 11

Client Update, April 11, 2024: The value of pulling back the curtain

“A plan is only useful if it can survive reality.”

Morgan Housel

In our past few letters, we have focused intensively on current and recent economic conditions and the extent to which they produce lessons or insights that can be applied to the GDS Investments portfolio. Today, however, we think it might be useful to step back and consider something more fundamental: pulling back the curtains on aspects of our lives that we don't think about or can’t ordinarily see. Taking the time to learn more about the backroom deal-making, backend processes, and invisible or opaque money-making schemes at companies whose work intersects with our lives can prove invaluable, not just for investment purposes, but for better understanding our world and making better day-to-day decisions. In other words, there is real value in thinking critically about things we normally don’t think about at all.

As an example, we have been reading a book about the healthcare industry, Empire of Pain: The Secret History of the Sackler Dynasty by Patrick Radden Keefe, about the opioid crisis and the Sackler family’s role in it. We consider this a recommended read: the book is a meticulously researched exposé on how the Sacklers' aggressive marketing tactics and manipulation of medical practices ended up fueling the widespread and tragic misuse of opioid painkillers, leading to addiction and deaths in communities across the United States. At heart, the book is a searing critique of unchecked greed and the undue degree of corporate influence over medical practices and even government regulators. The scale of the crisis is as staggering as it is horrifying: “More Americans [have] lost their lives from opioid overdoses than had died in all of the wars the country had fought since World War II,” writes Keefe.

To be clear, GDS Investments is not heavily invested in the healthcare sector. We own only a large cap pharmaceutical company and the SPDR S&P Biotech ETF (XBI). Still, despite relatively minor holdings, healthcare represents roughly 18.82% of GDP, plus it’s a sector with which all of us have no choice but to engage occasionally, so it’s fascinating and important to think about for many reasons beyond investing.

The opacity of business practices in this industry is one of the reasons why we are not heavily invested. Healthcare is a high-dollar industry, but unfortunately, it's also one where a lot of companies behave in questionable ways that result in harm for the consumer. Though they may represent an extreme situation, the Sacklers’ opaque approach to their business modeling and apparent disregard for their customers is, in some ways, representative of many entities in the industry.

Here, we might use Valeant Pharmaceuticals Intl (NYSE: VRX) as another example. Its former chairman and CEO, J. Michael Pearson, engaged in a degree of financial engineering that frankly never made much logical sense. He took out enormous amounts of debt to acquire other companies/pharmaceuticals with plans to raise prices and use the higher cash flows to service the debt. For example, Valeant acquired diabetes drug Glumetza and then raised the price from $800 to over $10,000 for a 90-day supply.

That is not a sustainable strategy, however. They were trying to use financial inefficiency on the balance sheet to create financial efficiency on the income statement, thinking one could outrun the other, all with a blind spot to the enormous ill will and potential harms that their actions could generate. As The New York Times wrote at the time, “Valeant’s drug price strategy enriches it, but infuriates patients and lawmakers.” (Also, it is arguable whether this strategy successfully “enriched” the company in anything other than very short term gains, given the company’s subsequent meltdown.)

We might also use a relatively new class of entity, Pharmacy Benefit Managers (PBMs), as another example. PBMs act as intermediaries, connecting drug manufacturers with the final buyers. Theoretically, they leverage their buying clout to secure reduced drug prices. They say they are trying to benefit consumers in the process, but it's not clear how they make their money. They could be exploiting weaknesses in the health care financial system or worse, their own customers.

These are untouchable situations for us. No one really knows what’s going on behind the scenes, and these kinds of business models have a high risk of producing bad outcomes for their own customers—and for the public at large.

For what it’s worth, all of this creates a prime opportunity for disruption.

Business models that are opaque and bad for their own customers are enormously vulnerable to competitors. Admittedly, that competition is unlikely to come from within the industry. Existing players don't have the incentives or culture to disrupt their own industries because they'd be killing themselves. That's why it takes an outsider who isn't saddled with legacy obligations, commitments, or business models.

Our read is that many layers of the health care industry are ripe for disruption due to its size, inefficiency, and lack of consumer appeal. Outsiders like Amazon (NASDAQ: AMZN) and Alphabet/Google (NASDAQ: GOOG) are already circling the space. In fact, Google and Amazon stand out from these other entities. Not only are they far more transparent about how they make money, but they also specifically look for ways in which they can profit by truly benefiting customers.

Consider the Amazon Prime program: for a $139 annual subscription fee, customers get nearly $1,000 in value after all of its benefits are considered. In turn, the average Amazon Prime member spends $1,400 annually, more than twice as much as non-members. Now Amazon is beginning to incorporate health care offerings (like membership in its One Medical service) for Prime members.

(Amazon CEO Andy Jassy’s 2023 Letter to Shareholders was released on April 11, and I plan to read it this weekend: https://www.aboutamazon.com/news/company-news/amazon-ceo-andy-jassy-2023-letter-to-shareholders).

Note that the dynamics we’re describing here are hardly limited to health care, however, and we should not get too caught up on all these issues being health-care specific; they’re not. We could draw examples of bad behavior obscured behind black box financial engineering from, say, the food industry or how cable and telco companies leveraged monopolistic positions to lock consumers into confusing, restrictive, and pricey subscription plans. This is another sector, like health care, where opaque, consumer-unfriendly practices endured because legacy players (the cable companies) had too little incentive and/or too little ability (too much debt) to alter their approach.

Enter the disruptors, like Google. Google has since successfully leveraged its acquisition of YouTube to shoulder its way past cable and telecom companies using a straightforwardly competitive, attractive, and consumer-friendly pitch: “We hear from our users that they want to be able to watch all their favorite content in one place, and they want to be able to manage all of their subscriptions in one place," Christian Oestlien, vice president of product management at YouTube, told Yahoo Finance. The proof is in the performance: YouTube just celebrated its 13th straight month as the most-watched streaming service on television screen.

Indeed, this is perhaps the central way in which the Amazons and Googles stand out from the Sacklers, Valeants, and PBMs of the world: how they make money is transparently clear and clearly beneficial to consumers. We don’t have to pull back a curtain; the curtain is already open. They can easily articulate the core value they create for their own customers, and their logic holds up to scrutiny.

Returning to what we said above: there is enormous value in taking a closer look at the businesses with which we deal, not just as investors but as consumers and citizens, to better understand how they operate. Ultimately, we like companies that are solving complex puzzles with a net result that will benefit customers financially. More than that, we like companies who approach their work transparently, with logical and sensible approaches to acquisitions, debt, and other forms of capital allocation. That’s as true in everyday life as it is investing.

A great example of a leader who focuses on smart, logical, transparent, and customer-friendly business modeling is Brad Jacobs. He is the executive chairman of transportation and logistics firm XPO, Inc (NYSE: XPO) and non-executive chairman of its spin-offs, RXO Inc. (NYSE: RXO) and GXO Logistics (NYSE: GXO). He recently appeared on The Knowledge Project podcast and YouTube show. It’s a must-listen, especially his comments on debt, leverage, optionality, acquisitions, and capital allocation overall.

Of course, these questions are what we at GDS Investments focus on every day, where we diligently and meticulously work to shine a light on the practices and underlying business models of every asset we touch. By doing so, our goal is to reliably enhance returns for our clients — and, hopefully, support businesses doing some good in the world along the way.

Annual ADV Offering:

ADV Part 2 has been updated as part of our annual update amendment. Material changes since the previous annual update include: