Client Update: January 13, 2024
““Happiness, as it’s said, is just results minus expectations.”
― Morgan Housel
Happy New Year from GDS Investments!
In what is sure to be a year filled with both opportunity and challenge, we extend our best wishes for a favorable year for you and your family. As the expression goes, may the worst day of this new year be better than the best day of last year.
For our part, we are using the ticking of the clock into a new year as we often do, as an opportunity to re-center around, and re-commit to, the core principles of our investing philosophy. As value investors, it’s not enough for us for a business to be cheap; it must also be strong — and strong enough to survive and thrive under a variety of conditions and economic environments.
Though 2023 did not produce the recession so many economists apparently expected, 2024 remains wide-open terrain. As Fool.com writes, in a brief look at economic expectations for 2024, “It's good to be perpetually prepared for a recession, just in case.”
They’re not wrong; and to that end, we are always looking for positions that can weather both upswings and downturns — and perhaps even use the balance sheet to create more value at times when competitors cannot.
One characteristic that we find increasingly attractive, especially in our current economic environment, is low debt. Specifically, we like to see a net debt surplus, i.e., when we look at cash relative to debt, we want to see a positive number.
Debt can, of course, be a cheap source of capital used to drive high rates of return under the right conditions, but too many businesses (and investors) focus too much on “cheap source of capital” and not enough on “under the right conditions.” Life happens. All kinds of events and challenges can catch companies off-guard: operating difficulties, managerial problems, new competitive entrants into the market, macro-economic issues, and more. Worse, some of these obstacles and threats will inevitably appear in already-difficult environments, like those created by rising interest rates or inflation.
Here, our question is whether the business favors “juicing” short-term returns by adding debt, even if it risks long term durability. Remember, as value investors, we are looking for positions we can hold for years (if not forever), but to be a franchise that offers a compounding interest over a long period of time, it has to survive for a long time. Any business will suffer if the level of risk it incurs over the long term exceeds the business’s capacity to handle those risks. In other words, is it better to make a little more money today if it puts future survival at risk? We hold the answer to be no.
Not everyone agrees. A class of business leaders whom we might call “renter CEOs”—those who expect their tenure at a given company to last no more than five to seven years—are often perversely incentivized to front-load returns even if doing so will impose long-term risks or costs. Even if these leaders hope to stay longer, they may feel pressured to generate results in the near term to prove their caliber.
Plus, there’s always basic human nature with which to contend. Many companies, when they’re flush with cheap capital, grow complacent and careless. They assume that whatever’s happening today is durable and thus attune their operating model to today’s specific conditions rather than to a wider range of more realistic conditions.
Unfortunately, renter CEOs and short-term thinking are pervasive. A study from Harvard found the average CEO tenure to be 7.2 years, but this figure may be misleadingly high because it’s weighted by the unusual CEOs whose tenure at a single company has lasted for decades. In short, most CEOs are renter CEOs.
Unfortunately, when a company has created, intentionally or unintentionally, a balance sheet that only works in one kind of environment (e.g., with low interest rates), they limit their options when the environment changes.
Consider telecom giant Charter Communications (NASDAQ: CHTR), which successfully used debt for years to build and expand because interest rates were so low and its core business was, at one time, so sticky. Since using debt to raise capital can offer a lower financing cost than using equity, it’s an attractive option. But it’s easy to go too far, and the calculus can shift rapidly when the environment changes. Add in market changes—like cable companies facing increased competition from alternatives like streaming—and the debt acquired yesterday can begin posing a serious threat today.
At its height in mid-2021, Charter was trading at $816. Today, it has lost more than half its value ($368) with little indication of any underlying strength. As one commentator put it in 2022: “Charter Communications has a debt problem.”
Another example might be industrial giant GE (NYSE: GE), first under former CEO Jack Welch and then Jeff Immelt. At the time, Welch grew and transformed GE. He left giving every appearance of a savior CEO: in 1984, three years after Welch began as Chairman and CEO, GE was trading at $14.19. When he departed in 2001, it was trading at $237.43.
What many investors didn’t fully realize was the lack of durability in what Welch had built. This is why we as investors need to be mindful of how the balance sheet is being flexed. Is it in an opportunistic way? Is it to serve the needs of current leaders, or to serve the needs of long-term owners? Welch’s successor, Jeff Immelt, inherited a new kind of company, one that was more of a financial institution with less of an industrial focus, built on the back of new debt, composed of separate businesses without much connection. By 2017, when Immelt departed, GE was trading at only $106.84.
Finding CEOs that commit to the good of the company (i.e., a CEO with an “owner” mindset) over the long-term is both hard and necessary. Andy Jassy of Amazon (NASDAQ: AMZN) may present a good example. His conduct suggests he remains connected to the original customer-centric vision for the company laid out by Amazon founder Jeff Bezos, a not-insignificant reason Amazon remains near the top of our list in client accounts. We could probably make the same argument about Tim Cook at Apple (NASDAQ: AAPL) following Steve Jobs, or Google (NASDAQ: GOOG) under CEO Sundar Pichai.
These leaders are the exception rather than the rule, however. Were any of them to be replaced, we would have to review and, likely, adjust our exposure.
Of course, identifying positions with leadership teams committed to long-term thinking—and then waiting until those assets grow cheap relative to value—is no small task. As always, at GDS Investments, it is our job to continually assess our portfolio and ensure that we hold only the best combination of valuation and quality.
To close, we at GDS Investments reiterate our good wishes for you in the new year. We know that many investors have been left unsettled by the turmoil and uncertainty of the recent past. Remember, however, that history has proven over and over that chaos can be a crucible for opportunity, including for the realization of the benefits of the GDS Investments strategy. We will continue to adhere to that strategy on your behalf in 2024 and beyond.
As ever, I remain grateful to you for your ongoing support.
With warm regards,