Inflation, Ukraine and Portfolio Updates
Inflation is the one form of taxation that can be imposed without legislation. —Milton Friedman
Inflation is the parent of unemployment and the unseen robber of those who have saved. — Margaret Thatcher
As 2022 gets underway, the American economic zeitgeist is characterized by wild swings in equity markets and concerns about an inflationary environment which is foreign to at least one full generation of investors. We previously wrote in this space about the normalcy of inflation following seismic social events such as war or pandemic. Now, the United States is reporting annual inflation rates not seen since the early 1980’s while money supply is up by $5T since the pandemic began. That increase in monetary supply represented a significant percent of American Gross Domestic Product.
In the Spring of 2020, nearly every driver of economic growth stopped operating altogether and all-at-once. The government’s massive infusion of cash into the economy over the past two years in response to that seizure was altogether fitting and appropriate. With limited opportunities to spend that cash in a “closed” economy many businesses and individuals held the funds in savings, speculative assets like crypto and NFTs, and other investments. For the past year, of course, that cash moved out of savings and into commerce with the altogether predictable (albeit undesired) resulting inflation.
That inflation is only exacerbated by the disruptions to the global supply chain which COVID caused. One result of the pandemic was a sudden shutdown of production. Because of that, manufacturers were unprepared and unable to satisfy the pent-up demands from consumers as we all emerged from our homes in 2021 wanting to spend money.
Of course, an economy awash in cash and with demand and supply chain volatility is a perfect recipe for inflation. The Federal Reserve is responding to that inflation by signaling its intent to increase interest rates even more quickly and steeply than previously expected. The expected result of that program, as well as fears of war in Europe, is the very market tumult which we’re now experiencing.
That tumult will not last forever. As supply chain issues resolve and we gain distance from the worst of the pandemic, and as the situation in Ukraine becomes clearer, current volatility should subside.
Regarding Ukraine, we express here our horror and outrage at the unprovoked, grotesque, and altogether unacceptable and unnecessary invasion of that sovereign country at the direction of Russian leader Vladimir Putin. No one can state with certainty what Mr. Putin truly hoped to accomplish with his foolhardy invasion. We can all, though, acknowledge the strong likelihood that the end-result of his actions will be a more united Europe and a significantly diminished Russian Federation. Another end-result will be a geopolitical landscape which is radically different from the post-World War II order which prevailed for nearly the past 80 years.
To fully appreciate Russia’s aggression in Ukraine, we must understand President Putin’s view that the dissolution of the Soviet Union in 1991was the single greatest geopolitical disaster of the 20th Century. Having come of age in, and then serving in the intelligence services of, the Soviet Union, President Putin was always destined to be profoundly ill-at-ease in a world in which Russia is not a dominant power. One of his goals, if not his singular focus, was always to rebuild Russian primacy within the sphere of what was the USSR.
Following 1991, though, countries which were within that sphere (and, indeed, some which actually formed a part of the Soviet Union) turned their gaze westerly. Some became members of the European Union and, in moves which President Putin found particularly galling, joined the North Atlantic Treaty Organization. By the early-21st Century, territory which 20 years earlier was cloaked in the Iron Curtain instead was protected by NATO forces while enjoying the benefits and responsibilities of European integration.
Mr. Putin, of course, finds that situation intolerable. For a man so closely tied to an ethos of Soviet dominance, though, the prospect of a European-oriented government in Ukraine is impossible to bear. So, too, is the (ironically, now, ever more likely) prospect of Ukrainian membership in NATO. Perhaps seeing no other option, President Putin launched his patently illegal and inhumane assault on Ukraine and the Ukrainian people.
Perhaps Mr. Putin believed that German pacifism and demand for Russian hydrocarbons, Polish concerns about its eastern border, the recent British/European Union divorce, and American domestic political discord would prevent the west from mounting a unified and powerful response to Russian aggression. Perhaps Mr. Putin believed that President Zelensky, the Ukrainian Armed Forces, and the Ukrainian people would not be able to resist the Russian military. Regardless of what he thought, though, Mr. Putin appears to have grossly miscalculated and, as is often the case with authoritarian leaders, found no one in his inner circle willing (or able) to offer contrary advice.
Now, with its economy in shambles and itself nearly wholly isolated on the world stage, Russia finds itself in a situation which may well rival its folly in Afghanistan. Sadly, many more people (including young Russian soldiers who have no desire or purpose to be fighting in the streets of Kyiv) will die before President Putin’s misadventure ends. When it does end, however, NATO and the European Union will likely be far more empowered than those institutions were just a few weeks ago. Conversely, Russia will be a pariah state with very little global leverage.
An even more diminished Russia will likely have little impact upon American investors. More concerning, of course, is the prospect of an emboldened China and Chinese views on Taiwan. Seventy percent of microchips are produced in Taiwan. Given the obvious importance of microchips in every aspect of modern life, therefore, Taiwan is more like Kuwait than it is like Ukraine. In other words, protection of Taiwan is very clearly in the United States’ national interest. We are sure, then, that the United States and our Pacific allies are very closely monitoring China while volatility reigns in eastern Europe.
Regardless of when that volatility resolves, though, the GDS Investments philosophy remains our guide - to invest in foundationally strong companies which are well-positioned for long-term growth.
That strategy directs our focus upon companies with talented leadership, long-term strategies which include current investment for future growth, and vision which extends well beyond the next news cycle. Ours is a strategy in opposition to market and media environments which are oriented toward short-term actors chasing the next big thing or responding to the latest moves by the Federal Reserve relative to current inflation. To paraphrase Howard S. Marks, the co-founder of Oaktree Capital, companies which are “excellent for a few years” are not nearly as powerful as those which are “pretty good for a long time.”
In searching for companies which are likely to be “pretty good for a long time,” GDS Investments uses current volatility which we discuss above to reposition the portfolio toward companies which have the following characteristics:
Are the company’s products and services so exceptional that consumers remain intimately engaged for extended periods of time?
Does the company have a defensible and growing competitive advantage (moat)?
Is the company’s balance sheet so strong as to enable investment optionality?
Are the company’s leaders missionaries instead of mercenaries?
Can company be purchased at a healthy discount to intrinsic value?
We begin with a case study of Spotify Technology, S.A. (NYSE: SPOT). This entertainment platform operates in a changing marketplace in which podcasts occupy an ever-increasing segment and which, already, boasts strong consumer loyalty.
In the 2000’s, the music industry was dying, and piracy remained rampant. In fact, by the end of that decade, more than 90% of all music downloads were illegal. Consumers who did not engage in piracy could, of course, either pay 99 cents for a single song or go purchase an entire CD for $15.00. Though the theft of intellectual property can never be condoned, that environment was a logical outgrowth of an outdated business model.
Now, of course, the entertainment sector is characterized by subscriptions and unlimited listening. In this world, Spotify’s subscription-based service is among the largest engines for revenue growth to artists and labels. The company boasts 381M monthly active users. Of those, nearly 175M are premium subscribers who contribute more than $9B in revenue. The company understands that music listeners who also engage with podcasts are more likely to move from ad-supported to premium memberships.
More importantly, Spotify acknowledges that “audio” and “music” are really different economic models. Spotify also recognizes its role as an audio platform and not a music company. In that regard, in contrast to music entertainment, podcasting, is relatively new and disruptive and allows advertisers to reach its audience in more targeted way. Furthermore, podcasting attracts users who want to be entertained AND educated, creating an even stickier user experience.
Spotify is a major participant in this wholly revolutionized segment of the entertainment industry. As a leader in the development and delivery of podcasts, as well as the go-to place for music listeners, the company is particularly well-positioned for the long-term.
Next, we consider Twitter, Inc. (NYSE: TWTR). As the company matures beyond its founding era and enters life with Chief Executive Officer Parag Agrawal at the helm, Twitter remains a position of particular interest in the GDS Investments portfolio. The platform continues to serve thought leaders in every profession and area of human pursuit. Though the company remains dependent upon advertisements, it is also pursuing new products such as Communities (which facilitates online discussions), Spaces (which allows for casual conversations), and Blue (which includes certain premium features).
Though advertising revenue was depressed in the fourth quarter of FY 2021, Twitter experienced a more than 35% increase in year-over-year revenue and ended the year with $6.5B in cash-on-hand. The company also reported making meaningful progress toward its goals of reaching 315M Monetizable Daily Active Users and $7.5B in revenue. Over the next several years, the company intends to roll out even more features to assist in reaching those goals. During that time, Twitter should continue to implement its new $4B share repurchase program which, of course, should add value for shareholders.
We are also pleased to announce GDS Investment’s new position in The Walt Disney Company (NYSE: DIS). The company recently reported adding nearly 12M more Disney+ subscribers (for a total of nearly 130M fee-paying viewers and announced plans to spend $33B on new content both within Disney’s much-renowned franchises
Furthermore, while Disney’s content service remains strong, the company also saw all-time-high revenue from its theme parks and consumer products. Despite this operational progress, Disney’s share price is down more than 25% from its 52-week high and trades at a healthy discount to fair value.
Finally, a note about long-time GDS Investments position General Electric Company (NYSE: GE). Chief Executive Officer continues to lead the company away from its prior era of conglomeration.
Through the end of 2021, General Electric reduced debt by more than $80B. The once bloated company is now lean and well-positioned to transition to three independent businesses operating in the aviation, healthcare, and energy sectors, respectively. Each company will be well-capitalized with investment-grade ratings.
Years ago, we began our position in General Electric with the expectation that its planned deleveraging and refocusing would, ultimately, bear fruit. We are happy that fruit is now blossoming, and we expect continuing positive results for shareholders.
Finally, and in response to interest rate and geopolitical risks but will still remaining true to the GDS Investments’ philosophy, we began or expanded positions in several “best-in-class technology companies.” Those positions include Amazon.com, Inc. (NASDAQ: AMZN), Meta Platforms, Inc. (NASDAQ: FB), and Fiserv, Inc. (NASDAQ: FISV). Those technology positions are in addition to our long standing holding in Alphabet, Inc. (NASDAQ: GOOG).
In this tumultuous investing atmosphere, we remain steadfastly committed to our core principle. That commitment keeps us focused upon companies which are structured and managed to succeed in the long term. Of course, there will be periods when stock values appear depressed. In these times, we’re best to remember Charlie Munger’s advice.
If you’re going to invest in stocks for the long term, or real estate, of course there are going to be periods where there’s a lot of agony, and other periods where there’s a boom. I think you just have to learn to live through them. As Kipling said, treat those two imposters just the same. You have to deal with daylight and night – does that bother you very much? No. Sometimes it’s night and sometimes it’s daylight. Sometimes there’s a boom. Sometimes there’s a bust. I believe in doing as well as you can and keep going as long as they let you.
At GDS Investments, we will continue to act for the benefit of your long-term interests by positioning the portfolio around companies which meet the characteristics we outline above and which can be obtained at discounted prices. We thank you for the trust you place in us and look forward to working together in 2022.
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With warm regards,