Mid-Year Investor Update: Summer 2021

Invest in inflation. It's the only thing going up.

Will Rogers

Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.

Ronald Reagan

Welcome to the GDS Investments 2021 Mid-Year Letter. Since I wrote to you at the end of 2020, I spent a lot of time analyzing the inflationary pressures of (what we then hoped would be) post-pandemic life in America. I did that while considering the dangers which inflation poses and about which President Reagan spoke. I also took steps to situate the GDS Investments portfolio in a position which reflects Mr. Rogers’ view of inflation.

That America is experiencing inflationary pressure is hardly surprising. For more than a decade, waves of fiscal policy and quantitative easing flooded the economy with cheap money. Most recently, the American Recovery Act and the soon-to-be enacted infrastructure bill are injecting (and will inject) trillions more dollars into what many see as an already self-sustained economy. That, of course, does not even consider the trillions more in domestic spending which Congress is now considering.

Inflation, of course, is a lagging indicator of under-productivity and over-availability of capital. In the Fourteenth Century, for instance, as the Black Death reached England’s shores and the labor force was decimated, productivity plummeted, and wages skyrocketed. The government responded with caps on wages and, ultimately, laws which prevented the laboring classes from purchasing goods which were reserved for the aristocracy.

Inflationary conditions are also often a historical result of efforts by governments to arrest the effects of national crises. In the years before the Napoleonic Wars, the United Kingdom significantly increased government spending. Predictably, price levels also rose. A similar scenario played out in the United States during and after the Civil War (in the North, due primarily to a decrease in the production of goods and, in the South, due primarily to the over-printing of (ultimately worthless, anyway) Confederate bank notes)). Likewise, and as shown on the chart below from the White House website, the removal of price controls and the unleashing of pent-up consumer demand following World War II led to prices in America growing at a rate of 20 percent (year-over-year).

Now the economy is awash in cash and parts of the country are emerging from more than a year of (A) pandemic-imposed limits on production and (B) consumers’ inability to engage in discretionary spending. As is clear from the following chart from the Federal Reserve, the M2 calculation of money supply experienced significant growth over the past 18 months. Unsurprisingly, therefore, America is experiencing inflationary pressures. As the White House notes on its website, however, those pressures “could quickly decline once supply chains are fully online and pent-up demand levels off.”

Though no one can predict how the inflation landscape will look over the next months and years, the GDS Investments portfolio is well-situated for the current (and potential future) environment. One way we are accomplishing that is with an investment focus on companies with expanding moats, a history of pricing power, low maintenance capital requirements (including labor costs), and which can be purchased at attractive valuations.

A great example of such a company, and one about which we remain particularly excited, is Twitter, Inc. (NYSE: TWTR). The social media leader continues to expand its base of Monetizable Daily Active Users, growing that important figure from 192M at the end of 2020 to 199M by the end of 2021 Q1 and, then, to 206M at the end of the 2021 Q2. In fact, on a Market Capitalization to Monthly Active Users basis, Twitter remains one of the cheaper names in its peer group.

Twitter’s growth and its positive comparison to other social media outlets is not surprising. No other online platform can boast of the sheer breadth and depth of information which is available on Twitter. Whether it’s politicians, corporate executives, non-profit leaders, celebrities, or sports figures, nearly everyone is active there. No matter the field of interest, industry and market leaders of all stripes are actively sharing information on Twitter.

Following Twitter’s release of its Q1 results, Elliott Management increased its stake in the company with an additional $200M investment. The company itself is also increasing the scope of services which it offers to users. Twitter acquired Revue, a service which allows anyone to publish editorial newsletters to followers which, in turn, creates ongoing rapport between the publisher and their followers. That dynamic strengthens the bonds of loyalty which those followers have for the publisher and encourages followers to continue engaging on the platform. Twitter also recently announced the development of “Twitter Blue” as the company’s first-ever paid subscription service. Twitter Blue will allow users to preview and edit tweets before posting them, create more readable threads, and access more premium content.

Twitter’s Chief Financial Officer recently told attendees at a JP Morgan investment conference about the desire for users to “be able to click and buy something on Twitter.” He noted that the company “appreciate[s] that people do a lot of research on Twitter before they buy something,” and that Twitter can serve a key role in connecting advertisers with consumers.

Twitter has low capital requirements, a dedicated and expanding user base, and significant upside to grow revenue. We are excited to hold this position and look forward to continuing good results.

In the technology/consumer electronics sector, we also continue to hold a position in Roku Inc. (NASDAQ: ROKU). The company recently released its 2021 Q2 Shareholder Letter. There, Roku announced a 130% YoY increase in gross revenue and the existence of 55.1M active accounts (a growth of nearly 12M accounts from 2020 Q2). Impressively, the company boasts a 46% YoY increase in Average Revenue Per User.

Roku’s increase in users is, of course, key to the company’s future success. That is seen in the “flywheel effect” in which more content leads to more engagement which leads to more (and better targeted) advertising.

In that regard, Roku looks to build its own content with the now-live and active Roku Originals. As Chief Financial Officer Steve Louden noted, “[w]e can also monetize better because we know who's watching. We can sell targeted premium . . . ads. And that's created this flywheel where we get more content onto The Roku Channel that drives more engagement. More engagement drives ad inventory. The advertisers are increasingly following the viewers over to streaming. That money, we can then put back into more content.”

During the first half of 2021, GDS Investments also continued to expand its positions in the pharmaceuticals and broader health care sectors. Though these industries can be capital intensive, the companies we hold supply products which consumers need and demand regardless of broader macroeconomic conditions. As such, these companies typically perform well in difficult market environments.

Within the pharmaceutical sector, early this year we initiated a position in Viatris, Inc. (NASDAQ: VTRS), a spinoff from Pfizer, Inc. (NYSE: PFE). In November of 2020, Mylan N.V. combined with Pfizer’s former subsidiary Upjohn Inc. to form Viatris and create one of the world’s largest manufacturers of branded and generic (or biosimilar) drugs. The new company’s products include some of the marketplace’s best-known medicines such as EpiPen, Lorazepam, Lidocaine, Lipitor, and Viagra.

Upon its creation and initial listing, Viatris announced an annual dividend of $.44/share while targeting $6.5B in debt repayment by end of 2023. The new company is well on its way to meeting that goal. Viatris reduced its long-term obligations by more than $1.15B in just the first half of 2021. Viatris also looks to reduce net debt from more than 5x EBITDA to 2.5x. Because less leverage will lead to less financial risk and higher multiples on equity, every dollar by which the company deleverages should create more than one dollar of new equity value. Furthermore, the ongoing reduction of debt should, of course, generate more free cash flow. In that regard, even without including an estimated $1B in annual cost synergies which the company expects to realize in 2023, corporate management’s 2021 guidance includes expectations of $6.2B in EBITDA and $2.1B in free cash flow.

Another GDS Investment position in the pharmaceutical sector is Merck & Co., Inc. (NYSE: MRK). On June 3rd, Merck completed its spinoff of Organon & Co. (NYSE: OGN), a new company which focuses on women’s health and biosimilars. That spinoff should help Merck improve operating efficiencies by $1.5B.

Viatris and Organon begin their corporate lives in very similar situations. Both companies are relatively small when compared to the parent corporations from which they were born. Shares in both companies were distributed to institutional shareholder bases which likely had little interest in holding the positions. That lack of interest might’ve been related to restrictions on the types of companies which those institutional investors are permitted to hold. Or, perhaps, the lack of interest was a product of the institutional investors just not wanting to bother with the smaller new companies.

In that scenario, institutional investors liquidated their holdings irrespective of fundamentals. That liquidation is often referred to as “Forced” selling. GDS Investments was able to take advantage of that dynamic and buy quality positions like Viatris and Organon at sharply reduced valuations.

Another long-term GDS Investments position is General Electric Company (NYSE: GE). On July 30th, the company completed a 1-for-8 reverse split. According to the company, the purpose of the reverse split was to “reduce the number of . . . outstanding shares . . . to levels that are better aligned with companies of GE’s size and scope and a clearer reflection of the GE of the future, not the past.”

Earlier in the year, GE announced a transaction to sell the company’s aircraft-leasing business to AerCap Holdings NV (NYSE: AER) for $24B in cash and a 46% stake in AerCap. That transaction continues GE’s recent pattern of focusing upon core competencies. The company’s remaining GE Capital assets are being transferred to GE Industrial’s balance sheet.

In addition, at an Investor Conference in late-May, GE’s Chief Financial Officer Carolina Dybeck Happe reported that the company expects to report greater YoY cash flow this year. Moreover, at a recent Bernstein conference, Chief Executive Officer Larry Culp committed to $10B in Industrial operating profit and a return to pre-COVID revenue levels ($85B-$90B) by 2023.

We close with a note about Berkshire Hathaway Inc. (NYSE: BRK-B). Longtime readers will recall that we initiated this position when shares were priced in the $180 range. With the stock now trading just about $281, we continue to be happy owning these shares.

Recently, Berkshire announced a successor-in-waiting for Warren Buffett. Greg Abel, who currently serves as the company’s Chief Executive Officer and Chairman, will assume the reigns at Berkshire when Mr. Buffett ultimately steps down. As noted above, the market responded favorably to that announcement.

The company’s performance in the market is also the result of Berkshire’s ongoing share repurchase program. As depicted on the following chart, the company committed approximately $25B to repurchases in 2020 and more than $6B in 2021 Q1. Pursuant to that program, the number of the company’s outstanding shares is down 5.5% YoY.

Finally, during the first eight months of this year we sold several former positions at significant gains. Those include QUALCOMM, Inc. (NASDAQ: QCOM), BYD Company Limited (OTC: BYDDF), and First Solar, Inc. (NASDAQ: FSLR). During that period, we also sold Alibaba Group Holding Limited (NYSE: BABA) and Pershing Square Tontine Holdings Ltd. (NYSE: PSTH) at small losses.

GDS Investments continues to monitor the pandemic’s impact upon the economy and inflationary pressures which might affect share price performance. We will take appropriate steps to position the GDS Investments portfolio accordingly with the goal of maintaining, and expanding, value for you . . . our investment family.

As always, we thank you for the confidence which you place in us and for allowing us to be an important part of you financial well-being. I remain grateful to you and humbled by your ongoing support.

You may request an updated ADV Part 2 brochure by calling or emailing us any time.

With warm regards,

GDS