GDS Investments letter for the first half ended June 30, 2016.
Legend has it that, when the British surrendered at Yorktown, a military band played the song The World Turned Upside Down, for such a radical restructuring of the global political scene could hardly have been imagined merely 10 years earlier. Now, on the occasion of the 240th anniversary of our independence from our mother country, we once more find our world in the throes of uncertainty and apparent chaos.
Much of that condition is caused by another seismic event in British history . . . the decision by a majority of that nation’s voters to reverse decades of movement toward closer union with the rest of Europe. Though the initial economic reaction to that decision was severe, and unsettling, for several reasons the long-term effects of Brexit are unlikely to cause long-term financial pain. Firstly, even as a member of the European Union, the United Kingdom always had one foot in Europe and another pointed across the Atlantic Ocean. Secondly, and though the process of negotiating the United Kingdom’s exit from the European Union may get messy and acrimonious, the likelihood of Britain shutting itself off from the rest of the world as some island fortress is nil. Finally, and likewise nil, is the probability of the United Kingdom shrinking from its role as a global leader. Despite the apparent chaos in which our closest ally now finds herself, the United Kingdom is not going anywhere anytime soon.
Most of you know that I’m both an investor and a parent. I’ve come to understand the strong similarities between both those roles. For instance, I know that the reward system in both investing and parenting often operates with a lag. Though my wife and I were sure we were doing our best as parents when our boys were younger, the only tangible evidence of our “great” parenting was a messy house, laundry piled to the ceiling, and kids bickering over nonsense. Let’s just say that the fruits of our labors were not immediately apparent! Investing works a lot that way, too. Oftentimes, we may need to wait years to reap the reward for great ideas. That waiting can be difficult, and some investors may be tempted to chase a perceived quicker reward. Our philosophy, though, is built on a long-term view of a world where discipline and growth matter.
Here, in our mid-year letter, we detail how we continue to implement a patient, value-oriented philosophy on behalf of you, our family of investors, and how we intend to seek future growth opportunities in a world which may, at times, seem turned upside down.
Though the past 18 to 24 months saw growth in the equity markets, much of that growth was the result of very narrow leadership. Driven by fear, investment dollars have been moving into lower risk Treasuries (the 10-year continues to make new lows at 1.4%) and into stocks that have bond-like characteristics (e.g. utilities and consumer staples)1. In fact, most food stocks within the consumer staples sector are trading at earnings multiples more than 30% above their long-term average. In that dynamic, we see a very real bubble within American stock markets, but one which is largely confined to the “who’s who” of consumer staples (i.e. Proctor & Gamble (NYSE: PG), Colgate-Palmolive (NYSE: CL), and McDonald’s (NYSE: MCD)). We also see in the negative yields on Japanese government obligations, and the historically low yields on 10-year Treasuries, strong market evidence for concerns about future growth and inflation. In short, while investors wait-out the perceived political (both foreign and domestic) tumult, most investment money is being committed to the supposed security of government bonds and stocks which appear safe at any price (but which, of course, are not). Indeed, as discussed in the attached article which appeared in The Wall Street Journal (http://www.wsj.com/articles/treasury-yields-hit-historic-lows-amid-brexit-fallout-1467414740), those asset classes are now trading at inflated levels.
Within that setting, GDS Investments looks for companies with long operating histories and solid balance sheets, but which are within the bottom quartile of their historic valuation. What we have found in this particular cycle is a willingness in certain undervalued companies to accelerate shareholder capital return plans as excess liquidity builds on the balance sheet. In that regard, all of the portfolio’s major positions are not only severely discounted on a price-to-cash flow and earnings perspective, but have major share repurchase and dividend authorizations in place (i.e. Bank of America (NYSE: BAC), Harley-Davidson (NYSE: HOG), Whole Foods (NASDAQ: WFM), Abbott Labs (NYSE: ABT), and Wynn Resorts (NASDAQ: WYNN).
Another such company is General Motors (NYSE: GM). As of June 30, 2016, General Motors was trading at $28.00 per share, a value which is 5.5 x 2016 earnings. General Motors also boasts an aggressive capital return plan (i.e. stock repurchases and a 5% dividend yield (which represents another step in a trend of growing dividends)). Management at General Motors remains fully committed to that plan, as it intends to return all excess capital to shareholders beyond a $20B cash-on-hand liquidity buffer which the company set (which is above-and-beyond returning $6B via dividends and share repurchases in 2015). While maintaining a market capitalization of approximately $45B, General Motors is approaching $10B in annual free cash flow. In theory, General Motors could bulk-up its capital return plan by reducing shares outstanding by 10% per year without endangering its investment-grade credit rating.
In the 1996 Berkshire Hathaway shareholder letter, Warren Buffett referred to Coca-Cola (NYSE: KO) and Gillette as “The Inevitables.” We believe that, at $28.00 per share, General Motors has qualities similar to which those stocks displayed at that point in time. We also find support in the fact that Berkshire Hathaway built up a position in General Motors over the last several years, and that position now stands at 50M shares.
Another market inefficiency of which we can take advantage is the fact that investors routinely over and under pay for cyclical businesses at the peaks and troughs of industry cycles. One of the “laws” of economics is that capital flows into and out of industries based on the strength and weakness of investment returns. High returns attract more capital, and lousy returns have the opposite effect. Obviously, current investment impacts future supply, and companies routinely bring on too much supply at the peak of cycles, and take out too much at the trough.
This “capital cycle” effect destroys profitability at market tops, and restores it at market bottoms. This is an important concept, and serves as a backdrop for our exploration of two prime examples . . . the oil and steel industries.
After a run-up in supply before the last market peaks in 2008 and 2014, those industries experienced huge decreases in capital investment in recent years. The industries have rapidly adjusted to lower prices by cutting back the production of existing assets and by cutting back on new projects. In fact, oil-field related capital spending is expected to fall more than 30% in 2016 as compared to 2015. That reduction follows similar cuts in 2015, and should bring industry supply into line with long-term market demand. Indeed, many experts believe that the recent under-investment will lead to a substantial supply shortage by the end of the