As we begin 2026, we want to start with a sincere thank you. Thank you for entrusting us with your hard-earned capital. We approach our work each day with a singular objective: to protect and compound your capital over time without taking undue risk. Your patience and willingness to trust a disciplined, process-driven approach are essential ingredients in achieving durable, long-term compounding.
The objectives of this letter are threefold:
- To review what transpired over the past quarter and throughout 2025.
- To discuss what worked, what did not, and why.
- To share our perspective on navigating markets increasingly driven by narratives and geopolitical events - forces largely outside the control of the businesses we own.
If an investor went to sleep on January 1, 2025, and awakened on December 31, 2025, a cursory glance at headline index returns would suggest a very strong year:
Source: FactSet
Equity markets experienced returns well above long-term average returns. What these figures obscure, however, is the path taken to reach them. From the start of the year through mid-April, markets declined roughly 19–24% depending on the index, before staging a volatile and uneven recovery. Episodes such as “Liberation Day,” shifting geopolitical narratives, and renewed enthusiasm around AI-driven disruption contributed meaningfully to volatility. Capital flowed away from solid but unspectacular businesses and toward highly narrative-driven stocks, many of which generated little or no economic profit.
Against this backdrop, our Large Cap and Large Cap Select strategies performed well and exceeded their respective benchmarks. We were recognized as a top-10 manager by independent rater PSN in Q1, Q2, and Q3 across several categories, with Q4 results pending. Our Small- and Mid-Cap strategies, by contrast, faced headwinds and performance was below their representative indices. In small and mid-caps, there was a notable factor inversion: free-cash-flow-positive businesses - historically a reliable source of excess returns - underperformed sharply. Our long-term screen data (shown below) highlights how unusual this outcome has been historically.
Source: Portfolio123 and FactSet
From a factor perspective, momentum meaningfully outperformed while quality lagged. We view this divergence as evidence of increasing market growth.
Source: FactSet
Nearly anything associated with data centers or AI attracted capital regardless of profitability or cash-flow generation. The inverse also existed, too, in which capital flowed away from companies with perceived disruption risk from AI. While free cash flow is not the sole determinant of our investment decisions, owning businesses that generate cash today remains a core component of our process.
Ben Graham famously observed that “the market is there to serve you, not instruct you.” In practical terms, this means resisting the urge to anchor on price action and instead focusing on the underlying fundamentals: Is free cash flow per share growing? Are margins and revenues improving? Does the company have the balance sheet strength and management discipline to endure industry downturns and even play offense when others are retrenching?
We are also frequently asked whether markets are expensive and risky. In aggregate, the answer to the first question is “yes”, and to the second, probably “yes” as well. Valuations are at or near record levels. That said, pockets of quality businesses trading at reasonable valuations still exist. Markets can deflate quickly in response to adverse developments, but history also shows they can remain elevated longer than expected. Periodically, market returns become concentrated in a narrow group of companies. We have been in such a phase for roughly three years, driven largely by exceptional economics at a handful of dominant firms (most notably the so-called “Magnificent Seven”).
The challenge is that human nature tends to extrapolate recent success far into the future, pushing valuations beyond what underlying business fundamentals can justify. Market-cap-weighted index funds accumulate disproportionate exposure to these names, and systematic inflows - such as those from retirement plans - can further amplify concentration risk. What was once a broadly prudent diversification tool can, at extremes, introduce unintended risk.
For our clients, the key distinction is that we do not buy index funds. We construct curated portfolios, trimming or avoiding securities where future returns depend on increasingly heroic assumptions. As in the late 1990s, many reasonably valued opportunities exist outside the most crowded areas of the market. Our role is to identify and own businesses where prospective returns are grounded in cash-flow growth and improving economics - not in continued multiple expansion.
International markets rebounded and outperformed the U.S., helped in part by increased deficit spending across Europe in response to geopolitical tensions and shifting alliances. Whether this outperformance is durable remains uncertain. While many non-U.S. markets trade at lower valuations than the U.S., they also, in aggregate, contain lower-quality businesses. Precious metals performed strongly, while oil declined. Because our discipline prioritizes sustainable business quality ahead of valuation, we tend to miss commodity rallies - and, just as importantly, avoid their inevitable reversals. This may cause us to lag during short-term speculative surges, but it protects capital when markets normalize and temporary winners are re-rated.
We enter 2026 with portfolios trading at meaningful discount to our estimate of intrinsic value, and we see attractive opportunities to deploy capital should volatility create any dislocation. We appreciate your continued confidence and partnership.