1Q 2025 Newsletter

In the first quarter, capital markets were volatile, to say the least. Domestic equity markets continued post-election optimism through the second week of February, then experienced a dramatic reversal lower through quarter-end. Developed international markets had the opposite experience and were leading year-to-date performance through quarter-end. The yield curve experienced considerable volatility too, with inverse correlation to the equity markets. For those clients with balanced portfolios – invested in both equity and fixed income securities – you saw more muted performance due to diversification across asset classes.

       Source: FactSet, Orion

Of note was the dramatic decline of a few high valuation growth stocks in the first quarter: NVIDIA Corporation (NVDA) fell 19.29% while Tesla (TSLA) declined 35.83%. We wrote about these businesses a few times throughout 2024, commenting on stretched valuations that seemed priced for perfection. The Magnificent 7 as a group, as exemplified by the Roundhill Magnificent Seven ETF (MAGS), declined 15.73% during the quarter, which weighed heavily on market capitalization weighted indices. As a reminder, we own five of the seven stocks in the Magnificent 7 within our Large Cap portfolio but have never owned NVIDIA or Tesla due to a combination of high valuation and low quality.

Within the Large Cap portfolio, we reduced exposure in Apple (AAPL) considering its China exposure while increasing our position in Amazon (AMZN). We also sold Johnson & Johnson (JNJ) outright in favor of adding Zoetis (ZTS), the largest pure-play animal health company globally with a history of solid execution and thoughtful capital allocation since it spun out of Pfizer in 2013. We also added Medpace Holdings (MEDP), an outsourced drug development business, and Salesforce (CRM), a software platform used for customer relationship management. Within the Small and Midcap Portfolio, we sold Molson Coors (TAP) and Artisan Partners (APAM) completely for Pool Corp (Pool), Medpace Holdings (MEDP), and Trinet Group (TNET). We continue to execute our equity selection discipline with considerable thought and research into businesses that we believe have the fundamental quality to perform well over full market cycles.

In the short term, market volatility is to be expected given the administration’s intent to challenge the status quo using the Department of Government Efficiency (DOGE) and tariffs, among other policies. Simplistically, new policies have introduced uncertainty for many, with ripple effects that are varied by industry, sector, and geography. Business executives have reacted to this uncertain environment with apprehension. While executives await more clarity on global trade policies, companies are delaying investing in new and ongoing initiatives and holding cash. Economists have been forthright in their estimates that tariffs will have a negative impact on GDP with inflationary effects on prices, which is the dreaded combination referred to as “stagflation.”  However, stagflation is not a given and there are numerous scenarios and outcomes for trade relations and the economy. We remain cautiously optimistic.

With many possible scenarios in a reactive and volatile environment, here are some of the business attributes we research related to business stability.

• Demand Elasticity. Elasticity of demand measures how sensitive consumer demand for a product or service is to changes in price. When demand is elastic, a price increase may cause a significant drop in sales, reducing revenue of the underlying business. Conversely, if demand is inelastic, consumers continue to buy despite price changes, helping preserve revenue. Companies with inelastic demand for their offerings often demonstrate stronger revenue resilience, as their products or services are seen as essential or less replaceable by consumers. Commodity businesses have elastic demand as switching costs are low. Mission critical products experience inelastic demand. For example, a company like Mckesson, a logistics company to pharmacies, has relatively inelastic demand compared to General Motors. Companies with inelastic demand tend to have stable revenue even if prices increase because their customers need their products or services.

• Pricing Power. Price is a function of the value derived from the product or service in an open market. Competitive forces within an industry - Porter’s Five Forces - have the largest impact on price variability and the range of prices: a competitive market – lots of companies or products with low switching costs for products - will have low price dispersion. Concentrated markets such as beer, phones, credit cards, search engines, or specialty drugs may only have a few competitors, which allows the companies to set their price, not have them dictated by market forces. We often invest in functional oligopolies due to their concentrated nature, ability to set prices, low threat of substitution, and high switching costs. Portfolio companies such as MSCI or FactSet command pricing power due to their mission-critical nature of their offerings in an industry with few alternatives.

• Maintenance CAPEX and Fixed Costs. Tangible asset-heavy industries and companies (like automobiles or airplanes) reinvest in their businesses to offset depreciation, even before choosing to modernize for efficiency and scale. In inflationary environments, maintaining the business (maintenance CAPEX) is higher than depreciation costs of the historically valued machinery. Inflationary environments cause considerable handwringing from business executives in these industries, forced to choose between paying higher costs or deferring reinvestments to maintain earnings, which can introduce new risks or starve the business. By contrast, companies that are less reliant on tangible assets for revenue generation have lower reinvestment costs and more stable operating margins.

There are numerous other considerations when analyzing a potential investment, especially in an unstable environment. As professional business analysts and investors, we scrutinize these details for the benefit of clients, always positioning the portfolio to invest in businesses with characteristics to perform in a variety of economic environments. Importantly, we do not try to predict the economic environment. Rather, we try to position for a variety of environments. Benjamin Graham famously said that “markets are voting machines in the short-term and weighing machines in the long-term." Narrative and news flow can cause considerable volatility in the short term. As long-term investors, we seek to use short-term dislocations in the markets to benefit clients and the portfolio. While we cannot make any investment portfolio immune to overall market volatility, we can use the volatility and reorient the portfolios based on new information about long-term market dynamics. In these volatile times, please know that we are working hard on your behalf understanding the decisions we make now have lasting impact in the future.

We are grateful to serve you and your family.