As is our practice when we enter a new year, we feel it is important to outline the prior twelve months, discuss how client portfolios performed relative to major market indices and provide our views for the year ahead. After the year we just experienced, disappointing in relative terms to the S&P 500 Index to say the least, we have also spent a significant amount of time analyzing our recent performance, our current model portfolio holdings, and thinking carefully about where we see the world and markets going in the next 3 to 5 years. Given this year’s underperformance, we also feel it is very important to outline our investment discipline again in greater detail, so you better understand why we are currently positioned the way we are and how that led to this past year’s results. This letter will be longer than normal, but we hope that you read it carefully in its entirety as we are of the view that markets could be nearing an inflection point requiring a change in thinking around how portfolios are structured in the future; and when we next have a conversation around your portfolio positioning, the topics we are outlining here should be discussed in the context of your investment goals and risk tolerance.
We feel strongly that there are some market dynamics at play here that have changed the way one should be positioned to avoid excessive risks to your portfolio principal. As we have said frequently in the past, our investment discipline is based on two interrelated tenets: first, we always position client portfolios to avoid the risk of a significant principal drawdown. Second, and no less important, when we commit your investment capital, the valuation of the security or the instrument under consideration is critical. Said simply, valuation matters. In our eyes, the positions we currently own in our Drum Hill model equity portfolio closely adhere to both these tenets. We picked these securities carefully to provide a stable return based on cash flows (which should drive share prices higher in the long run), and we have sought to protect your investment capital from what we perceive to be excessive risk in the largest capitalization stocks currently driving the performance of the major stock indices. (For those of you that also hold “legacy” equity holdings with embedded capital gains in your portfolio, we perform a similar analysis, but obviously with tax consequences factored into the risk/reward analysis.) While the world seems to be focusing all of its time, attention and capital on a narrow subset of (now quite expensive) businesses, there are no shortage of high-quality businesses that markets are leaving unnoticed and, in some senses, “starved” for capital. For fundamental investors like ourselves, this change in market dynamics opens the door to what we feel are significant potential opportunities, especially if one is patient and willing to look past the recent disconnect between the outperformance of a small subset of the equity markets and focus instead on the remaining available opportunity set.
As we are sure you are well aware, U.S. equity markets as measured by the largest equity indices have continued to build on the gains made in the first half of 2024, with the S&P 500 index ending the year up 25%. In recent months, especially since August, this ascent accelerated as uncertainties surrounding the election have dissipated, and markets priced in the potential policy ramifications of a second Trump administration. The economic backdrop also appears relatively benign; inflation appears to have decelerated somewhat, not so much as to imply dramatically slowing growth, but enough to provide a tailwind to corporates and households. Perhaps even more importantly in today’s markets, this backdrop has allowed the Federal Reserve the ability to begin incrementally cutting interest rates, although their recent communications would indicate that they feel inflation expectations should be tempered as we move into 2025. Nonetheless, for many investors this combination of factors could indeed be seen as a very positive scenario, and in many ways, one should likely be unsurprised the U.S. equity market indices continue to record new all-time highs.
With such a seemingly constructive setup for equities, we recognize many of you may be wondering why your portfolios are not keeping pace. As we noted in our Half-Year Review, equity market returns remain driven by a select few large-cap U.S. tech-focused names, the so-called “Magnificent 7”. In the final quarter of the year alone, while the S&P 500 was up 2.4%, the Magnificent 7, which represent nearly a third of that index, were up 15.9%. Even as market commentators point to greater “breadth” in this market rally, with more companies participating in the upside, the fact is that returns continue to be quite concentrated. As we have previously noted, this rise in concentration has given us pause, and when considering the collective valuation of these businesses, we still have a difficult time justifying owning them at these levels. While we view this to be a prudent decision in the long term, it is not lost on us that this all but guarantees underperformance in our holdings when compared to the S&P 500 in the near term given the market dynamics at play.
There are many data sets that show these concentrations and excessive valuations in the largest companies that comprise indices like S&P 500 or Nasdaq 100. No matter which valuation metric one picks - Price to Earnings, Price to Cash Flow or Price to Sales - we clearly have entered a unique period. For example, consider the Price to Sales ratio, a common valuation metric, for the S&P 500 Index going back about 30 years; not only is it elevated versus history, but the multiple has expanded about sixfold since the Global Financial Crisis, from about .5 times sales to a nearly unprecedented level of over 3 times currently:
What is even more worrying to us is that the information technology segment of the S&P 500, which now comprises 32.5% of the capitalization weighted S&P 500 Index (up from about 13% in 2002), is at an incredible level of almost 10 times sales:
It should be noted at this point there are many that disagree with our thinking about the elevated valuations of the largest information technology companies. No shortage of investors and pundits feel 10X revenues is an acceptable and fair valuation given potential future growth in revenues. They typically cite the rise of artificial intelligence technologies and how that may alter the business cycle, meaning that one should be willing to pay more for future earnings than they typically have in the past. (We’ve even seen a well-known tech investor quoted in the press who suggested that Nvidia, one of the Magnificent 7, would in 10 years’ time have a stock price that in our estimation required implied revenues to roughly equal current total U.S. GDP.) To be clear, we think that the rise of artificial intelligence will meaningfully change the economy in a positive way. However, we believe there is a disconnect in terms of what represents a fair price to pay for the businesses in that space. In fact, it is interesting to note that the last time that Price to Sales ratios were anywhere as elevated as now was during the late 1990s internet boom. At that time, there were many that felt the internet was a transformative technology, and indeed it ultimately was. However, the prices paid for the stocks of the companies selling into that technological transformation were not justifiable and after the correction of 2000 to 2002, it took many years to recoup one’s investment in these businesses, including great companies that still exist today like Microsoft and Cisco.
We see this type of thinking a lot during exuberant periods - that in some way “it is different this time” - that one should suspend traditional methods of valuing companies based upon cash flow and reasonable growth rates. Such periods will often feature discussions that a new technology will alter the cyclical nature of the business cycle. It has happened numerous times in the history of modern markets over the last 200 years. Transformative technologies such as the rise of railroads, electrification and the rise of computerization were all tied to this type of thinking with respect to the discipline of valuing stocks and the “fair” multiple applied to future earnings. Most recently, we saw it during the late 1990s internet boom. The notion that productivity gains from the rise of the Internet would forever alter (or even eliminate) the business cycle was a common refrain. This propelled the valuations of some of the largest information technology companies at the time (Cisco, Oracle, Microsoft, etc.) to excessive valuations that were not sustainable.
Alarmingly, we are also beginning to see signs of this now with respect to the current AI boom. Just a month ago, BlackRock, which currently manages about $11.5 trillion in investment assets, released their 2025 Global Outlook and stated that the rise of artificial intelligence would be transformative and, in some ways, change the nature of business cycles:
"Mega forces are reshaping economies and their long-term trajectories - it's no longer about short-term fluctuations in activity leading to expansion or recession. 2024 has reinforced our view that we are not in a business cycle: AI has been a major market driver, inflation fell without a growth slowdown and typical recession signals failed." - BlackRock Investment Institute, “2025 Global Outlook”
When we see mainstream research reports making statements like this, we sit up in our chairs and take notice, but not because we believe it is true. We firmly believe that as long as human beings are involved in economic decision making, it will never be “different this time”. The cycles of exuberance and despair associated with how human beings process losses (and gains) will always be there (at least until the machines fully take over.) Sir John Templeton, one of the greatest long-term investors in the last 100 years, once famously said “The investor who says, ‘This time is different,’ when in fact it’s virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing.”
We believe that our careful positioning, not only with regard to the Magnificent 7, but exposure to U.S. large capitalization equities in general, is justified in the context of the current market environment. While the S&P 500, in the aggregate, has seen earnings grow by about 7.6% in the past 12 months, the multiple at which the market has valued those earnings has expanded by roughly 15% over that same period. At 26.5x on 31 December 2024, that leaves it close to the levels seen during the post-pandemic speculation of 2021, and before that, the late 1990s:
If history is any indication, such valuations tend to bode poorly for equity returns as measured by these indices in the years to come. Over the last 30 years, long-term earnings yields, calculated by simply inverting the price/earnings ratio and expressing it as a yield, have tended to be a fairly decent predictor of future returns. At the end of 2024, the long-term earnings yield on the S&P 500 was 2.8%, a level last seen in the late 1990s. Though investors then, as they very much are now, expected the S&P 500 to continue its upward ascent, subsequent returns during that period left much to be desired as shown in this next chart:
Indeed, by any number of metrics, equity valuations of the largest U.S. companies, especially those which are technology-related, appear elevated at the moment, and would signal to us that it is a time to be cautious and disciplined with your portfolio capital. We have some theories as to why this concentration at the top end of the equity markets is occurring, including the easy availability of leverage of many different forms to short-term “active” traders who currently “set” stock prices, along with a significant rise in indexed-based or “passive” investing, where investors simply “take” market prices and by definition assume that those stock prices are “fair”. We won’t elaborate on these theories here as this letter is already long. We would, however, welcome talking through our thoughts on what we feel is causing this current equity market concentration risk and showing you the data, if you are interested. The bottom line is that there has been a significant change over the last 50 years in how markets function related to the very important notion of “price discovery” in the context of healthy market mechanics. We feel it is extremely important to pay close attention to this change and how it affects our portfolio risk and positioning.
We would also note that equity markets are not the only place showing signs of investor complacency. Credit spreads, which effectively measure the additional return markets demand to lend to corporates over “risk-free” U.S. Treasuries, are also quite low versus history. This suggests that lenders’ risk appetite is quite high when compared to other periods, despite the fact that such tight spreads have tended to precede volatile periods for the corporate bond market (to say nothing of the economy). Here again, we see yet another good reason to be cautious:
We bring up these signals from equity valuations and credit spreads for a reason; while much of the work we do from day to day involves identifying individual opportunities across asset classes and markets, just as important in our eyes is contextualizing those opportunities against the backdrop of both the macroeconomic environment and investor behavior. A weak outlook for global growth can cause investors to grossly undervalue assets, thinking that such an environment will persist forever. Conversely, a robust economic environment can often cause investors to extrapolate growth ad infinitum, causing even the highest quality assets to command valuations that, at best, fail to adequately compensate for risk, or at worst, make the potential for earning an acceptable real return almost impossible in the long-term. This tendency for market participants to frequently overexaggerate their expectations (one way or the other) means that one must not only identify quality assets, but also listen closely to what the market is telling you about them. This should not be construed as “market timing”, but more so an understanding of the opportunity set available and whether or not it makes sense to risk your capital across different sectors and geographies.
One need not go terribly far back in time to see where “listening to the market” has proven beneficial. During the dislocations that came with the pandemic in 2020, we saw a great number of places to prudently deploy capital and acted swiftly to do so. As markets gave warning signs of froth as we moved into the following year given the massive amounts of liquidity inserted into the global monetary system, we sought to dial back our exposure to risk assets, leaving us well positioned for the headwinds that arose in 2022, as the Federal Reserve was forced to tighten monetary policy in its bid to get inflation under control. In many ways, this multi-year period was quite reflective of what we see to be core to our investment and risk management philosophy: taking advantage of market opportunities when they present themselves, while entering a more cautious positioning when markets show signs of excess. If you were a client of Drum Hill in 2008 during the substantial stock market decline associated with the Global Financial Crisis, you might remember our focus on this principle during that crisis, although understandably, that seems like an incredibly long time ago. Our portfolios performed significantly better than the S&P 500 during that 2008 to 2009 period because of our focus on risk management at a time of excess. We have come to find that such an approach generally yields good results, but only when measured over a longer time horizon.
Quite simply, we are willing to underperform in some years to avoid significant portfolio drawdowns in other years, because the math around compounded returns is straightforward in terms of the damage a significant drawdown can cause to your financial wellbeing. As a good example of the consequences of a significant principal drawdown, the 2008 to 2009 period is again a useful example. (It is also significant as it is the largest decline in the stock market in the last 20 years.) From the end of August 2008 to early March 2009, the S&P 500 fell nearly 48 percent. For illustrative purposes, let’s call that 50%. At the end of that period, a portfolio of $1MM invested solely in the S&P 500 Index would obviously be worth $500,000 on a mark-to-market basis. Assuming one could make the average return of the S&P 500 over the last 50 years of about 12% (which would again mean your portfolio was 100% invested in the S&P 500 index alone), it would take almost six years to get the portfolio back to $1MM and its original nominal value (leaving inflation out of the discussion.) For obvious reasons, these are the types of risks we try very hard to avoid.
On the topic of risk, we should note that it is not merely rich valuations alone that give us pause. While markets seem to be increasingly pricing in only the rosiest outlooks for reaccelerating growth, they are also ignoring a number of factors that could derail the narrative. As we have noted in the past, markets seem to be telling us that the “war on inflation” is all but won, leaving room for central banks, namely the Federal Reserve, to significantly reduce interest rates from their current levels. While the rate-cutting cycle has indeed begun, financial conditions were already loose beforehand, and a further acceleration in economic growth could easily restoke inflationary pressures. While one could make the argument this is a good thing, it could limit the extent to which the Federal Reserve and other central banks can viably reduce rates from here.
In some ways, this would not be a massive problem were it not for the fact that we have concerns about the levels of leverage we are seeing in various corners of the market. While many point to the relatively solid state of U.S. households, easy lending conditions have allowed corporate debt levels to continue rising, much of it through financial intermediaries of various types. Though some point to the improvement of certain credit metrics post-pandemic, the flood of issuance in recent years raises questions for us about the long-term sustainability of the debt loads at some corporates, especially those owned by private sponsors. At the same time, movements in rates markets have revived the conversation around the long-term sustainability of U.S. government debt loads, newly floated efforts to rein this in notwithstanding. To be clear, we do not foresee any type of crisis in the market for U.S. government debt in the offing, as the UK experienced a couple of years ago. That said, the notion that long-term interest rates on U.S. government debt have trended higher than they were before the rate cutting cycle began in September suggest rates markets may be reconsidering the long-term trajectory for interest rates. With equity markets seemingly pricing in quite lower financing costs in the years ahead, we believe this warrants close watching, and it is a significant reason that both our equity and fixed income portfolios contain extremely low-cost insurance against an unexpected period of higher inflation.
The concerns about leverage also extend to the behavior of market participants themselves. Multi-strategy hedge funds, a category which includes some of the world’s largest such investment vehicles, have significantly levered up their positions in recent years. The Office of Financial Research, a branch of the U.S. Treasury, keeps track of such data based upon regulatory filings, and has found that multi-strategy hedge funds are, on a gross asset-weighted basis, levered over 10x. This could have significant implications in the face of an equity market dislocation, further exacerbating any volatility that would arise in such a scenario:
All of this could be particularly problematic if economic growth going forward were to surprise to the downside. Aside from the obvious implications this would have for an indebted corporate sector and its investors, the fiscal response necessary from Washington could create challenges in bringing rates down. While a weaker economy could reduce the risk of further inflation, it still leaves monetary policymakers in a challenging position. Again, to be clear, while we do not necessarily see a recession on the horizon, we believe it important to note that navigating such a scenario may be more complicated than it has been in the past. In addition, all of this is occurring against a far more unstable geopolitical backdrop than we have seen for much of the past few decades, whether one is considering “hot wars” or trade wars. Simply put, our worry is that increasingly, the margin of safety being priced into most risk assets at the moment leaves little room for unforeseen interruptions.
You would think after this litany of concerns and potential risks we have outlined above, that we were not in any way constructive on the future or the potential opportunities for our client portfolios. That could not be further from the truth. As mentioned at the outset of this letter, this change in market dynamics opens the door to what we feel are significant potential opportunities, especially if one is patient and willing to look past the recent disconnect between the outperformance of a small subset of equity markets and to focus on the remaining available opportunity set. The concentration at the top end of the market and focus from the press on the largest tech stocks in the U.S. has created a bifurcation in the markets that hasn’t been seen for over 25 years. On a price to earnings basis, the small and mid-cap Russell 2000 index now trades at a steep discount to the large-cap S&P 500:
Based on this observation, we have recently identified a number of smaller businesses in the U.S. we believe are attractively valued, even in this environment. For example, in September of this past year, we purchased Terex (TEX) for client accounts utilizing our model equity portfolio. It is a perfect example of a smaller company that is not included in the S&P 500 Index and as such, is currently largely ignored by large pools of investment capital. To give you an idea of Terex’s relative valuation, at the end of the year the company traded at a Price to Earnings Ratio of 6.1x and a Price to Cash Flow of 9.1x, while the S&P 500 traded at 26.5x and 21.9x, respectively. Terex’s return on invested capital (ROIC), a metric we look at carefully, has recently been over 20%, much higher than the average S&P 500 component, which typically sees returns on invested capital around 10%.
Terex has historically focused on providing aerial work platforms and materials processing equipment, both businesses we see as benefiting from a renewed global focus on infrastructure investments and digitization. Its recent acquisition of Environmental Solutions Group from Dover Corporation adds a third line of business in providing equipment to waste management businesses. Environmental Solutions Group is the largest provider of waste collection and compaction equipment in North America and has grown its top line 7% per annum on an organic basis. We see this as an interesting platform for growth at Terex, already levered to key megatrends, and likely to reduce the cyclicality of the business. Having spent a significant portion of the past decade divesting low-margin business lines and focusing on improving profitability, we believe Terex is well positioned to continue growing in the years to come. We were able to take an initial position in the business at a reasonable discount to where it has traded over the past decade, and believe there is significant room for upside, especially if the company can meet its revenue and profitability goals for the coming years. To be clear, we feel that there will be no shortage of these types of businesses in the U.S. over the next 5 years, growing companies that are below a $10 billion market capitalization and are not a component of the large cap U.S. market indices.
While Terex is located quite close to us (its headquarters are one town away, in Norwalk, Connecticut), our search for opportunities continues to take us further afield as well. As we have stated at various points over the years, we continue to see no shortage of high-quality, undervalued businesses outside of the U.S. It is no secret that U.S. equities have dramatically outperformed those of the rest of the world over the past decade, with that growth accelerating in recent years. Today, the market capitalization of U.S. stocks is over half that of the entire market capitalization of equities worldwide, a level unseen in the past 20 years (and despite the fact that the U.S. is only 15% of global GDP on a purchasing power parity basis):
The narrative around the U.S. market, with its world leading technology businesses and relatively attractive demographic and economic tailwinds, has been a compelling one. That said, we believe it has resulted in many great businesses overseas being wholly ignored by investors. One region we believe this has been particularly pronounced has been in Europe, where small and mid-cap businesses also trade at a significant discount to large-cap U.S. equities, the most since the early 2000s:
We have highlighted this discount before, only to see it widen further, especially this past year. Having spent quite some time analyzing this opportunity, we have selectively added a couple of European-listed businesses to taxable client portfolios utilizing our model portfolio this year. Among these businesses is Indus Holding AG, a leading investor in small and medium sized enterprises (SMEs) in the German-speaking world. The company owns a collection of 44 industrial technology companies focused on one of three core segments (Engineering, Infrastructure and Materials), typically with strong positions in very niche markets.
Given the frequently dire headlines about the state of Germany’s industrial sector, one may question the wisdom in owning these assets. However, the gloomy environment in the region has allowed Indus’ management to frequently purchase these businesses at compelling valuations, with a great deal of room for improvement and internationalization of their operations. Having spent the past five years getting to know the management team at Indus, we are confident in their ability to create value for shareholders. Recently, this has been further evidenced by two share repurchase programs in 2024 (one currently ongoing), at a time when the market has, in our eyes, likely been undervaluing the earnings power of the Indus portfolio. Whether investment companies like Indus, or more conventional operating businesses, we believe there are a good number of high-quality enterprises in Europe currently being ignored by U.S. (and global) investors, and we will look to add more of them to client portfolios in the future as compelling opportunities present themselves.
We should also remind you that we offer a dedicated strategy that seeks to own a concentrated portfolio of businesses in this region, leveraging the same methodology as core client portfolios. We believe that it may offer a meaningful complement to that core, especially as U.S. large capitalization equity market valuations look increasingly demanding. More recently, we have worked in conjunction with our custodian, Fidelity Investments, to make gaining exposure to this strategy quite easy for taxable accounts. Should you be interested in learning more about the work we are doing on this front, or the opportunity we are seeing in small and mid-cap Europe, we would encourage you to set up a conversation with Zach, who has spearheaded our efforts on this front.
Overall, we believe that, especially in an environment where investor attention and returns have been so concentrated, it is important to widen one’s investment universe to find meaningful opportunity. Yet even with our expansion of these efforts, we would note yet again that, no matter where one looks, genuinely compelling opportunities in “household” names have been more scarce in recent years. Even amongst relatively less efficient market segments or geographies, finding quality assets has been harder, and our risk exposure at the moment reflects that. As such, it is important to note we view it best to only allocate capital in those situations where the proposition is genuinely interesting, and not merely allocate capital because markets are rising. However, we should again emphasize we are hopeful that the opportunity set may well widen significantly from here, even if the question of timing is uncertain (as always).
Given the current environment, and investor behavior being what it is, we could easily see major U.S. market indices moving even higher in the coming months. Markets are markets and will often go well beyond what seems reasonable, as has happened many times in the past. Aside from making us look even more foolish, at least on the surface, that could also mean the underperformance relative to widely reported indices you have witnessed as of late may well persist for a time. However, we feel strongly that if history and a close study of the current empirical data is any indication, we will be subsequently presented at some point with the opportunity to once again allocate a significant amount of capital on more favorable terms, particularly when it comes to the balance between risk and return. While this does not make the current state of affairs any more satisfying, we would note that our current positioning is in and of itself an active decision in the interest of risk management and avoiding the risk of a large principal drawdown.
We don’t want this letter to be construed as in some way “predicting a top” or to alert you to an imminent market crash, as making predictions of the exact timing of those types of events tend to be fool’s errands. Our desire is for this letter to be an outline of the signs of excess we see in certain areas of the markets, why we are avoiding them, and how through our disciplined process, we plan on taking advantage of opportunities in other areas we feel are currently largely ignored.
We also recognize that none of this may make looking at recent account statements any less disheartening. When widely quoted markets on the surface appear only capable of moving in one direction (up), lagging those headline numbers can make the temptation to commit more capital to well-known names that much greater. While we would be emphatic that we do not feel now is the time to do so, we do encourage you to reach out if you believe that your circumstances would justify repositioning further out on the risk/return spectrum. Indeed, in any case where you feel your portfolio is not properly aligned with your needs, risk tolerance or risk capacity (reduced or increased), we would highly suggest getting in touch so that we can discuss your particular circumstances and address your concerns.
No matter the state of the markets, we would emphasize that we view communication to be a core part of our relationship with our clients. As such, even absent questions about your own portfolio specifically, if you wish to discuss our general positioning further or our views on the market as the year begins, we always welcome the opportunity for a further conversation.
Our commitment to maintaining and growing your capital prudently remains our utmost priority. While we state this quite frequently, we sincerely appreciate your support and trust, especially during a period like this. Whatever may be in store for markets going forward, our team wishes you and your loved ones a happy, healthy and prosperous 2025.