Quarterly Review
The market's recent bifurcation, where a narrow segment has dramatically outperformed while our core holdings have lagged, has tested our resolve. While this divergence was particularly acute during the first five months, representing a fraction of our long-term investment horizon, such sharp performance disparities naturally challenge our conviction.
In response, we conducted a thorough evaluation of our investment approach. This comprehensive review ultimately reinforced our confidence in the Strategy's fundamental soundness. We view the year's early underperformance not as a structural concern but as a temporary deviation from our portfolio's demonstrated pattern of sustained growth, a pattern we're already seeing reasserting itself.
Reiterating last quarter's observations, we believe the portfolio's lacklustre performance stems from a few factors. First, over 50% of our holdings have faced earnings contractions. Second, post-COVID operational challenges continue to impact several positions, particularly in supply chains and consumer behaviour shifts. Third, market dynamics have worked against us. Specifically, our bias towards small and mid-cap stocks has lagged as investors favoured large-cap technology and AI-driven companies with strong momentum.
The aftermath of COVID continues to influence company performance, primarily due to the unwinding of massive fiscal stimulus from 2020-21. Many companies experienced unsustainable growth spurts during this period, leading investors to misjudge their normal growth trajectories. As performance reverted to historical means, disappointment with year-over-year declines triggered multiple compressions. Fortunately, this comparison cycle has largely concluded, with several portfolio companies now emerging from its shadow.
The interest rate environment affected our acquisition-driven companies, representing over half the portfolio. Our research demonstrates that disciplined capital allocators can generate substantial shareholder returns through frequent, smaller private acquisitions at attractive rates of return. During COVID, artificially low interest rates prompted Private Equity (PE) firms to deploy capital aggressively, driving valuations to unsustainable levels. While our CEOs maintained discipline and avoided overpaying, the inflated market reduced acquisition opportunities, temporarily constraining earnings growth.
Recent transactions show promising developments: valuations have normalised, acquisition activity has accelerated, and our companies maintain strong balance sheets for future deployment. This suggests the COVID-era distortions are finally dissipating, positioning our portfolio for more normalised growth.
While earnings growth has historically been the primary driver of stock market performance over long-term periods, 2024 has demonstrated that shorter-term market dynamics can significantly influence valuations. This year has notably diverged from historical patterns, with company size and price momentum emerging as dominant forces influencing returns.
The impact of these factors has been remarkable. Large-cap-focused strategies delivered returns of 22% through Q3 2024, while momentum-based approaches have generated an unprecedented 34% gain year-to-date. However, this overwhelming preference for large, trending companies has created a significant valuation gap with small and mid-cap companies, representing a tremendous opportunity.
Beyond size and momentum, AI has also emerged as a critical market factor. Software company valuations have fallen to their lowest levels in decades as investors cope with uncertainty about AI's impact on traditional software business models. The sector now faces a crucial challenge: demonstrating that AI will enhance rather than erode their competitive positions. Our software companies are confident that AI will expand rather than contract their Total Addressable Markets (TAM).
Portfolio Review
The portfolio's performance has been flat since experiencing sharp underperformance from January through May. While small-cap stocks showed promising signs of recovery in July, the momentum dissipated due to lacklustre earnings and persistent interest rate concerns.
Our portfolio trades at a large discount to its average P/FCF valuation. The valuation spread between our portfolio and broader market indices has reached levels not seen since March 2020, marking its second-widest gap in ten years. Despite this discount, our holdings demonstrate superior quality metrics, stronger growth potential and lower leverage ratios. This combination of higher quality and lower valuation presents a compelling investment case. Portfolio activity has focused on rebalancing investments to maximise the return in the recovery.
Artificial Intelligence
The rapid advancement of AI has created uncertainty across a wide range of industries. Our investment portfolio has been affected by fears that AI may render certain software and technologies obsolete. It's important to recognise that perception and reality are often two sides of the same coin, separated by time. While market perceptions can shift rapidly, the true impact of technological change often takes time to manifest fully.
That said, there do appear to be genuine use cases and efficiencies emerging for AI, particularly in areas like search, workflow automation and information retrieval. These types of AI-powered enhancements are increasingly entering mainstream usage. We suspect more practical applications will continue to emerge, but the elusive "killer app" or transformative AI product has yet to be discovered.
As discussed in previous letters, if this is a new era of technological change, the true test will be whether the benefits are broadly distributed across companies and industries, not concentrated among a select few. The potential AI business models and value capture mechanisms are interesting to explore. Here are three we have discussed; there are sure to be more.
- The "hyperscalers" (large tech platforms) may evolve into the core "rails" for AI, similar to payment networks like Visa and Mastercard, charging fees for access to their models and infrastructure. This seems like an almost inevitable outcome in some form.
- A platform model could emerge where users pay a fee to access AI-powered applications and services that hyperscalers or independent boutique providers provide. This would be analogous to app stores, allowing for a more diverse ecosystem while still maintaining a strong position for the major platforms.
- Alternatively, AI models and capabilities may become so ubiquitous and commoditised that the financial benefits shift more towards the consumers of AI rather than the "manufacturers". This is a common outcome for many new technologies as they mature and become more widespread.
AI will likely provide significant societal benefits, but its financial and commercial reality may not match today's lofty perceptions and expectations.
U.S. Election
The timing of this letter coincides with the release of many companies' Q3 earnings reports and the outcome of the U.S. presidential election. The election of Donald Trump is expected to bring significant changes to economic policy and asset returns.
Trump's main economic policy proposal is to lower taxes, which he plans to offset with increased trade tariffs. The markets believe this policy shift will generate higher inflation and interest rates, boost smaller domestic businesses, and reduce regulations. This very pro-business agenda is generally seen as supportive of higher stock prices in the near term.
The key uncertainty lies in how the world will react to the proposed tariffs. If implemented without provoking escalation into a trade war, they may function more like a tax rather than driving up prices. However, if a tariff war were to erupt, it could stoke inflation and stall economic growth.
We believe the policy changes will likely be implemented with some restraint, similar to Trump's first term in office. Barring any major external shocks, the stock market may enjoy a period of gains over the next couple of years, though the sustainability of such a "sugar high" is uncertain.
Closing Remarks
Despite the challenges of the past nine months, we remain confident in our Strategy and the long-term strength of our portfolio. The factors that led to our recent underperformance appear to be subsiding. Our companies are well-positioned for a recovery, with improving earnings growth and attractive valuations compared with the broader market.
Looking ahead, we believe our disciplined investment approach, focused on high-quality well-managed businesses with strong growth potential, will continue to drive superior long-term results for our investors. We appreciate your continued trust and partnership and remain committed to delivering consistent, market-leading returns.
Please let us know if you have any other questions.
Note
This is a redacted version of CDAM's Q3 2024 Investor Newsletter. Should you be interested to learn more, please contact us by emailing ir@cdam.co.uk.
Disclaimers
This document and any attachments are intellectual property owned by CDAM (UK) Limited and are protected by applicable copyright and trademark law.
Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed.
This material is not an invitation to subscribe for shares or interests in any fund and is by way of information only. The information is as of the date(s) indicated in this document, is not complete, is subject to change, and does not contain certain material information regarding any CDAM investment strategy, including tax consequences and risk disclosures. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment.