The Back Half

To my partners, 

One of the greatest misconceptions in investing is the belief that a strong economy, revolutionary technology, or exciting innovation automatically translates into exceptional investment returns. History repeatedly demonstrates that this is not the case. Technological progress and shareholder returns are related, but they are not synonymous. An extraordinary business can produce disappointing returns if investors pay too high a price for future growth. Likewise, periods of remarkable economic advancement have often been accompanied by periods of mediocre, or even negative, investment performance.

Today, I believe we find ourselves at another important intersection. Artificial intelligence is likely to become one of the most transformative technologies of our generation. I have little doubt that AI will reshape productivity, alter labor markets, improve healthcare, revolutionize software development, and fundamentally change the global economy over the coming decades. To take it a step further, there are parts of the world that we don’t even know enough about, currently, to even begin asking the question of “how will AI change this?!” 

Yet my enthusiasm for AI does not eliminate my concern regarding current valuations, inflationary pressures, and the possibility that investor expectations have become detached from economic reality. These concerns are not predictions. They are simply risks that deserve careful consideration whether you own a broad based market index fund or a highly concentrated investment portfolio. 

Inflation Rarely Arrives All at Once

Inflation is often misunderstood because its effects rarely appear immediately. Instead, inflation behaves much like a wave moving through the economy. It begins in one area before gradually working its way through every layer of production and consumption. When energy prices rise, consumers rarely feel the full effects overnight. Businesses initially absorb higher costs. Inventories purchased months earlier continue flowing through supply chains. Existing contracts delay price adjustments. Companies hesitate to increase prices for fear of losing customers. (all things you can see from financial statements and listening to management) Eventually, however, economic reality catches up.

Transportation becomes more expensive.

Manufacturing costs increase.

Packaging becomes more expensive.

Shipping costs rise.

Insurance premiums increase.

Construction costs rise.

Food prices gradually climb.

Labor eventually demands higher wages to compensate for reduced purchasing power. (already happening!) 

The result is not a sudden explosion of inflation, but a slow accumulation of higher prices that eventually reaches nearly every household. For this reason, inflation is often best understood as a lagging indicator rather than an instantaneous event.

Energy is the Foundation of Every Economy

Most people associate energy prices with the cost of filling their vehicle. In reality, energy represents one of the most fundamental inputs into modern civilization. Every product purchased by a consumer has required energy at every stage of production:

Agricultural equipment consumes fuel.

Fertilizer production requires natural gas.

Factories require electricity.

Raw materials must be transported.

Finished products must be warehoused.

Delivery trucks consume diesel.

Retail stores require heating, cooling, and lighting.

Data centers powering cloud computing and artificial intelligence consume enormous amounts of electricity.

Nearly every dollar spent within the economy contains an embedded energy cost. As energy becomes more expensive, businesses face an uncomfortable decision: Absorb lower profit margins, or pass higher costs to consumers. Eventually, most businesses are forced to do both. This reality helps explain why inflation tends to persist even after energy prices stabilize. The higher costs have already worked their way into the broader economy.

Stock prices are not determined solely by how well companies perform. They are determined by how companies perform relative to expectations. This is crucial. A company may grow earnings by 20%, yet experience a declining stock price if investors had expected 30%. Likewise, a business growing only 8% may outperform dramatically if investors expected only 3%. Today's market environment reflects extraordinarily optimistic expectations surrounding artificial intelligence.

These expectations may ultimately prove correct, but investors must constantly ask: Have these expectations already been reflected in today's prices?

Artificial Intelligence Can Transform Society Without Rewarding Every Investor

I remain extraordinarily optimistic regarding artificial intelligence. I believe AI may ultimately prove as transformative as the Industrial Revolution, electrification, or the internet itself. The ability to increase productivity, automate routine tasks, accelerate scientific discovery, and improve business efficiency may permanently raise global living standards and is a highly valuable consideration for all of society. However, I would note, technological revolutions and investment returns have rarely moved in perfect harmony. The history of financial markets offers numerous examples: 

Railroads transformed commerce throughout the nineteenth century.

Automobiles reshaped transportation.

Commercial aviation connected continents.

The internet changed virtually every aspect of modern life.

Yet many investors in these revolutionary industries experienced disappointing investment results after paying excessive prices during periods of widespread optimism. One of the clearest examples occurred during the dot-com boom of the late 1990s. The internet ultimately fulfilled the extraordinary expectations placed upon it. Yet many of the companies investors believed would dominate the future lost more than 80% of their market value because valuations had become detached from business fundamentals.

A revolutionary technology does not guarantee revolutionary investment returns.

Price always matters.

My mental framework is remarkably simple. Investment returns are ultimately determined by two variables: The quality of the business and the price paid for that business. Most investors devote nearly all of their attention to identifying outstanding businesses. Few devote equal attention to determining whether those businesses are available at attractive prices. This imbalance often leads investors to confuse a wonderful company with a wonderful investment. Even the highest-quality businesses can produce years of disappointing returns when purchased at valuations that already assume exceptional future performance.

Patience remains one of the greatest competitive advantages available to investors.

My Caution

Taken together, several developments deserve careful monitoring. Persistent inflationary pressures continue working their way through the economy. Higher energy costs affect virtually every industry, often with significant delays. Interest rates remain elevated relative to much of the previous decade. Consumer purchasing power may gradually weaken if wages fail to keep pace with rising prices (as noted this is already happening.) Meanwhile, market enthusiasm surrounding artificial intelligence has driven substantial valuation expansion across many technology companies. None of these developments guarantee weaker markets. However, together they increase the probability that future investment returns may fall short of the exceptionally strong gains many investors have recently experienced. Periods of elevated optimism frequently produce elevated expectations. Elevated expectations leave little room for disappointment.

Long-term investing is not only an exercise in predicting the future. It is an exercise in weighing probabilities while maintaining discipline when uncertainty is greatest. I remain deeply optimistic about the future of innovation, artificial intelligence, and American enterprise. At the same time, optimism should never replace discipline.

The businesses that reshape the world do not always reward investors who purchase them at any price. “Price is what you pay, value is what you get.” Our objective remains to be patient, disciplined, and rational, regardless if the tides are with us or against us. I am constantly searching for the “fat pitch” and I believe when such an opportunity presents itself, we will be well-positioned to take advantage. 

Over long periods of time, discipline and patience have proven to be the most valuable assets.

Thanks for reading! 

Kyle Delmendo 

Founder & CEO