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Past performance is not indicative of future results. <\/p>\n\n\n\n
We think this divergence in returns and market multiples speaks to the underlying issues facing the economy: all things AI are growing rapidly, while tariffs have clobbered certain sectors of the U.S. economy by elongating the inflation cycle, and higher interest rates are biting companies and consumers that previously relied on cheap debt.<\/p>\n\n\n\n
The AI Haves<\/h2>\n\n\n\n
According to The Wall Street Journal<\/em>, as much as half of real GDP growth in the first six months of 2025 was driven by business investment in AI. The divergence between the AI economy and the rest of the economy is well captured by a BofA analysis that estimates private nonresidential fixed investment (i.e., investments in physical assets, including plants, machinery, construction, etc.) has roughly tripled for data centers since the end of 2022, while all other nonresidential fixed investment has been roughly flat over that same timeframe.<\/p>\n\n\n\n While the AI investment boom deserves careful scrutiny given the scale of investment by a handful of companies \u2014 Goldman Sachs estimates hyperscalers invested nearly $400 billion in CapEx in 2025, equivalent to roughly 1% of U.S. GDP \u2014 our research indicates that large companies are seeing tangible returns from implementing AI for everything from better targeting of online advertising, to coding efficiencies, to improved customer service, to predictive manufacturing, to better routing and logistics. As a result, we believe the AI boom is sustainable and the investment appears to be justified thus far. However, we are ever vigilant in monitoring companies\u2019 investment plans and the returns (or lack thereof) on AI spend.<\/p>\n\n\n\n Maybe most importantly, the so-called Magnificent 7 companies, many of which are deeply involved in AI spend, generated roughly 27% EPS growth in 2025, according to Bloomberg, reflecting significant financial benefits from the AI investment cycle.<\/p>\n\n\n\n As it relates to inflation and tariffs, the industrial and consumer discretionary sectors appear to have been hurt the most. In fact, these two sectors by far account for the largest number of U.S. corporate bankruptcies. We attribute this concentration to the fact that many industrial and consumer discretionary businesses import products from abroad. Already facing persistent inflation from the post-Covid supply chain crisis, the rise in average tariffs from roughly 2% entering 2025 to roughly 11% as of September 2025 has meant that companies reliant on imports have faced massive further cost increases for certain inputs. If a company lacks pricing power and\/or is not nimble enough to shift production, the heavier burden can crush already strained profitability almost overnight. Add in the fact that interest rates moved significantly higher over the course of 2022 and have largely stayed elevated despite recent rate cuts, and companies with strained balance sheets cannot survive, or are forced to just limp along.<\/p>\n\n\n\n Unfortunately, many average consumers must deal with these same pressures. While incomes have increased in recent years, inflation has persisted, made only worse by the tariff regime, saddling consumers with ever higher prices on everything from apparel, to automobiles, to food. Add in rising interest rates on credit card debt, auto loans, and home mortgages, and consumers are also facing a litany of headwinds.<\/p>\n\n\n\n Reflecting these realities, the ISM Manufacturing PMI has been below 50, indicating a contracting U.S. manufacturing base, for ten straight months since March 2025. In fact, the U.S. manufacturing base has been in contraction since November 2022, with the exception of just two months in early 2025, before the tariff regime came into effect. Furthermore, consumer confidence is hovering at 45-year lows.<\/p>\n\n\n\n We would note at least three mitigating factors. First, the Federal Reserve began cutting rates in 2025, easing the interest cost burden on both companies and consumers. Second, both business and consumer leverage are at healthy levels, dramatically reducing the risk of a debt-fueled crisis in our view. Third, high-income spenders are making up for softness among low-income consumers, as the top 10% of earners now account for roughly half of all consumer spending.<\/p>\n\n\n\n Consistent with the narrative above, the S&P 500 Index, excluding the Magnificent 7, grew EPS at roughly 12% in 2025 according to Bloomberg. While growing at less than half the rate of the Magnificent 7, the non-AI economy is still expanding, and we believe the largest companies in the economy (those in the S&P 500) are much better positioned than most others given competitive advantages they enjoy like economies of scale. In fact, The Wall Street Journal<\/em> recently ran a story detailing how \u201cover the past six months, private firms with fewer than 50 workers have steadily shed jobs\u2026cutting 120,000 [jobs] in November alone.\u201d Meanwhile, midsize and especially large firms have in fact added jobs over the same timeframe. The article explains this widening gap by pointing out that \u201csmall-business profits are faltering\u201d while larger businesses are better equipped to deal with the current economic headwinds and grow.<\/p>\n\n\n\n As noted above, we view the economy as increasingly divided between AI and non-AI companies. We believe there are merits to investing in businesses in both camps, especially when considering valuation discrepancies between the two. We continue to invest in companies exposed to AI, although our investments in this area are in businesses that we believe will continue to thrive even if there are bumps in the road in the AI investment cycle. At the same time, we continue to invest aggressively in non-AI players operating in other sectors like Financials, Industrials, Consumer, and Health Care but with a strong preference for sectors benefitting from secular tailwinds. This helps ensure persistent growth in most environments.<\/p>\n\n\n\n Regardless, we believe every position held in client portfolios fits our quality growth framework, underpinned by strong competitive advantages reflected in growing free cash flow, a reinvestment opportunity to drive future growth, and strong governance. When purchased at reasonable valuations, we believe these companies will generate attractive investment returns, regardless of what theme is driving markets at any one moment.<\/p>\n\n\n\n While headlines reflect a strong and growing economy, there are many crosscurrents that must be examined. AI investment is booming, and for good reason in our view, but is not without risk. Meanwhile, the non-AI economy in general is exhibiting slower growth with a broad range of outcomes: from small, poorly managed and undercapitalized businesses facing many headwinds to well-run, excellent companies posting solid growth. We believe that owning a select basket of well-researched quality growth businesses at attractive valuations spanning the AI and non-AI economy should reward patient, long-term oriented investors.<\/p>\n\n\n\n We thank you for your continued confidence in our management, and we wish you a prosperous and happy new year.<\/p>\n\n\n\n —<\/p>\n\n\n\nThe Non-AI Have Nots<\/h2>\n\n\n\n
How We Are Positioning Portfolios<\/h2>\n\n\n\n
Concluding Thoughts<\/h2>\n\n\n\n