The Road to Albuquerque

Imagine for a moment that you are seated on a plane at O’Hare airport preparing to depart for Albuquerque. Yes, Albuquerque. Unbeknownst to you, near-freezing temperatures have created ideal conditions for the rapid accumulation of ice on the wings and control surfaces of the plane — a potentially dangerous development. Additionally, a low ceiling has slowed all departures, raising the risk that ice could re-form after de-icing. Faced with these conditions, the pilots and airline make a deliberate decision to delay the flight until conditions improve.

Fortunately, this type of weather-related delay is relatively rare, but it happens. The delay is inconvenient. It does not, however, alter the targeted outcome — a safe flight. There may be some reflexive grumbling, but even annoyed passengers prefer a late arrival to not arriving at all.

The airline industry relies on rigorous processes, checklists, and disciplined decision making to manage risk and maximize the probability of safely arriving at the intended destination. In this respect, safely operating an airline has a great deal in common with successful investing.

DGI’s approach to navigating challenging market environments is not all that different from a pilot confronting deteriorating flight conditions. It is grounded in a simple, yet powerful belief: sound process does not eliminate risk, but it improves the odds of good outcomes over time. Our investment results in 2025 — and throughout DGI’s history — have been a direct result of executing on this foundational belief.

What is not always explicit, but equally true, is that a process designed to optimize long-term outcomes will occasionally produce disappointing short-term results. Just as inclement weather can delay a flight and frustrate passengers, disciplined investing can lead to periods of weak relative performance that tests both clients and investment managers. Our experience in 2025 reflects this reality.

To be direct, 2025 was a difficult year for our strategy. Absolute performance was ok; we generated a modest positive return. Relative performance, however, trailed the indices meaningfully. As with a pilot choosing to delay a flight under unsafe conditions, our underperformance versus the benchmarks was in part the result of deliberate decisions rooted in a discipline focused on optimizing long-term results rather than short-term comparisons.

The distinction between process and outcome is easy to accept in theory, but far harder to embrace during periods of underperformance — whether in a portfolio review or sitting on the tarmac in Chicago. Nonetheless, we remain convinced that maintaining discipline and adhering to a proven process is the way to successful long-term investment results, not to mention a safe arrival in Albuquerque.

Examining the Market Environment in 2025

The defining feature of the 2025 stock market was narrow, momentum-driven leadership. In this environment, stirring narrative frequently overwhelmed economic reality. Artificial intelligence (“AI”) remained the dominant market narrative, but speculative behavior extended well beyond AI into areas where excitement and the promise of short-term riches mattered more than price/value relationships. Put simply, in 2025 stock prices behaved less like claims on future cash flows and more like popularity contests.

This dynamic was particularly evident in the performance gap between profitable and unprofitable companies. With the notable exception of the “Magnificent 7” megacap technology companies, stocks of businesses with negative earnings outperformed those generating profits.

This result is not a judgment on innovation or long-term growth potential. When money-losing companies outperform, markets are typically rewarding momentum rather than intrinsic value — a hallmark of speculative environments. One may argue that these money-losing companies are merely investing in bright futures and future profits. That is true in some cases, but our work suggests that reasonable levels of profitability for many of these businesses is a dubious assumption, especially in any realistic timeframe.

A simple factor-based analysis reinforces this conclusion. As illustrated in Figure 2, momentum and negative earnings were among the strongest contributors to market returns in 2025, while most measures of business quality lagged. Return on invested capital — one of the clearest indicators of durable business strength — performed particularly poorly. Markets rewarded stock price velocity over business model quality, which is another familiar condition during speculative market phases.

Two major capital forces amplified these trends: flows into passive investments and increased retail investor activity.

In 2025 alone, more than $750 billion flowed into passive investment strategies, bringing total inflows over the past five years to more than $3.5 trillion. Passive strategies buy what is in the index, regardless of valuation, profitability, or business quality. The goal of an index fund is to mirror the performance of the index, not determine if an investment in any holding is warranted. Consequently, when leadership narrows, flows into passive strategies become self-reinforcing — pushing more capital into already expensive stocks and embedding risk as valuations stretch.

Retail investor activity has further intensified speculative trends. Retail investors have added approximately $2 trillion to the equity market since 2018, with a growing share flowing into increasingly speculative assets. Figure 3 highlights some of the larger pockets of speculative activity both within and outside the equity markets.

Money flowing into these types of assets is emblematic of momentum-driven markets, where “investment” activity comes to resemble betting on red or black and Wall Street more than willing to supply the casino chips. This mindset treats stocks as betting slips rather than ownership stakes in businesses with intrinsic value derived from real cash flows. This combination of an influx of momentum-motivated investors with passive approaches that inherently must buy more as market capitalizations rise creates dangerous feedback loops of rapid, narrow pockets of radical outperformance untethered to underlying value.

One archetypal example is Robinhood’s expansion into prediction markets, allowing customers to bet on events ranging from sports and politics to economics and entertainment. (For those tracking such markets, Golden from “KPop Demon Hunters” appears to be the current favorite for Song of the Year.)

Value Underperformance

While momentum-driven investments thrived in the 2025 market environment, value-conscious approaches struggled. Stocks of companies with durable businesses, healthy fundamentals, and attractive valuations were often overlooked because they lacked a compelling narrative. This is precisely the type of environment in which discipline feels most uncomfortable and historically has been most valuable.

Figure 4 provides a simplified view of the return dispersion by valuation using price-to-sales multiples. On this measure, more expensive stocks outperformed cheaper ones by a wide margin. Admittedly, some stocks trading above 5x sales may deserve those richer valuations. However, even after adjusting for quality and growth factors, the performance gap is striking — and painful for disciplined, process-oriented investors.

We understand the temptation to ask: Who cares about value when speculation is working? Our answer remains: we do, because it matters over time. Discipline can be uncomfortable in the short run, particularly when a bet on momentum makes speculation feel like a sure thing.

No Change to Our Approach

While market sentiment shifted, our investment philosophy and process did not. We did not chase momentum. We did not abandon valuation discipline. We did not relax our analytical rigor. These remain non-negotiable aspects of our investment process and risk management framework.

Additionally, this is not the first momentum-dominated market we have navigated. It is the third extended momentum phase since the inception of DGI. In the two prior instances, relative performance leading into the turn was similarly challenged (gray columns in Figure 5).

Importantly, those periods of relative underperformance were followed by multi-year stretches of outperformance once markets refocused on fundamentals and value recognition (orange columns in Figure 5). We do not know when sentiment will shift, but history suggests it will.

Value Recognition, Not a Business Problem

As we discussed earlier, we do not view short-term underperformance as evidence of flawed analysis or a broken process. Rather, our work suggests it reflects a temporary disconnect between market prices and intrinsic value. We have observed this dynamic in many individual holdings where stock prices have been volatile or stagnant while intrinsic value has steadily increased — followed, eventually, by price convergence.

Satellite communications company Viasat, Inc. (VSAT) provides a clear example of the value recognition process in action. The stock has appreciated more than 350% over the past 12 months. Did the intrinsic value of the business suddenly increase by that amount, or did the market begin to recognize the value that was already there? The latter explanation aligns far more closely with our analysis.

As illustrated in Figure 6, the financial progress of the portfolio as a whole remains consistent with our long-term return targets. The orange bars show the growth in Economic Profit from Long-Tail Investments (EPFLI) for our mid cap model portfolio. In this calculation, we capitalize (rather than expense) R&D spending, which we view as the “manufacturing capacity” of the knowledge economy.

EPFLI measures the aggregate financial progress of our portfolio companies. For the 9-month period ended September 30, 2025, EPFLI increased approximately 13% year-over-year and has compounded at a rate of over 11% for our mid cap strategy since 2006. The black line shows the return on capital generated by portfolio investments, calculated using EPFLI and including R&D in the capital base. Return on capital provides important context for EPFLI growth — while EPFLI captures how much economic value the portfolio is generating, return on capital shows how efficiently that value is being created.

Cause for Optimism

So where does this leave us? Constructively optimistic about the return potential of our portfolio. Two factors underpin our outlook:

• Our portfolio owns high-quality businesses with durable cash flows, purchased at attractive valuations.
• A substantial portion of our assessed intrinsic value remains unrecognized by the market.

The magnitude of the unrecognized business value is best captured by our expected return forecasts. For our mid cap equity strategy, the expected return as of this writing is approximately 15%, comfortably above our long-term target of 12%.*

Expected returns are not guarantees, but they provide a disciplined, forward-looking framework grounded in fundamentals rather than sentiment. This underpins our optimism.

Conclusion

As Benjamin Graham observed: In the short run, the market is a voting machine. In the long run, it is a weighing machine. 2025 was firmly a year of voting.

Periods like this are uncomfortable, but familiar. They occur when narrative overwhelms business fundamentals and momentum displaces valuation.

We have always navigated such environments by adhering to our process and risk framework, confident that disciplined execution increases the probability of good outcomes over time. This episode is no different.

Thank you for your continued trust and patience.