Less Diverse, More Momentum

One of the striking developments over the past several years has been the changing structure of public equity markets. Individual stocks and subsectors have become more reactive to both positive and negative sentiments. The market has become less efficient, which has improved the opportunity to add value.

To step back briefly, in 2020, there seemed to be no price too low for travel stocks and pandemic losers, while companies like Zoom and Peloton traded to lofty levels. Zoom’s market cap at its peak was nearly as large as SAP’s today. At the time, we attributed this to the market not knowing how to price a hundred-year event. Now we see it as an early indicator of this changing market structure.

In 2021, we had the meme stock and SPAC craze. In 2022, with the war in Europe, we had an inflationary shock, and internet giants like Amazon, Meta, and Netflix declined precipitously, while the commodity complex exploded higher amid temporary shortages. More recently, we have an increasingly euphoric AI capex trade. The picks and shovels are doing great while perceived losers gap down on provocative headlines as the market tries to sort this out.

The reason we’re seeing this degree of reaction is the change in market structure. Passive has taken so much of the market that there are fewer active market participants setting prices. Active sets price, passive takes price, and that works well so long as the remaining participants are sufficiently wise and diverse.

Over the past decade, multi-managers, also known as pods, have significantly expanded their footprint. They operate with leverage and tight risk frameworks, and they tend to cut losers quickly. Many of these strategies have de facto earnings momentum at their core. Systematic quant strategies typically incorporate momentum as well. Growth managers have outperformed value managers, and flows have followed suit; growth investors tend to operate with a momentum bias. Finally, retail is playing a bigger role and tends to chase momentum.

The result is that there is less diversity, and momentum is playing a more dominant role than in the past. It’s increasingly valuable to mine controversial or underexplored areas for great assets and then harvest the results as earnings growth unfolds. Eagle has been monetizing this development over the past several years, and we think it will continue offering good opportunities for the foreseeable future.

Eagle’s competitive advantages may be widening. Having duration is critical. It takes time, often years, for an earnings thesis to play out. It’s equally important to do deep research on individual companies. A lot of short-term trading is built around thematic baskets, but company microeconomics come to matter over the long term. Get the earnings right, and you’ll get the stocks right. Finally, it takes a willingness to be different. This can be uncomfortable at times.

When making investments, we think in terms of probabilities. For example, certain high-quality software companies seem to be priced for a 10th-15th percentile outcome. That means that across 85-90% of what we consider plausible, things should work out well. We know we won’t be right about everything, and that’s fine. A portfolio of bets like this should do well.

We want to build a portfolio for a range of possible futures, not bet on a specific future. While this often isn’t as exciting as chasing the hot thing, these little wins tend to compound.

A useful mental model is how small advantages in tennis unfold. Even the world’s best tennis players win scarcely more than half of their points. And yet, they convert this into winning more than 80% of matches. This carries three implications. First, they must play the point in front of them as hard and as well as possible. It is critical to get those little edges. Second, despite playing hard, they will lose almost half the time and must move on to the next point with equanimity. Third, they must separate the noise of random ball bounces from the signal of what is driving the true edge.

Eagle’s approach is similar, just on a different timescale. We aim to do the best work that we can each quarter, in both our research and decision-making. And yet, we underperform the market almost half of the time. As in tennis, these small, irregular advantages compound.

Our North Star is generating strong long-term absolute returns. Indeed, historically, Eagle shows a higher likelihood of clearing a double-digit hurdle as the time horizon extends. Meanwhile, as horizons extend, the odds decline that the S&P 500 and the Russell Value will clear this bar, for a simple reason: Most of the time, earnings, the economy, and markets are growing. But, from time to time, excesses build and then unwind. If investors can participate in the good times while avoiding getting caught up in the excesses, they achieve superior results.

One way to visualize these unwinds is to examine periods of market declines. When measured over a quarter or a year, both Eagle and the overall market regularly post negative results. In the short term, stock prices are determined by supply and demand. However, as the time horizon extends, there is a gravitational pull exerted by business quality, earnings growth, and valuation discipline. Historically, as demonstrated in the following chart, there has been a roughly 1-in-7 chance that the S&P 500 will post negative returns over the next 3 or 5 years. For Eagle, it’s been 1-in-20 and 1-in-100, respectively.

On the following pages are several representative positions that Eagle has established or added to over the past several quarters. 5 Across the group, we see companies making decisions to build enduring businesses; we also see current market debates that may shift in our favor over time. Collectively, these companies trade at a wide discount to the overall market, despite our belief that they will have much faster-than-market earnings growth.

UnitedHealth Group and Humana, two of the leading providers of managed care, have significant scale advantages in a consolidated industry that outgrows the overall economy. The two companies have struggled over the past few years as Medicare Advantage went through a downcycle of cost/price squeeze. We believe conditions have bottomed and that we are transitioning to a multi-year improvement in margins and returns. Actions by each to reduce costs and implement AI through their businesses are incremental tailwinds. At our weighted position, we expect annual EPS growth exceeding 20%.

Mercado Libre is the leading e-commerce platform in Latin America, with a complementary fintech business. The company has a dominant share in most of its markets. It has used this position to build an integrated flywheel with payment and banking products that allow it to further monetize its platform and better engage with consumers and sellers. Latin America has relatively low e-commerce penetration —we estimate it at the mid-teens, compared with nearly 30% in the U.S. — enabling a longer runway for extraordinary growth.

The company is investing heavily to capture this opportunity. Last year, revenue growth accelerated to 39%, while margins declined. We expect further declines this year. We believe current earnings would be more than 50% higher without these investments. But foregoing this spending would be a mistake. In some ways, the company reminds us of Amazon a decade ago. As with Amazon, management operates the business well, doesn’t manage for short-term earnings, and has a superb track record of creating long-term value. We expect EPS growth to exceed 30% over the coming years.

SAP, Workday, and Intuit are highly entrenched application software businesses. SAP’s ERP software is among the stickiest and most durable businesses in the world. Workday is the only de novo ERP to be successfully built in decades, with the leading global human capital management position and a large financials platform. Intuit is a household name because of TurboTax, but its largest business and growth engine is QuickBooks, which operates as a functional monopoly in small-business accounting software in the U.S.

Software is lately controversial due to AI-driven disruption. AI is deflationary for engineering costs and will change many workflows in how software is used. The technology is widening the distribution of 5-to 10-year outcomes for these businesses. In some cases, the central tendency shifts lower; in others, it’s stable or even shifts upward. The entire space has sold off over the past year, and we believe the recovery will be more heterogeneous than the decline. Many businesses will be impaired, but a number will likely benefit.

We have positioned ourselves with companies that we expect to be comparatively resilient, that also have idiosyncratic earnings growth paths or call options. SAP will face tougher competition in its peripheral products, but its core is highly defensible, and we think it will grow rapidly over the next five years, driven by its cloud migration. Workday earns well bel ow normalized margins today and may reignite product development with the return of its founder to the CEO role. Intuit’s QuickBooks has singularly valuable distribution to small businesses and is weaving AI capabilities into its products to bette r serve this hard-to-reach customer. We expect EPS growth of around 20% for the group.

We’ve built a position in Danaher, a leading life sciences company. Danaher sells a broad mix of consumables and tooling that are mission-critical to biological R&D, diagnostic testing, and biopharma drug production. It has high market share, differentiated technology, strong management, and good growth prospects.

Over the last several years, Covid-related revenue disappeared, the biotech end-market boomed and then crashed, China slowed, and NIH funding was cut. As a result, this historically stable grower has been anything but stable or growing. It’s n ow trading at a depressed multiple on depressed earnings. With lower-quality earnings flushed out of the base and other parts running below trend, we expect improving, and possibly even above trend, growth over the coming years. Moreover, one of the most exciting areas of exploration for AI technology is in biopharma research. This has the potential to be a medium-to long-term accelerant for Danaher’s business. We expect EPS growth in the mid-teens.

London Stock Exchange Group (“LSEG”) and S&P Global operate critical financial market infrastructure. LSEG has trading and clearing venues, data and applications businesses, and the FTSE Russell Index business. S&P Global operates the S&P ratings business, the S&P index business, Platts, and a portfolio of data and applications businesses. The segments generally have dominant market share or even monopoly positions, above-GDP revenue growth, high margins with even higher incrementals , and good free-cash-flow conversion.

These stocks are interesting today because each also has AI-disruption risk in parts of the enterprise. Our analysis indicates that these risks are limited to a small subset of the business and are likely more than offset by AI-driven upside in the data segments. In time, we believe the stocks are reasonably likely to be perceived as beneficiaries of AI. Given today’s depressed multiples, this situation presents an attractive asymmetry. We forecast EPS growth in the mid-teens in the coming years.

EQT is the largest pure play U.S. natural gas producer. The company has long-lived assets, with decades of inventory. It also has a low-cost structure due to its enviable position in the Marcellus shale and captive pipeline assets. Management has an excellent track record of making wise strategic and capital allocation decisions. Despite selling a commodity product, EQT is a high-quality business with operating margins exceeding those of 80-90% of S&P 500 companies. Natural gas in the U.S. trades at a wide discount to global prices. The combination of the inflection in U.S. electricity demand, LNG export growth, and disruption in the Middle East may narrow this discount over the next 5-10 years. We expect EPS growth in the mid-teens.

The pace of change is accelerating, and the market structure we described at the start of this letter amplifies its effect on prices. When more participants are chasing momentum, sharper moves create sharper opportunities. That’s an uncomfortable environment to weather, but a productive one to invest in. We plan to keep doing the work, company by company and point by point, letting the compounding take care of itself. Thank you for the partnership and trust that make this approach possible.

As always, if you have any questions or would like to discuss anything herein, please call us at (212) 293-4040. Also, if your financial situation or investment objectives have changed, if your IPO eligibility or U.S. Person status has changed, or if you would like to modify or discuss any investment restrictions or guidelines, please reach out to your contact on the client team or email ClientServices@eaglecap.com.