Quarterly Review & Activity
The fundamental disconnect we highlighted in our Q3 letter has only intensified. Our compounders continue to deliver solid earnings growth, approximately 14% annualised, yet this progress has been entirely consumed by multiple compression. Since December 2023, our portfolio has generated 10% cumulative EPS growth while experiencing a 15% contraction in valuation multiples. Over the same period, the MSCI World has returned more than twice its EPS growth, driven by multiple expansion concentrated in a narrow cohort of AI-related mega-cap names.
Q4 2025 portfolio activity was lighter than the previous quarter, with most trading centered on reducing a consumer discretionary holding after its remarkable quarter and year pushed its multiple to the upper end of its range. The proceeds from the sale were reinvested into holdings where we see more compelling risk-reward at current valuations. Overall, long equity exposure remained stable and strategic currency hedging remains actively in place.
Earnings Update
As a brief reminder of our approach, we invest in a concentrated portfolio of compounders, comprising roll-ups that scale through disciplined acquisitions in fragmented industries and roll-outs that compound organically by reinvesting profits into new locations or product extensions. The Q3 earnings season (reported during Q4) produced mixed results for our compounders with a portfolio alpha of +0.39%. Of the 19 companies reporting, 7 beat estimates, 5 met expectations, and 7 missed. While the headline beat rate was lower than our typical profile, we believe this reflects significantly lowered market expectations rather than fundamental deterioration. Encouragingly, several of our cyclical holdings showed clear signs of inflexion, and early Q4 results are confirming the trends we anticipated. These results are promising and, in many cases, validate the recovery thesis underpinning our portfolio positioning.
Portfolio Fundamentals
Our portfolio's valuation remains extremely compelling. The P/FCF multiple has historically traded in line with the MSCI World Index but currently sits 61% below historical norms. Our compounders demonstrate faster earnings growth than the broader market, and history shows this fundamental strength best explains long-term returns. Critically, our roll-ups and roll-outs reinvest 80% of their profits—almost twice the level of the broader market—fueling sustained compounding. EPS growth equals ROE multiplied by reinvestment rate, and on both metrics, our portfolio is significantly advantaged.
Portfolio Strengths and Vulnerabilities
We believe in a transparent assessment of our portfolio's positioning. Our strengths are considerable: geographical diversification with approximately half the exposure to U.S. markets compared to the broader indices; sector diversification in high-quality companies; a small and mid-cap focus providing strong potential for alpha generation; approximately 18% in technology and software providing long-term secular growth potential including exposure to AI; and a portfolio of market leaders with strong competitive positions.
Our infrastructure holdings are well-positioned for both U.S. and European infrastructure spending. Approximately 60% of the portfolio is roll-ups, compounding via M&A and boasting excellent track records of generating shareholder value. Most importantly, the portfolio is extremely cheap on an absolute and relative basis, providing meaningful downside protection.
We are equally aware of our vulnerabilities. Approximately 50% of the portfolio is in cyclical sectors, which makes it sensitive to economic conditions. Interest rate sensitivity affects several holdings. European economic exposure at approximately 27% carries risks from slower growth and energy challenges. Additionally, some small and mid-cap positions may face elevated volatility during periods of market stress.
Looking Forward
There are several near-term scenarios where our portfolio can significantly outperform:
1. AI Hype Cycle Correction / Multiple Compression in Mega-Cap Tech. Our portfolio has no exposure to the Magnificent Seven and AI darlings that have driven index returns. Passive investing has become exceedingly concentrated in a handful of U.S. tech names. When the market rotates away from high-multiple AI beneficiaries, whether due to monetisation disappointments, regulatory intervention, or simply valuation fatigue, our portfolio's absolute and relative performance improves dramatically.
2. Infrastructure Supercycle Materialises. Our infrastructure holdings are direct beneficiaries of U.S. infrastructure spending through the IIJA, which continues to deploy capital through 2026–2028, as well as water infrastructure replacement, reshoring and manufacturing facility construction, and data centre buildout. If infrastructure spending accelerates or political support strengthens, these investments could significantly outperform.
3. Interest Rate Normalisation / Cuts. Higher rates have pressured several of our holdings. A Fed cutting cycle could unlock meaningful multiple expansion across 30–40% of the portfolio.
4. M&A Cycle Accelerates. A significant portion of the portfolio consists of roll-ups, proven consolidators in fragmented industries. Lower rates and improved credit availability typically accelerate private company transactions. These platforms can be acquired at attractive multiples, compounding shareholder value.
5. Value/Quality Factor Rotation. The portfolio has a distinct quality compounder tilt. When the market rotates away from momentum toward quality and value factors, our roll-ups and roll-outs could benefit. Companies with negative earnings have continued to outperform those with positive earnings since April 2025, a dynamic that is unsustainable and has historically favoured fundamentally sound businesses.
6. Software Names Prove AI-Resilient Rather Than AI-Disrupted. The recent bear case on some of our software holdings is that AI commoditises their offerings. The bull case, which our research supports, is that these companies demonstrate they can integrate AI as a feature rather than be disrupted by it. If sentiment reverses, the de-rating in this cohort could sharply unwind.
Deep Dive: Software, AI, and the Competition Question
The software sector experienced a sharp de-rating beginning in October 2025 that has accelerated through the first two months of 2026. At the end of the quarter our portfolio held five software-related compounders, which collectively represent approximately 20% of NAV and have been meaningfully impacted by this sentiment shift. We believe it is important to address the AI disruption narrative directly, because our research suggests the market is conflating a genuine long-term structural shift with an overly simplistic near-term conclusion.
The prevailing bear case rests on two pillars: first, that AI makes software easier to build, reducing barriers to entry and compressing pricing; and second, that AI can directly replace certain software categories where the core value proposition was performing a task that AI can now do at a lower cost. We acknowledge that both concerns have merit for a subset of the software universe, particularly horizontal SaaS companies performing relatively simple data processing, basic analytics, or workflow automation. AI agent companies are emerging with near-zero marginal costs, gross margins above 90%, and exponential scaling potential, fundamentally challenging the economics of incumbent software businesses. The AI agent market is projected to grow from $7.6 billion in 2025 to $47 billion by 2030. With 78% of organisations already deploying AI in at least one function, the pace of adoption is accelerating.
However, we believe the critical question the market is failing to ask is not whether AI will transform software, but who captures the economic value of that transformation. History offers a clear and consistent answer: competition drives surplus to consumers. The railroad boom of the 1880s created enormous economic value, but railroad investors were largely wiped out as overcapacity destroyed returns. The fibre optic buildout of the late 1990s revolutionised telecommunications, yet the builders went bankrupt while consumers and businesses reaped the benefits of cheaper bandwidth. Today, major technology platforms are spending over $700 billion annually on AI infrastructure, approaching 95% of their operating cash flow, and some are already showing negative free cash flow. When every competitor is making the same investment simultaneously, the result is a prisoner's dilemma: no single company can afford to fall behind, but collective overinvestment ensures that returns on that capital will be competed away. The economic surplus flows not to the builders but to the users of the infrastructure.
This dynamic has direct implications for software valuations. As AI capabilities become widely available, the ability to build software becomes less scarce. Still, the ability to deploy it within complex enterprise environments does not. Companies that perform cyber risk and security operations, with deep integration into customer infrastructure, mission-critical security functions, regulatory compliance moats, and years of accumulated threat intelligence data, are fundamentally different from generic project management or CRM tools. Enterprise adoption cycles for security software span 5 to 7 years, even for demonstrably superior products, and the risk-adjusted cost of switching is enormous. Similarly, our software holdings operating in workflow orchestration, life sciences regulatory expertise, and enterprise content management are deeply embedded in ways that AI agents cannot easily replicate. We believe the market is repeating a familiar error: extrapolating a powerful new technology into immediate universal disruption, when enterprise technology adoption is constrained by organisational capacity for change, integration complexity, and the practical gap between capability and deployment. Our research suggests that our software holdings are more likely to integrate AI to gain a competitive advantage than to be displaced by it, and we expect multiples to recover as earnings results bring reality to current perceptions.
Closing Remarks
2025 was a year of contradictions. Our portfolio delivered approximately 14% annualised earnings growth yet underperformed as multiple compression overwhelmed fundamentals. The market rewarded speculation and momentum at the expense of quality, creating a valuation gap between our holdings and the broader indices that is as wide as we have seen.
But within that frustration lie the seeds of future returns. The Q3 earnings season confirmed that our compounders are executing, and early Q4 results have further strengthened the case.
Looking ahead, the portfolio's strong projected TSR is underpinned by concrete evidence and identifiable catalysts rather than hope. We own 19 companies with 15% earnings growth, 23% free cash flow return on equity, and 13% management ownership—trading at a 39% discount to the market on P/FCF.
We know from decades of evidence that fundamentals ultimately drive returns, and, as in our portfolio, when they have been severely suppressed, they rise as quickly as releasing a beach ball underwater. The compounding our businesses are delivering today will be reflected, and the current dislocation will appear, in hindsight, as a remarkable opportunity. We remain fully committed to our process and positioned accordingly.
Note
This is a redacted version of CDAM's Q4 2025 Investor Newsletter. Should you be interested to learn more, please contact us by emailing ir@cdam.co.uk.
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