2026 First Quarter Commentary
- Jul 14
- 15 min read
For a printable version, click here.
If you are a client, click here for a copy of the client commentary which includes discussion of recent investment activity.
“Price is What You Pay, Value is What You Get”
In January 1964, the Surgeon General of the United States released a landmark report titled “Smoking and Health” which for the first time concluded that cigarette smoking causes lung cancer, chronic bronchitis and several other illnesses. In the following decade, new regulations were enacted in the United States to discourage tobacco use. The percentage of adults in the US who smoked declined from around 43% in 1964 to around 11% today. Cigarettes sold peaked at an astonishing 10 cigarettes per adult per day in the early 1960s and declined nearly 70% over the next 25 years as shown in the chart to the right.
Given this very pessimistic background for the tobacco industry, most are surprised to hear that one of the best performing stocks over the 20th century was tobacco company Philip Morris (now Altria Group). A $1,000 investment in Philip Morris in 1925 would be worth a staggering $1 billion today. The nearby chart plots the dramatic stock outperformance of Philip Morris stock when compared to the S&P 500 since the early 1980s versus the perpetual decline in domestic cigarette sales over the same period.
How can it be that investors in Philip Morris stock had a dramatically different experience from the negative conditions of the underlying industry? Several factors set up Philip Morris stock investors for success despite the secular decline in the rate of smoking and the coinciding reduction in the number of cigarettes sold. A declining industry meant that Philip Morris had few new competitors and could actually grow their brand positioning. Very high taxes enacted on cigarette sales inadvertently increased the tobacco companies’ pricing power because they could increase their margin less noticeably given their smaller relative portion of the retail price. (Cigarette prices today are 56 times higher than they were in 1964 compared to the broader CPI index which is about 10.5 times higher over the same period.[1]) As a result, operating margins for tobacco companies increased from around 16% in 1970 to nearly 55% today. Additionally, shareholders received a high dividend yield which made a strong contribution to the overall return when reinvested. Finally, the perpetual investor predisposition to avoid tobacco stocks allowed the company to continually repurchase their shares at attractive valuations – boosting the earnings per share of remaining shareholders. All of these factors allowed investors in Philip Morris / Altria Group stock to have a very strong return while their largest product was undergoing a structural decline.[2]
The practice of value investing involves making a key distinction between the price of a stock and the value of a stock. These two terms are regularly conflated by investors even though they are two very different concepts. The price of a stock at any given time is a function of marginal opinion and is usually heavily influenced by the immediate and present condition of the company and industry. The price is subject to emotional and irrational swings in this marginal opinion – a concept that Benjamin Graham refers to as “Mr. Market” in his seminal book on value investing titled “The Intelligent Investor.” Graham introduced this metaphor to illustrate how long-term investors should only be concerned with the daily quoted price by irrational, emotional “Mr. Market” to the extent these price quotes give him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. But at other times, long-term investors should forget about the stock market quotation and pay attention to their dividend returns and to the operating results of the companies they own. These fundamentals of the underlying business are what determine the true value of a stock.
Our approach to equity investing is slow and methodical. We analyze the fundamentals of companies and set a consensus-based assessment of our estimate of their intrinsic value per share. We set a “buy” price at a discount, usually at least half, to this estimate of worth. This discount is called the “margin of safety,” and our assumption is that the closing of this discount to true worth will, when added to the income return from dividends, constitute the total stock return we expect to receive as shareholders. We then compare our buy price to the stock price. Often, the stock initially trades for a price well above our buy price and often even above our estimate of intrinsic value. This was the case for our recent purchase Diageo plc (NYSE: DEO). We first analyzed Diageo in January of 2024. At the time, the stock had already sold off -35% from its all-time high following the Covid-related boom in alcohol sales. This sell-off was what prompted our analysis of the company for the first time. Despite the sell-off, our conclusion was that though the stock was below our estimate of intrinsic value, the discount to our estimate of intrinsic value was not large enough to give us a compelling margin of safety. Our buy price at the time remained around 40% below the already “marked down” price! Still, the strong returns on capital, dominant market share, diverse business and premium spirits exposure made us conclude Diageo was a company we wanted on our “wish list” of high-quality businesses that we would love to own at the right price. For two years following that initial review of the company, we followed Diageo’s business and results and kept our buy and sell prices updated. We set new prices three additional times, always within 15% of our initial targeted buy price despite increasingly negative headlines about the spirits industry.
We believe there is an inverse relationship between valuation paid and ways to win. The higher the valuation you pay for a company, the narrower your likelihood for a strong investment return. Usually companies that trade for high valuations do so because investors have high expectations for the future. So not only do you need the high valuations to persist, but you also need the company’s business results to live up to the very high expectations. This narrows your odds of investment success because everything has to go your way for a strong return given only optimism is priced into the stock. A valuation with no margin for error provides investors no margin of safety. On the contrary, most of the time the stocks that are cheap enough for us to find attractive are facing some near-term headwinds: either company-specific or industry-wide challenges that are very well known. The pessimism surrounding the company drives the price to a discount that is significant enough to make us optimistic about the probability of above average future returns. In fact, often our decision to initiate a position is related to the fact that we see a sliver of hope where most other investors are only focused on the negatives.
This is a central tenet of value investing – looking for opportunities where the market is overestimating the odds of a bad outcome but underestimating the odds of a slightly better outcome. In these situations an investor has more levers that could go right (surprising to the upside) and lead to a strong total return as a shareholder. Most often, we are paying a cheap enough price that we don’t even need all of the levers to break in the company’s favor to have a good return – we just need one or two.
Eventually, the pessimism plaguing the alcohol industry drove the price of Diageo (NYSE: DEO) stock down to a sufficient discount from our assessment of its intrinsic value. We initially added Diageo to portfolios in the fourth quarter of 2025 and scaled further at an even lower valuation this quarter. (Clients can read our detailed write-up of recent updates at Diageo in the Portfolio Activity section below.)
We believe that Diageo’s current valuation is low enough that you don’t have to make a call on future growth in global alcohol consumption to make the case for a strong return as a stock investor. Furthermore, while it maybe easier to have a strong stock return within a growing industry, the Philip Morris case above illustrates that a strong stock return is even possible in an industry without overall growth. If the current downtrend in alcohol sales reverses, this is the most obvious way Diageo stock investors could have a strong return. However, we believe the low valuation, good dividend yield (even after the recent dividend cut), diverse portfolio of assets and strong brand positioning (dominant number one market share across whiskey, gin, tequila, vodka and non-alcoholic spirits) combine to give us several levers to win as an investor in the company. This is a set-up we like. The low valuation allows the company to use excess capital to buy shares, reducing the shares outstanding and increasing earnings per each share that our clients own. The dividend yield gives us current income and pulls forward more of the total return – requiring a lower future capital appreciation in the stock to reach our total return expectations. The diverse portfolio of assets gives the company flexibility to manage debt levels by selling non-core assets. The strong brand positioning allows Diageo pricing power even in an environment where the industry is facing near-term demand headwinds. We do not know the future and do not know whether Diageo will end up being a stock that provides our clients with a strong annualized return over our ownership tenure. However, because we invest with humility and never promise to know the future, we like situations in which the expectations are low, the margin of safety is high and we can see many possible scenarios that could lead to a strong rate of return as long-term investors.
SaaS-pocolypse or SaaS-pportunity?
As recently as 2021, Software as a Service (“SaaS”) companies were considered the “holy grail” of business models. SaaS companies develop software that is sold and distributed via the cloud, which eliminates the need for any local installation or infrastructure. The “as a Service” component refers to the fact that the software was sold via a subscription model which was considered a much more attractive model than the prior software distribution method of selling one-time “licenses” that had to be resold again every 5-10 years or whenever the software company could create a new iteration that was compelling enough for customers to upgrade.
There are several reasons why the “SaaS” business model was considered such an attractive one. Selling subscriptions created a much more stable recurring revenue stream than selling licenses. The cloud-based distribution model meant that SaaS companies could easily increase their number of users with a very low marginal cost. Lower up-front costs for customers (because of the lack of on-site infrastructure) resulted in higher adoption rates. All of these positive attributes led to incredible optimism in the investor community about any software business with a SaaS model. On queue, Mr. Market began to exhibit increasingly irrational exuberance in the valuations he assigned to SaaS businesses. At the peak of SaaS optimism in 2021, SaaS companies were estimated to represent about 40% of all private equity deal flow with an average purchase multiple of 40(!) times Earnings before Interest, Tax, Depreciation and Amortization (EBITDA) and around 6x debt to EBITDA according to several industry analyses.[3] (For comparison – our composite portfolio trades for 9.3 times EBITDA and 2.5 times debt to EBITDA.) SaaS businesses were valued as if there were no price too high.
While we do appreciate the positive attributes of SaaS businesses noted above, as value investors we still have a price discipline and do not believe there is any business model so good that it makes valuation irrelevant. Although we are willing to pay higher valuations for better quality business models, discipline necessitated that we sit on the sidelines during the software craze, scratching our heads at the eye-popping valuations afforded most any company with a SaaS business model.
The release of artificial intelligence (AI) agents that could write code and autonomously conduct multi-step workflows sent tremors through the technology sector earlier this year and led to a dramatic decline in valuations across the software industry.
The share prices have fallen so markedly that the move has garnered multiple names such as "SaaSpocalypse" or “Casaastrophe”. The fear is that AI agents—such as Anthropic’s Claude Code and OpenAI's Frontier— will begin automating software workflows, requiring fewer workers and threatening the traditional seat-based (subscription fees based on the number of users) SaaS business model. Anticipating the worst, investors earlier this year triggered a ~$300 billion decline in the stocks of traditional software companies. Investors do not appear to be selectively assessing AI risk on a company-by-company basis, rather they seem to be blindly selling or opportunistically shorting all SaaS companies. For us, it is a very rare thing to be able to find a growth company that we can buy for a value price. And so we started to analyze the sector looking for a software business we felt was being unduly punished by Mr. Market’s indiscriminate new pessimism. Many of the businesses we analyzed did seem to face a genuine existential threat from AI. Others were too difficult for us to confidently assess how they may be impacted by AI. However, we came across one particular 44-year-old software business with a suite of products that are critical systems of record for its over 40 million active subscribers. This company enjoys a dominant market share in many of its products. So far, this company is actually growing its business because of AI – adding new subscribers because of the AI features it has added to its products. The ubiquity of its products among its customer base has created network effects we believe will be enduring. The company has gross margins of 90%, free cash flow margins of 37% and is still growing its earnings around 15% per year. The company has an excellent balance sheet with no debt and has repurchased 10% of its shares in the last two years during the sell-off. The SaaS sell-off has driven this company’s stock down over -65% from its 2021 peak. Clients can read below in the Portfolio Activity section about this new company we were excited to add to portfolios in the first quarter and have since scaled at an even more attractive price. While we would have considered this stock to be very overvalued at its peak, our initial purchase price equated to approximately 15x trailing 12-month earnings and 11x trailing12-month free cash flow, a very reasonable price for a dominant franchise. This is the very first software company we have ever bought. While we remain very humble about our expertise in the software field, we believe the valuation of our most recent purchase gives us a sufficient margin of safety and multiple levers to win – once again, a set-up we like. We believe it is yet another example of the separation between sentiment-driven stock price and fundamentals-driven stock value.
Broad stock market (i.e. S&P 500) valuation levels continue to be at historic extremes, which we do not believe bodes well for broad stock market returns over the next decade. In contrast, we continue to find opportunities to invest our clients’ capital in companies we believe to be offered by the market at prices far below their intrinsic value. In fact, Diageo (NYSE:DEO) and the SaaS company discussed above are just two of the six new companies we have added to our clients’ portfolios in the last year. It is rare for us to be able to find so many attractively valued companies with stocks generally being as highly valued as now. This unusual dynamic underpins our continued excitement in the portfolio of companies we own for our clients today.
Dire Straits
It will likely surprise no one that we have recently fielded numerous questions from clients about the energy positions in their portfolios. Many of the questions have been framed along these lines: “After a $50 increase in the price of a barrel of oil in a month, why do we still own these companies? Will there ever be a better environment for them?” We understand the sentiment; however, we strive to reorient the conversation to a longer-term perspective.
Let us start by stating that we have no special insight into how the conflict with Iran is eventually resolved or how a framework for transport through the Strait of Hormuz is finalized and then enforced. Regardless, the combination of a drawn-out road to recovery in supply and a renewed emphasis on maintaining elevated reserves for emergencies is likely to place a long-term, if not permanent, premium on oil and natural gas prices, as well as the prices of many other products affected by the war.
Approximately 20% of the world’s oil and liquified natural gas (LNG) supplies transit Hormuz. Energy Aspects, a leading energy research consultant, estimates that 13 million barrels of oil per day are currently blocked by the closure of Hormuz. Over the course of the shutdown to the publication of this commentary, that equates to over 585 million barrels of oil, 40% larger than the entire United States Strategic Petroleum Reserve. The physical interruption to global oil markets is unprecedented. Considering that it takes a large oil or petrochemical products tanker 20 – 30 days to travel from Hormuz to China or Amsterdam and 30 – 40 days to travel to the U.S. Gulf Coast, the physical constraints of supply have only just begun. Also, to date, some of the supply disruption has been offset by countries taking proactive measures such as releasing oil and oil products from strategic reserves. Consequently, most of the price impact from the war in Iran has primarily been due to anticipation of supply shock versus actual decreases in supply. Even if hostilities were to cease today, it would take several months to clear the vessel traffic jam, make necessary infrastructure repairs and restore production from damaged wells. For liquified natural gas (LNG), prospects of restoring exports to prewar levels are fundamentally a different situation. According to QatarEnergy's CEO, it may take 3-5 years to repair or replace damaged liquefaction capacity to the extent needed to bring LNG export volumes back to prewar levels.
Entering this environment, we would argue investors were extremely underexposed to energy producers. Energy makes up less than 4% of the S&P 500 Market Capitalization versus 5% in 2022 and 25% in the 1970s. Investors who have avoided the Energy sector may need to reassess the importance of access to energy and other commodities rather than assume everything will return to the prewar status quo. We have no doubt countries and companies will be reassessing their vulnerability to supply shocks. Supply chain management was already beginning to shift from just-in-time to just-in-case emphasizing access over cost and efficiency. The current disruption will only increase the urgency to accelerate building resilience into supply chains, especially for energy. A recent study conducted by Hartford Funds using data between March 1973 and December 2025 found that Energy has been the best performing sector during periods when inflation is 3% or higher and rising.[4] Historically, there is no protection like energy against an energy-driven inflation shock.
Given our exposure to energy companies, we also wanted our clients to understand the direct production exposure the energy companies in their portfolios have to the Middle East. APA Corp. (NYSE: APA) has the most significant exposure to the Middle East (some clients may not own shares of APA depending on when their FRM relationship began). However, all of APA’s Middle East production comes from Egypt’s Western Desert and the Egyptian state is the owner of the development while APA is only a contractor that is paid based on a 30% share in the project’s profits. Additionally, the most likely path for missiles and drones targeting the Western Desert would require a significant amount of time spent in Saudi airspace where they would likely be intercepted. Furthermore, Egypt does not host any U.S. military bases and is not thought to have aided the United States or Israel in attacking Iran. For these reasons, we would consider APA’s Egyptian operations to be a low probability target for Iran.
The limited geographic exposure of our portfolio companies to Middle East production leads us to believe that the risk of exposure to Iranian attacks on Middle East production will be more than offset by the significant increase in oil and natural gas prices due to lingering effects of the war after the cessation of hostilities.
Chart 3 shows that 67.2% of the production exposure for FRM’s composite portfolio is in the Americas and 21.3% in Asia Pacific. These barrels should be able to get to market at the higher prices now being offered. For example, on April 8th, Exxon put out a press release detailing special items that will affect first quarter earnings. The list included a $2.1 - $2.9 billion boost to upstream earnings versus fourth quarter 2025 due to higher prices. The release also included expected unrealized losses on derivative contracts that will be offset by future sales, which can be read to mean the boost to profits would have been larger if the company had not locked in profits on some of its production before the war. Furthermore, on April 9th, Chevron said that higher oil and gas prices will lift upstream earnings by $1.6 billion over fourth quarter 2025. We continue to actively monitor the valuation of your energy exposure with the same slow and methodical focus on the long-term value of each stock we own for you. On that basis, we continue to be very comfortable with our exposure to this vital sector.
[2] Our summary of the Phillip Morris case study used stock price data pulled from Bloomberg LP and also points from these comprehensive summaries of the Phillip Morris history:
[3] https://www.apolloacademy.com/a-reset-in-software-and-why-discipline-always-matters/#_ftn2https://aventis-advisors.com/software-valuation-multiples/
Disclosure
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. “FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at amckelvy@frmlr.com.
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