FISCAL 2026 – THE YEAR OF ROTATION, APOCALYSE AND WAR.

There is little doubt in my mind that 2026 has had significant challenges, especially for my style of investing. Every style has its time in the sun and in the shade, but this year seems a bit different to the usual outcome of being out of favour every three or four years. My style, quality growth had its last difficult year, in 2022, the post-C19 hangover, when interest rates were jacked up after the Central banks kept interest rates too low for way too long, in their infinite wisdom. Fair enough, if every style continued to outperform every year, it would get overbought and overheld and preclude favourable investing. So, every style needs a clean out of the momentum guys and camp followers, etc., again, fair enough. With all that in mind, 2026 has had a bit more to it than usual, and that’s what I want to comment on here. So, 2026 is a year for the mean-reverting value guys to do well, and they have been waiting a while, so good on them. I want to explore the likely risks that we could see the unfavourable trends continue for quality growth investing.

As an aside, I have just been reading the results of a well-regarded value investor, that is, value style as opposed to valuation, and his past 4 years' results were 1%, 11%, 7% and 41%. There is a good lesson for all of us in these numbers. Imagine if he abandoned his style because it was losing at the start of last year. Disastrous, and that defines a poor investor. You must have belief in what you are doing and the ability to execute, and the patience for your thesis or style to play out.

ROTATION

After the August reporting season, I wrote the following: (isn’t Strawman great for having a history of written evidence)

LESSONS FROM REPORTING SEASON-AUGUST 2025 (highlights added)

Ok, I've been through quite a few results seasons since 1987. There are always good results, average results and poor results. Every reporting season has its pluses and minuses. Again, this time there were good and poor results as always. What I found a bit different this results season was that it was a bit of an emotional rollercoaster for me. Why? Usually, I quickly go through the result before looking at the SP and have an idea of what to expect before looking. There is usually a good correlation with the SP and my expectations; this results season saw more than usual volatility. No big deal, but shifting sand. Secondly, through my customised benchmark, I monitor a universe of potential stocks, and so far this FY, we can clearly see a change in the leadership, and this results season further cemented that change. There is clearly a broadening of participation, especially in the Australian market. Leadership changes are due to several things, and they are difficult to pin down. It could be that the former leaders are now expensive and losing momentum, investors are getting bored and need new stories, or there is “catch-up” going on, some form of mean reversion. We can observe it, but correctly identifying why it is occurring is another issue. Of course, guessing how long the rotation occurs, be it one week or one year, we do not know.

The other thing is, what to do about it? My answer is not much except to be psychologically prepared for that scenario. Where you have been doing well, but we are entering a period where you may not do as well, or even lag, who knows? I haven’t seen many (none) in my career that can consistently catch these market changes. We know that the market is a chocolate wheel over the short term (0-1 year) and starts to correlate with earnings the further you look out. This ride is volatile.

Therefore, I stick to my investment philosophy and process, which I can execute and have a belief that in the long term will do very well, but there are times that it won't, be prepared. If any process always won, it would be arbitraged out of existence; the randomness scares off investors and therefore creates the opportunity for LT investors.

Finally, think carefully before changing a LT winning formula because of any ST upsets. The numbers in aggregate are ok for me this results season, but they came unexpectedly, that happens, don’t panic. Stick to the process.

My reading now of the above, imo, clearly shows I thought there was a possible style shift coming and to be prepared for a possible poor year. However, stick to the process and style that has done so well before.

Understanding rotation means understanding style investing. The concept is that under different market conditions that are usually hard to predict (like macro), different investing styles perform very differently, the growth and value styles being the two most common. A (very) brief recap on what I do and the significance of it in this context. My philosophy is based on my belief that the best returns for the lowest risk come from buying companies that can grow their earnings, with a reasonable degree of certainty, and not paying too much for them. One of the reasons I like this approach is that the failure points can be identified quite easily. The earnings growth must take place, and you can’t pay too much. You can make reasonable assessments of both, which is a better proposition than I see in other approaches. So, for example, if I can see a company growing its earnings for many years, at a rate above the overall market growth, and I can pay a small or reasonable premium for that, it’s a good deal, and I should do well over the longer term, and this process can be repeated. Of course, there is judgment (and probably skill) in the calibration required between assessing growth and an adequate premium. There is another issue lurking that can undermine this style of investing, and we will come back to it: the consistency of terminal multiples.

We know that over the longer term, earnings growth shows the best correlation with share prices. We also know that over one year, there is no correlation between valuation and share price; it’s a coin flip. Therefore, patience and belief in the process that sustains it are critical.

Overall style rotation doesn’t overly worry me; I can last a year or so before the longer term prevails. Given that, my instinct is to concentrate on my best stories if there is a general sell-off. And I have done some of that in this sell-off as well.

But there is more to the story this year.

APOCALYPSE AND WAR

If the 2026 story ended there, I would be quietly confident of a fast return, but there is more to this year. The war does not concern me greatly, of course, it could degenerate into a long-lasting drain on economic growth or spill into a broader war; no one knows, and everyone will have an opinion. I can’t add much to that debate, just another opinion. My base case is that the US started it and can end it at some point.

What concerns me more is the implications for terminal values that have arisen from two areas, both of which concern me. Why are terminal values important, especially to my style of investment? The main reason is that quality growth investing has a higher proportion of value to be generated in the later years, as the multiples are higher. Value investing is shorter duration, as the cash flows come sooner.

If the market is trading around a 20X multiple, buying a stock for 25X takes some extra assumptions into the future, but they are usually not heroic. When we get above 30X, the run rate increases. I know some of my former PM colleagues who pull up stumps at over 50X, just too high, or they give the stock 2-3 years to get back to a market multiple, to be more precise. And well, there are those companies priced into the stratosphere. When we pay up, we are making assessments of the world well into the future. It is not good enough to say, these are a great company, the company must be great in 5 or 10 years or longer. That focuses us on terminal values and whether the market is confident to continually pay up for something well into the future.

Currently, imo, there exist two potential threats to terminal values. One is AI, and the other is high inflation. Enough has been written about the AI threat, and I will not go on about it again here. The “AI will become God” argument, at this point, is a bit redundant; it can't be proved or disproved, it lingers, and everyone has a free kick with their view. My approach to this is to take some exposure, well short of where that exposure could go and see how the story develops. Sustainability of profits will ultimately determine the outcome, imo. One thing I am fairly certain about the market will not linger forever. If anything, taking a long-term view is not what we see every day; we see short-term views having a big weight, so it is interesting that the market is obsessed with something that is long dated and could require some time to be proved. That is uncommon and uncomfortable for markets. The markets are not likely to be that patient; there will likely be decisions, maybe bullish and bearish, well before the proof has come.

Here I want to spend some time on inflation and its possible repercussions. Having lived through double-digit inflation in the 1970s and 1980s, I think some of the commentary is a bit misplaced. When I was at uni, I remember a lecturer saying that inflation was irrelevant if everyone in the economy was fully compensated for the loss of purchasing power. If we just used more dollar bills, and nothing really changed. After being in finance and business for so long, I can say that view is not correct IMO. Only a uni lecturer could say that. BTW, my base case is that inflation will be conquered and the deflationary effects that have been predominant, especially since the GFC, will again prevail. However, I may be wrong. Inflation is often looked at and spoken of like an inanimate object, like its footy score or something that can be physically contained. It's not that. IMO, it’s similar to taking your temperature; high inflation indicates a disease. Usually, we don’t know for sure where, but it's there. Maybe the disease disappears, maybe not. Inflation is the sum of a multitude of prices across the economy. When it goes up, it indicates a malfunction in the functioning of the process of delivering goods and services. Such as bottlenecks, imbalance in bargaining powers, and structural issues. What inflation does is increase the uncertainty of outcomes. That is the main point and what the university lecturer missed. With low inflation, you have extra certainty; with high inflation, a field of uncertainty grows. Prices go up, but which prices, where in the chain and for how long and how high?  Capital investment becomes more problematic if input prices can't be estimated properly. Pricing strategies have to be made more often, and demand elasticities continually tested. All along the value chain, there is uncertainty of outcomes due to prices moving at different rates, and margins become much more problematic. Even if management can control their margins, there are more question marks around what comes next. Drawing this back to quality growth investing and the sustainability of a high Pe. I hear people saying the best thing you can do in inflationary times is buy strong companies, and that is absolutely right. However, and this is the rub, inflation increases the uncertainty of profitable growth. Unlike the low inflation periods when strong companies grow, and weak companies don’t, we have more variability of outcomes and that leads to a lower multiple. There remains a difference between the weak and strong, but it is not as clear as in a low inflationary environment, and PE compression is devastating to the growth companies. The war does not worry me, but it does slightly increase the chances of an inflationary world and that spells trouble imo to my style. You can let your mind wander free on inflationary possibilities; there are plenty. Bessent said he wants Main Street to benefit more, not Wall Street. What does that mean? The point is, if the inflation genie gets out of its bottle, my positioning will be quite vulnerable. Here, I wanted to show how that manifests itself in multiples.

What do I worry about, as a quality growth investor and having a higher growth, higher PE portfolio, is not the strength of the companies; they will remain strong, but a future where that strength is just not valued as much as today.