The positive momentum in the stock market picked up considerably during the second quarter. Most of the gains were again concentrated in AI-related areas of the market, where heavy investment coupled with supply/demand imbalances has driven earnings well ahead of expectations. Bonds, meanwhile, continued to be influenced by inflation readings and changing expectations for Federal Reserve policy.
This remains a constructive environment in many respects, but it is also one that requires perspective. Earnings are strong, but expectations are high. AI investment is powerful, but the ultimate distribution of economic and market benefits remains uncertain. Inflation has improved from its peak, but it remains above target. Market indices have performed well, but participation has been narrow. In periods like this, it is useful to return to our longstanding philosophy.
“What were they thinking?”
Scott McNealy, CEO of Sun Microsystems, 2002
Before we get to the quote, let us explain exactly what we are thinking. We believe the capital markets, and equities in particular, are an excellent way to compound wealth. Our mechanism for achieving this is different from the way the popular stock market averages are constructed. The framework we use is quality-centric and valuation-sensitive. Stated simply, we want to own good businesses, and we want to be careful about what we pay for them. This means we are discerning about financial strength, earnings consistency, cash flow generation, dividend durability, balance sheet quality, and valuation. This discipline has served our clients well over our firm’s history. It has also produced a pattern of returns that has generally been smoother than the broad market, but one that does not always correlate with shorter-term headlines.
These core beliefs, and our high conviction in the process behind them, mean that periodically our portfolios will look different and perform differently than the overall stock market. At times, we may appear to be missing short-term appreciation in certain areas of the market. We are in one of those times today. We know we cannot predict the market in the short run, so we do not know when this period will end. We do know, however, that periods where price momentum matters more than fundamental durability have historically not lasted forever.
What else do we believe at Crawford? We believe Artificial Intelligence is real, important, and likely to have a lasting impact on the economy and our lives. It is clearly the dominant force in the equity market today. AI is driving capital spending, earnings revisions, market concentration, and investor psychology. It is also creating a meaningful gap between companies perceived to be direct beneficiaries and those viewed as vulnerable to disruption. In other words, the current AI investment cycle is large, and the potential productivity benefits are meaningful. How and when those benefits ultimately appear in revenues, margins, and earnings is still unknown in many cases. Investment is being made upfront, while the revenue and productivity gains may arrive over a longer period of time.
What do we not believe? We do not believe investors have to be early in every new technology company to earn attractive and competitive returns over time. As companies mature, they actually become safer investments in many cases. The internet changed the world, but not every company that benefited from early internet enthusiasm and adoption proved to be a good investment. We expect AI will follow a similar pattern. The technology will proliferate, many companies will prosper, and some businesses will become more productive and valuable. But not all of the initial investment darlings will persevere.
This is where the quote becomes relevant. Scott McNealy made his comment after Sun Microsystems had experienced a share price decline of more than 90%. Sun had been one of the “pick and shovel” companies of the internet boom, providing key technology infrastructure in servers during a period of extraordinary growth. Its business expanded rapidly in the late 1990s, but it became a cult stock, and the share price rose much more than the underlying fundamentals, which is typical for stocks that are enjoying cyclical benefits in a speculative, high-growth environment.
After the dot-com bubble burst in 2000 and share prices declined, McNealy questioned the logic of investors paying more than 10 times sales for his company a couple of years prior. His point was simple and powerful. At that valuation, an investor was effectively requiring the company to return 100% of its peak annual sales for ten straight years just to support the price paid and for investors to get their money back. Sales, unlike earnings, assume no costs, no taxes, no reinvestment, no employees, and no business disruption. In the real world, very few companies can support that type of valuation for long.
Our point today is not that AI is the same as the internet bubble, but there are similarities. Twenty-seven years ago, our clients had a return experience in 1999 that is reminiscent of today, but we maintained our discipline, and we were handsomely vindicated in the next few years. The difference today is that the businesses leading the current market are generally stronger, more profitable, and more established than many of the companies that led the market in the late 1990s. However, even great companies can become poor investments if too much optimism is embedded in the price. Valuation mattered then, and it still matters now.
Today, a striking share of the S&P 500’s market capitalization is represented by companies trading at more than 10 times sales. A relatively narrow group of companies has accounted for a large share of market returns, while many high-quality, growing businesses that are AI-agnostic have not been rewarded at all. This has created a disconnect between stock prices and current business fundamentals, especially as investors have migrated toward the AI beneficiaries, fearing those that might experience slower growth in the future. Stocks of companies with durable earnings power, strong balance sheets, consistent cash flow generation, and long records of returning capital to shareholders are not being appreciated, even as many of these businesses themselves have delivered strong revenues, solid earnings, and favorable forward revisions.
The broader economic backdrop also remains constructive, but more complicated than headline equity returns suggest. Growth is positive, but uneven. The labor market remains stable, but consumer confidence and lower-income spending are showing signs of pressure. Inflation has not returned fully to target, and it has now been above 2% for over 5 years. Higher energy prices have only made the path forward less certain. Expectations for lower interest rates have been pushed further into the future. This may create a more difficult environment for consumers, smaller businesses, rate-sensitive industries, and highly levered borrowers. The capital-intensive nature of the AI buildout, highly indebted governments, and growing private-market financing all also contribute to a more levered financial system that may be more vulnerable to shocks. In our view, the current environment and backdrop are not weak, but they are fragile.
These crosscurrents argue for balance, selectivity, and patience. At Crawford, we are actively evaluating where AI may enhance productivity, expand margins, improve customer value, or create meaningful competitive advantages. We are also considering where AI may disrupt existing profit pools. Importantly, we believe many of the businesses we own are better positioned than their current valuations suggest. Some may benefit directly from AI adoption, while others may use AI to improve efficiency and deepen existing competitive advantages. Still others may prove resilient because their value proposition is rooted in essential products, recurring demand, trusted relationships, or disciplined capital allocation.
Our longstanding fundamental discipline can be challenged when speculative areas of the market are moving rapidly, as they are today. In some ways, this is a period when price momentum appears to matter more than business durability. We continue to believe that quality, valuation, and long-term fundamental sustainability are especially important when enthusiasm is high. Over our firm’s history, we have applied discipline that has helped us avoid many areas where speculation, a focus on the short term vs. long run, enthusiasm, leverage, or valuation risk moved faster than underlying fundamentals. We are doing the same today. This philosophy will not always keep pace with the most speculative areas of the market. However, we believe it provides a more predictable path to compounding capital over full market cycles.
Stock market cycles come and go. And they can revolve around an investment philosophy. Of utmost importance is that the philosophy remains in place. Ours will, and we continue to believe that it will serve our clients well over the longer term. Thank you, as always, for your continued trust and confidence.
Crawford Investment Counsel (“Crawford”) is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Crawford, including our investment strategies, fees, and objectives, can be found in our Form ADV Part 2and/or Form CRS, which is available upon request.
This material is distributed for informational purposes only. The statements contained herein reflect opinions, estimates and projections of Crawford as of the date hereof, and are subject to change without notice. This material is not financial advice or an offer to sell any product. Forecasts, estimates, and certain information contained in this commentary are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Any projections herein are provided by Crawford as an indicator of the direction Crawford’s professional staff believes the markets will move, but Crawford makes no representation such projections will come to pass. Crawford makes every effort to ensure the contents have been compiled or derived from sources believed reliable, and contain information and opinions that are accurate and complete; however, Crawford makes no representation or warranty, express or implied, in respect thereof; takes no responsibility for any errors that may be contained herein or omissions; and accepts no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Crawford reserves the right to modify its current investment strategies and techniques based on changing market dynamics or individual portfolio needs.
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