Third Quarter Market Discussion
There are periods in the market when paying attention to valuations can be penalizing, and the third quarter was one of those times. We saw a continuation of trends that began accelerating in the second half of Q2. Growing optimism surrounding the AI boom and the corresponding surge in electricity demand have helped power large- and mid-cap growth stocks to new highs regardless of business model quality or valuation. Honorable mention goes to continued chasing of speculative bets on crypto currencies where a business model is not required and where leverage is treated like vegetables, the more the better. If only our children would consume vegetables like crypto “investors” crave leverage. Not owning the highest-octane cyclicals put our Strategy at a disadvantage during the quarter, as lower multiple and/or defensive parts of the market were left behind in the market’s embrace of the thematic narratives regardless of price. To be clear, we believe AI is a disruptive technology, but many current perceived “winners” could fail to live up to the hype. This has been the case with other disruptive technologies ranging from the internal combustion engine to the internet.
Over the past three months, the Russell Midcap® Index advanced 6.18% while the tech-heavy Nasdaq Composite Index gained 11.24% in the quarter. Even within our universe of stocks, we saw similar trends play out. Returns for momentum in the Russell Midcap® Value Index outpaced value factors such as free cash flow to enterprise value by more than 14% over the past 12 months.
Still, pockets of economic weakness persist, including in the residential housing market where several industry participants have recently called out deteriorating demand in new construction and remodeling activity. Even areas of historical resilience, like replacing an air conditioning unit when it fails, are exhibiting abnormal demand weakness. Affordability is a persistent issue. Several negative economic datapoints on the job market developed in September, including disappointing job creation in August coupled with a larger-than-expected downward revision to non-farm payrolls for the prior year, dropping employment estimates by almost one million jobs.
As the chart below shows, changes in the trajectory of the job market, as evidenced by initial jobless claims, tend to persist for some time. A 20% spike in unemployment claims has foreshadowed recessions and the associated drop in equity valuations.
Source: FactSet Research Systems Inc. and The Leuthold Group. Monthly data, 12/31/1968 to 8/29/2025. This chart shows the year over year percent change for initial jobless claims on a 12-month moving average verses the S&P 500 normalized price to earnings ratio. The S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. Initial Unemployment (“Jobless”) Claims is a measure of the number of jobless claims filed by individuals seeking to receive state jobless benefits. Chart peaks for YoY % Change not shown are at a high 582% on 2/28/2021 and at a low of -75% on 3/31/2022. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
We’re not forecasting the timing of a recession, but history shows that when jobless claims start to rise, the trend generally doesn’t magically reverse course on its own. To us, this is suggestive of an environment where it makes sense to consider a wide range of potential outcomes and determine which of those outcomes are reflected in current valuation. This also seems to be the type of market where paying attention to the quality of what you own, and the price paid to own it is critical. For us, these traits are always at the forefront, along with the price paid for said attributes, based on our 10 Principles of Value Investing™.
As noted earlier this year, our Strategy’s day-to-day relative performance has been inversely correlated with the relative performance of a factor like momentum compared to a valuation attribute like free cash flow yield. The dramatic outperformance of momentum over free cash flow yield continued during the quarter and has coincided with extreme outperformance of high vs. low volatility stocks. However, we must also acknowledge that our stock-picking has made life harder in a generationally euphoric backdrop that challenges our style to begin with.
In the long run, we are confident that our approach to value, which is guided by our 10 Principles of Value Investing™ and its focus on attractively priced, financially sound businesses, will demonstrate its efficacy. We remain confident that a four-price target approach that respects a range of outcomes, valuation discipline and downside risk will prove its merits again. We remain unwilling to chase many companies in our universe that we consider either speculative or priced for perfection. In a generally expensive broad market, we observe valuation disparities across companies that are as wide as we can ever recall. We think this can be exploited with the right process and right time horizon.
Attribution Analysis
The Mid Cap Value portfolio was up 1.63% in the third quarter, trailing the Russell Midcap® Value Index, which was up 6.18%. Stock selection was responsible for most of our underperformance, as our selection effect was negative in Health Care, Financials, Consumer Discretionary, Energy, Industrials, Real Estate, and Materials.
In addition to our 10 Principles of Value Investing™, our Strategy is built around our “two-bucket” approach to portfolio construction. At all times, we aim to hold both high quality mid cap companies trading at bargains (“Quality Value”) and deeply discounted businesses that have produced poor economic returns over time (“Deep Value”) but that have a self-help catalyst to unlock value. Within value, each of these styles tend to take turns outperforming, just as periods of growth and value outperformance tend to alternate over time.
Portfolio Activity
Consumer Discretionary. Our best-performing holding in the quarter, D.R. Horton (DHI), came from our Deep Value bucket. The largest homebuilder in the country, DHI enjoys around a 10% market share with scale advantages in a highly fragmented industry.
The company has a particularly strong position in entry-level homes. To produce affordable housing, D.R. Horton runs the business with speculative inventory, meaning it builds homes before buyer contracts are signed. This allows the company to operate the business more like a manufacturer thereby reducing unit costs with most savings passed to the homebuyer. To accommodate this business model, the company’s balance sheet is notably strong, allowing for maximum flexibility in capital allocation. For more than a decade, management pivoted the company’s balance sheet away from owning large swaths of undeveloped land, preferring instead to use less capital-intensive methods to source buildable lots. This self-help strategy reduced the capital commitment to the business and increased returns on investments.
Along with the entire homebuilding industry, DHI sold off late in late 2024 and early this year, owing to weak demand and heavy discounting across the industry. We used the selloff to establish a position, marking our fourth time owning DHI. We further increased our weighting during the broad market selloff at the end of the first quarter and in early Q2.
The stock rose sharply this quarter on earnings that beat analyst expectations on both home deliveries and gross margin. In addition, orders — while flat year over year — exceeded the street’s expectations by more than 4 percentage points. Management accelerated its share repurchases, buying back more than 3% of the company in Q3 alone. That, plus falling long-term interest rates and a 13-F filing by Berkshire Hathaway detailing a new stake in DHI, also propelled the shares.
DHI currently trades at 2.1x book value, which is slightly higher than the company’s long-term median multiple of 1.8x. In our view, the company’s return on and of capital has structurally improved, which will inflate this multiple, all else equal. If not for $7 billion of share repurchases over the past 12 quarters, DHI would be trading at a discount of 1.5x, despite a sustainable return on equity of greater than 15%.
Information Technology. A standout Quality Value holding was Lam Research (LRCX). Lam is a supplier of semiconductor capital equipment (SemiCap) with a leading market position in technology integral to the production of the chip industry’s most advanced integrated circuits.
Over the past decade, the SemiCap industry has consolidated, with 5 companies controlling almost 75% of the market. Lam is dominant in the Etch market, a process by which chips are created by selectively removing materials from the wafer to transfer patterns. Industry consolidation and improved customer profitability helped create a structurally more profitable SemiCap industry over time. Lam’s leadership position with Memory customers proved fortuitous, as many of the key applications used by those customers became mission-critical for manufacturers producing today’s leading-edge chips (even outside of the Memory industry). This leaves the company uniquely positioned to gain share in an industry that already benefits from structurally higher customer capital intensity and growing base of recurring revenue. A cyclical downturn and market volatility earlier this year gave us the chance to buy shares at a compelling valuation. A new upcycle and clear market share gains helped drive strong recent performance in the shares.
Health Care. Our worst performing holding in the quarter was Centene (CNC). Shares of the managed care company suffered from a policy-induced risk pool shift in the ACA Healthcare Exchanges that negatively impacted profit margins and caused a pre-announced earnings cut, nearly a month ahead of the scheduled earnings release date. Frankly, we were evaluating a position size reduction given the policy changes but were surprised by the announcement timing. Recognizing the short-tailed nature of the liabilities (allowing faster adjustments than other forms of insurance), we waited for management to formally articulate their plans to address the issue in late July. We came away encouraged by aggressive pricing actions meant to reflect recent developments and restore margins. In September, the company provided a positive update on the action plan that helped shares begin to recover from July’s sharp selloff. Meanwhile, political pressure has intensified from both sides of the aisle to address the looming health insurance affordability crisis. Any policy improvement would further supplement the actions taken by CNC, which assume no relief. The stock trades at 11x 2026 earnings estimates which look increasingly beatable based on the recent update.
Outlook
Last quarter, the markets punished those who weren’t all-in on the AI boom and who paid attention to downside risks. However, as long-term-minded investors, we consider this basic table stakes for being active managers. It’s our job to consider as wide a range of outcomes as possible when constructing the portfolio to allocate capital based on the best risk-reward scenarios. This isn’t because we know exactly how the economy will unfold and fear trouble ahead; it’s precisely because we don’t know. In the meantime, our job is to focus on those things in our control, such as trying to select companies with strong balance sheets, management teams, business strategies, and earnings dynamics— and how much they paid for those attributes.