Portfolio Review
Our results are detailed in the table below. As we have often said, we place no weight on short-term results, good or bad. When we think we can improve our prospective long-term returns and lower risk, we will make those decisions without regard to their effect on short-term performance.
We generally write a detailed annual letter focusing on the long term and more abbreviated quarterly letters. This first quarter 2026 letter is an exception. Throughout 2025, accelerating in the fourth quarter, and reaching a fever pitch during the first quarter of 2026, “the market” has become frantic about AI disruption fears. We believe investors are prudent to consider the positive and negative impacts that AI might have. However, this proper response to what we believe will be transformative technology has morphed into hysteria. As a result, some of the best businesses in the world, that are rarely ever cheap, have become significantly discounted. We believe that some companies will be disrupted by AI but that others will benefit from it and for some it will have a neutral impact. The market is not differentiating between the three.
The current panic over AI disruption reminds me of the financial crisis when any company that had anything to do with financial services was thrown into the trash heap. It was sell first and ask questions later. We did differentiate and avoided ALL banks while making Mastercard (MA) one of our largest positions. Its average weight in 2009 was approximately 6.5% in Large Cap and approximately 9.7% in Focus and Focus Plus. Mastercard has delivered a nearly 23% gross compounded annual return during the 17 plus years we have owned it versus 14.1% for the S&P 500 over that same time period. Our money weighted return is even better because, following our investment discipline, we have added to it when it was more discounted and trimmed it when it became more fully valued. Obviously, not every investment follows this path and outcomes will vary, but our experience with Mastercard demonstrates the importance of hard-nosed, objective, deep research instead of following the whims of “Mr. Market.”
We believe that we are buying Mastercard quality businesses at financial crisis era discounts. We have owned some of these businesses in the past and sold them many years ago. Some we have followed for many years, but we have never been able to own them because they have always been overvalued by our math. The same math today suggests they are extremely discounted. How discounted? $0.50 on the dollar. Just over $0.40 on the dollar. Consequently, we have been very active in executing our investment discipline. We have sold more fully valued companies to buy more discounted companies. Moreover, we believe the deeply discounted companies we are buying are even more competitively entrenched than the businesses we are selling.
This once in a decade opportunity has resulted in two outcomes. Very importantly, we have improved our price to value ratios across the board. Every portfolio has a weighted average price to value ratio approaching $0.50 on the dollar and some are in the upper 40’s. This accomplishment means that we have reduced risk in our portfolios and have also improved our prospective returns. We have done so within the context of a market that is certainly not cheap by historical standards. While the market averages have remained relatively steady there has been violence below the surface with individual names. The second outcome is that we are paying a price in terms of short term performance. In every letter we have ever written we have said we will willingly sacrifice short term performance when we can reduce risk and improve our prospective long term returns. That is exactly what we have done starting in last year’s fourth quarter and continuing through the first quarter of 2026.
In our view, stock price volatility is not risk if we limit ourselves to companies with inherently stable values. It is an opportunity to improve our margin of safety. That begs the question, are our values stable? From a financial point of view our companies are very stable – more on this below. Our companies produce prodigious amounts of free cash flow and have strong balance sheets. From a qualitative perspective they are competitively entrenched. That leaves disruption risk from AI. The fear is that even though our companies are doing well financially now, they will be negatively impacted by AI in the future so that our terminal values are at risk. How do we have conviction that the companies we are buying will not be disrupted?
We have always been hyper-focused on disruptions of any kind. We exited “old media” stocks approximately ten years ago because we believed their business models would be disrupted by streaming. In the first decade of our operations they were a large and successful part of our portfolios. On the other hand, we have continued to successfully own a number of companies in the payments industry, which we first started buying during the financial crisis. Those businesses also faced potential disruption from fintechs, blockchain, cryptocurrencies, digital currencies, and most recently, AI agents. Unlike the old media companies, we believed that the payments companies we owned were competitively entrenched enough to withstand potential disruption and, in some cases, benefit from it.
We have been evaluating AI related disruption risks for years and have been especially active in evaluating those risks since OpenAI released ChatGPT. We feel like we have some insights in this area having internally developed our own AI models years before anyone heard of ChatGPT. We maintained our investment in Alphabet (GOOGL) in the face of AI related worries because we believed their competitive strengths would enable them to defend their core business and that they were more likely to benefit from AI than to be disrupted by it. That decision has paid off extremely well. What kind of research do we do to assess disruption risks facing the businesses we own? We talk to everyone all the time. Who exactly is everyone? We spend a lot of time talking to people who disagree with us. Many of them are on the sell side. Many of them are journalists. We talk to independent consultants who advise Chief Technology Officers as to how to allocate their resources. We talk to the chief “AI decision makers” at very large organizations. We talk to the companies we own and to companies that we might own. We talk to key investors in OpenAI and Anthropic. We talk to CEOs who are making strategic decisions regarding AI. Some of them are the CEOs of companies we own and some of them we do not own but they are our friends. We talk to people who have made investments in software companies and in AI companies.
We place more weight on insights from operators and decision makers who have capital at risk. As mentioned above we spend a lot of time talking to people who disagree with us. We compare their negative thesis to ours and try our best to objectively determine which argument is more valid. When new facts emerge, we change our minds. Our research has led us to several insights which are incorporated into our capital allocation decisions. They are:
AI disruption fears are valid in general.
We avoid businesses with a higher risk of AI disruption.
AI disruption risk is unknowable for a number of businesses. We avoid them as well. If we do not know we do not play.
These businesses sell at steep discounts to our estimate of intrinsic worth, so we own them with a large margin of safety if we are wrong.
We see three basic categories of businesses with real and/or perceived risk of AI disruption. They are:
- Software
- Alternative Asset Managers
- Indirectly impacted businesses which include insurance, credit ratings, financial data providers, real estate service providers, and payments among others. Who knows, soon it might include fast food companies (our feeble attempt at humor).
SAP (SAP) is in the first category – software. We owned it a number of years ago. We also owned its primary competitor, Oracle (ORCL). Since we sold it, it has not been discounted enough to be even remotely interesting until recently. During the first quarter, SAP reported double digit earnings growth in 2025, forecasted continued double digit earnings growth in 2026 and accelerating earnings growth in 2027. Its stock price declined 16% that day. We started buying it a couple of weeks later.
SAP and Oracle both dominate Enterprise Resource Planning software or ERP. ERP is an extremely complex software system used by larger, complex companies to manage their core operations and coordinate activities across all functional areas. They enable managers to have the information they need across the organization to allocate resources, make real time decisions, and execute those decisions across multiple intertwined aspects of the business. For example, Mercedes-Benz Group (MBGYY) uses SAP to coordinate its global operations – everything from supply chain management, inventory management, factory utilization optimization, and retooling, to sales and marketing forecasts, human resource management, compliance with regulations from multiple jurisdictions around the world, finance, budgeting, and financial reporting. The company could not produce audited financial statements without SAP’s ERP system. Delta Airlines (DAL) also uses SAP’s ERP. I could describe the complexities of its global operations, but I am trying to write a letter instead of a book. Some have described trying to “rip out” an ERP system akin to attempting to remove the circulatory system from a human being. In other words, it is impossible.
We have bought businesses at discounts because they were missing their quarterly projections due to the difficulty of implementing a new ERP system. ERP is a system of software, not a single product, operating across the enterprise, which creates a powerful network effect. It is extremely unlikely that a company would use AI to build and maintain its own software application for a specific part of an operation. However, if they did it would still have to communicate with and coordinate through the entire organization to be effective. How would it do so? It would have to use ERP. CEOs and AI leaders we have talked to tell us that ERP drives AI, not the other way around. We believe that SAP will be able to use AI to make its ERP systems more useful and therefore even more valuable to their customers.
Ares (ARES) is in the second category. It is an alternative asset manager widely considered to be the leading private credit provider globally. Its value has compounded at double digit rates while we have owned it. Its stock price declined 6.2% last year and 31.6% during the first quarter on AI related fears. Specifically, bears are worried about its exposure to software companies and about clients allocating capital away from ARES because of AI related fears about that same software exposure. Let us dissect both related arguments.
First, ARES exposure to software is a relatively small proportion of its portfolio. Second, its exposure is in credit, so ARES has the most senior position if the companies begin to struggle. Their loan to value ratio is approximately 37%. The companies are not struggling, and default rates are close to zero. The average duration of their loans is about three and a half years so they will get all of their money back or refinance relatively soon, before AI causes financial stress, if it ever does. ARES has been aware of AI risks for many years and has been very selective in the types of companies in which they invest. Assuming we are wrong and 15% of their software loans default we estimate it would only reduce the company’s growth rate by 3% or 4% for one year and that ARES would continue to grow at a double digit rate.
Second, ARES has a very impressive track record minimizing credit losses going back to the financial crisis. Most of the funds they manage are institutional, which provides stability. Their assets under management continue to grow nicely. Their primary “wealth channel” or “retail” related assets under management comes from ARCC, a business development company that acts like a closed end fund. Investors can sell ARCC’s stock but they cannot force ARES to liquidate ARCC’s loans. Bears have cited meaningful fund withdrawals at Blue Owl (OWL), a smaller ARES competitor that is much more retail oriented with less stable capital than ARES, as a reason to sell ARES. We looked at Blue Owl several years ago and decided it did not qualify for investment precisely because its structure is inferior compared to ARES. We believe that fears expressed by the bears are not supported by facts so that ARES’ value is stable and that its stock price decline represents a compelling buying opportunity. We have been buying. Ryan Specialty Holdings (RYAN) is in the third category of perceived indirect AI risks.
Ryan was founded by Pat Ryan, who also founded AON (AON) and turned it into the second largest insurance broker in the world. RYAN is one of three Excess and Surplus or E&S brokers that dominate the U.S. market. E&S is more complicated, specialized insurance that is sold to manage risks not adequately covered by the highly regulated admitted or standard insurance market. The E&S market is growing much faster than the admitted market and RYAN is gaining market share, so it has been growing at a solid double digit rate for many years. E&S and RYAN continue to gain market share, but the insurance market is inherently cyclical with regard to price. We are entering a soft market with price declines for certain segments, especially property. As a result, RYAN’s growth is slowing in the short run and its stock price declined meaningfully in 2025.
More recently, RYAN’s stock price has declined meaningfully again on AI related fears. During the first quarter, OpenAI announced a partnership with Insurify, a privately held company using an app to sell auto insurance to consumers. They are adding AI functionality to the app. Most auto insurance is sold through the admitted market. RYAN does not sell any consumer auto insurance. RYAN mostly sells very complex E&S insurance for its clients, who include very large insurance companies. They trust RYAN to help them manage risks that can be as much as several hundred million dollars. We asked the CEO of one of these large insurance companies if they would consider using AI instead of an E&S broker such as RYAN to place these large, complex risks. The answer was an emphatic, “No.”
On the other hand, RYAN is using AI to lower costs and provide faster, better risk assessment by making its brokers more efficient. We believe that RYAN will benefit from AI as opposed to being harmed by it. We have been buying RYAN.
You will learn more about these businesses and see other examples as you read the portfolio activity in each of our strategies.
To give you a sense of what you and we own together we are going to share some characteristics of our Focus and Focus Plus portfolios with you. The companies in Focus and Focus Plus are among the largest weights in our Large Cap portfolio and also feature prominently in All Cap. We cannot reveal details about individual names because that could interfere with our ability to trade on your behalf. Instead, we have taken a weighted average of the key metrics of each company and combined them to form one “company” we can analyze together. We will call it Focus Industries ¹ .
What does Focus Industries look like? It is one of the global leaders in every business in which it participates. It produces a large and growing free cash flow coupon. It has a strong balance sheet. Its value is stable and grows consistently. Its management team members are excellent operators, hyper focused on improving their competitive position, ethical, shareholder oriented, and very good at capital allocation. They have a strong sense of what the business is worth and are using its free cash flow to repurchase its discounted shares, which is increasing our value per share growth over and above the company’s organic growth rate.
Some numbers: Focus Industries’ return on invested capital is approximately 37%. Think about that number for a moment. When this company retains capital instead of paying it out to us in the form of dividends or share repurchases, we enjoy a 37% return on that capital. Focus Industries grew its revenue approximately 13% over the last twelve months. Profits, most of which are in the form of free cash flow, grew approximately 15%. Combined with intelligent reinvestment of the free cash flow coupon, its value per share grew approximately 21% over the past year. Its “stock price” as measured by our Focus and Focus Plus trailing twelve month total return was -12%. This disconnect caused its price to value ratio to improve dramatically.
Please note that approximately 1/3 of the improvement in our price to value ratio was from a lower price and two-thirds was from value growth.
How about recent results? In the most recent quarter, revenue growth was approximately 12% year over year. Profits grew approximately 13% year over year. Free cash flow was robust. Focus Industries continued to repurchase its stock at ever more attractive prices. During the first quarter of 2026 when its “stock price” declined by -21%. Its value per share increased approximately 2.35% compared to the fourth quarter of 2025. That 2.35% increase in value per share over the last three months does not sound very impressive but it is certainly stable.
These numbers demonstrate Vulcan Value Partners’ dual discipline. We limit ourselves to companies with inherently stable values. We only purchase them when we can do so with a meaningful margin of safety in terms of value over price. We cannot protect you or us from short term stock price volatility but we can take advantage of it to lower risk and improve our long term prospective returns, following our investment discipline. Said differently, our investment philosophy is not designed to shelter us from short term volatility. It is designed to take advantage of it to lower risk and improve returns for long term investors.
The value is very stable compared to its stock price which gives us the opportunity to buy more at an extremely attractive price to value ratio. Client-partners, this means you. You have the opportunity to buy more by adding capital to your accounts. Those of you who have done so at these price to value ratios in the past have been well rewarded.
We can back up this statement with numbers. Call us and we will be happy to share it with you. Here is one piece of data: In the first 23 months of our operations, just one month shy of two years, our best strategy had a compounded return of negative 24.49%. We avoided the overvalued names that had their last gasp of outperformance in 2007. We then allocated capital into some of the best businesses in the world at $0.60 on the dollar in 2008 as the great financial crisis began to unfold. Their prices continued to fall, and we added to them at $0.40 on the dollar in early 2009. Our weighted average price to value ratios were similar to today. Ten years from our inception date, a period of time that included the first two years of dismal performance, Large Cap was in the top 2% of its peer group, Small Cap was in the top 2% of its peer group, and Focus Plus was in the top 3% of its peer group. Focus and All Cap did not have ten year track records at that time. I repeat, those of you who have added capital at these price to value ratios in the past have been well rewarded.
C.T. Fitzpatrick, CFA
Chief Investment Officer
References
- 1 Focus Industries provides a hypothetical, aggregated representation based on internal assumptions and is subject to limitations. It does not reflect any actual client portfolio or performance
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