Identifying Durable Value in a Market Reverting to Reality

The starting point for any disciplined investor is a clear sense of price versus value. As of December 31, 2025, the US equity market was trading at a 4% discount to a composite of our fair value estimates. This precise gap is the core of the current opportunity. It marks a decisive shift from the recent past, where nearly 90% of S&P 500 companies posted positive returns from 2020 through 2024-a period some have called a "casino" market. Now, with the market finishing 2025 up more than 17%, we see a return to a more traditional investor's market, where around 40% of stocks are heading for a negative year in 2025.

This discount, however, is not evenly distributed. It is heavily skewed by the extreme concentration of mega-cap technology stocks. The valuation of the market as a whole is being pulled down by these giants, which have seen their fair value estimates increase dramatically. For instance, our intrinsic valuation for Alphabet rose by $2.5 trillion, Nvidia by $1.2 trillion, and Broadcom by $740 billion in just the fourth quarter. When you remove these three behemoths from the calculation, the picture changes dramatically. Excluding Nvidia would increase our price/fair value estimate metric to 0.98, and excluding Alphabet and Broadcom would yield a price/fair value estimate metric of 1.00. In other words, the market is fairly valued only when you strip out the three largest companies.

This concentration is the key to understanding the setup. The market's average discount is a statistical artifact of how much these few names now dominate the index. For the patient investor, this creates a fertile ground. The discount is real, but it is also a signal that the market's focus has been distorted. The broader market, particularly in sectors like technology and communication services, is now trading at an 11% and 9% discount respectively. Small-cap stocks, meanwhile, remain especially attractive, trading at a 15% discount. The shift from a market where nearly all stocks were rising to one where a clear majority are facing a negative year is a return to normalcy. It is in this environment, where value is being priced in and the noise of the mega-cap rally has receded, that durable opportunities begin to emerge.

The Competitive Moat: Assessing Durability

The market's new reality is one of sobering valuations. The S&P 500's price/earnings ratio stands at 31, a level reached only a few other times in history. This high bar sets a brutal standard. It means that for a stock to be fairly valued, its future earnings must be exceptionally durable and predictable. In a casino market, any risk could pay off. Now, with the lights up, the house edge is clear: only companies with a wide economic moat-their ability to compound earnings over long cycles-can support such prices.

A wide moat is the foundation of compounding. It comes from a dominant market position, a significant cost advantage, or powerful customer lock-in. These structural advantages protect profits from competition and allow a business to reinvest its cash at high returns. In the current environment, where the market is pricing in perfection, these moats are not a luxury; they are the absolute requirement for survival and growth.

The rise of artificial intelligence adds a new layer to this analysis. Companies using AI to improve operational efficiency or deepen customer relationships are more likely to sustain and even widen their advantages. This is operational leverage, not just another line item in the capex budget. The market is beginning to look past the hype and demand results from all that AI spending. The risk is for companies that are merely investing in AI as a cost center, hoping for future benefits, without a clear path to a durable competitive edge. Their valuations will be the first to face pressure.

The bottom line is one of narrowing opportunity. With concentration high and valuations stretched, the path to outperformance is no longer about chasing the latest trend. It is about identifying those rare businesses whose moats are so wide and their prospects so durable that they can still compound through a slower-growth, more competitive reality. For the patient investor, the search is for companies that can earn their high price, not just hope for it.

Specific Value Opportunities: Intrinsic Value vs. Price

The market's 4% overall discount is a starting point, but the real opportunity lies in the specific pockets of deep value. The data reveals a clear performance gap: the Morningstar US Market Index gained more than 17% in 2025. For the patient investor, that rally is now in the rearview. The path to outperformance in 2026 likely involves a rotation into sectors and styles that have been left behind, where the margin of safety is most significant.

By style, the deepest discounts are found in small-value stocks, which trade at a 23% discount to our fair value estimate. This is a powerful signal. It suggests that the market's focus on mega-cap growth has left behind smaller companies with strong fundamentals, creating a fertile ground for value investors. For all that, the broader small-cap universe remains especially attractive, trading at a 15% discount.

Sector analysis points to several compelling areas. Real estate stands out as the most undervalued sector, at a 12% discount. This includes defensive areas like healthcare facilities and wireless towers, which offer stability. Technology and communication services, while still trading at an 11% and 9% discount respectively, show that the mega-cap concentration is the primary driver of the market's average valuation. The energy sector, which significantly underperformed the market last year, is another key area. US domestic oil producers like Devon Energy (DVN) exemplify the deep discounts available in this space, where negative sentiment on oil prices has created a clear mispricing.

The setup is straightforward. A rotation into these undervalued sectors-driven by a search for better intrinsic value-could be the engine for market outperformance this year. The high bar set by the market's elevated P/E ratio means that only durable businesses can support a move higher. The current discounts in small-value stocks and real estate, combined with the clear performance gap of 2025, frame a clear path: wait for the market to reprice these overlooked areas, where the margin of safety is most generous.

Risks and Catalysts: What Could Change the Thesis

The patient investor's resolve will be tested by a mix of political and economic catalysts in the coming months. As we enter 2026, further volatility is anticipated, driven by a new Federal Reserve chair taking the reins in May, ongoing trade and tariff negotiations, and the ramping political rhetoric of midterm elections. These are the external shocks that can turn a steady compounding story into a turbulent one. The market's high bar-its price/earnings ratio of 31-leaves little room for error. Any disruption to the economic growth that supports these lofty valuations will be met with swift repricing.

The primary catalyst for the value thesis, however, is a rotation out of overvalued mega-cap growth. History suggests that outperformance like that from a single sector doesn't last forever. With the tech sector accounting for nearly 35% of the S&P 500 and the top 10 positions making up roughly 40% of the index, the lack of breadth is a structural vulnerability. The likeliest path for value stocks to outperform is not a crash, but a growth slowdown. If the current economic momentum, which saw annualized GDP growth of 4.3% in Q3 2025, begins to moderate, the market's focus could finally shift to the deep discounts now available in sectors like real estate and energy, and in styles like small-value.

For the investor, the test is clear. Watch for earnings growth that meets the high bar set by current valuations, particularly in the undervalued areas identified. The market's discount is a starting point, but it is not a guarantee of future returns. The catalyst for a move higher will be a rotation that is validated by fundamentals, not just sentiment. Until then, the risks-both political and economic-will continue to test the resolve of those waiting for the market to price in durable value.