Valuation and the 2026 Landscape: A Value Investor's Perspective

The 2025 market cycle was a study in divergence. On the surface, it was a powerful rally, with the S&P 500 rising 17.9%. Yet this broad advance masked significant underlying pressure and volatility. The year opened with a sharp 16.5% drop in developed market equities in early April, a direct reaction to fears of a tariff-driven inflation spike. That the market ultimately shrugged off such a severe shock speaks to the powerful, risk-on sentiment that dominated the year. This "everything rally" was the first since the pandemic where all major asset classes delivered positive returns, driven by fiscal and monetary stimulus.

The setup for this rally was one of concentrated spending and stretched valuations. Artificial intelligence remained the dominant theme, with the communication services and information technology sectors significantly outperforming the broader market. This concentration is now a structural feature of the index. Evidence shows the gap between the best and worst performing sectors in the S&P 500 year-to-date remains historically narrow, with all sectors posting positive returns. This narrow dispersion, the lowest in 35 years, indicates a market where broad-based rotation is absent, and performance is being driven by a handful of mega-cap names.

This concentration is reflected in the index's composition. The top 10 holdings in the S&P 500 make up about 40% of the index, with NVIDIA alone accounting for 8%. The effective number of securities truly driving returns is just 44, the lowest level in decades. For a value investor, this is a critical signal. It means that a small cluster of companies, many with lofty valuations tied to future AI growth, are carrying the entire index. The market's forward price-to-earnings ratio is approaching levels seen before the 2000 tech bubble, a clear warning of elevated expectations.

The bottom line is that the 2025 rally, while strong, was built on a narrow foundation of concentrated AI spending. It left the market vulnerable to shifts in sentiment and raised questions about its resiliency. When the year ended, the US stock market was still trading 4% below Morningstar's fair value estimate. This gap, while modest, highlights that some areas remain undervalued even as the overall market appears stretched. For the disciplined investor, this creates a potential opportunity: a market where the broad advance has been driven by a few, leaving others to be found.

The Value Investor's Toolkit: Price, Moats, and Margin of Safety

The Vulcan Value Partners Fund operates on a simple, enduring principle: buy a dollar for fifty cents. Its strategy is to identify companies trading below its own estimate of fair value, with a particular focus on those possessing a durable competitive advantage. This is the classic value investing formula, applied with discipline. The fund's portfolio, as of September 2025, held 32 companies, with top holdings like Microsoft Corporation and UnitedHealth Group exemplifying its preference for large, established businesses with wide moats.

This philosophy is reflected in its performance. The fund's Large Cap Composite strategy has delivered a 7.9% net return year-to-date and a 9.6% annualized return since inception. More importantly, it has consistently outperformed its benchmark, the Russell 1000 Value Index, which returned 15.9% year-to-date. The fund's managers explicitly state they place "no weight on short-term results." Their focus is on improving the price to value ratio of the portfolio, even if that means accepting underperformance in the near term. They are willing to pay a price for a higher margin of safety, a stance that echoes the patient accumulation of "old economy" stocks during the dot-com bubble.

The fund's current valuation metrics frame this discipline. The portfolio trades at a P/E of 23.7x and offers a free cash flow yield of 6.4%. These numbers are not low by historical standards, but they represent a conscious choice. The fund is not chasing the cheapest stocks blindly; it is seeking value within quality. The free cash flow yield, in particular, signals a focus on companies generating substantial cash, a critical input for intrinsic value calculations.

The bottom line is that this fund is a textbook application of the value investor's toolkit. It targets a sustainable competitive advantage, demands a margin of safety through price discipline, and prioritizes long-term compounding over quarterly noise. In a market where the S&P 500 trades near historical highs, this strategy is a deliberate counterpoint. It acknowledges the bull market's strength but does not surrender to its momentum, choosing instead to build a portfolio where the odds of long-term success are tilted in the investor's favor.

Catalysts and Risks for 2026

The investment landscape for 2026 is set for a test of conviction. The base case, as outlined by Goldman Sachs, calls for a 12% total return for the S&P 500, driven by a projected 12% increase in earnings per share. This forecast hinges on a combination of healthy economic growth and continued Federal Reserve easing. For a value investor, this setup presents a clear framework: the market's advance will be validated by corporate profits meeting or exceeding these expectations. The catalyst is straightforward-earnings growth providing the fundamental base for a continued bull market.

Yet this broad outlook masks a critical divergence. While the index may climb on aggregate profit strength, the performance of its most concentrated holdings will be under a microscope. The AI stocks require even stronger growth to support their lofty valuations. This is the central tension. The top tech stocks, which accounted for over half of the S&P 500's return last year, are now carrying the weight of the entire rally. Their valuations are not just high; they are stretched to the point where any stumble in AI adoption or profit growth could trigger a sharp repricing. The market's forward P/E of 22x, matching the peak in 2021, offers little room for error.

This concentration also defines the key risks. A new Federal Reserve chair takes office in May, a transition that could signal a shift in policy tone. Ongoing trade and tariff negotiations add another layer of uncertainty, potentially disrupting supply chains and corporate margins. Then there are the midterm elections, which historically test market resolve. These events could serve as catalysts for volatility, challenging the market's dependence on a handful of mega-cap names. The fund's disciplined approach is to make decisions based on improving long-term returns and lowering risk, regardless of short-term performance. In this environment, that means focusing on the margin of safety.

The current valuation gap provides a useful benchmark. At the start of the year, the US stock market was trading 4% below Morningstar's fair value estimate. This suggests that while the broad market may be fairly valued, pockets of opportunity exist. The real risk is not a market-wide collapse, but a rotation away from the overvalued, concentrated AI names and into the rest of the index. For the value investor, the path forward is clear: monitor earnings growth for the broader market, but scrutinize the exceptional growth required to justify AI stock prices. The goal is to position for the catalysts that drive broad-based value, while remaining vigilant for the risks that could break the current, fragile consensus.