As we close out the third quarter and look toward the final quarter of 2026, the investment landscape has changed considerably from where we began the year. The Federal Reserve has now raised interest rates by 0.25% at their September meeting. This was the first rate increase in more than three years and reflects a meaningful change in the inflation picture. The Fed continues to describe economic activity as solid, but inflation remains elevated and recent energy cost increases have made the path back toward the Fed’s 2% target more difficult.
One of the biggest concerns we see heading into the final quarter is the changing nature of inflation. Earlier in this cycle, much of the inflationary pressure was associated with supply-chain disruptions and temporary shortages. Today, parts of the pressure appear more structural in nature. For example, diesel prices have reached record levels, with the national average recently exceeding $6 per gallon. Higher diesel costs work their way through a much broader portion of the economy than a simple increase at the gas pump. This is because diesel costs are far more embedded throughout the economy as they affect nearly all facets of supply chains—from trucking and agriculture to construction, manufacturing, and the transportation of food and other consumer goods.
This creates what we would describe as an inflation “hangover.” Even if energy prices stabilize from current levels, businesses and consumers are likely to continue to feel the effects of higher transportation and production costs for some time. This is an important distinction for investors. A temporary spike in oil prices may eventually reverse, but the increased cost structure created by sustained diesel prices can take considerably longer to work through the economy.
The other major theme we continue to monitor is the enormous investment taking place in Artificial Intelligence. We remain confident that AI has the potential to be one of the most important technological developments of our lifetime. However, the scale, competition, and financing of the current buildout deserve attention.
The four leading hyperscalers are engaged in an extraordinary race to build data centers, secure power, acquire chips, and expand computing capacity, with each company essentially competing for many of the same customers and ultimately the same pool of AI-related revenue. Which creates an important economic question: how much revenue will ultimately be generated relative to the enormous amount of capital being deployed to produce it?
Increasingly, these investments are no longer being funded by existing cash flows, but now through significant debt and equity issuance. As the amount of debt needed to finance the AI buildout increases, investors are beginning to demand higher yields to compensate for the additional credit risk and uncertainty surrounding the ultimate returns on that capital.
Equity issuance presents a different but equally important headwind. For much of the past decade or two, many of these companies were significant buyers of their own shares, through stock buybacks, allowing strong free cash flow to reduce share counts and enhance per-share earnings. Issuing new shares reverses this dynamic, increasing the number of shares outstanding and potentially diluting existing shareholders and per-share earnings.
None of this diminishes our belief in the long-term potential of AI. Quite the opposite. The question is whether the economic returns from that technology will arrive quickly enough to justify the enormous amount of capital being invested today. As we discussed in previous commentaries, there are similarities to the telecommunications and fiber-optic buildout of the late 1990s. Companies had to invest heavily to remain competitive, but the resulting infrastructure eventually exceeded near-term demand. The technology was real and transformative; however, the investment cycle simply moved faster than the economic return. The same possibility exists today. The opportunity may be enormous, but separating the potential of the technology from the economics of the investment required to build it will be increasingly important.
Companies will ultimately need to generate enough revenue and free cash flow to support the capital being deployed. As these enormous projects move into operation, depreciation will also become a larger expense and could become a meaningful headwind to margins if revenue growth does not keep pace with expectations.
These market conditions reinforce something we have discussed throughout 2026: concentration matters. The largest companies now represent an extraordinary portion of the market indices, and Technology and AI-related companies continue to account for a disproportionate amount of market performance. When a small number of companies drive such a large percentage of an index, investors can easily mistake index strength for broad market strength.
This is one area where our investment philosophy continues to differentiate our portfolios. Our more equal-weight approach across our core holdings naturally provides greater diversification than a capitalization-weighted index. Rather than allowing the largest companies to become an increasingly large percentage of a portfolio simply because their market capitalizations have increased, we maintain meaningful exposure across sectors and industries. This does not eliminate market risk, but it can reduce concentration risk and lessen the impact of any single investment theme falling out of favor.
There are many excellent companies participating in the AI revolution, but there are also many high-quality businesses outside of Technology that are being overlooked as capital continues to flow toward the AI theme. Companies with consistent earnings, strong balance sheets, durable competitive advantages, and a history of returning capital to shareholders may not generate the same headlines, but their ability to produce cash flow through a variety of economic environments is exactly what we value.
The market has continued to demonstrate an interesting ability to look beyond significant geopolitical events. We saw this earlier in the year when oil prices surged and concerns surrounding the Strait of Hormuz raised the possibility of a much broader economic disruption. While those events created volatility, the market ultimately continued to focus on the underlying health of corporate America. This remains an important reminder that headlines can dominate the short term, but earnings and cash flow tend to matter more over the long term.
As we move into the final quarter of 2026, we expect volatility to remain part of the investment landscape. Higher interest rates, elevated energy costs, the changing Federal Reserve environment, and the enormous capital requirements associated with AI all present legitimate challenges. However, we do not believe these challenges require abandoning a long-term investment strategy. Instead, they reinforce the importance of what we have emphasized throughout this cycle: quality, diversification, and discipline.
No one knows exactly how quickly AI investments will generate economic returns, how long elevated energy costs will persist, or when the Federal Reserve will be able to resume lowering interest rates. Attempting to predict each of these variables with precision is impossible. What we can control is the quality of the businesses we own, the diversification of the portfolios we construct, and how we react to headlines.
We continue to favor companies that have demonstrated the ability to grow earnings and revenues through multiple economic cycles, maintain strong balance sheets, generate meaningful free cash flow, and return capital to shareholders through dividends and/or share repurchases. These characteristics may not always produce the most exciting headlines, but they have historically provided a foundation for long-term stability and wealth creation.
As we have said many times before, volatility is not a matter of if, but when. The current environment provides another example of why we believe portfolios should be built before volatility arrives, rather than attempting to react after it does. Our focus remains on owning quality companies, maintaining diversification, and allowing the underlying earnings power of those businesses to compound over time.
| Thomas A. Toth, Senior Chairman | Kenneth Bowen, II President & CEO |