Dear Partners
Throughout 2024, Delphi’s performance was primarily driven by a significant improvement in the profits of the companies we invest in. According to third-quarter 2024 data (as fourth-quarter reports have not yet been released), the average operating profit of the companies in our portfolio grew by more than 30%, a rate significantly higher than overall market profit growth.
If we consider the S&P 500 as representative of the market, its profit growth was about one-third of the profit growth of the companies in our investment portfolio. Without a handful of large technology companies (most of which we invest in), profit growth in the market was single-digit, about one-fifth of the profit growth of the companies in our portfolio. This is the essence of Delphi, in our view, to try to select companies whose business performance is significantly better than the market.
In 2024, we made no major changes to the companies we hold, apart from a significant reduction in our investments in Apple and Interactive Brokers. While both companies continue to perform well operationally, their current stock prices no longer meet our return targets. Our goal is to invest in the highest-quality businesses, as long as their stock prices reflect the potential for double-digit average annual returns. We would be happy to repurchase shares in these companies at more attractive prices. In addition, we reduced our investment in General Motors until we have more clarity on U.S. policy regarding companies with substantial production operations in Mexico.
Conversely, we are purchasing shares of Adobe, as its share price declined over the course of 2024 and we believe it holds strong profit growth potential in the coming years.
Beyond the substantial performance gap between our portfolio companies and the broader market, we believe it’s equally important to emphasize the gap we see in future return potential. Despite delivering a net return of over 18% this year, we believe the current share prices of our holdings still do not fully reflect their superior profitability, exceptional growth potential, and financial strength.
What does it mean when a stock is cheap or expensive?
This can be illustrated using two charts published by The Economist in an article discussing the long-term return potential of the S&P 500 over the coming decade. The basic idea is straightforward, the more expensive the index, the lower its long-term return potential; the cheaper it is, the higher the return potential. In simple terms, it’s better to buy low and less attractive to buy high.
The right-hand chart shows the price level of the index, measured by the price-to-earnings ratio, that is, how many times higher the price of the stocks is compared to their earnings. At present, the ratio is close to 40. This means that if you want to invest in a company earning one billion dollars a year, you would need to pay 40 billion dollars for it and wait 40 years to recover your investment. In other words, such an investment would yield a return of just 2.5 percent annually. By contrast, if the multiple were 5, you would only need to pay 5 billion dollars, generating a 20 percent return and recouping your investment in five years.
The left-hand chart shows the actual returns the index generated over the decade that followed each entry point, depending on the valuation at the time of investment. The x-axis shows the implied expected return at the time of the investment, while the y-axis shows the actual return realized over the following decade. Unsurprisingly, when the expected return was low (i.e., the price was high), actual returns were very low, or even negative. When the expected return was high (i.e., the price was low), actual returns were also high.
These charts demonstrate that today’s market valuations are relatively high and that the future return potential of the broad market over the next decade is likely lower than what investors have grown accustomed to over the past 15 years. At Delphi, we don’t invest in the general market or in leading indices. Our focus is on identifying profitable, growing companies whose prices still reflect high return potential. This not only significantly increases the long-term return potential of our portfolio, but also helps reduce the risk associated with investing.
In Conclusion
The earnings growth of the companies in our portfolio during 2024 was exceptional, both in absolute terms and relative to the broader market. We believe this strong earnings growth will continue in the years ahead. Among the companies delivering market-beating performance, we continue to allocate your capital to those trading at prices that reflect the highest profit potential we can find. Given the current valuations of most companies in the market, selectivity is more important than ever for investors seeking to reduce risk without compromising on long-term return potential.