2025 was a particularly difficult year for active equity managers broadly. At its core, Sage Capital’s investment process focuses on company earnings while controlling for valuation swings driven by macroeconomic risk. However, the market we have witnessed has been one where some stock valuations have continued to rerate upwards despite earnings remaining flat or declining.

This was most evident in parts of the Australian banking sector. Stocks such as Westpac and Commonwealth Bank currently trade around three standard deviations above their long-term average price-earnings multiples, despite earning more than they had forecast to a decade ago in any of the next three years. We believe this outcome has largely been driven by structural fund flows, particularly an extended period of industry super funds bringing investment teams in-house. This has involved redemptions from active investment managers and increased allocations to index strategies or internal overlays, resulting in broad-based buying of large index constituents. Similar valuation effects have been observed across other low-growth large-cap stocks, including Wesfarmers.

Traditionally, retail investors have favoured these stocks for their income characteristics. In our view, super funds have driven valuations to levels that encouraged retail selling and the realisation of capital gains. Conversely, several high-quality companies that are well owned by active managers, such as ResMed, experienced valuation compression despite delivering positive earnings. We believe these flow-driven dynamics are beginning to moderate. As ownership levels normalise, we expect equity market returns to increasingly reflect underlying earnings outcomes rather than capital flows.

Historically, our investment process can experience periods of underperformance, whether due to suboptimal stock selection or when sound stock selection is not rewarded by the market. Elements of both factors were present over the past year. This is not a new experience for the investment team, the investment process has been in its current form since 2006, with its quantitative foundations dating back to the late 1990s at AMP. Over this time, it has navigated multiple market cycles, including the dot-com bubble, the Global Financial Crisis, the European sovereign debt crisis, and more recently COVID, underscoring its robustness.

Our investment team faced a particularly challenging drawdown in 2013 before rebounding strongly the following year to become the best performing fund in 2014. Periods in which earnings and valuations diverge, and where thematic trades reduce stock dispersion within subsectors, have historically proven difficult but temporary. Importantly, these periods have also created attractive alpha opportunities as markets normalise.

Our approach remains unchanged: diversified, style and sector controlled, and firmly focused on company fundamentals.