Half Year Review 2026

Humans have an impressive ability to rationalize all sorts of illogical behavior. Consider someone living on a fixed income, whether a retiree or a student. They may insist they are “sticking to their budget,” yet a vacation here, a dinner out there or a gift for a friend, each one filed away as a “one-time” expense, can collectively mean they are quietly spending a good deal more than they earn. This tendency is hardly confined to personal finances. It manifests itself across a wide variety of situations, and in today’s market environment, we believe that the power of this kind of rationalization is on full display. Much like our spendthrift on a fixed income, we also suspect it could, at least at some point, end with some rather unpleasant consequences.

Our team spends a good deal of its time analyzing businesses, and we encounter this kind of rationalizing regularly in the form of “adjusted” profitability metrics. In some cases, the adjustments are entirely warranted: an extreme currency translation effect, a write-down of a genuinely underperforming division, things that are truly unique and non-recurring. Stripping these out can help an investor understand the ongoing earnings power of a business, and we take no issue with that. The trouble arises when the “one-offs” show up every quarter, and then every year. At that point one must question the true, steady-state profitability of the business. At the same time, one must also begin questioning the credibility of management and their ability to account for their own expenses period after period and ask why all of these “one-time” events keep happening with such regularity. It is a simple example, but it sits close to the heart of what we do: working out what a business actually earns, and then deciding what multiple those earnings deserve, given the quality of the business and just how many “one-offs” we are being asked to look past.

None of this is to suggest that managements are acting in bad faith, or that every adjustment is a sleight of hand. Rather, we believe that the frequency and the pattern of the “one-offs” often tells you something that the headline, “adjusted” figure is designed to soften (or obscure). Learning to read that pattern can be incredibly useful in order to discern a truly durable earnings stream from one that only appears so on the surface. With that in mind, the current environment offers no shortage of interesting case studies.

Consider, for example, the number of IPOs currently coming to market with the promise of significant future cash flows. One such example, OpenAI, set to go public later this year, recently saw its financials leaked, revealing substantial losses alongside rapid revenue growth. The company generated roughly $13.1 billion of revenue in 2025, up from about $3.7 billion the prior year, against roughly $34 billion of total costs and expenses, leaving an operating loss of nearly $20.9 billion. It is easy enough to wave this away by arguing the losses are a necessary down payment on enormous future profits, and that scale will eventually sort everything out. There is even some data to lean on to support this: the research firm Exponential View recently estimated that global AI revenue, excluding China, reached roughly $25 billion in the first quarter of 2026, edging out the industry’s estimated $21 billion in depreciation tied to data center and chip investment for the second consecutive quarter. However, taking a closer look, there is also an argument to be made that this rests on its own quiet rationalization. Revenue may now indeed be covering depreciation, but depreciation alone still consumes more than two-thirds of revenue, leaving precious little to cover the very real (and rising) costs of power, labor, and financing. For many, especially those searching about for a reason to get involved in these “hot” businesses, the argument is essentially as follows: if you squint (and set aside a number of actual and necessary expenses) these companies are very nearly in the black.

On the topic of IPOs, consider the recent decision by Nasdaq to rewrite the rules of its Nasdaq-100 index to fast-track large new listings. Effective 1 May 2026, a newly listed company that ranks among the very largest by market capitalization can now enter the index within weeks of its debut, rather than waiting for the annual reconstitution. Nasdaq was not alone, with FTSE Russell adopting its own fast-entry rule allowing the biggest IPOs into its indices after as few as five trading days and relaxing its minimum float requirements to accommodate them. Similarly, MSCI moved to fast-track these names as well. The timing here is worth noting, considering that SpaceX came public on 12 June at a valuation of roughly $1.75 trillion, raising more than $75 billion in the largest IPO in history, at something on the order of 90 years’ worth of trailing revenue. The stated rationale for the rule changes was reasonable enough on its face: as companies stay private longer, they arrive at the public markets far larger than they once did, and the indices must adapt in order to keep “representing” the market. Yet this is hardly a new phenomenon, as companies have opted to stay private longer for quite some time now. It is at least interesting that the index providers managed to discover the need to change their inclusion rules precisely as a wave of mega-cap technology IPOs appear on the horizon. Indeed, FTSE Russell’s own consultation expressly cited the projected 2026 listings of SpaceX, OpenAI, and Anthropic as the impetus for the change. If nothing else, we will simply call the timing curious. To its credit, S&P Dow Jones Indices declined to follow, electing to keep its profitability and seasoning requirements in place, which leaves the very same companies that received the fastest, most accommodating treatment from some providers ineligible for inclusion in the S&P 500 for the time being.

It is worth pausing on what these inclusion changes actually set in motion. Taking into account ETFs, mutual funds, derivatives and other financial products like structured notes, roughly $1.4 trillion tracks the Nasdaq-100 alone, and the rule changes are estimated to compel billions of dollars of mechanical, price-insensitive buying across the Nasdaq-100 and the Russell indices as a name like SpaceX is absorbed. Funds that track these benchmarks are obliged to sell down their holdings in every other constituent, from Apple to Nvidia, in order to buy a single, very large, and very thinly-floated newcomer, and do so without regard to price. We have written before about our concern over the steady erosion of genuine price discovery as passive, index-based investing has grown, with an ever-larger share of capital simply taking prices as given rather than setting them on the basis of fundamentals. Within these inclusion changes, we are seeing this dynamic in an unusually vivid form: the index rules effectively manufacture a wall of demand for a business changing hands at roughly ninety times revenue, divorced from any judgment about what it is actually worth. It is difficult to think of a cleaner illustration of a price being set by index mechanics rather than by analysis.

Developments like these only reinforce our concerns about froth in equity markets, which by our reckoning has worsened, not improved, over the first half of the year. Comparing the historic earnings yield of the S&P 500 against the returns that have tended to follow over the decade hence as shown in the chart below, we cannot help but wonder what current valuations tell us about the long-term future returns on offer from large-cap U.S. equities, especially given the significant breakdown in the typically strong relationship between these two factors as of late:

Source: Bloomberg

Indeed, the S&P 500 traded at roughly 38 times its 10-year, inflation-adjusted average earnings in June, a level that once again surpasses the very peak of the late-1990s technology bubble and is decidedly well above its long-run median of roughly 22 times. It is not only the level of valuations that gives us pause, but the narrowness of what is driving them. Until at least very recently, a handful of very large, thematically linked businesses have accounted for a disproportionate share of index returns, which tends to leave the market unusually sensitive to any stumble in the prevailing narrative. None of this tells us much about where markets will head over the next quarter, or even the next year. It does, however, sit squarely with a view we have held for some time: we are best served staying cautious, and owning businesses that do not need to rationalize away their fundamentals but instead generate real cash for their owners. The crowd may feel differently, but if prior episodes of “this time is different” are any guide, we suspect that at some point, the timing of which no one can know, this all proves unsustainable.

Source: Bloomberg

Equity markets hold no monopoly on this sort of rationalization, with credit markets also showing signs of complacency. Spreads on corporate bonds over Treasury yields suggest investors are demanding quite little in the way of compensation for the risk of lending to most businesses. In the private credit sphere, we would argue the situation is even more pronounced. The Financial Stability Board, in a report published in May, laid out a number of concerns about the private credit market, which it now sizes at between $1.5 and $2 trillion globally. Among them, leverage at the companies tapping private credit has been climbing, reaching roughly five to six times debt-to-EBITDA, compared to something closer to four times in the broadly syndicated loan market, and it may in fact be higher than reported. The culprit, familiar by now, is the growing use of EBITDA “adjustments,” which flatter a borrower’s earnings and thereby understate its true leverage. Accounting for these add-backs, the FSB notes that “true” leverage in private credit may sit closer to seven times debt-to-EBITDA. Here again, more adjustments, and more rationalization, to say nothing of the fact that, at least in our eyes, levering most businesses at seven times debt-to-EBITDA leaves very little room for error.

The financial health of these borrowers is being obscured in other ways as well. One increasingly common device is the payment-in-kind, or “PIK,” loan. In plain terms, a PIK arrangement lets a borrower skip paying its interest in cash and instead settle the bill by piling the unpaid interest onto the principal it already owes. The loan looks current, but the debt quietly compounds, with the day of reckoning pushed further out. It is, in effect, paying off the credit card bill with the credit card. PIK features now appear in roughly 12% of private credit loans, and their use has risen sharply since 2022, alongside higher interest rates, with no real sign of slowing. While the use of PIKs by no means say anything definitive about the quality of a loan, we would note that the exercise of so-called “PIK toggles” is associated with a measurable increase in the likelihood that a loan will turn delinquent in the future.

Simply put, a good number of the businesses that borrowed during the private credit boom are now in trouble, and once again we see a great deal of effort going into rationalizing the problem away. Many arrangements that would, in plain language, be called defaults are instead treated as anything but, thanks to various contractual technicalities. Fitch reported the private credit default rate climbing to 6.0% on a trailing-twelve-month basis in May, its highest level since the company started tracking this metric two years ago. This measure, which includes “selective” restructurings, where a lender effectively bails a borrower out on non-arm’s-length terms to help it avoid an outright default, contrasts with the 1% at times quoted on the narrowest definition of default. Beyond PIK, lenders lean on maturity extensions and covenant amendments, an effective “extend and pretend” toolkit, to keep a troubled loan marked near par and accruing income as though all were well. In effect, private credit investors are rationalizing imprudent lending standards by quietly defining the consequences out of existence.

None of this is theoretical. Late last year, the back-to-back failures of First Brands and Tricolor offered a preview, with both companies undone in part by hidden, off-balance-sheet leverage that left their lenders with a poor picture of true indebtedness right up until their bankruptcies, which ultimately ensnared creditors across some eleven different jurisdictions. While we recognize that fraud appears to have also played a role in each (which itself could say something about the diligence process around these loans), the more telling point is that the leverage was there to be found and simply was not seen, obscured by a complexity that a good many participants had every incentive to accept at face value. It is worth noting, too, where much of this lending has been flowing. Private credit’s share of deals tied to AI-related sectors reached 34% in 2025, up from an average of roughly 17% over the prior five years, which means a meaningful and growing slice of the asset class is now underwriting the very data-center build-out whose economics, as we noted earlier, remain very much an open question.

As with the rest, this cannot go on forever. Investors are beginning to ask for their money back. In late June, Apollo’s roughly $25 billion retail-focused private credit fund capped withdrawals at 5% of shares after investors sought to redeem some 16.8%, up from 11.2% the prior quarter, the second straight quarter the fund has had to “gate” or in laymen’s terms, restrict redemptions, which many funds have the contractual right to do. It was hardly alone: comparable funds run by Cliffwater and BlackRock fielded redemption requests of roughly 17% and 13%, respectively, and likewise held withdrawals to 5%.  Whatever the headline yields these vehicles advertised, a growing number of their investors appear to be questioning the risk they took on, and when, exactly, they will see those hoped-for double-digit returns paid in cash (rather than in kind). We would note that we believe there is an additional, structural issue at play here as well, as these vehicles promise their investors periodic liquidity while holding loans that are anything but. Most of the time, that liquidity mismatch is perfectly fine, but it can become an issue if enough investors head for the door at once. The funds restricting withdrawals today are doing so precisely to avoid being forced to dump illiquid assets into a soft market, which is the very outcome the structure was designed to prevent. Last summer, we produced a piece encouraging individual investors to think critically about their allocation to alternative investments, and we think recent headlines have only driven that point home further. In any case, we are of the view that the “wrap it for retail and the money will come” phase of private credit may be starting to meet its natural limits.

This habit of rationalization extends well beyond the consumer and the corporate borrower. Consider, for example, the path of inflation, and its impact on interest rates. Here too, we have been treated to a steady parade of “one-offs” on this front in recent years. First there were the tariffs, expected to push up costs. Then came the conflict with Iran, which broke out late in February. That conflict brought a near-total halt to traffic through the Strait of Hormuz, through which roughly a fifth of the world’s seaborne oil passes, a scenario which has long been the fodder of investor nightmares. As one would expect, this sent energy prices sharply higher, with Brent crude vaulting past $120 a barrel at the peak. Yet by late June, with some tankers again moving through the Strait, oil had handed back essentially all of its wartime gains, the U.S. benchmark slipping back below $70. Now the talk has turned to the data-center boom, whose appetite for energy and materials is, as the Wall Street Journal recently put it, sparking a “third wave” of inflation, lifting prices on everything from smartphones to electricity. It seems that, just as one issue subsides, there is always some fresh new “one-off” said to be driving inflation. Leaving aside the fact that we would dispute if any of these issues are actually resolved, we cannot help but wonder if the honest conclusion here is that higher inflation ought to be treated as a structural feature of the landscape rather than a string of unhappy coincidences.

History is instructive here. The post-pandemic inflation spike was first blamed on supply-chain disruptions, then on fiscal stimulus, then on “revenge” spending that consumers had deferred during lockdowns. There was always a tidy explanation, and central bankers and commentators alike kept calling it “transitory”, right up until it became clear that tighter policy would be needed to bring it to heel. The inflation of the 1970s told a similar story, with a fresh headline driving each leg higher: the U.S. departure from the gold standard, the 1973 oil embargo, the Nixon administration’s unorthodox economic interventions, expansionary fiscal policy paired with loose monetary policy. There was always some new catalyst, and always one that was going to be resolved soon. That decade closed, fittingly in light of today’s situation, with another energy shock, this one tied in part to the 1979 Iranian revolution, which set the stage for much of what has transpired recently. Here again, we see that people can rationalize away the proximate causes of inflation one at a time, but once an inflationary period takes hold, there is always a new driver, and eventually the weight of it weighs upon the broader economy.

As we discuss the potential parallels with the 1970s, we would also note that inflation during that period did not rise in a straight line, but rather ebbed and flowed. While we do not wish to make too much of this fact, nor find ourselves falling into the trap of “overfitting” data points, we do find it interesting that the trajectory of inflation so far this decade does look quite similar to that encountered during the last era of significant inflation in the U.S. economy half a century ago:

Source: Bloomberg

We would note that if higher inflation indeed proves structural rather than incidental, the consequences run well beyond the price at the gas pump. The level of long-term interest rates, which is ultimately set by markets rather than central banks, is the baseline cost of capital for every borrower in the economy, from a company weighing a new plant to a household contemplating a mortgage. Central banks can cut short-term rates in response to weakness, but long rates can stay stubbornly elevated in a structurally inflationary world, as investors demand to be paid for the uncertainty of the future value of their interest payments and principal. This matters a great deal for the valuation of risk assets, equities very much included, whose elevated multiples have been underwritten in part by an assumption that the cost of capital will drift back toward the lows of the past decade. At risk of stating the obvious, we are not at all convinced that will be case.

We recognize we have painted a rather dark picture: equity markets rationalizing extraordinary valuations, credit markets rationalizing a decline in loan quality, and markets broadly rationalizing what may well prove a persistent bout of inflation. In an environment where so many seem intent on justifying away, or put more plainly, ignoring, a fairly harsh set of realities, the question is what a prudent investor ought to do. In our eyes, the answer is to stick to our knitting and manage portfolios for a world that will, sooner or later, have no choice but to acknowledge reality. Markets can stay irrational for a long while, sustained by their remarkable capacity to justify that irrationality, but in the end cash flows and valuations begin to matter. To that end, we continue to seek out businesses that trade at reasonable valuations and can create value for shareholders, whether through dividends and buybacks or through reinvestment at compelling rates of return. We own several businesses levered to rising energy consumption, both conventional and renewable, and we maintain direct exposure to commodities themselves. Elsewhere, we look to own businesses that stand to benefit from advances in technology but trade at far more reasonable valuations than their headline-grabbing peers, and that are in some cases wrongly maligned for a supposed vulnerability to technological disruption.

Simply put, in a world that seems determined to look past a difficult set of facts, our task is not to predict the precise moment those facts reassert themselves, which is a fool’s errand, but to ensure that when they do, your capital sits in businesses whose worth does not depend on this “irrational rationalization” persisting. A reasonable purchase price is itself a form of protection, and it is the margin of safety that lets us be wrong about the timing, as candidly we often are, without being wrong about the eventual outcome. That discipline has served our clients well across full market cycles, and we see little reason to set it aside now simply because the crowd is being paid, for the moment, to do the opposite.

Our most recent addition to portfolios this year, Euronet Worldwide, is, in some ways, a good example. Euronet began its life building out an ATM network in Central and Eastern Europe in the years after the collapse of communism and has since grown into a diversified financial-technology business spanning point-of-sale terminals, cross-border payments, and digital value networks that power everything from gift-card programs to mobile top-ups. In our view, the market misunderstands the dynamics at work across many of these businesses and, amid calls from some investors to break the company up, fails to appreciate the value of running them on a single, unified technology stack. What’s more, despite fears to the contrary, we are of the view that the business stands to benefit from advances in data processing and artificial intelligence, rather than be disrupted by them. Despite steady, profitable growth, the shares change hands at a single-digit multiple of forward earnings, a steep discount both to the company’s own history and to the broader market. At least in our eyes, there is a mismatch between this valuation and the quality of the underlying business: Euronet has been earning returns on equity north of 20% in recent years while growing revenue at a double-digit pace, all the while steadily reducing its share count through buybacks. The discount, in our reading, reflects a market that has lumped a genuinely advantaged payments franchise in with a broad fear of technological disruption, rather than any real deterioration in the underlying enterprise. We are encouraged that management both understands the intrinsic value of the business and has a clear, balanced plan to grow while continuing to return capital to shareholders through repurchases in the face of the current undervaluation. As a recent purchase, we expect it will take time for price and value to converge, but we have been impressed so far by management’s plans to build on an already strong franchise while creating value for shareholders in the here and now.

As you are likely well aware, we are always seeking out, and doing ongoing diligence on, new opportunities like Euronet. We would note that, despite its name, this is a U.S.-listed, U.S.-based business, albeit one with a truly global footprint. However, in that context, we would also be remiss not to once again note that for investors willing to look overseas, the opportunity set remains quite wide. Valuations are more attractive, not only relative to the U.S. but on an absolute basis, and there is no shortage of quality businesses levered to durable long-term trends and run by management teams capable of compounding value over many years. Within our Focused European Value Strategy, for example, we have lately been finding a number of opportunities in the infrastructure space, ranging from energy, both conventional and renewable, to logistics and industrial real estate. Several have already entered the portfolio, while others remain under active diligence. We continue to be genuinely excited by what we are uncovering on the other side of the Atlantic: smaller businesses that, for all their quality and capital-allocation acumen, remain ignored by the market and available at compelling prices. If you would like to learn more about this opportunity, and how to participate, we would encourage you to set up a conversation with Zach, who is always happy to discuss in greater detail.

We would also like to share an important development within the firm. On July 1^st, we welcomed Frank Berrios to our team. Frank joins us from Bank of America’s Private Bank, where he worked across a range of functions, from portfolio management to trust and estate advisory. Before Bank of America, he earned his A.B. from Harvard University, majoring in Economics and Computer Science, and along the way did some fascinating research on market microstructure. As Wealth Advisor and Investment Research Associate, Frank will provide additional coverage to all of Drum Hill’s clients while also contributing to efforts on the investment research side. He is a passionate student of the markets, and we could not be happier to have him on board. We look forward to introducing him to you all personally in the months ahead, and we hope he will provide yet another resource as we work to serve our clients and their families.

Indeed, we believe the case for staying in close contact with you is stronger now than ever. Given all that markets have done, particularly in the first half of this year, communication is essential, especially when it comes to understanding how and why we are positioning portfolios and how that positioning relates to your own circumstances. If you feel your portfolio does not adequately reflect your situation or your views, we strongly encourage you to get in touch. At the same time, if you are simply curious about our broader opinions on markets, or where we are finding specific opportunities, we would welcome the opportunity to connect. Recognizing that we make this appeal in nearly all our regular communications, we want to be emphatic that these types of regular interactions are not only important to our work in serving you, but ones we genuinely value greatly.

Whatever may be in store for markets in the second half of the year, we remain confident in our current positioning. However, we recognize the road ahead may prove increasingly challenging for all investors, and we are grateful, as always, for the trust and support you place in our team. We hope you enjoy the balance of the summer, and we look forward to being in touch soon.