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Market enthusiasm for AI has caused many durable compounders to be sold as funding sources, creating what we view as a rare opportunity in high-quality businesses with strong fundamentals but depressed valuations. Our analysis of what we view as the “Top 200 Compounders” demonstrates healthy fundamentals at an unusual discount to the S&P 500.
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Over time, our portfolios have been repositioned using a “barbell” strategy: substantial exposure to AI infrastructure beneficiaries on one side and high-quality compounder businesses trading at attractive valuations on the other.
As capital has increasingly flowed into companies with AI exposure, many exceptional quality compounders have been left behind, serving as the source of funds for AI exposure. As a result, we are finding durable and dominant businesses that have long histories of driving growth—often insulated from AI disruption—trading at one to two standard deviations below their five-year average valuation multiples. In many cases, the businesses have seen no deterioration in their fundamentals, with healthy core growth. Rather, they are just viewed as “too boring” for many investors hyper-focused on AI. This, we believe, has created a potential once-in-a-generation opportunity in quality and innovative “compounder-type” businesses. We have conducted a detailed analysis of these companies, and the valuation opportunities across this select group are outstanding, which we detail below.
We define compounders as high-quality businesses that deliver consistent, profitable, above-average growth over the long term. They tend to have dominant market positions, recurring revenue business models, pricing power, attractive margins, and high return on equity (ROE) and/or return on invested capital (ROIC). As a result of these traits, the earnings and free cash flows of these businesses tend to be resilient across macroeconomic cycles. In the past, investors generally placed high value on the visibility into future growth that these quality businesses provide, leading to substantial premium valuations, in many cases well deserved. However, more recently, the excitement surrounding the AI buildout has turned compounders into a source of funds, with many of these high-quality franchises trading at significant discounts to historical averages, including discounts to the S&P 500. We believe this dynamic creates a unique opportunity for long-term investors.
It’s important to note that the aforementioned group of compounders are not ex-growth with deteriorating fundamentals available at cheap valuations. Rather, they continue to grow revenue and earnings at above-average rates, driven by their capacity to innovate and to reinvest profits back into the business—organically and, in many cases, through M&A—at high returns on invested capital. Yet, as of the writing of this blog post, the valuation premiums for these quality businesses have become completely wiped out, on average. The AI-driven selling of compounders has created a historic opportunity for select quality compounders.
The reason for the valuation disconnect matters, because it determines whether a given name is an opportunity or a value trap. In many cases, we believe the de-rating has been market-related rather than fundamental. Our own analysis bears this out. Looking across what we view as the Top 200 of the highest-quality compounders in our investible universe, we found that on average they trade at roughly a 20% discount to their three- and five-year average next-twelve-month P/E multiples—about one standard deviation below those historical norms. More striking, the average company in this group now trades at a discount to the average S&P 500 company!
Despite the pullback in valuations, in most cases, forward-looking earnings estimates have held up or moved higher. The market, in other words, is not only penalizing businesses at risk for AI disruption—which makes sense—it is also de-rating high-quality companies with dominant franchises, attractive growth, and strong returns on equity—which does not make sense—simply because they sit outside the center of the AI infrastructure theme.
As we think about where the highest-value opportunities lie, we assess a few key questions for these types of businesses. First, is the business at risk for AI disruption? Second, does the business have any company or industry-specific issues and are they fixable in the near term? And third, are the business fundamentals healthy, and do we expect them to remain healthy in the future? Our work has focused on high-quality compounders where we have comfort across all three of those questions.
Below we detail a few examples across our strategies.
Abbott Laboratories (ABT) is a leading innovator and consolidator in medical technology, with a diversified portfolio spanning diagnostics, medical devices, established pharmaceuticals, and nutrition, and a long track record of pairing internal innovation with disciplined M&A to drive growth at high returns on invested capital. More recently, a slowdown in its nutrition business has weighed on the stock—but we view these issues as short-term and fixable, and the breadth of Abbott’s portfolio and innovation pipeline serve as an offset. We see several drivers that can reaccelerate growth: its recently FDA-approved Volt pulsed field ablation (PFA) system is well positioned to take share in the treatment of atrial fibrillation, and its acquisition of Exact Sciences meaningfully expands its exposure to the large and fast-growing early-cancer screening market. While the business faces slower growth in the near term, we expect that new product launches combined with M&A execution can help Abbott reaccelerate topline growth and return to attractive double-digit EPS growth. Despite this outlook, Abbott recently traded at 16x NTM P/E, more than two standard deviations below its five-year average of about 23x P/E.
Axon Enterprise (AXON) is a leading provider of public safety technology, with a growing ecosystem of integrated hardware and software spanning law enforcement and, increasingly, new enterprise customers. We view Axon as a high-quality compounder because its hardware—TASERs, body/fleet cameras, and drones—feeds a sticky, expanding software ecosystem that grows more valuable as customers adopt more products as a bundle, producing 125% net revenue retention with a long runway still ahead across core public safety, enterprise, and international markets. In the most recent quarter, total revenue grew more than 30% for the ninth consecutive quarter, helped by more than 700% growth in AI Era Plan revenue and by 95% growth in Platform Solutions, which includes the counter-drone business. Like the best compounders, Axon pairs internal innovation with disciplined M&A, and this quarter it reported that two recent acquisitions, Dedrone and Fusus, have already booked more than 1.5x their combined purchase price. During the quarter, Axon’s stock pulled back to attractive levels—at well over one standard deviation below the long-term average for P/E—levels where we added to the position given the unwarranted disconnect between a healthy business and the valuation.
CACI International (CACI) is a leading provider of defense IT and technology for national security to the Department of War and other government agencies. We view it as a high-quality compounder because it has positioned itself as a consolidator of highly specialized capabilities across critical defense segments—signals intelligence, counter-drone/UAS, space-based laser communications, cybersecurity, and the application of AI—making it a direct beneficiary of rising national security priorities in a world where defense increasingly involves bits as much as bullets. Management pairs that with a strong track record of profitable growth and disciplined capital allocation across internal R&D, accretive acquisitions, and value-added share buybacks. In its most recent quarter, CACI grew revenue 9% while adjusted EPS grew 17% year over year. Additionally, management raised full-year revenue guidance by $100M at the high end, and total backlog reached $33.4B—a sign of durable demand across its defense and technology portfolios. Despite that execution, the stock recently traded at just 15x NTM P/E, close to one standard deviation below its historical P/E averages, a discount we attribute to market flows rather than any deterioration in the business.
Meta Platforms (META) operates the world's largest social media and digital advertising franchise, a business with enormous reach (over 3.5 billion users), high margins, and strong free cash flow generation. The company-specific concern weighing on the stock is the sheer scale of its AI-related capex spending, and we think investor skepticism on the returns to that spend is fair. However, we would make two points: Meta is already seeing tangible ROI from AI spending in its core advertising business, and, critically, the higher capex spend is largely discretionary, leaving the company a cash-flow machine ex-discretionary capex spend with the flexibility to pull back if the returns do not materialize. Beyond that, Meta holds real optionality in how it monetizes its AI spend—through potential new revenue streams such as AI subscriptions, WhatsApp for Business, and more, or by monetizing the AI data center infrastructure itself, including renting out excess capacity. The result, in our view, is a potentially favorable setup: the valuation already reflects the capex skepticism with the stock recently trading at ~17x NTM P/E or about one standard deviation below five-year averages, while Meta stands to be rewarded if the AI spend drives continued top-line acceleration, Meta pulls back on this spend, or if it monetizes that capacity in new ways.
Together, these businesses play a specific role in the portfolio, with return potential from two avenues. First, they should continue to drive growth—growing earnings as they execute, at attractive valuations. Second, when deceleration and profit-taking eventually arrive across the AI trade, the same source-of-funds dynamic that made them cheap can run in reverse, sending capital back toward these compounder-type investments and offering meaningful re-rating potential.
In the meantime, their durability through the economic cycle and, in many cases, their countercyclicality—paired with valuations well below historical averages—have tended to cushion them when the broader market falls. Importantly, these are not defensive holdings we own merely for safety reasons, rather they are high-quality, highly innovative growth businesses available at unusually attractive—possibly once-in-a-generation—valuations.
