“An economy built on endless consumption and debt is fundamentally unsustainable.” – Ray Dalio
Things that are unsustainable, by definition, must change. Decades of unchecked government spending, coupled with a lack of fiscal restraint, have pushed the U.S. balance sheet to its limits. Too much debt restrains economic growth, limits the flexibility for countercyclical support in future downturns, raises borrowing costs over time, and could even have national security implications if it restricts defense spending. As a result, President Trump has made reducing the deficit one of his top priorities.
This commitment, noble as it is, comes up against a market and economy that have become addicted to government spending, effectively forcing the economy to go cold turkey overnight. There is “going to be a detox period,” admits Treasury Secretary Scott Bessent, who knows a thing or two about markets. Aggressive federal cost cuts through initiatives like DOGE are the first part of the new administration’s one-two punch against the deficit. Tariffs and other revenue-generating opportunities such as “gold card” visas are the second.
President Trump’s view is that the global trade system has eroded U.S. manufacturing competitiveness and left America footing the bill for its global defense umbrella and, as the reserve currency, the financial backbone of international trade. His aim with tariffs is to rebuild domestic manufacturing might to counter China, and shift some financial strain onto others, preserving the dollar’s dominance while enhancing America’s industrial and geopolitical power. This runs counter to the mainstream economic theory of comparative advantage, which states that countries should specialize in producing goods they are most efficient at and trade with nations that excel in other areas, benefiting both parties.
Tariffs are likely to boost inflation, at least in the near-term, as companies pass through the higher costs to consumers. Inflation expectations are already ticking up, leaving the Fed in a bind. While the market is currently pricing in two more Fed rate cuts this year, inflation from tariffs could make any further easing difficult. And it would certainly be an unwelcome pivot if the Fed’s next move is instead to raise rates to temper rising prices.
Though the pace of change feels dizzying, President Trump’s habit of reversing his stance remains a constant. Should current initiatives overly disrupt the economy or stock market, we expect the administration to backtrack swiftly. He has also shown a willingness to negotiate, and we anticipate some of the tariffs currently being discussed could come off in trade-offs for other priorities. In either case, tariffs can be removed just as quickly as they are imposed.
Another fundamental transformation is within the global security framework. For years, under both Democratic and Republican leadership, the U.S. has urged NATO to increase its defense spending. Trump’s rapid policy change regarding Ukraine has finally prompted Europe to ramp up their military budgets. We expect the heated rhetoric to eventually get toned down, and our NATO partners to continue as important allies despite the posturing. Meanwhile, the U.S. is likely to redirect its defense spending towards the Pacific, where China’s aggressive actions have heightened tensions.
The path to resolving these intertwined challenges remains unclear, as newfound fiscal restraint, bold trade reforms, and tough talk to longstanding allies collide with a richly valued stock market with an aversion to uncertainty, of which there is plenty.
As for your portfolio, we believe you are well positioned for the higher volatility environment we expect. You own high-quality companies with fortress balance sheets that will find their way through any turbulence. After a period of disorientation due to the aggressive policy changes, we expect these companies to adapt to the new rules of the game and the American economy to regain its footing and trudge forward like it always has.
You’re also holding ample cash – yielding over 4% risk-free – which we hope to judiciously deploy into new opportunities that are certain to arise. We have a long list of candidates but are patiently waiting for a fat pitch. Our cash position increased during the quarter, as we trimmed one of our biggest winners and completely exited a disappointing performer that veered off course.
Sprouts Farmers Market, the specialty grocery store chain focused on fresh produce and low cost better-for-you products, has been as outstanding performer. Our first purchase of SFM was made in the summer of 2019 at $17 and change. Several worries were weighing on the shares at the time, including the recent departure of the CEO, sluggish produce pricing and the competitive threat from Amazon’s acquisition of Whole Foods, causing the multiple to contract to a reasonable 15x forward earnings.
We saw plenty of room for expansion within the large and attractive natural and organic food segment of the grocery industry, and believed the depressed multiple offered an adequate margin of safety. A few weeks later, the company announced the appointment of Jack Sinclair as CEO, who had previously led Walmart’s U.S. grocery business, where he drove big growth by pushing local products and fresh foods.
Since that initial purchase, Sprouts has grown its store base from 320 stores to 440, and it plans to continue growing its store count by roughly 10% a year. It’s ramped up its online offering, expanded the breadth of its private label products, started a loyalty program, and rolled out smaller, more productive new stores. Same store sales growth, a measure of the performance of a retailer’s existing stores, hit 7.6% in 2024.
With the shares up almost tenfold from our original purchase and trading at over 35x next year’s earnings, we trimmed it twice during the quarter. Sprouts is, after all, a grocery store retailer and that’s a multiple that would make a software company blush. We are maintaining a right-sized position as the company has substantial operating momentum, but we have taken some chips off the table as the remarkable execution seems priced in.
Alas, not every investment works out as well as Sprouts, and we sold Fortrea during the quarter because management has been unable to deliver on the margin expansion they promised. Fortrea is a contract research organization that runs clinical trials for its biopharmaceutical customers. Following its spinout from Labcorp in June 2023, we anticipated the highly regarded CEO would improve margins towards the peer average over time, a thesis he himself laid out at the time of the spin. Instead, it’s been one self-inflicted problem after another, culminating in 2025 guidance that implies margins are heading the wrong way, with the high teens margins we ultimately anticipated nowhere in sight. With the thesis well off track, we took a loss in March.
We are always appreciative for the trust you’ve placed in us. We’re navigating a landscape where the market calm we have enjoyed for several years has become temporarily unsustainable. But with our disciplined approach and current positioning, we’re poised to capitalize on the emerging opportunities this shift will undoubtedly reveal.
Penn Davis McFarland, Inc.
April 2025
