From the sublime to the ridiculous

It is 20 years since we began managing money in Australia, and this quarter’s excellent performance has been a welcome birthday gift. It hasn’t been a smooth ride for our clients, with the past five years having been unusually tumultuous, due to COVID-19, the rise of artificial intelligence (AI) and placard-waving day (aka Liberation Day), all of which have caused significant market dislocations.

To put this into context, the prior 15 years had only one event of a similar scale: the Global Financial Crisis. Dislocations in the price of share market constituents are not unusual, but we feel they are more pervasive today than at most times during our 20 years in Australia.

A lesson learned?

20 years ago, Macquarie Infrastructure Group (MIG) was a good example of price dislocation. Its major asset at the time was its equity interest in 407ETR, the company that held an initial 99-year concession to operate Highway 407 (then a 108-kilometre toll road in the greater Toronto area).

Like all toll roads, the two most important drivers of value are the actual tolls charged (and their growth trajectory) and the amount of traffic using the road (and its future growth trajectory). MIG was a popular company with stable and trending earnings, which were seemingly easy to forecast and therefore easy to value using a discounted cash flow.

Figure 1 | 407ETR’s concession map

Extending the market’s toll and traffic assumptions well beyond most investors’ time horizon to the end of the concession period in 2098 resulted in a final year revenue stream from this single toll road equivalent to about 0.8% of Canada’s forecast GDP in 2098, assuming Canada’s nominal GDP continued to grow in line with its own long-term average until then. On reflection, everyone should have agreed that this was a ludicrous assumption, but it didn’t seem to matter at the time. Until it did.

For the quarter ended September 2025, 407ETR’s total revenue was C$580 million, or about 0.07% of Canada’s GDP. That is less than one tenth of the initial end-of-concession forecast. Thankfully, there are over 70 years to go…

Or did we learn nothing?

A more recent example of share price dislocation is CSL (ASX: CSL), whose share price peaked at over A$330 per share in February 2020. Its market capitalisation then was A$160 billion, it was Australia’s largest index constituent and it traded at about 45 times 2020’s forecast earnings, well above the broader share market’s 17 times. None of this was a problem, as its earnings were forecast to continue to increase 10 – 12% a year, well above those of the broader share market, and therefore, in the eyes of investors, deserving a price-to-earnings (P/E) multiple 2.5 times that of the market.

Graph 1 - CSL share price and P/E multiple

Few companies can sustain growth rates that high for that long, and, similar to MIG, when you dragged the Excel cell far to the right, CSL’s implied revenue base looked very punchy.

It is worthwhile remembering that on the other side of every company’s revenue base is a consumer, directly or indirectly via taxes, or a bulging government deficit. Corporate profits exist in a delicate ecosystem, not a bottomless pit of riches. CSL’s recently reported 2025 profits were 32% above its 2020 profits, a very respectable 6% growth per annum, and are forecast to continue to grow at around the same rate. But you pay 17 times forecast earnings for it today, a discount relative to the broader share market, which is growing more slowly than CSL. Perhaps the dislocation pendulum has swung to the other side. Let’s hope so; the Equity strategy invested in CSL earlier this year.

From the sublime to the ridiculous

Today’s share market is rife with examples that we believe are significantly dislocated from likely or even possible economic reality. Where heroic assumptions are required to justify share prices. Under normal circumstances, this is not unusual at the smaller end of the market, where the runway for growth for a fledgling company can be wide and long. But today, heroic assumptions are required for larger companies, including not only index heavyweights like Commonwealth Bank (ASX: CBA), Wesfarmers (ASX: WES) and Goodman Group (ASX: GMG), but also current market darlings like NextDC (ASX: NXT).

Pro Medicus, though, is in a league of its own

Pro Medicus (ASX: PME) is primarily a developer and supplier of healthcare imaging software. According to the company, it has achieved an impressive 10% market share in North America. With revenues of A$213 million in 2025, Pro Medicus’ total addressable market is slightly over A$2 billion. Its market capitalisation today is A$27 billion.

Let’s assume that Pro Medicus grows its already impressive 10% share to a 100% share(1). Let’s further assume that margins increase from their current 73% to 85% due to scale benefits. This world domination would result in post-tax profits of approximately A$1.2 billion (= A$2 billion × 85% × (1 – 30% tax rate)).

Trading at over 22 times those earnings today, Pro Medicus shareholders are clearly banking on something decidedly better than world domination. It is likely to include the company’s addressable market increasing significantly as it expands its software into adjacent markets. Whatever the thesis, it is optimistic in the extreme and has a very high chance of coming horribly unstuck.

Graph 2 - Pro Medicus’ share price and price-to-sales ratio

Where to from here?

There are many desirable companies in the world with extensive growth trajectories, but only a small proportion of these will ultimately yield great investments. Competition for a share of the growth pie becomes fierce and returns diminish as new entrants attempt to enter the market and establish scalable businesses. In other instances, consumer preferences change and the disruptors become the disrupted. Some of these companies eventually fail.

We have tried to steer clear of companies such as these. While our portfolio companies may seem boring and slow-growing, they trade at attractive prices relative to today’s earnings, and none of them are priced for world domination.

We recently wrote in our Q2 2025 Quarterly Commentary that the market’s performance over the past few years has been concentrated in just a few large shares. These companies now require heroic assumptions to justify their prices. Our positioning away from them should stand us in good stead.

This is an extract from our December 2025 Quarterly Commentary. Download the full Quarterly Commentary.

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Contrarian investing is not for everyone, however there can be great rewards for the patient investor who embraces Allan Gray’s approach. Learn more by visiting the Allan Gray website. 

(1) At this stage it is important to recognise that this would require Pro Medicus’ entire competitor base to go out of business; and for no new competing products to emerge later; and for Pro Medicus’ end-customer base (radiologists) not to themselves be disrupted by AI (who needs picture archiving and communication systems if there are no radiologists, just machines?).