Chapter 54: Earnings Quality, Scarcity and Fragility

Dear Investors,

The last time we wrote to you, we described our base case scenario of bifurcation. We described this as a pervasive theme across & within sectors, geographies, wide moat versus narrow moat businesses, and the ensuing quality differences of their earnings profiles. This earnings season, Q1 2026, bifurcation was on full display for all market participants, opening up a sizeable valuation gap between companies that successfully supported their quality premiums; and those that did not. Our overarching thesis heading into earnings was that quality is scarce; and hence, companies with defensible moats able to justify their quality characteristics would command a scarcity premium. We reasoned that quality earnings, delivered consistently, would warrant a valuation premium; and over time, this premium would enlarge the more scarce the growth became (see chapter 47 on Survivorship Bias). On the flipside, we avoided companies with less durable moats, resulting in earnings that are more fragile and that can be disrupted readily. Earnings fragility, in turn, leads to compressing valuation premiums as growth gets recalibrated. Furthermore, these same companies we avoided were often over-crowded investments, leading to heightened expectations that could not be matched in the real world. In avoiding and underweighting these over-crowded names with high earnings fragility, we insulated the portfolio from unnecessary business risks (industries avoided included managed care, payments processing, and legacy technology).

One sector we have been invested in since 2018 – where quality leads to scarcity which leads to valuation premiums – is the semiconductor capital equipment names (KLAC & ASML). Our investment thesis is that data center expenditures are shifting from less cyclical to more secular; hence capital equipment names (termed “Semicaps”) would benefit from both a valuation re-rating and durably higher capital intensity – a “new normal” in the sustainability and longevity of their profits. This thesis continues to produce absolute and relative outperformance, with KLAC’s 1-yr and 3-yr returns at 122% and 309% respectively; and ASML’s 1-yr and 3-yr returns at 102% and 137% respectively, as of this writing (March 11th, 2026 close).

This earnings season continued to validate our investment thesis. With structurally higher capital expenditures feeding into the need for semiconductor power, performance, and complexity, we believe that capital intensity will remain elevated in a multi-year cycle benefiting semicaps. We would now like to explain the quality characteristics of both companies that lead to their sustained scarcity premiums:

• First, KLAC specializes in inspection and metrology (i.e. “measurement”) equipment vital to the value chain in manufacturing complex semiconductors. This specialized equipment is termed “process controls.” In an era where the demand & complexity for AI-driven chips is increasing, process controls intensity is rising because the complexity of these leading-edge chips requires more capital expenditure. As a result, we believe the total addressable market for process controls investments is being underestimated; this will lead to sustained rising earnings per share (EPS) revisions over a multi-year cycle as further chip investments are made in an environment of rising chip cost, complexity, and performance requirements.
• Second, ASML is the only producer of extreme ultraviolet lithography (EUV) technology, using laser technology to imprint patterns on chips below 7 nanometers. Because of the need for absolute precision, no manufacturing downtime, and R&D advances as chip nodes become smaller; ASML has a formidable barrier to entry in the production of EUV machines, such that a single machine can cost $200 to $400 million USD depending on the configuration. We began a starter position in ASML in February 2023, opportunistically adding to our position on valuation dislocations, for a total holding period return of 71%.

In conclusion, semicaps are an excellent example of the criteria we seek in our investment process, which is predicated on the sustainability, longevity and profitability of an industry group, supported by multi-year tailwinds with respect to their revenue generation. Sustainable, long-lived, and consistently rising profitability is a scarce phenomenon, such that companies that sport these quality characteristics will warrant a valuation premium due to their scarcity. On the other hand, companies with fragile business moats and easily disrupted earnings will see compressing valuation premiums. KLAC and ASML are examples of unique players that benefit from structurally higher capital intensity in the space; as AI infrastructure is built out, chip miniaturization requires greater investment, and this investment is accompanied by increasing R&D requirements. In an environment of rising power, performance and complexity, we believe these valuation premiums will remain scarce and hence be sustained. Despite the geopolitical and rotational volatility currently being witnessed, we will remind clients that energy prices as well as non-fundamental style factors are highly mean reverting, and that quality growth and quality value characteristics tend to prevail over a full market cycle; hence our reminder that “Quality Prevails.” We hope this installment has been elucidating and we are wishing clients an enjoyable, early start to their spring.

Warmest regards,

 

Grace Wang | Senior Portfolio Manager

Samuel Jang, CFA | Investment Associate

Leslie Mah | Associate Advisor

Katherine Yang | Associate

Steven Bos | Administrative Assistant

Heidi Xu | Administrative Assistant

Grace Wang Portfolio Management Practice of RBC Dominion Securities
Email: gracewangpractice@rbc.com

Phone: 604-257-2483
745 Thurlow Street, 20th Floor
Vancouver BC, V6E 0C5

gracewangpractice.com

 

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