2026 Q3 Letter to Investors: AI and Interest Rate Risk

The AI boom has driven an historically concentrated rise in U.S. equity valuations that is increasingly disconnected from free cash flow, GDP and the financial capacity of the companies funding it.

• Over the past three years, Russell 1000 stocks gained $32 trillion in market value while estimated next-twelve-month free cash flow rose only $400 billion; the 20 largest AI stocks contributed $20 trillion of the gain, now represent more than 40% of the index and trade near 100x NTM FCF.
• The remaining roughly 860 stocks, representing about 60% of the index, delivered healthier free-cash-flow growth and only modest multiple expansion, although leverage is a concern as interest rates rise.
• U.S. market capitalization rose about $30 trillion over three years, more than 6 times the increase in GDP, exceeding the roughly 4-times divergence seen during the 1990s technology boom; the S&P 500's market value relative to U.S. GDP is at a record peak.
• The six hyperscalers Alphabet, Amazon, Meta, Microsoft, Oracle and SpaceX saw free cash flow fall by about $450 billion as their investment spending shifted profits toward companies such as NVIDIA; their capital expenditure is expected to level off near $1.3-$1.4 trillion, with the group not expected to return to positive free cash flow until 2029.
• Estimates of the AI revenue required to earn a 10% return on investment range from $2.4 trillion to $6 trillion annually by 2030, while only half of the 26 GW of U.S. capacity planned for 2026 had begun construction and just 10 GW of the 55 GW planned for 2027 was under construction.
• Distillate's strategies produced mixed results year to date: U.S. FSV returned 9.39%, SMID QV 18.46%, International FSV 8.57%, Long/Short Equity 20.92% and U.S. Free Cash Flow 500 15.83%, compared with benchmarks ranging from 12.73% to 19.23% where provided.

Takeaway: Investors should treat the AI concentration, elevated valuation multiples, leverage and interest-rate sensitivity as substantial risks, while looking for attractively valued companies with stable economics, limited leverage and sustainable free cash flow; the comparison with the late 1990s is informative but the current cycle is larger and structurally different.