The issue of valuation is getting more of our attention, because companies, especially the best-quality businesses, and the fastest-growing ones, have seen their stocks rise faster (in local currency, at least) than their earnings, starting with the US, then in Japan, and now in Europe. Nowhere, of course, has this problem of valuing the rare growth stock in a sluggish growth environment facing aggressive central bank stimulus been more pronounced than in Japan, where those conditions have lasted for two years, so far. Yoko Sakai, our analyst for Japanese companies, found that our valuation model, using a semi-fixed discount rate to value expected future corporate cash flows, produced fair values for her companies that were quickly outstripped by the prices set in the soaring market gripped in the reflation fever of “Abenomics.” To remain invested in Japan, Harding Loevner portfolio managers had to be tolerant of stretched valuations on our internal DCF models, recognizing two important corollary effects of the government’s policies on stocks: first, that most analysts would not be able to forecast accurately the full extent of the operating leverage the yen’s “maxi” devaluation would have on reported earnings, especially of exporters; and second, that alternative investments other than equities for domestic Japanese investors were being rendered unpalatable from the standpoint of preservation of value.
Returns in the Frontier Emerging Markets (FEMs) have historically been heavily influenced by the idiosyncratic risks associated with each individual country. A portfolio that is well diversified across the FEM universe should exhibit lower volatility than might be expected if one only considered the volatility of each market in isolation. As we abide by the rules of diversification we have set for ourselves, we recognize the direct impact the Strategy’s risk-control constraints can have on relative performance due to the unusual nature of the MSCI Frontier Emerging Markets Index. Our underweight to the top-performing Philippines was a drag on our returns compared to the benchmark in the first quarter. We will continue to be underweight the Philippines unless its weight in the Index changes, and this positioning could again have a negative impact on relative returns if this market similarly outperforms in the future (and, similarly, could be a positive in the event of a significant correction in the market). But our view is that the Strategy’s long-term, risk-adjusted returns will benefit from maintaining a well-diversified portfolio that consistently adheres to the guidelines we have established.
We build diversified portfolios of high-quality, growing companies identified through fundamental research.