Out of
Our Minds

Ideas, arguments, and musings from inside Harding Loevner.
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What If Fashion Were Taxed Like Cigarettes?

The fast-fashion industry produces a lot of waste but has largely avoided any consequences for its impact on the environment. That is starting to change.

The lower house of France’s Parliament passed a bill in February that would impose a “sin tax” of up to 10 euros or 50% of the selling price on fast-fashion clothing, a severe penalty given that many of these products cost less than €10. The bill would also ban advertising and demands that companies in the industry disclose the environmental impact of their businesses. The bill was approved unanimously and moved to the upper house of Parliament. If it becomes law, it will make France one of the first countries to impose this type of penalty on fast-fashion companies.

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A Quality Problem

For almost half a century, a niche within empirical finance has dedicated itself to sifting through accounting data in search of company traits that influence stock prices. Despite the plethora of factors unearthed, figuring out the precise drivers behind their behavior is still a bit of a mystery. For investors, simply identifying a factor isn’t enough; you also need to understand who’s on the other side of the trade—and why. Otherwise, who’s to say if a historical pattern will repeat in the future.

The difficulty in pinning down exactly what’s behind such canonical factors as quality, value, and momentum shouldn’t be a surprise. Factors can only be observed after the fact, but the underlying mechanisms that produce them are hidden. They are birthed from the complex interplay of buying and selling against a backdrop of economic and geopolitical shifts, all woven together by intricate feedback loops. Because they emerge as properties of a complex system, and because their returns wax and wane over decades, pinpointing a definitive root cause is quite the challenge.

India’s Net-Zero Progress

Maria Lernerman, CFA, portfolio manager for our Global Paris-Aligned and International Carbon Transition Equity strategies, recently traveled to India to observe the country’s emission reduction initiatives first-hand. In this video, she shares thoughts from her trip and highlights hurdles that the country must overcome to progress toward net-zero status.

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At Costco, Lower Prices, Higher Club Fees May Stoke Competition

Until recently, Costco charged US$16.99 for a 24-pack of San Pellegrino. Now, that same item retails for US$14.99—a 12% reduction.

Sparkling water isn’t the only product looking cheaper at Costco these days. During a quarterly earnings call in March, Chief Financial Officer Richard Galanti seemed to signal an inflection point when he rattled off a variety of goods for which prices were being lowered: Kirkland batteries (from US$17.99 down to US$15.99) and reading glasses (US$18.99 to US$16.99), as well as sporting goods and lawn-care products. A bag of frozen fruit was even reduced by US$4. Plus, there was a more subtle clue about the direction of retail pricing: inflation was mentioned just seven times on the call, compared with 35 times during the March 2023 earnings call. (As for the recent trade disruptions in the Panama Canal and Red Sea, management said this hadn’t pushed up prices because of the long-term nature of shipping contracts.)

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Japan’s Reforms Lift Stocks of Lowest-Quality Companies

Japan remains the single-largest country weight in the MSCI All Country World ex US Small Cap Index. However, the country’s weak economic growth, aging population, tight labor conditions, and chronic deflation have long made it a challenge to find high-quality, growing companies there.

Government regulators and the Tokyo Stock Exchange recently introduced a flurry of reforms aimed at improving corporate governance and shareholder returns. As discussed in our fourth quarter 2023 report, these actions have primarily benefited the cheapest stocks, given that they are typically associated with the least-profitable and slowest-growing companies. Additionally, the Bank of Japan has raised short-term interest rates, ending its decade-long era of negative rates. This landmark move boosted Japanese value stocks in the first quarter, further exacerbating the region’s style headwinds.

As the chart above to the right shows, the cheapest stocks in Japan outperformed the most expensive by nearly 1,600 basis points in the first quarter. For the trailing 12-month period, it’s worse: The spread between the most expensive and cheapest quintile was nearly 46%. The left and center charts show that investors also have favored slower-growing and lower-quality companies.

We don’t know how long this value rally will persist. In the short run, some of the changes have clearly exacerbated, and could prolong, style headwinds for higher-quality, faster-growing companies. But over the long term, the changes in Japanese business policy and mindset are positive developments. As more businesses raise their standards, the number of high-quality companies in Japan may increase.

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NVIDIA’s Competitive Structure May Be More Fragile Than Its Valuation Implies

Advances in artificial intelligence have created an AI gold rush, and one company—NVIDIA—supplies the necessary picks and shovels. With a dominant position in a fast-growing market, shares of NVIDIA have soared. However, NVIDIA’s competitive advantage may be more fragile than its stock price indicates.

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Quality Is Becoming More Affordable in China, Less So In India

While challenges in China persist, Chinese companies look better than China’s economy.

Some key parts of the Chinese economy continue to stabilize. Manufacturing activities expanded in March for the first time in six months, led by new orders from domestic customers as well as by export orders. The government is pushing for more domestic production in strategic industries such as green technology and advanced manufacturing. Growth in services activities has remained good, with travel and tourism continuing to rebound. We are also seeing increasing localization as Chinese companies prefer Chinese suppliers over multinational corporations to de-risk their own supply chain. This is leading to domestic market-share gains for many companies. Finally, valuations for some high-quality companies look compelling at these levels.

Quality growth stocks in China have derated significantly since 2019 and are now trading at a nearly 40% discount to developed-market counterparts and emerging markets (EMs) as a whole. Conversely, while valuations of Indian companies have moderated slightly over the past year, they continue to be expensive relative to the rising valuations in developed markets. Quality growth stocks in India still trade at a significant premium to other EMs.

India’s evolving economy is promising, as witnessed by our analysts on a recent trip to the country; however, the stock market rally in response has probably gone too far, especially with regards to small and mid-cap stocks. Today, valuations remain stretched across most sectors.

Note: Top QG quadrant is defined as companies with a QR score > 0.5 and a GR score > 0.5. VR Score based on weighted average.

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Chips of the Trade: TSMC, Samsung Benefit from AI Demand

In international markets, a big theme of investor interest relates to companies developing the underlying technology that powers AI. This includes the designers and manufacturers of the advanced semiconductors necessary to run AI, as well as producers of semiconductor manufacturing equipment and providers of the critical computing infrastructure required by AI systems.

Expectations are that semiconductor industry revenue growth will accelerate to annualized double-digit levels this decade, spurred by demand for AI chips. This would be a growth rate well above levels that we’ve seen since the mid-1990s, with predictions that the roughly US$50 billion dollars of AI chips sold in 2023 could rise to US$400 billion dollars of sales before the end of the decade.

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Amazon’s Latest Logistical Feat Delivers Long-Term Profit Gains

As generative artificial intelligence (AI) captures investors’ curiosity, Amazon’s AWS web-services division has been in the spotlight. How the performance of AWS is affected by the growth in AI is important because even though the business accounts for less than 20% of Amazon’s overall revenue, it has been the source of most of the company’s profits in recent years.

But with so much focus on AI, what is perhaps under-appreciated is that Amazon’s e-commerce business recently underwent a transformation of its own—a rethinking of how it gets customers’ packages from point A to point B. Because of this new strategy, the business, where profitability has been low and erratic, may be on the cusp of a new era in which margins finally reach—and sustain—an attractive level.

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Baidu Abandons Moonshots to Search for Earthly Profits

In early January, Chinese internet giant Baidu surprised markets with the news that it was donating a cutting-edge quantum computer, the lab where it was built, and all the associated technology to the Chinese government.

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Ramadan’s Shifting Dates Have Complex Effects on Businesses

The holy month of Ramadan affects companies and products differently each year, and it is essential for investors in Muslim-majority countries to understand these effects. The holiday, during which Muslims fast from dawn to dusk, starts 10-12 days earlier each year, unlike fixed holidays such as Christmas. This year, Ramadan starts at sunset on March 10 and lasts until April 9.

Ramadan’s Slowly Shifting Seasonality

Timing of Ramadan relative to Northern Hemisphere seasons, 2010-2040

The fact that the holy month moves each year means that the effects of Ramadan on businesses change over time. Recently, when Ramadan was during the summer, it was a significant headwind for companies such as brewers, as the fast suppressed demand for beer during what would otherwise be a peak month. But now as Ramadan is moving earlier in the year, that headwind will lessen.

Learn more about Ramadan’s effect on businesses in Muslim-majority countries, or those with significant Muslim populations, in our extended analysis.

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How Persistent Are Quality and Growth?

At Harding Loevner, we are quality growth investors, which means we seek to invest in well-managed, financially sound businesses that can sustain profitable growth across economic cycles. But what do we mean when we talk about quality and growth as attributes of a company? While there is no standard definition of quality or growth in the investing world, our quality rankings consider factors such as the stability, level, and trend of a company’s profitability as well as its balance-sheet strength, and our growth rankings consider historical and estimated future changes in sales, earnings, and cash flows.

How companies perform on those measures can change over time. Industry dynamics evolve, which can lead to a shift in competitive positioning. Macroeconomic cycles and deviations in management strategy can also alter the long-term outlook. Even companies that consistently rank highly for quality and growth must be continuously assessed for signs of deterioration in their financial health, competitive advantages, and other factors. The challenge isn’t just determining the businesses that meet our criteria today, but also which businesses will sustain their quality and growth characteristics over the long run.

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Fewer Babies Means Better Business for Diaper Maker

Japan has been undergoing a baby bust for decades. In the early 1970s, there were years where more than 2 million babies were born in Japan, but since then, those numbers have declined steadily. By the 1990s, there were about 1.2 million babies born each year in Japan, while in 2022, births fell below 800,000 for the first time.

Source: The Statistics Bureau of Japan

Skiing in Avalanche Terrain Is a Lesson in Risk Management

Cognitive biases can wreak havoc on decision making. That’s why the Harding Loevner investment process is structured to help avoid errors in thinking that can lead investors to make irrational decisions. By identifying a strict set of criteria for the companies we hold and the method by which we track and debate these requisite characteristics, there’s less room for human behavioral flaws to influence our actions.

Backcountry skiers—who routinely navigate avalanche-prone terrain—seek to avoid danger in much the same way, says Patrick Todd, CFA, a portfolio manager and analyst at Harding Loevner. For example, every trip to the backcountry involves scrutinizing the snow conditions beforehand and making a pre-commitment that outlines the actions he and his group will take should the conditions differ once they ascend the mountain. Sometimes, the best decision is to turn back despite the time, effort, and money that already went into the trip. When skiers wrestle with this decision, it’s the sunk-cost fallacy at play, one of the many cognitive biases that can rear its ugly head in backcountry skiing—and investing.

In the video above, Patrick discusses more of the parallels between the risks in investing and backcountry skiing and how a thoughtful process can mitigate both.

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Low Debt Companies Fare Better in High Interest Rate Times

Portfolio manager Andrew West, CFA, explains how selecting companies with strong balance sheets and low debt safeguards against the potential erosion of the value when interest rates are elevated.

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Can a Raw Deal Be Good for Netflix?

Did Netflix just put a headlock on the entertainment industry? On January 23, the company announced a US$5 billion deal to stream the professional wresting show Raw and other programs from World Wrestling Entertainment, expanding into live sports programming (the recent sexual-assault allegations against WWE founder Vince McMahon, which led to his resignation from the board of WWE’s parent company, appear unlikely to derail the partnership).

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Japan Digging Out of Chronic Deflation One IT Worker at a Time

In Japan, it’s common for an employee to work for the same company for their entire career. Indeed, lifetime employment has been a central feature of the nation’s economy since World War II, and with such limited job mobility, nominal wages haven’t grown for three decades.

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Our 2023 Letter to Shareholders

Three years since the first COVID-19 vaccine was approved, growth investors have felt the pain of a relative bear market compared to their value peers. In our annual letter to shareholders, we examine the current economic climate, and discuss why we believe that the types of companies in which we invest are well-positioned to navigate the challenges ahead.

In sum, this time is no different from similar periods in the past in which our taste for high-quality, rapidly growing companies has been out of step with market fashion. We foresee an eventual return of investor focus on such fundamental factors in the face of uncertain and slower economic and corporate profit growth. We therefore remain committed to our favored targets, while reinforcing our attention to the price we are asked to pay for them.

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Investments involve risk and loss is possible.

The Portfolio’s investment objectives, risks, charges and expenses must be read and considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company. They may be obtained by calling toll free (877) 435-8105, or visiting hardingloevnerfunds.com.

The Portfolio is distributed by Quasar Distributors, LLC.

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Experience in a “Wicked” World

We often hear about the value of experience in the investment business. But what, really, is that value? Implicit in the idea that experience is valuable is a belief that experience necessarily leads to expertise. (I’m using psychology professor Gregory Northcraft’s definition of being a expert here—experts have superior predictive models that work.)

Analyzing Industry Structure through Porter’s Five Forces Model

As bottom-up investors, we aim to invest in high-quality growth businesses at reasonable prices to provide superior risk-adjusted returns over the long term. To determine what constitutes a high-quality growth business, we research a company’s management, financial strength, growth prospects, and we closely examine the industry in which it operates to determine the company’s competitive advantage.

It’s as important to examine a company’s industry as it is to examine the fundamentals of a company. An analysis of industry structure can inform how well-positioned a company is relative to competitors, as well as the profit potential for the company.

Our analysis is guided by Harvard University professor Michael Porter’s Five Forces, which were first introduced in a 1979 issue of Harvard Business Review and later detailed in his 1980 book, Competitive Strategy: Techniques for Analyzing Industries and Competitors.

In this six-part video series, we examine each Porter Force and discuss how we use them to analyze industries. Watch the series introduction below and click through to see how we leverage Michael Porter’s Five Forces framework for industry analysis.

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Japan’s Past Hints at China’s Future

China faces a demographic shift similar to Japan three decades ago. Portfolio manager Jingyi Li explains how that comparison can help guide investors looking at China today.

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NVIDIA and the Cautionary Tale of Cisco Systems

NVIDIA, the giant semiconductor company founded by Taiwanese American Jensen Huang, seems invincible these days. Annual revenue has more than doubled since 2020. Its stock price has more than doubled this year and is up more than 700% over the past five years. It is one of the rare trillion-dollar market-cap companies.

Competitive Advantage and Pricing Power

Portfolio manager Jingyi Li discusses how several Global Equities portfolio companies are using their pricing power to navigate through this period of higher interest rates and higher inflation.

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The Democratic Republic of The Congo Could Be the Next Big Frontier Market, Eventually

The Democratic Republic of the Congo, which has abundant natural resources, rich farmland, and the powerful Congo River, has the potential to become the renewable-energy hub for the entire world and Africa’s breadbasket. I toured Kenya and the DRC in July on a trip organized by Nairobi-based Equity Bank, which operates a subsidiary in the DRC. As an analyst of frontier-market companies, what I saw intrigued me. The DRC is a nation with vast potential, as well as significant hurdles to overcome.

Navigating Conflict in the Middle East

Portfolio manager Anix Vyas, CFA, discusses how the current conflict in the Middle East is affecting International Small Companies portfolio holding CyberArk.

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Chinese Companies Look Better than China’s Economy

In 2023, Chinese markets have been roiled by continued trade tensions, slowing economic growth, and deleveraging in the property sector. Despite this difficult backdrop, there are reasons to be optimistic about the growth prospects of some Chinese companies. Portfolio Managers Andrew West, CFA, and Lee Gao discuss their current perspectives on China with Portfolio Specialist Apurva Schwartz, including how they weigh the opportunities and risks of investing in the market.

Slowdown in Economic Growth

Real estate, the biggest source of wealth for Chinese consumers, was in bubble territory and has been slowing for a while. This has negatively affected consumer confidence and household consumption.

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Cable Strikes Back

Most people viewed the recent contentious negotiations between Walt Disney and Charter Communications like a prize fight: two combatants, one winner.

I see it differently. Viewed through the lens of Michael Porter’s competitive forces, which we use at Harding Loevner to analyze industry dynamics, the dispute was a clear example of a change in the bargaining power of buyers amid the changing economics of streaming services.

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Ozempic and the Substitution Trade

The diabetes drug Ozempic has made headlines recently as the secret behind several slimmed-down stars of the Bravo network’s “Real Housewives” franchise. Tabloid fodder doesn’t usually matter to investors, but the story of Ozempic is one worth reading.

The twist is that Ozempic, a trade name for semaglutide, is a diabetes drug, not an obesity drug. Semaglutide is however effective in inducing weight loss; its creator Novo Nordisk markets a separate version called Wegovy specifically for obesity. Wegovy became so popular there were shortages of it, so doctors began prescribing Ozempic “off label” for a condition other than its intended use. That popularity fueled Novo Nordisk shares and this month it pushed past LVMH as Europe’s most valuable company.

Growth Opportunities from Electrification

Portfolio manager Scott Crawshaw highlights several companies in our Emerging Markets portfolio that are poised to benefit from increasing electrical power demand.

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Meta Accelerates Its AI Game

Meta has been quieter about its artificial-intelligence-focused endeavors this year than some of its big-tech peers like Microsoft and NVIDIA, but it expects just as massive a transformation of its business from the much-hyped technology.

In its second-quarter earnings conference call, Meta founder and CEO Mark Zuckerberg detailed how AI permeates the company. For example, nearly all of Meta’s advertisers now use at least one AI-based product, allowing them, for instance, to personalize and customize ads. He also touted an increase of 7% in time spent on Facebook after launching AI-recommended content from accounts that users don’t follow.

Now the company plans an aggressive push of its own version of generative AI, the kinds of large language models that have gotten so much attention lately. In July, the company released an open-source—i.e., free for even commercial use—generative AI platform called Llama 2, which Meta hopes will emerge as a competitor to OpenAI’s GPT-4. Meta is betting its platform will unleash users’ creative potential and result in a flood of content. If that occurs, Meta’s powerful algorithms for matching content with users—4 billion of them across all of its platforms—will become indispensable as a content-discovery tool with a rich set of monetization options from advertising to ecommerce to subscriptions.

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Generative AI Through a Fundamental-Research Lens

The following is an excerpt from our second-quarter report for the Global Equity strategy. Click here to read the full report.

Anyone who has interacted with popular AI models—asked them about the mysteries of life and the cosmos or created convincing Van Gogh replicas using AI-enabled image generators—can sense that we may be in the midst of a technological revolution. That prospect has consumed equity markets lately, with seven US tech-related stocks responsible for most of the market appreciation in the second quarter.

As an investor in high-quality, growing businesses, we have always tried to position this portfolio to benefit from secular trends, the kind that transcend economic cycles and are driven by fundamental changes in key areas such as tech. Still, it is incredibly difficult for anyone to predict how such trends will unfold; the vicissitudes of cryptocurrency are a sobering reminder of this. Furthermore, as seen with the rise of the internet and, later, mobile connectivity, technology is merely a platform; it’s the applications of the technology that eventually determine many of the winners and losers. In the case of generative AI, some of the future applications may not yet be conceivable, although many companies, even outside the tech field, are now pondering the possibilities.

India: Four Takeaways from Our Travels

With high GDP growth and a rapidly expanding industrial base, there is a lot of optimism about the Indian economy. And having passed China earlier this year as the world’s most populous nation, there is the potential for a “demographic dividend” to bolster that growth in the coming decades. Recently, three Harding Loevner colleagues traveled to India to talk to companies and see conditions on the ground for themselves. In the video series below, portfolio manager and analyst Jafar Rizvi and analysts Sean Contant and Chris Nealand discuss what they saw on their trip and their perspectives on India with portfolio specialist Apurva Schwartz.

Vietnam’s Labor Costs, Taxes Attract Chinese Manufacturers

Portfolio Manager Wenting Shen, CFA, and Portfolio Specialist Apurva Schwartz discuss why Chinese companies are relocating production facilities to Southeast Asia. Watch the rest of their conversation.

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What P&G’s Pricing Decisions Tell Us About Inflation

Inflation has been the relentless economic theme of the last two years. Even with interest rates higher than before the pandemic, global supply chains no longer paralyzed by virus-related bottlenecks, and the World Health Organization declaring an end to the COVID-19 emergency, prices for goods and services in many parts of the world continue to climb.

As the world’s largest consumer-goods company, Procter & Gamble provides insight into what’s driving the pricing decisions at big brands.

How Are Earnings of Emerging Markets Companies Holding Up?

Portfolio manager Pradipta Chakrabortty discusses the earnings bright spots within emerging markets regions and sectors.

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Why Own International Companies?

When US stocks have outperformed for as long as they have—creating the world’s first trillion-dollar companies in the process—it’s easy to forget that plenty of highly profitable businesses exist a long way from Silicon Valley or Seattle.

While US companies account for just over 60% of the market capitalization of the MSCI All Country World Index, their weight is a tad misleading given that a few technology giants—Alphabet, Amazon, Apple, and Microsoft—weigh heavily on the scale. Together, those four are valued at nearly US$8 trillion, more than the next 15 largest US stocks combined.

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Small Caps: Adventures in Fundamental Research

How do you begin to research a company when so little information is readily available beyond a name and a set of regulatory filings? This is the challenge that defines small-cap investing, an asset class that invariably entails an adventure in fundamental research.

The superheroes of the stock market—mainly US corporations valued at or close to a trillion dollars—tend to dominate investment news and research. And yet little-known small companies—often based outside the US—that never generate a headline remain some of the most vibrant sources of innovation. If the biggest large caps sell the finished products that investors and consumers know well, small caps often occupy a small niche along the global supply chain, providing a critical piece of technology known only to its intended audience.

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Macro Do’s and Don’ts

This commentary is excerpted from the Harding Loevner Third Quarter 2022 International Report.

One of our more acid-tongued colleagues likes to observe that “just because we don’t do macro, it doesn’t mean the macro cannot do us.” The observation is a challenge to our bottom-up investment philosophy and merits a response. What does his comment really mean? Is he correct?

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Demolition Work in Progress

After cheering asset prices higher for the best part of two decades, the developed world’s central banks have dusted off their hard hats in preparation for a controlled demolition of real estate and equity prices. Much attention has focused on whether the central planners can tame inflation without crashing the real economy. Unfortunately, inflation is a syndrome—the manifestation of an interlocking set of imbalances between the real and financial economies. As such, it does not lend itself to being fine-tuned by even well-intentioned technocrats. Ultimately, the removal of monetary largess not only risks damaging real economic activity but also collapsing flimsy structures built up over 15 years of easy money.

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Going Home: An Account from China’s “Zero-COVID” Frontline

Prior to COVID-19, Wenting Shen travelled to China regularly to visit managements of current and prospective investments. Round-trip travel to China from the US was impossible during the first two years of COVID-19, but recent easing of US travel restrictions encouraged her to plan a trip. With seats going fast, she snagged one on a flight from Newark to Shanghai for March 30. After three negative PCR tests over seven days at a Chinese-government-approved clinic in Queens, New York, she was ready to fly.

But days before Shen’s departure, new complications arose: outbreaks of the Omicron variant in several Chinese cities, including Shanghai, were prompting citywide lockdowns. The flight was still due to depart, but had been rerouted to Fuzhou, a coastal city across the strait from Taiwan, 450 miles to the Southwest.

The natural—some would say, prudent—decision at this point might have been to postpone her trip. But Shen, worried she might not easily get another ticket, pressed ahead. Here are her travel bulletins.

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Does the Equity Market Know Something the Fixed Income Market Doesn’t?

Despite recent volatility the bond market has yet to lose its composure over the multi-decade high in inflation. In the US, ten-year Treasury yields have risen, but only to levels they reached prior to the pandemic, and, while ten-year real yields have been a little perkier, they are still below zero. As a result, the longer-term inflation expectations baked into today’s bond prices remain bunched up around 2% despite headline inflation running at over three times that rate. Short-term yields anticipate a series of hikes in the federal funds rate, the central bank’s standard response to persistent inflation, but even forward curves expect short-term yields to top out at only around 2.5%, within spitting distance of where they peaked back in 2018 when inflation was slumbering at 2%.

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Russia, Risk, and Decision-Making

Our portfolio results have suffered from the impact of Russia’s war with Ukraine that began on February 24 and from the sanctions exerted on Russia by the Western powers. On the eve of the invasion, our Emerging Markets (EM) Equity strategy owned four Russian stocks representing 8% of the portfolio, and our International Equity strategy owned two of those representing just over 2%. As I write this, trading has been halted in Russian securities, and we have assigned all our Russian holdings, for now, a carrying value of zero.

While ours certainly is not the only firm to have been caught out by Russian exposure, and the past few months of rising inflation and interest rate fears have in some ways brought even bigger headaches for our quality-growth investing style, the Russia losses were still “a gut punch,” as a colleague recently told NPR. And we have been asking ourselves, what did we get wrong, and debating what could have been predicted.

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Beauty and the Beast

The rise in passive investing is undoubtedly among the most important developments in asset management. The mass adoption of cheap, easily accessible portfolio building blocks that mimic the performance of market capitalization-weighted indices is nothing short of a paradigm shift. Indexed assets now account for over 50% of US domestic equity funds, 40% of global funds, and, despite a later start, already constitute 30% of fixed income fund assets.1 The shift is ongoing and it’s far from clear where the upper bound, if any, might lie.

Much of the debate surrounding indexing centers on the relative merits of taking an active versus passive investment approach. But the question of how indexing might be reshaping market structure is largely unexplored. The standing assumption is that, since passive investment flows mirror the prevailing distribution of capital, index trades are bereft of information and therefore have no effect on the pricing of the underlying securities; hence the overall scale of indexing is irrelevant. But this assumption becomes more tenuous as the share of passively managed assets grows. What if passive increased to, say, 100% of all equity assets? Would those investments still have no effect on prices?

It’s unclear how the widespread use of indexing may be affecting market structure; that is, at what point the sheer quantity of assets mimicking market behavior could start to change the behavior. Maybe it already has.

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A Ground’s Eye View on Inflation and Its Persistence

The pandemic sowed the seeds of today’s inflation. That much is clear. Last year, fear and government-mandated lockdowns sparked a global recession. Businesses rushed to cut production ahead of an anticipated slowdown in consumption, or were hobbled by forced plant closings, anxious workers, or snarled logistics. But the sheer sweep of the income support in many developed countries meant that household incomes didn’t fall nearly as far as had been expected based on the rise in unemployment. Unable to spend on services like eating out and travel, consumers flush with cash turned to buying, or attempting to buy, big-ticket goods and better houses.

The outsized demand for durable goods has run headlong into the diminished supply. While the springboard for price increases may have been reduced supply, the strength and persistence of those increases, which are now feeding through to labor markets, are raising the specter that aggregate demand is outpacing even normalized aggregate supply. There is precious little that monetary policy can do to counter supply-led inflation, but—Omicron willing—it is likely to be temporary. But if inflation comes to be led by stubborn excess demand, then tight monetary policy is the orthodox response, and we can expect central banks to hit the economy over the head with a brick to prevent a sustained wage-price spiral. Demand-led inflation would have significant implications for asset prices.

Inflation is notoriously difficult to forecast; even some at the US Federal Reserve (Fed) concede that it has no working model for inflation.1 We could do no better and accordingly make no effort to forecast future inflation. What we can do is talk to the companies we own or follow and tease out the impact on their earnings from the rising input costs they’re experiencing; their changing bargaining power vis à vis their suppliers; whether they are able to pass on higher costs to their customers before stifling demand; and how all that is coloring their business outlook. The following represents what our research analysts have been able to glean from those conversations.

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What’s Driving China’s Regulatory Transformation

On the surface, there are few precedents for China’s quick-fire regulatory changes, which over the past few months have transformed everything from e-commerce and education to health care and real estate.

One can only speculate on the reasons for this synchronous timing, but one possibility that stands out is the confluence of the five-year policy and leadership cycles in China. This is the first year of the 2021-25 Five-Year Plan, but more importantly, it is the final full year before the top 200 or so members of the Central Committee of the Communist Party of China are selected at its National Congress in October 2022. It bears remembering that those politicians are similar to counterparts elsewhere in facing challenges that have diverted them from other priorities. They spent the first two years of their terms coping with escalating US-China trade tensions, and just when “normal order” loomed after the signing of the Phase One trade agreement, COVID-19 hijacked everyone’s lives. Only recently have they gotten a chance to work on much-delayed goals.

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Culture Club

In sports, dynasties like the American football Packers of the 1960s, the New Zealand All Blacks national rugby squad, and basketball’s San Antonio Spurs have demonstrated the power of culture to bind individuals together and enable a team to produce results above what could be expected by simply adding up the expected contributions of each member. The business world has tried to produce similar results; although exactly what culture is remains poorly defined, the hundreds of jobs available on LinkedIn seeking an individual to oversee a company’s culture certainly attest to its importance. I’ve been fortunate to have a front row seat at an investment firm (Harding Loevner) known for its strong culture and, more recently, at a UK football club (Plymouth Argyle) that is trying to develop a culture that will strengthen the organization behind the team on the pitch. As is frequently the case because of my dual roles, the parallels between the two industries and the two organizations are very much on my mind.

There are many similarities between cultures at football clubs and investment organizations, despite the underlying processes required by their core activities—making decisions on the pitch about how to try and score and defend or making decisions about buying and selling securities—being very different.

In both industries, the goal is for the team to be greater than the sum of its parts. On the pitch, an individual must rely on teammates, but certainly not debate or challenge them. Rather, coaches teach decision making so that, like muscle memory, it is instantaneous and requires little active thought.

At Harding Loevner, rules and processes constrain decision making to prevent it from being dominated by cognitive biases. Colleagues think for themselves but must expose their ideas to challenge. This is the core of our investment culture—what we call “collaboration without consensus.” We believe that one of the most difficult biases to overcome in conducting research is the tendency to give precedence to evidence that confirms our beliefs and to ignore evidence that challenges them. So, it is important that our ideas be continuously exposed to challenge. However, this leads to other problems. Humans, as social beings, generally don’t like disagreement; they are literally fearful of it. That’s why an important part of a culture of collaboration without consensus is that it be enabled by both transparency and the value of tolerance. We strive to sustain an environment in which colleagues do not feel threatened by disagreement and recognize that challenges—while discomfiting—are essential for good decision making.

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From A to Xi: Regulatory Risk in China

Recent changes in the regulatory environment in China have sparked questions and debate about the future of investing in the country, both among people in the wider world and inside Harding Loevner. On August 4, 2021, we hosted a special webcast that featured a lively discussion about these issues. A complete video replay of the conversation is above, but if you prefer to read what was said, a transcript of the discussion follows below. The answers have been lightly edited for clarity.

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Stock Portfolios, Football Teams, and the Stories We Tell Ourselves about Each

The world is complex and unpredictable, but humans prefer order, and cause and effect, so therefore tell stories that purport to explain what is simply random. Narratives pre-date writing. They help make events coherent and memorable, while arousing emotions in the listener. Behavioral biases, which all humans share, are in many cases essentially products of the stories we tell ourselves. The more detailed the story, the more entertaining it is and the more powerfully it can affect our emotions. We love stories. That can often be wonderful, but in decision making it can be dangerous.

In investing, there has been at least a little progress towards improving decision making by resisting the power of stories. Quantitative investors describe how they adhere to purely objective rules (rules and lines of code that, of course, they themselves have written) to govern their behavior and reduce bias. “Quantamentalists,” another breed of investor, allow some judgement to enter their decision making once they have established the framework. They do this in part in recognition that, as a rule, most humans don’t like rules. We suffer from what psychologists call “algorithm aversion,” i.e. preferring to go with our gut. That preference results from our need to remain in control, or at least to believe we are. Permitting human override of an algorithm may degrade the quality of its output, but in granting themselves the comfort of exercising some degree of control, decision makers likely improve their rate of adherence, for an overall improvement in outcomes. I fully expect self-driving cars to come with a steering wheel that will have no impact on direction of travel, but will allow the human passenger to feel more secure than if she were simply sitting back and giving herself over fully to the computer under the hood.

In his book The Success Equation, Michael Mauboussin writes extensively about the importance of a strong process and rules in activities where the immediate outcome is driven by luck and skill. He describes how it is possible to improve skill through what has become known as deliberate practice: repetitive, purposeful, and systematic repetition with immediate and specific feedback. Luck, however, can only be managed by having a strong process, with rules or standards constraining decision making and the urge to impute too much importance to our role in any one result. In activities such as investing or team sports—arenas where skill and luck both come into play—narrative is particularly seductive, making adherence to this recipe for success a constant battle.

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Big Health vs. Big Tech: A Fight over the Future of US Health Care

The $4 trillion US health care system represents both the best and worst of health care globally, responsible for the vast majority of leading-edge treatments and providers as well as high rates of uninsured, a staggering $11,000 in annual expenditures per person, and among the worst levels of infant mortality and life expectancy in the developed world. The system’s structure—a hodgepodge of private employer-subsidized, public, and quasi-public insurers, for-profit and not-for-profit networks and unaffiliated providers—famously incentivizes some providers to ring up higher volumes of procedures while inflating fees to cover the huge overhead required to administer the complexity.

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Meme Stocks and Market Structure

Unless your investment horizon is measured in milliseconds, it’s usually best to ignore what everyone else is doing. But, occasionally, the market throws up something so peculiar that you have no choice but to sit up and pay attention.

The GameStop debacle, and the meme stock phenomenon more broadly, certainly fit that category. The story bears all the hallmarks of a Hollywood script: how a ragtag group of mostly retail investors, armed with commission-free trading apps and loosely coordinated across online message boards, executed a colossal short squeeze on the hedge funds betting against a down-at-its-heels brick-and-mortar video game retailer while inflicting bloody noses on some of Wall Street’s supposedly most-sophisticated operators. Predictably, several films are already in the works. But beyond the thrill of extravagant market pyrotechnics served up with a generous side of schadenfreude at seeing the odd master of the universe brought low by the great unwashed, why should we care?

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Don’t Just Do Something—Stand There

Humans prefer to do something rather than nothing. We like office environments that are a “hive of activity” and commend “men of action.” When stuck in a traffic jam, we will take an alternate route just to keep moving, even if it prolongs the journey. We tend, though, to conflate activity with productivity, mistaking the people whom we see doing the most with those who are the most valuable.

We see this bias in many domains. Our political leaders tend to respond to a crisis with ill-considered policies that capture attention but often do little good and may even do harm. It would be unacceptable for them to stand by and simply do nothing. While serving as both vice chairman of Harding Loevner and as chairman of a professional soccer club that competes in the English Football League (EFL), I have been struck by the parallels between investing and sports when it comes to the biases that damage effective decision-making. Studies have looked at penalty kicks in soccer. When a penalty is awarded, the ball is placed 12 yards from the center of the goal and a kicker gets the opportunity to score with only the goalkeeper standing in the way. It turns out that because of the goalkeeper’s bias for action, the optimal place to kick the ball is directly at the center of the goal. A goalkeeper will almost always dive one way or another in anticipation. If he dives the wrong way, he’s forgiven as having simply guessed wrong, or as being sent the wrong way by the kicker’s supposed feint. If he dives the right way, he has a chance to stop the ball entering the goal. If he merely stands in the middle, however, he is the subject of much abuse for doing nothing.

Investors fall victim to similar pressures and impulses. The immediate costs of transacting are low, and the propensity to transact is high. The result is that investors transact too much, and their returns suffer. They tend to transact at the wrong time, buying after prices have risen, and selling after prices have fallen.

Underlying these behaviors is a general misunderstanding of the roles of luck and skill. In sports and in investing, short-term results are the outcome of a combination of the two. Yet, we tend both to attribute the outcome more to skill than to luck and to extrapolate a series of outcomes (good or bad) into the future. This tendency stems from our deep-seated need for explanation, and a need to feel we are in control even when we are not. This occurs particularly in those sports, like soccer, that are generally low-scoring affairs. Unlike in basketball, for example, where there will be more than a hundred points in a game, the average number of goals in a professional soccer game is roughly three. The result of a single game will largely be driven by luck—one bobble of the ball, the inches between hitting a goalpost and scoring, a poor refereeing decision. Yet the narrative in post-match interviews is seldom “we got lucky.” At least, it’s seldom the case that “we got lucky” when the interviewee’s team wins. When the team loses, the loss is the result of bad luck! How similar this is to investment narratives, where there seems to be only two kinds of investment managers: the talented, and the unlucky.

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4 Sources of Edge for Active Managers

People are deeply flawed when it comes to making investment decisions. It is vital for active investment managers to be aware of their own behavioral defects as humans and counter these shortcomings with process. Good active managers must be able to identify their “sources of edge,” the characteristics that enable them to generate sustainable alpha.

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Too Much Information

In the late 1950s, in his book Common Stocks and Uncommon Profits, Phil Fisher recommended making investment decisions based on “scuttlebutt,” the kind of information an investor could get by asking around. This entailed tracking down and interrogating customers and competitors, employees, and former employees. Doing research, in the sense of gathering evidence and analyzing it to reach a conclusion, was hard work, but enabled analysts committed to such intellectual labor to obtain an edge over their competitors simply by having better, and more complete, information.

Indeed, when I started my career in investing in the late 1970s, obtaining even basic financial info about a German car company still required going to Germany and knocking on the company’s door.

Now gathering information no longer takes much effort. We are deluged by floods of data—not only the details of prices, volumes, margins, and capital investments of individual companies, but also highly granular data about credit card receipts, numbers of cars in parking lots, or words used in media reports. These new, “alternative” sources of information have briefly given some stock pickers a slight edge in predicting short-term stock price movements. The informational advantage provided by such data is but fleeting, however; once this data is commercially accessible to everyone, the advantage disappears. Thus, even for the short-term investor, information gathering itself no longer provides a lasting edge.

For long-term investors, the relationship to information has changed even more fundamentally. You no longer need to seek information; it finds you. Your job, rather, is to act as what Lou Gerstner, the former CEO of IBM, called an “intelligent filter”—determining the information that is important and ignoring data that (in the case of the investor) doesn’t help you forecast cash flows and estimate the value of a security.

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When Will Life Return to Normal?

If we are honest with ourselves, it is a question that almost all of us, as investors and people, are probably wondering right about now. In this case, it took the form of the following note from a young colleague based in locked-down London directed to me and my fellow Health Care analyst as part of the daily, ongoing Research Information Group email discussion that has always comprised much of our meeting, brainstorm, and “water-cooler” time here at Harding Loevner.

Considering the challenges of [vaccine] manufacturing and distribution, what would be your best estimate for when developed economies will return to “normality”? I.e., people in developed economies are allowed—and feel safe enough—to live a life more like 2019. E.g., Sept 2021? Jan 2022? Never?

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Getting Real About Inflation … and Gold

As favorable vaccine news piles up, the winds of reflation are stirring. Early signs of an equity market style rotation in favor of cyclical value stocks, a weakening of the safe-haven US dollar, and a run-up in market-derived measures of inflation expectations all point to a resurgence of animal spirits despite a gloomy outlook for the economy. With our monetary maestros promising easy money into the distant future come what may, it is time to spare a thought for what the possible return of higher inflation might do to your portfolio. Inflation is viewed as the bane of fixed income investments, and rightfully so. But inflation can also wreak havoc on stocks. In theory, inflation should have no impact on equities provided companies are able to pass along higher input costs to their customers. In practice, equity valuations are highly sensitive to changes in the price level, tending to plummet when prices jump. No wonder investors are already casting about for inflation protection.

For a vociferous minority, the only bankable hedge for inflation is gold. For them, every spike in the gold price is reproof of government perfidy and foreshadows an inflationary surge. The evidence linking gold’s price and inflation, however, is curiously threadbare. If gold is an unreliable hedge against rising prices, what role, if any, should it play in a portfolio?

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Down the Rabbit Hole

In trying to make sense of the state of things today, I found myself thinking of snippets I’ve heard from Lewis Carroll’s Alice in Wonderland. Until recently, however, I had never actually read the story. So, I went to Amazon.com and ordered a copy of the entire Alice in Wonderland Collection (Alice’s Adventures UndergroundAlice’s Adventures in WonderlandAlice Through the Looking Glass, and The Hunting of the Snark). While I was underwhelmed by the character development in these stories, I did find some takeaways that seem relevant today. Still, perhaps the most provocative line from Alice that I came across is one that was written not by Lewis Carroll but by Czech film director Jan Švankmajer for his 1988 film Alice.

The film opens with Alice saying, in part, “But, I nearly forgot, you must close your eyes otherwise you won’t see anything.” After all, Alice would never have experienced Wonderland or journeyed through the looking glass if she had not closed her eyes. And we’d have no Mad Hatter, no March Hare, and, of course, no Red Queen.

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Out of Our Minds—From the Beginning

People who know a little about the history of our firm sometimes credit us with being ahead of our time. When we set out 30+ years ago we made an early decision that we would only invest in stocks of high-quality companies capable of growing revenues and cash flows over long periods of time, and then only when we could purchase them at reasonable prices. Mind you, this was two years before Eugene Fama and Kenneth French proposed their three-factor model incorporating value, and more than a decade before Cliff Asness’s seminal work on quality or the conflicting studies on the long-term premium provided by growth. So, we weren’t thinking of these aspects of our process as “factors,” or permanent sources of returns, in the current sense of the term. We thought they were merely sensible principles, based on our own beliefs about the markets, that would give us the best chance of achieving the above-market returns necessary to satisfy our clients and sustain our fledgling enterprise. Considering we had left well-paying jobs to stake our futures on these ideas, there were probably some people who thought us out of our minds. And, in a sense, they were right.


“Out of Our Minds” presents the individual viewpoints of members of Harding Loevner on a range of investment topics. For more detailed information regarding particular investment strategies, please visit our website, www.hardingloevner.com. Any views expressed by employees of Harding Loevner are solely their own.

Any discussion of specific securities is not a recommendation to purchase or sell a particular security. Non-performance based criteria have been used to select the securities discussed. It should not be assumed that investment in the securities discussed has been or will be profitable. To request a complete list of holdings for the past year, please contact Harding Loevner.

There is no guarantee that any investment strategy will meet its objective. Past performance does not guarantee future results.

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