Out of
Our Minds

Source: YCharts

By all accounts, NVIDIA is strong—in its last full fiscal year (2022), it earned US$9.8 billion on US$27 billion in revenue—and in an enviable position. Semiconductors are the oil of the 21st century, an essential component for the tech-fueled modern world. The company produces chips that allow for the most advanced computing, expanding from its core gaming prowess into related lucrative areas like data centers, autos, and of course AI.

But as Cisco shows, the success of a company and the performance of its stock aren’t the same thing, and as valuations increase, it’s more and more difficult for a stock to outperform. Over the past 50 years, 231 companies have reached a similar multiple. Only 20% of the stocks trading with a price/sales ratio between 30 and 40 outperformed the market over the next 12 months. The more you extend your time horizon, the worse the results get. Over a 10-year period, that number drops down to 6%.¹

NVIDIA is a good company with all the quality and growth prospects we look for in an investment. The critical question is how much one is willing to pay for those prospects. As Cisco showed in the waning days of the dot-com boom, overpaying for a good company is a bad choice.

Endnotes

¹ Siegel, Jeremy with Schwartz, Jeremy. Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, Sixth edition. McGraw-Hill Companies, 2022

Portfolio Manager and Analyst Babatunde Ojo, CFA, at a Somika mine in Lubumbashi Katanga, Democratic Republic of the Congo.

That potential is attracting companies like Equity Bank, the largest bank in Kenya. The company has acquired two DRC-based banks in recent years, which now comprise 30% of its total assets. Equity Bank is early to the DRC, but we expect to see more investments flow to the country in the coming years. It is barely scratching the surface of what it could become.

Decades of autocratic rule and corruption have kept the country from tapping its potential. Beginning with Mobutu Sese Seko in 1965, the DRC was marred by wars and political instability under a series of dictators. Because of that, the country’s economic development has been weak, even by African standards. Ranked by GDP per capita, it is one of the poorest nations in the world. The entire country produces only about 3,000 megawatts of power, leading to constant shortages. Less than 10% of the country’s arable land is currently being farmed, making the country dependent on others for food. Only 6% of the population have bank accounts.

The DRC’s financial infrastructure is bare bones. Equity Bank’s DRC-based subsidiary, Equity Banque Commerciale du Congo (BCDC), is the largest bank in the country in terms of bank accounts but has only 1.9 million clients. And the DRC effectively has no capital market; there aren’t markets for government or corporate equities or bonds, which results in a low savings rate, deters economic growth, and makes the economy less efficient.

The physical infrastructure isn’t much further along. Simply generating power is a challenge; energy shortages are regular and severe. Somika, a mining company in Lubumbashi, the DRC’s second-largest city, provides its own electricity with diesel-powered generators, making energy and logistics the areas of some of its biggest challenges and costs. The result is that, despite having some of the highest grades of copper and cobalt in the world, local mines are not cost-competitive compared to mines in Australia.

Today, the DRC is addressing those and other issues. There’s been political stability since the 2018 election of current President Felix Tshisekedi. Working with developmental partners such as the United Nations, the World Bank, and the International Monetary Fund, his government enacted key political, judicial, and economic reforms that are beginning to unlock the country’s potential. Tshisekedi has attempted to weed out corruption and bring transparency to the government and the markets; these efforts resulted in a US$750 million World Bank financing package in 2022. His administration has proposed nearly 70 reforms focused on boosting business creation, facilitating property transfers, improving international trade, and more. The DRC’s entry into the East African Community trade bloc, also in 2022, opened access to neighboring markets with a combined 300 million residents and a combined GDP of US$285 billion.

Today, the DRC is Africa’s third-fastest-growing economy. Add its vast natural potential to that fact and you can see why companies like Equity Bank are moving there. That makes it enticing for forward-thinking investors.

Two-thirds of private developers cannot service their debt. Deleveraging may continue but Beijing has plenty of policy options available to help revive growth.

Investment Rewards vs. Risk

Quality growth companies are doing well, and valuations look better now than at any point over the last 30 years, suggesting prospective returns could be high. We maintain diversified portfolios and carefully monitor risks to try and take advantage of the opportunities that we see.

Impact On Our Investments

China is a big place; different things happen in different sectors. Despite the broad market slowdown, many of our holdings, which are in globally competitive industries such as solar, electric vehicles, and industrial components, are still growing rapidly.

Source: Statista

Meta’s embrace of AI is one of several efforts the company’s made over the past year to reverse the slump that followed its 2021 shift into the metaverse. Zuckerberg showed common sense on reining in spending, the company executed on its new identifier for advertisers (IDFA) independent ad-targeting model, and it ramped up new initiatives like Reels, Advantage+, and most recently Threads. Meta has also delivered robust recoveries in free cash flow and revenue, with free cash flows for 2023 now forecast at approximately US$30 billion, a big increase from the US$10 billion forecast at the end of 2022. Even critical media coverage about privacy concerns and Facebook’s effects on democracy have waned and regulatory pressures have eased (except in the EU).

All this doesn’t mean Meta’s out of the woods, though. While impressive, the turnaround only just got the company back to where it was a year ago, when it was facing hard questions on rising costs, large infrastructure investments, and its incredibly audacious spending on the metaverse. Reality Labs—the division of the company building the metaverse that has already burned through US$30 billion since 2020—is losing a further US$15 billion per year, and Meta expects those losses to increase meaningfully in fiscal year 2024. Meta has yet to provide an explanation about how this is going to pay off. Even with its recent good fortune and AI potential, Zuckerberg will have to provide some real clarity soon to avoid another investor rebuke.

Endnotes

Image source: Romain TALON – stock.adobe.com.

Economic Advances and Hurdles

People haven’t been this bullish about India for 20 years, although there are reasons to question that enthusiasm.

Government’s Role

Governmental efforts to support industry and the country’s geopolitical positioning are boosting India’s attractiveness to companies.

Unique Spending Habits

Some of what makes India attractive are the unexpected or underappreciated investment opportunities.

Prices Warrant Patience

Investor patience will be required to purchase shares of high-quality companies at appropriate valuations.

Best known for brands such as Cascade, Gillette, Pampers, and Tide, P&G sells items typically found in the bathroom cabinet or under the kitchen sink. They aren’t the sort of hot items consumers blithely splurge on—but they are necessities. Despite P&G’s brands being among the most expensive in their categories, customers are loyal partly because the premium price and name recognition suggest they can expect consistent quality. Family and home care are areas “where the consumer doesn’t want to risk failure,” Andre Schulten, P&G’s chief financial officer, said during an April earnings call. “You don’t want to wash your clothes twice, and you certainly don’t want to deal with a diaper failure.”

With the latest round of price increases, P&G sold just 3% fewer items during the quarter (with the company’s decision to scale back operations in Russia responsible for one percentage point of this decline). This tells us that P&G may be losing some customers to sticker shock, but most are still coughing up the extra money. In fact, shoppers were entirely undeterred in the US, where the company’s sales volumes were up.

P&G is starting to see pushback in Europe, where the problem of stubbornly high inflation is worse due to the conflict in Ukraine and resulting energy crisis. P&G’s private-label rivals, which sell cheaper alternatives to brand-name goods, have been slow to raise prices in those markets as European consumers opt for the more affordable choice. This contrasts with the US, where consumers aren’t trading down and market share for private-label brands remains stable at about 16%, according to P&G. Rather than cut prices in Europe, though, P&G is spending on product and packaging enhancements as well as marketing to boost its brand prestige. For example, it’s promoting Ariel and Tide laundry detergents for use in cold water for consumers wanting to reduce their environmental impact or energy costs.

One reason P&G continues to raise prices for consumers is that the company is feeling the pinch of inflation, too. While higher prices benefited its gross profit margin last quarter by 470 basis points, much of that was offset by higher input expenses. Even as freight and transportation costs have come down, certain commodities and materials, such as ammonia and caustic soda, have gotten more expensive as P&G’s suppliers look to cover their own increased labor costs. Meanwhile, as the company reinvests in its brands to entice shoppers through means other than competitive prices, its operating margin widened by just 40 basis points, an improvement nonetheless.

Inflation isn’t in the rearview mirror, even if it is starting to ease. The companies with the greatest pricing power are taking advantage while they still can.

Because small companies solving esoteric problems usually aren’t well-covered by outside analysts or journalists, building a deep understanding of their businesses requires starting from scratch. For some investment firms, this lack of information means the foray into small-cap territory demands an entirely different way of thinking and working. But for Harding Loevner, it’s why small caps are a natural fit.

Our firm’s investment philosophy is based on the premise that we cannot forecast the direction of stock prices, but that through bottom-up analysis of the more durable aspects of companies we can identify the most exceptional among them. We look for strong competitive advantages, sound finances, and capable leaders, with the belief that companies possessing these attributes can be reasonably expected to produce superior growth and weather unforeseen events better than the average company, which will eventually be reflected in their stock prices.

Because small companies solving esoteric problems usually aren’t well-covered by outside analysts or journalists, building a deep understanding of their businesses requires starting from scratch.

For small companies especially, what this research process means in a practical sense is spending a great deal of time with engineers in manufacturing and R&D facilities, seeing the guts of machinery and the software that forms the mainspring of a company’s growth and competitive advantage. At times, our team has been the first to request a meeting with a small company’s management, never mind visit its factory. We must develop our own expertise—whether it be learning the ins and outs of recycling technology (to determine TOMRA’s role in meeting European climate-change directives) or the intricacies of atmospheric sensors (to understand why customers would choose Vaisala’s for their biolabs, air-traffic control, or space missions).

One challenge of investing in small caps is trying to ascertain whether a company’s niche is one that can provide growth for a very long time. Another is that the barriers to entry are far from assured. Small companies that don’t continually innovate risk ceding their competitive advantage to rivals, particularly when larger, well-capitalized companies take an interest in the same area. Our on-site visits and discussions with suppliers and customers help us gauge R&D initiatives and product launches to make sure that our companies are investing appropriately to protect their turf.

Some investment firms keep small-cap teams separate from the rest of their analysts, a potential limitation to collaborating on bottom-up research. Our small-cap strategies are instead directly supported by Harding Loevner’s global research platform in the same way as all our other strategies. This helps us to understand small companies in the context of their broader industries and develop a more complete view of their supply chains and competitive position relative to rivals of all sizes.

Getting to know businesses and their managements intimately through a systematic process can also tip off investors to disconcerting traits long before routine financial reports do. For example, when the parking lot of one company that wasn’t yet generating free cash flow looked like a Maserati dealership, we suspected management had its priorities wrong and steered clear of the stock; it’s nearly worthless today.

Throughout my ten years managing the International Small Companies (ISC) strategy, most of the entrepreneurs I have encountered didn’t have ambitions of becoming the next celebrity CEO. Or driving a supercar. They mainly want for their businesses to be the best in their niche, and because of that, they tend to face less pressure to expand beyond those core competencies than large companies do. We consider such clear focus to be a hallmark of good management.

As a result, small companies can be quite skilled at what they do. Take Uno Minda, which produces automotive components such as alternate fuel systems used in electric vehicles. Years ago, the Indian company adopted Japanese techniques such as kaizen to supercharge its manufacturing processes and growth. Now, Uno Minda’s Japanese partners visit its factories to learn how to improve their own operations.

With so little of what small companies do visible to the outside world, they aren’t well-understood by markets—and may not be for some time. It requires investors to take a long-term view, another way in which small caps are particularly suited to our firm’s philosophy. But as much as we’d like to hold onto the best small caps forever, the bittersweet reality is that those are the companies most likely to move on from the asset class. Some get acquired. Others graduate out of the portfolio because they grow too valuable to fit the definition. (In just the last year, several of our ISC holdings—including Chr. Hansen, Dechra, EMIS Group, and Network International—have received takeover offers from strategic buyers or private equity firms.)

Some people enjoy covering the superheroes. But after getting to do both, for me there is nothing like the joy of discovering the greatest small companies most investors haven’t yet heard of.

Source: Federal Reserve and St. Louis Federal Reserve.

What Is the Bond Market Telling Us?

What are we to make of such an acquiescent yield curve in the face of the highest inflation in a generation? Are investors so convinced of central banks’ inflation-fighting credibility that they are willing to forego any compensation for the risk that things might not turn out exactly as planned? Or have successive efforts by central banks to prop up asset prices at the first sign of trouble by generously spraying markets with liquidity scrubbed away any vestigial memories of inflation and left investors in a state of learned passivity? Or perhaps there’s a simpler explanation: the information contained in bond prices must be taken with a large pinch of salt.

There are plenty of reasons for not taking bond prices at face value, and they bear repeating, if only to remind ourselves of the profound distortions bedeviling sovereign yield curves. The biggest culprits are the quantitative easing programs undertaken by central banks following the Global Financial Crisis (and extended or revived during the pandemic) to push down long-term interest rates and thereby spur economic growth. Despite plans to wind them down, these asset-purchasing programs continue to hoover up much of the sovereign bond supply in the US, the eurozone, and Japan. The rate-dampening effects of these programs are augmented by the ongoing bond purchases by other central banks, notably in Asia, whose recurrent need to prevent large current account surpluses from sending their currencies spiraling higher compels them to keep adding to their towering foreign reserves.

The increased adoption of risk-parity strategies has cemented the role of bonds as foremost an insurance asset. If instead of demanding compensation for bearing inflation risk, investors are willing to pay a premium to protect their portfolios, inflation expectations derived from bond prices will be understated.

But while central banks, along with other non-profit-maximizing participants, have always been a feature of bond markets, what’s new today is the rise of a class of investor for whom default-free government bonds are a hedge first and a return-seeking investment a distant second. The increased adoption of risk-parity strategies, along with various permutations that fall under the umbrella of volatility-targeting strategies, has cemented the role of bonds as foremost an insurance asset. In these strategies, as equity market volatility rises or falls, exposure to bonds is dialed up or down to equalize the contribution to total portfolio volatility coming from each asset class. The inherent assumption is that bonds will be a hedge when the rest of the portfolio heads south. And that’s a problem because the inflation expectations that are backed out from bond prices assume that investors demand a reward for bearing inflation risk. But if instead of demanding compensation for bearing inflation risk, investors are willing to pay a premium to protect their portfolios, inflation expectations derived from bond prices will be understated.

What this means from a practical perspective is that bond prices are likely to be far less reactive to nascent inflation concerns than in the past, and equity prices may be the better guide for those concerned about what’s brewing with inflation. Moreover, today’s strained equity valuations magnify the markets’ sensitivity to prospective increases in inflation. Ominously, high valuations not only make equities more sensitive but also more vulnerable, as we shall see.

Equities and Inflation

Whenever inflation and equities are mentioned in the same breath there is always someone who will reflexively insist that, because equities are a claim on real assets, holders can safely ignore inflation. There is a kernel of truth to this. Equities are a claim on real assets and so over the very long term should be more resilient than, say, nominal bonds, but that doesn’t mean inflation can be ignored. Far from it. Because inflation has knock-on effects to cash flows and discount rates, the impact of higher inflation on equity valuations can be dramatic. The hit to cash-flow expectations comes from the combined effects of a squeeze on company profits from rising input costs and the demand destruction that typically follows the policy response—an increase in tax levels or interest rates—needed to bring inflation back under control. Moreover, because monetary instability also strikes at the heart of the economic compact between labor and capital, it can have a dramatic effect on equity discount rates beyond its mechanical effect on borrowing costs.

Assuming companies can pass on their costs one-to-one with inflation, they should be able to pay higher dividends and their share prices should go up. What this simple story leaves out, of course, is the colossal bun fight that inevitably breaks out as everyone flails around trying to dodge the inflation hit to profits, wages, and pocketbooks.

A simple model for equity returns can help to elucidate the mechanics. One workhorse model for equity returns is the Gordon Growth model, a variant of the dividend discount model that assumes the current dividend D grows at some constant rate g in perpetuity and that investors discount those future expected cashflows at a fixed rate r. The price P for such an asset is the present value of the entire stream of future cash flows, which can be expressed as follows:

What’s clear from this simplified model is that, assuming companies can pass on ballooning input costs by raising prices for their goods one-to-one with inflation, the resulting increase in nominal dividends will be matched by a corresponding increase in nominal share prices. If that were the only thing going on, then inflation could indeed be safely ignored. What this simple story leaves out, of course, is the colossal bun fight that inevitably breaks out as everyone flails around trying to dodge the inflation hit to profits, wages, and pocketbooks.

The precise contours of the conflict depend on the source of the inflation shock and the relative bargaining power of the various stakeholders. But the broad outlines tend to follow the same pattern, with a shock to living standards sparking a demand for higher wages that gets passed on through higher prices as businesses try and defend their margins. Because each step is contentious, none of it unfolds smoothly, which lowers productivity and interferes with resource allocation and ultimately is manifested in slower earnings growth.

Eventually, a central coordinator like a central bank or fiscal authority steps in to try and break this dynamic. The standard cure involves them reining in economic activity with some combination of higher interest rates or increased taxation, which does eventually bring the inflationary cycle to a shuddering halt but at the cost of lower profits and wages. These interventions typically produce additional unintended consequences—see the miners’ strike in Great Britain during Margaret Thatcher’s early years—which further increase frictions.

Given that backdrop, it’s hardly surprising that consistently rising prices tend to also push up the required rate of return for risky assets. This reflects the real sense that elevated inflation embodies the unraveling of the social contract in the economic sphere. And that’s because inflation is not so much a rise in the price of goods as it is a decline in the value of money. This erosion in the unit of account ripples through balance sheets, blunting price signals, and makes it harder for businesses and households to plan for the future. The longer inflation persists, the more debilitating the harm.

High Valuations Increase Equity Market Sensitivity

The Gordon Growth model also has a role to play in explaining why the confluence of elevated valuations and inflation is so toxic. To understand how that works, we need to introduce another concept known as modified duration. The notion of modified duration is central to bond analysis, but it’s rarely applied in the context of equities. And that’s a shame because equity market duration has a lot to tell us about the stock market’s current sensitivity to inflation.

Duration is the average maturity of the expected future cash flows for any security. Purely speculative assets that have no expected cash flows, such as gold or Bitcoin, have infinite duration. The duration for a zero-coupon bond with a single known cash flow at expiry is simply the number of years to maturity. If you divide the duration of an asset by its discount rate, you have a measure of its sensitivity to changes in that discount rate, which is called modified duration. For bonds, modified duration is the sensitivity of its price to changes in its yield to maturity, or, said otherwise, the percent change in price for a given percent change in yield. For equities, modified duration tells you how much of a share price change you should anticipate for a given small change in the discount rate, r.

Although in the case of equities the cash flows are uncertain, we can still use the Gordon Growth model to approximate a measure of modified duration for the broad market. I’ll leave the tedious math for the footnote¹ but suffice to say that a few manipulations reveal that the modified duration of the equity market is simply the inverse of the market’s dividend yield. With a dividend yield of 1.43%, the S&P 500 is currently sporting a modified duration of around 70 years (100/1.43 = ~70).

It’s quite possible that the recent ruckus in the market for growth stocks—those securities with cash flows furthest out into the future and therefore with an even more extended duration—is exactly what we’d expect as the first tremors in the discount rate reverberate through the amplifier of high valuations.

Over the past 20 years, already a period of elevated valuations relative to long-term history, the average modified duration for the S&P 500 has been 50 years. A current modified duration of 70 implies a 40% increase over the historical average in the sensitivity of share prices to small changes in the discount rate. In practice, at a modified duration of 50 years, a 50 bps increase in the discount rate would translate to roughly a 20% decline in prices. This decline is somewhat less than the 25% we would expect from modified duration alone (.05% x -50 = -25%) because, for larger changes in the discount rate, we need to also account for a bit of arcana known as convexity. Even so, today, with a modified duration of 70, the effect of a 50 bps increase in the discount rate at a modified duration of 70 years is a 27% drop.

It’s quite possible that the recent ruckus in the market for growth stocks—those securities with cash flows furthest out into the future and therefore with an even more extended duration—is exactly what we’d expect as the first tremors in the discount rate reverberate through the amplifier of high valuations. Meanwhile, the resilience of the broader market might indicate that so far, at the aggregate level at least, this rise in the discount rate has been partly offset by rude economic health and no indications of an unravelling of the social fabric caused by inflation. If only such an assessment wasn’t directly at odds with the recent inversion of the US yield curve pregnant with recessionary portents. Let us hope that the bond market’s distortions that scramble its inflation signaling are also adding to its inutility as a predictor of economic slowdowns.

Endnotes

The Beauty Contest

To its advocates, the virtues of indexing are beyond reproach. With low fees and high transparency, index funds offer a cheap and straightforward way for an investor to earn average returns. This perspective is buttressed by mounds of academic research that have characterized passive investing as a stable equilibrium, meaning that even were everyone to index their investments, it would make no difference to either prices or the cost of capital.

Underlying this claim is an assumption that markets are populated by rational beings, whose collective behavior delivers market prices that always perfectly reflect all available information. But markets don’t work that way, and grubby reality is a world away from this frictionless ideal.

“We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
—John Maynard Keynes

The early 20th-century British economist John Maynard Keynes understood this only too well, famously comparing investors to participants in newspaper beauty contests. A popular feature in the London press of his time, these contests asked readers to choose the six prettiest faces out of a collection of a hundred photographs. The winner was the entry that came closest to the average selection. Although nominally about personal aesthetics, winning the contest meant successfully anticipating the anticipations of others. “It is not a case of choosing those which…are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes wrote. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”

Investors tasked with choosing which stocks to own face the same quandary as players in the beauty contest. Should they expend time and energy to understand companies’ long-term business prospects and to project cashflows decades out? Or, given limited resources, is it wiser to try and figure out which stocks are likely to be popular six months hence? Writing seven years after the great crash of ’29 and attempting to make sense of the devastation left in its wake, it was clear to Keynes that only the former had any merit, but that most investors favored the latter, trying to “beat the gun, […] to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” A slight shift in mood is enough to set off cascading price changes as investors react en masse. The inherent instability spawned by this recursive guessing game is why prices are far more volatile than what is known of underlying fundamentals, and why life for investors struggling to get a purchase on cash flows and discount rates, in Keynes’s view, can be so forbidding.

But what happens when most investors opt out of selecting individual stocks? When beauty contestant judges pick the same pretty faces week after week?

The question is relevant because the answer would go some ways toward explaining today’s higher-than-average valuations. An end to the beauty contest would equate to a permanent decline in undiversifiable risk, which all else being equal, would justify paying a higher multiple for uncertain future cash flows. It might even make life a little less unpleasant for those relying on their projections of long-term fundamentals. After all, with fewer active traders whacking prices around, shouldn’t the signal be a little easier to unscramble from the noise?

The evidence on the ground, however, suggests a more complicated picture. The beauty contest hasn’t ended so much as shifted its locus of speculation from individual securities to trading vehicles that clump together groups of securities based on mechanical trading rules.

One indication that this is happening is the puzzling reversal in the positive serial dependence of short-term index returns. Serial dependence, or autocorrelation, refers to the degree of correlation between two observations of the same variable at different points in time. A random variable, the flip of a coin say, has an autocorrelation of zero, each flip independent of the one before. Historically, short-term index returns have had a small (but consistent) positive serial dependence, meaning that, on average, a positive return one day will be followed by a return in the same direction the next day and vice versa. One possible explanation for this phenomenon held that stocks reacted with a lag to non-fundamental shocks.²

But in 2000, this relationship turned negative, and it has remained so ever since. The chart below shows correlation between daily returns for the S&P 500 averaged over a ten-year window going back to 1949. Positive serial dependence increased steadily throughout the 1960s and ’70s, peaked shortly before the introduction of index futures in the ’80s, then declined steadily for two decades before falling consistently below zero at the start of this century.

Source: Bloomberg, Harding Loevner

According to a new study³ by researchers at Erasmus University and the University of Notre Dame, the explanation for this reversal can be laid squarely at the feet of indexing and the seismograph-like movements of mechanical trading rules amplifying the daily response to new information. The research considered 20 equity indices across 15 countries and found an identical change in the behavior of short-term returns. Moreover, they found a direct causal relationship between these patterns and the combined increase in index products including futures, ETFs, and mutual funds. According to the authors, “introducing indexing products seems to change the behavior of the underlying stock market across indexes and over time,” and more critically a higher level of indexing leads to “a more negative serial dependence.” It is unclear what the full consequences of the new pattern will be, but we may be seeing it on display at the far right of the graph above, in the sharply negative one-day autocorrelation in March 2020 at the onset of the pandemic. In plain language, it used to be that uncertainty about the future flowed from individual stock prices into indices; now, the tide has been reversed and uncertainty propagates from indices to individual stocks.

Vol of Vol

Another unsettling sign of change is the rise in the level of implied volatility of volatility (vol of vol), a measure of the market’s capacity for registering unexpected shocks. Roughly speaking, implied volatility—the volatility that is backed out from the price of options—reflects the market’s expectation for the range of potential outcomes for an asset over a specific period. When implied volatility is high, markets expect larger price moves (in either direction), or when it’s low, smaller moves. The most well-known measure of these signals is the VIX, which is calculated from the price of short-dated index options on the S&P 500 and is frequently referred to as the “investor fear gauge.”

Despite its notoriety, the VIX is a measure of disorder and quite distinct from a measure of potential disorder. For that we need to consider volatility of volatility, the true measure of market entropy. To measure that entropy, we use VVIX. Just as the VIX is calculated from the price of options on the S&P 500, the VVIX is based on the price of options on the VIX. Future returns are unknown, but the VIX tells us something about the range of returns we should expect. The VVIX, on the other hand, indicates how uncertain we are about the variability of that range.

Intuitively there are strong reasons to believe that while this vol of vol itself should vary day-to-day as the market digests unexpected shocks, like the VIX it should be stable around some long-term average. But, as can be seen in the chart below, since 2006, a period coinciding with the boom in passive investing, volatility of volatility has shown a consistent upward trend—a sign that the range of potential disorder is expanding.

Source: Bloomberg, Harding Loevner

Doubtless there is more than one culprit behind the increase in vol of vol. Low real interest rates driving down risk premiums probably figure in, as does the growth in systemwide leverage which magnifies fragility by accelerating the interdependence of financial flows. But we would be remiss to ignore the effects of ballooning index flows. Index replication relies on a well-behaved and liquid market for the underlying securities, a presupposition that is paradoxically undermined by the expanding share of index flows. Keynes’s insight was understanding the role of psychology in fueling the tussle between long-term investors and short-term speculators. But things are different at the asset class level. Strategic allocations are typically set in stone, which leaves precious little capital to take the other side of the trade and lean against speculative flows, and a tussle can turn into a rout.

“When you invent the ship, you invent the shipwreck.”
—Paul Virilio

The cultural theorist Paul Virilio asserted that every new technology embeds the potential for new unanticipated accidents. As he put it: “When you invent the ship, you also invent the shipwreck.” Indexing is an invaluable new vessel, which has ushered in a new era for many types of investors. And yet, as indexing has mushroomed over the past two decades, the switch in serial dependence to an amplification as opposed to dampening of short-term shocks and the increased probability of tail-risk events with the rise in vol of vol are ominous signs that we’ve yet to reckon with the consequences of a market swamped by passive flows. Shoals may await just over the horizon.

Price Makers vs. Takers

As a rule, companies whose products are more specialized are in the best position to pass increased production costs onto their customers. The difference in how such price “makers” and price “takers,” whose products are less differentiated, manage inflationary pressures can be dramatic, even within the same industry. This is illustrated in the diverging responses of Elanco and Zoetis, two US-based animal health companies. Both have been proactive in their response to rising input costs, but Elanco decided to protect its margins mainly through cost savings by eliminating 380 upper- and middle-level management positions. Zoetis, with a portfolio of unique medicines and vaccines, was able to increase its prices enough that the adjustments helped expand its gross margin by 110 bps despite higher costs.

NITORI, a Japanese retailer of imported furniture and one of the largest users of containers destined for Japan, was forced to charter an entire ship to guarantee inventory for its stores.

Some differences in taking and making, however, are more structural in nature. In something of a departure from past cycles, developed economies have generally seen higher inflation than emerging economies, with the US seeing the highest. The one big exception to the inflationary trend in developed countries has been Japan, where inflation has actually fallen. Japanese consumers are resistant to price increases after experiencing decades of low growth and falling prices. What this means is that input price increases tend to be absorbed by the companies in the production and distribution chain, putting downward pressure on their margins. Importers have taken it especially hard on the chin from rising freight costs and the fall in the yen. NITORI, a Japanese retailer of imported furniture and one of the largest users of containers destined for Japan, was forced to charter an entire ship to guarantee inventory for its stores. For exporters with domestic operations, on the other hand, the fall in the yen has offset some of the climb in input costs. Companies as diverse as machine-vision leader Keyence; factory-automation equipment producer MISUMI Group; Rinnai, a manufacturer of energy-efficient tankless water heaters; and Unicharm, a maker of diapers and feminine hygiene products, are all reporting sales or profits that have exceeded their pre-pandemic levels.

Around the Sectors

Given the shipping bottlenecks and the increase in energy prices over the past year, transportation costs have soared around the world. According to the Cass Freight Index, freight costs in the US increased by 37% in October 2021 year over year. Canadian National Railways (CNR), which operates rail freight across North America, saw its costs per unit of volume increase by 15% in third quarter 2021 alone, with almost all the increase due to the hike in fuel costs. So far, CNR has been able to offset two-thirds of the increase by raising prices.

Some of the same factors hurting transportation companies and their customers have benefitted producers of raw materials, where selling prices have risen faster than input costs. This is true for two of the mining companies we follow, Rio Tinto and Vale, which are among the lowest-cost producers in their segments. Meanwhile, in the oil industry, exploration and production as well as integrated energy firms are cautious about the oil-price recovery after the drubbing they took over the previous six years and are holding the line on capital expenditures for expansion.

Among industrial firms, most seem to be passing through higher commodity prices in some form, but only those with the strongest pricing power have passed them on in full. For instance, 3M, producer of a vast variety of specialized and less-differentiated products, raised its prices by 1.4% on average in the third quarter—but, after accounting for the rising cost of raw materials, its margins still declined by 1.3%. On the other hand, Ametek, a US-based global maker of electronic instruments, expanded its margins, even while acknowledging the challenges of higher raw-material prices and supply-chain issues.

In China, where domestic consumption remains hostage to the government’s zero-COVID policy, rising factory-gate prices have generally not translated into much higher prices for consumers. Nevertheless, pockets of pricing power exist. Nearly all of home-appliance manufacturer Haier’s revenue growth in China this year has been from pricing, partly as some consumers trade up to higher-end offerings. Sanhua Intelligent Controls, a manufacturer of thermal management systems for the HVAC and automotive industries, has automatically passed through most cost increases for its appliance parts, where its bargaining power is strongest, and is negotiating them for other products. The voracious demand for electric vehicles is insulating CATL, a leading producer of lithium-ion batteries. Not only was it able to raise prices; it has also used its bargaining power over its suppliers to control input costs and further increase its margins. Even CATL’s smaller rival BYD was able to raise the price of its batteries by 20% or more just last month.

Within Information Technology, semiconductor prices have continued to climb due to the inability of manufacturing capacity to keep up with exploding electronics demand: the “chip shortage” that was one of the earliest inflationary triggers, and is ongoing, as significant capital expenditures take time to turn into capacity additions. Most foundries that manufacture the chips used in automotive and industrial applications have already pushed two, sometimes even three, rounds of price increases this year, and they believe the pattern is set to continue into 2022. Demand for leading-edge semiconductors produced by Samsung and TSMC has been more stable, resulting in only modest price increases. Semiconductor tool makers have seen small improvements in their gross margins, but nothing compared to the 10% jump seen for some of the foundries. The consensus view in the industry is that the hikes in chip prices that have occurred are sticky and will not revert after supply normalizes.

The area where cost inflation seems most acute is among retailers and consumer goods manufacturers, most of whom are facing unprecedented increases in labor and input costs, as well as supply-chain problems. Couche-Tard, the Canada-based gas station convenience store operator behind the Circle K brand, has overhauled its recruitment and retention policies, adding bonuses and more training to cope with the labor shortage. The company estimates almost one-third of its 7.7% increase in operating expenses is due to increased labor costs. Multinational consumer goods manufacturers, which have more flexibility to reallocate production to manage labor shortages in given locales, have fared better, and several have noted that consumers appear more willing to accept higher prices than they have in the past. Procter & Gamble has increased prices in 90% of its core product categories without seeing a falloff in demand, a trend also echoed by Colgate-Palmolive and Unilever.

Looking Ahead

Presently bond markets are anticipating that central banks will soon bring the inflationary pressures under control. Low real long-term rates, low forward-inflation expectations, and flat yield curves are all indications that, despite raging inflation today, investors believe that central banks will act firmly to raise short-term interest rates, pre-empting the need for more aggressive tightening later. But the seemingly rock-solid confidence in central banks could be eroded if prices continue to rise unabated. If that point were reached, richly valued equities would likely fall victim to central banks’ imperative to restore their inflation-fighting bona fides.

With annual inflation in the US hitting a 40-year high, the Fed has already indicated it will wind down its asset purchasing program by March 2022 instead of June. More clarity about the first of a series of short-term rate hikes will be next, with the market expecting three hikes over the course of 2022. Will that do the trick? We come back to what we hear from companies. For what it’s worth, while many consumer goods companies expect prices to trend higher into 2022, some of them believe that the rate of increase will reach its zenith in the first half. Some, such as Couche-Tarde, L’Oréal, Compass Group, and Costco Wholesale, are already seeing signs of stabilization. L’Oréal’s management has even gone so far as to suggest that deflation may be a risk if supply chains over-correct for today’s shortages.

Left to Themselves, Even Great Cultures Die

Part of a winning culture is the ability to adapt to changing circumstances, to have processes that change, and to take risks with new ways of behaving. Above all, perhaps, is the willingness to keep learning. Arie de Geus, former head of Royal Dutch Shell’s Strategic Planning group once said, “In the future, the ability to learn faster than competitors may be the only sustainable competitive advantage.” That ability must be embedded in culture no matter what other values the culture incorporates. A good example comes from the success and subsequent decline of Arsenal Football Club, which in the late 1990s broke with English football tradition by hiring a Frenchman to manage the team. Arsène Wenger’s on-the-pitch tactics and approach to nutrition and training overturned decades of English football culture and brought a level of domination rarely seen in professional sports. The Arsenal team of 2003-4 was unbeaten during an entire season, a feat that had not been accomplished since the late nineteenth century. Although the club went on to further success, other clubs gradually learned from, adopted, and refined its methods. Arsenal failed to innovate further and gradually slipped down the league table to a point where Wenger was eventually replaced.

The 2003-2004 Arsenal team earned the nickname the “Unvanquished” for becoming the first elite-level UK football club in more than 100 years to go an entire season undefeated—in large part thanks to its disruptive culture. Above, Kolo Toure, Robert Pires, and Ashley Cole celebrate the 2-2 tie with Tottenham that sealed the feat.

Source: ODD ANDERSEN / Staff via Getty Images

As we endeavor to strengthen Plymouth Argyle’s culture, my experience at Harding Loevner has been critical in giving me a clearer sense of what will work. At Harding Loevner, we were taking cautious steps in the dark, with nothing to give us confidence that we were on the right path. But we did learn, and that has been helpful as we try to make an Argyle culture that will enable us to achieve our vision. As such, we are approaching our task with an intentionality that would have felt presumptuous to my younger self. It starts with a more specific goal. English football is a multi-level pyramid in which especially good or poor performance brings promotion or relegation to the next level up or down in the hierarchy. At the end of 2019, a year after we had lost our spot in League One (the third level from the top), we said that in five years our goal was to be financially sustainable and playing two levels above where we were then.

To realize that vision, one of the key values we have espoused at Argyle, just as at Harding Loevner, is transparency. One difference is that our transparency extends to writing down our Vision & Values and posting them to our website. In this way, everyone at the club—as well as our supporters and sponsors—knows what the vision is and what the values are that we expect will underlie every decision. Another of our core organizational values is to be efficient and process oriented. Here, again, we are not exactly inventing the wheel. Increasingly the lessons those of us in finance and organizational science took to heart about the role of process in managing our cognitive biases have also found their way into successful sports cultures. The most famous example comes from baseball where the Oakland A’s, under general manager Billy Beane, incorporated objective data into their decision-making processes to come up with new ways to gain competitive advantage on a limited budget. Once it was widely revealed in Michael Lewis’s Moneyball, Beane’s approach influenced most of the rest of baseball, spread to basketball, and is now beginning to have an impact on English football. At Argyle, our most immediate source of inspiration has been the outrageous success of Brentford F.C., for years a lower-league club of modest means, which, under the ownership and guidance of Matthew Benham (who made his fortune successfully managing his own cognitive biases gambling on football matches) has risen to the English Premier League, the pinnacle of the football pyramid.

I could elaborate on how these and our other values trickle down via our areas of strategic focus to Argyle’s CEO’s goals and to the goals he sets for every individual. But for my purposes here, the point is just that these values and goals are written down, enabling the board to communicate to our fans how we will behave and to our staff what we ask of them. The result has been powerful. Two years into our five-year plan, we have regained our position in League One, halfway toward our goal of climbing to within a level of the overachievers at Brentford. More importantly, everyone at Argyle now knows what we are trying to achieve, what is expected of them, and the values that should underly their everyday decisions.

We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession.

I’ve learned from Harding Loevner the kind of culture that leads to sustained success. I’ve learned from Plymouth Argyle how impactful transparency and communication can be in cultivating that culture. Harding Loevner has reached the age where it can no longer rely on the people who made up the founding generation as its cultural torchbearers. Over a decade ago, we began laying groundwork for the transition of ownership and management of the firm from that generation to the next. We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession. As the people in whom the culture is most embodied prepare inevitably to move on, they have no choice but to write more of it down. We early settlers will need to be more transparent (at the risk of being annoying) about what our culture has meant to us personally and to the firm’s success under our leadership—not so that it may be set in stone to be accepted immutably, but that it may be evaluated critically. Our younger colleagues may have slightly different beliefs and values. We expect them to receive the vision, turn it over in their minds and revise it so that they may carry it on as their own. It will be their responsibility to make sure that the firm’s culture enables it to serve its clients as well in future as it has since 1989.

Ferrill Roll, CIO: We’ve convened this discussion because after coping with four years of US-originated turbulence in Chinese equities—from tariffs and trade wars, to congressional action against Chinese companies listing in the US that hadn’t gone through the usual US auditing requirements, to executive orders prohibiting Americans from owning companies controlled by the Chinese military—we are now faced with turbulence in Chinese equities that has originated from Chinese regulatory actions. In that new, different environment, we thought it would be useful to discuss how we cope with this, what’s actually going on, and what our thinking is for the future.

First, I’d like to comment about our risk guidelines at Harding Loevner. We insist on diversification in all our strategies. And insofar as that pertains to Chinese equities, you will recall that it was just a year ago that we were in lively discussions about the limit that we had placed on Chinese equities—in our Emerging Market Equity strategy in particular but, in fact, in all of our strategies. We had set our limit—when times were calm, and we were being thoughtful about the future—at a maximum weight of 35% in China for a diversified emerging market portfolio.

When China managed to get the coronavirus under control faster than the rest of the world, Chinese shares surged relative to everywhere else. Our emerging market PMs were chafing under the inability to own as much as the index, let alone go overweight, in China. Clients were asking us questions about how we could be so ultra-conservative as to constrain our PMs from doing whatever they needed to achieve returns. And, frankly, we had rather tense discussions among our partners as some clients thought about leaving Harding Loevner as a manager because of our intransigence over these risk controls.

We think of our risk controls as constraints against our future selves—in the way that Ulysses tied himself to the mast before he passed by the sirens that would otherwise have lured him to destruction. We thought when we were setting our limits on China that they were sensible. A year on, we are now flooded with client calls about, “How much risk do you have in China? What are your exposures to the companies being buffeted by these regulatory shifts?” And we feel vindicated that we stuck to our pre-commitments. This is a well-established area of behavioral finance, that pre-commitments are the hardest things to keep when they are the most important things to keep. I think this is a lesson that we will take with us through the years going forward.

That said, Harding Loevner has a very clear long-term outlook that China is going to be a fruitful place to invest our clients’ money and to hopefully add value using our process of fundamental analysis and valuation. We launched our first single-country strategy, the Chinese Equity strategy, late last year. So, we’re optimistic that we will find lots of ways to add value in China.

Pradipta, you’re the Lead PM for the Chinese Equity strategy. Your entire portfolio is subject to these recent regulatory shifts. Why don’t you give us a quick summary of what’s happened recently and how it’s affected you?

Pradipta Chakrabortty, Lead PM Chinese Equity: So, there have been a slew of regulatory actions across different sectors and industries. I classify them under four buckets. First were the antitrust regulations that manifested through fines on Alibaba and moved on to fines on other companies in the internet space such as Tencent and Meituan. That has subsequently moved on to breaking down several barriers and walls that these gigantic platform companies had created around themselves.

The second bucket relates to the stability of the financial services sector and was manifested through regulations that resulted in the cancellation of the Ant Financial IPO. The third area, data security regulations, is much more recent. Immediately after the IPO of the ride-hailing service Didi Chuxing, you saw cybersecurity concerns emerging, leading to restrictions of Didi’s ability to onboard new users. And the fourth bucket, social issues-related regulations, is pretty broad across different sectors. One of those sectors affected was after-school tutoring, where you had severe restrictions, converting that industry into not-for-profit. This week, we saw news about concerns about how online gaming affects children. So that sector has been under a little bit of pressure. There’s also been noise around the gig economy and fair compensation for workers there.

So, it’s a whole gamut. The net result is that investors have been spooked. The MSCI China All Shares Index is down close to 8% in the first seven months of the year, underperforming the MSCI ACWI Index, which is up 13%.

FR: Jingyi, can you talk to us about the high-level goals the Chinese government is pursuing with all these changes?

Jingyi Li, Co-Lead PM Global Equity: The Chinese government’s long-term goal is to continue to develop the economy. It has done a good job leading China from a low-income country decades ago to where it is a mid-income country today. And it has showed the ambition to continue to grow the economy in the next decade or 15 years to become an entry-level developed country. That means the economy needs to grow around the mid-single digits for the coming one or two decades at least.

To continue to drive the economy to reach the next level, you need a lot of structural reforms, reforms that we have seen, but also at the same time, you need to address a lot of social issues. Some are social issues caused by new economies and new technologies. Some are common issues everywhere in the world, like inequality, like the competitiveness of the labor force. Without addressing these kinds of long-term profound social issues, the Chinese government—who rely on long-term growth as one of the key legitimacies of their government—is concerned that they may not be able to continue on this trajectory, just like many Latin American countries stuck in the so-called mid-income trap.

FR: Craig, would you agree that’s the main goal, or do you think there are some more jaundiced, pernicious goals that the government is pursuing?

Craig Shaw, Co-Lead PM Emerging Market Equity: China is run by the Communist party. It is not a democracy. You could call it a dictatorship, and the way they stay in power is by keeping people happy. There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history. They are doing their best to stay in power and keep their people happy, which is something we always have to be cognizant of.

There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history.

FR: So, you don’t think they’re going after companies that have skirted the domestic listings rules by raising money outside? You don’t think they’re targeting prominent individuals who made a lot of money and turned that into a personal soapbox for their own use?

CS: Well, those are issues. We’ve seen this over the decades in emerging markets. Remember how in Russia Mikhail Khodorkovsky at Yukos got involved in politics and lost everything and was in prison for quite a while. To a certain extent, if someone becomes influential and wealthy and powerful, they are perceived, whether they really are or not, as a threat to the government’s control over the population. It’s a risk. We certainly saw that with Jack Ma at Alibaba a little while ago, when he made some comments about the future of finance in China. And the powers that be didn’t seem to like it.

FR: Andrew, before you became Co-Lead PM of the International Equity strategy, you were the manager of research. In fact, you started at Harding Loevner as an emerging market analyst. So, you’re deeply familiar with how we think about regulation in the structure of our research process. Can you lay out for us how we assess regulation?

Andrew West, Co-Lead PM International Equity: Sure. We have three key features of our process that leads to us being aware of regulatory risk and reacting to it, and hopefully anticipating it. One is our constant analysis of Porter’s “Five Forces” that dictate industry structure. For each of the five—whether it’s bargaining power of buyers or suppliers, rivalry, threat of new entrants—we ask our analysts to both understand the existing regulatory issues that may influence those forces and to keep an eye out for incoming potential changes that could influence them. It’s all part of helping us understand the trajectory of profitability in the future, of growth opportunities, and helping us reflect that in our forecasts. The second key feature is our ongoing monitoring of environmental, social, and governance (i.e., ESG) risks. And third is our requirement of higher returns from riskier countries, where we tilt our valuations of stocks based on the riskiness of the countries in which they’re operating.

FR: I’m interested in the ESG analysis. At Harding Loevner, ESG analysis is really a risk analysis rather than a pursuit of return of goodness, if you will. We’ve had a lot of client inquiry over the last two years about the E part of ESG, and almost no inquiry about the S—the social part. Do you think that we have underemphasized the regulatory risks that have emanated from these social risks in ESG in the case of China?

AW: It is a topic that we have actively debated. And social risk is a risk. A lot of the concern has been around looking from the outside in, with international companies and other countries threatening China in some way over their internal political activities. But there are also internal social pressures inspiring new regulations. And that ties into what Jingyi spoke about before, when you asked him about the goals of the Communist party.

Have we under-recognized it? I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices. Awareness of that comes and goes. I think the actions in some industries were harsher than just about anybody would have forecast. Even if we’d been aware of the pressures for change, we may not have anticipated such sudden and violent regulatory reaction to those pressures.

I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices.

FR: Pradipta, in addition to your new role as a Lead PM of the Chinese Equity strategy, you have long been Co-Lead PM on the Frontier Emerging Markets Equity strategy. You’ve invested in a bunch of countries that have a lot of risk. How do you assess risk in China versus the regulatory risk in China versus the regulatory risk in, say, Turkey, which has an authoritarian president?

PC: I mean, Turkey is obviously a different case altogether. You can’t really put it in any bucket. But in several other frontier countries—Kenya, Nigeria, the Philippines—they all have a significant amount of regulatory risk, and we’ve seen regulatory actions in those markets. The difference is in terms of the communication and the transparency of the debates that go on in the public domain. In most of these other countries, you would see lawmakers and regulators going through a lot of public debate where you’re privy to their thoughts and their potential future actions, much more than you would in China.

But to be fair to the Chinese regulators, there have been hints about each of these regulations that have been enacted this year. The problem is that those clues have been rather cryptic and the end result quite shocking. For example, the after-school tutoring sector having been converted into a not-for-profit—there was really no clue about that coming. So, I would say communication is where there is definitely more work to be done by the Chinese regulators. If they do communicate their intentions or their thinking more clearly, there would be less disruption in the markets.

FR: Craig, you mentioned Russia and the case of Yukos and the expropriation of assets in that case. That was at least as shocking as the vaporization of billions of dollars of market value of these Chinese education companies. How do you think about risk in China versus regulatory risk or expropriation risk in Russia or any other of the emerging market countries that you’ve invested in over the last 20 years?

CS: China’s a little different. You can argue how effective democracy is in some of the emerging markets, but at least they are democracies, to some extent. Whereas China is not. And so, the government has total control over everything. They debate within themselves, but as far as dealing with representatives of the populace, it’s a little different. They have a lot more control and a lot of these moves that we’ve seen are all about enhancing that control.

If you look at Russia, it’s changed quite a bit over the years. There was a time that share prices would fall 20% if Putin was annoyed with something. Certainly, Putin has a great amount of control over what happens. But he has not been overly aggressive in terms of doing anything to industries. I mean, if you go back to the Yukos case, there was an arrangement made a long time ago when Putin first came to power, that he would let the oligarchs keep whatever they managed to gather during the chaos of the fall of the Soviet Union as long as they stayed out of politics. And to a large extent, he’s kept that promise. But he certainly can scare people.

FR: Presumably, you’ve come to rely on that, because you’ve been overweight Russia in your emerging market portfolio for five years.

CS: Yes. It’s not the easiest place to be, but we do what our process and philosophy guides us to, and have found some good quality-growth companies at reasonable prices.

FR: It’s one thing for emerging market or frontier emerging investors to parse these risks because they’re all risky neighborhoods, and each one is risky in its own way. But Jingyi, you’re now a global portfolio manager, having concentrated on China for a long time as analyst. How do you compare the regulatory risk in China versus the regulatory risk in the US?

JL: I think the regulatory system in the US is much more mature and proven to be better for entrepreneurs and innovators, very good and reliable for business, and, of course, very favorable for investors, especially long-term investors like us. Speaking of the regulatory risk, I would also like to point out the risk of not taking actions on some of these long-term issues. Because when we talk about cybersecurity, antitrust, all kinds of social issues—these are not specific to China. These are very common issues in every part of the world. The US is trying to address them. Europe is trying to address them.

If other countries are not able to take on these issues in sensible and timely ways, they will have challenges, and their long-term economic development eventually will affect the return of long-term investors like us. Also, there’s a question of how much regulatory risks have been discounted in the current stock crisis. In the past several months, obviously, the market has been more alert toward the regulatory risk in China. Maybe that’s sufficient, maybe that’s over-reaction. But in other parts of the world, in other markets, maybe the regulatory risks have not yet been fully discounted yet.

FR: How about it, Andrew? Are the price changes in Chinese equities causing you to be more interested in Chinese equities? Or does the scope of the regulatory risks cause you to be more cautious?

AW: It’s a tug of war. On one side, risks have risen, I think. Or the awareness of risks that were there have crystallized. And we don’t know exactly how much more is to come. My suspicion is that there might be a slowing down, but that’s not for sure. On the other hand, there’s definitely more risk discounted than before. So, on the one hand, you’ve got maybe some concerns about future margins, future growth for some companies. On the other, a lower price.

The International Equity strategy, which you and I are Co-Portfolio Managers of, has been underweight China for the past several years as China has risen in terms of the index weight. And that was modestly negative for us when Chinese stocks were going up. It’s been favorable for us as the market has declined recently. And so, we are looking at whether to add new securities or add to some existing securities that have become cheaper relative to fair values. My natural tendency is to be fearful when others are not, and to be less fearful when others are more. So, I would say, I would be looking to reduce that underweight on the assumption we find some securities that are over-discounting risk and under-appreciating long-term growth and profitability.

FR: Craig, you were chafing under the limit of 35% in China. I happened to check this morning. China is now less than 35% in the MSCI Emerging Markets Index. Are you more inclined to buy? And will you go overweight now than you can?

CS: We are doing the same thing we’ve always done—looking for quality-growth companies at reasonable prices. Andrew said it very well: It’s a tug of war. And it’s always been like that. Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities. We had five purchases in the second quarter. Four of them were in China in response to 1) new ideas from our analysts, and 2) lower share prices and valuations. This is what we do. It’s not always easy. Sometimes it’s not fun.

Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities.

FR: Pradipta, you have no choice but to invest in Chinese companies in the Chinese Equity strategy, but you do have choices between industries. Are there industries at this stage that you would avoid, other than the obvious one of the tutoring industry?

PC: Picking up on the ESG front, we’ve always considered ESG risk in these companies, and I think the social element has to be increased.

When I look at it through that lens, there are sectors like the property development sector, for example, where after the recent Politburo meeting there was talk about how housing is for living, not for speculation, right? Those kinds of comments give you hints that there are more regulatory strictures to come.

FR: Isn’t Harding Loevner generally biased against property development in the first place?

PC: Yes. So, that’s an industry thankfully we don’t own right now. We don’t want it because of quality and growth reasons, obviously. But then, there is another layer of risk that is coming.

FR: Confirming our bias against it.

PC: Yes. But I would also be very cautious about some of the other sectors where we do have stocks, like Health Care. Under the social equality principle and health care affordability for all, I would think—especially generic drugs, which have lower content in terms of technology and innovation—those probably are at risk of further price compression. Then the anti-trust regulations are breaking down barriers, which are changing industry structures from what we knew them to be a year back.

So, from the point of view that Andrew talked about earlier, the Porter structure is changing. We need to re-look at the growth cases. We need to re-look at the competitive advantage cases for some of our companies. And then act accordingly. Optically, the valuation might have become better. But in some cases, the valuation may not have become as much better as it seems.

FR: Jingyi, are there industries you have increased your aversion to in the last couple of months?

JL: The short answer is no. I don’t see any sort of a wholesale attitude change to any particular industry. That said, we need to look at our business from an ESG angle, especially the social angle, in a deeper and more profound way. We need to try to understand the social implications of their business models and to think about whether there’s any very profound social impact we should be aware of.

You asked about the sectors to avoid. I should point out that higher regulatory standards, or standards for social awareness, could also open investment opportunity in companies that are more aware of those issues to begin with, or with the management teams who can do a better job to adapt to these kinds of requirements, or even companies that provide solutions to address some of the social issues. So, all these regulatory changes may also provide us some interesting new investment opportunities, again using our fundamental Porter lenses and ESG frameworks.

FR: I’m going to sum up, and then, we can get to questions from outside. As Andrew pointed out, we explicitly try to assess regulatory risk in the framework of our research process, through the lens of Porter’s Five Forces. And I think importantly, we do have a culture of debate between analysts—between PMs and analysts, between people who know a lot about China and people who have questions about China—and that culture of debate is a very active part of getting to the underlying truth of what’s going on. The third thing I would point out is that the insistence on diversification in all our investment strategies is something that we are deeply wedded to, as I alluded to at the start when discussing the nature of pre-commitments.

I think ESG is getting a new take that is reinforcing our belief that ESG risks are exactly that, and that the way we’ve embedded ESG analysis into our research structure is the right way to approach the whole set of issues. And then, finally, the price declines in these Chinese equities are giving us a chance to reassess each of the companies within our coverage and ascertain whether future returns are higher because the prices are lower, or the prices are accurately reflecting the new risk. That is a company-by-company and stock-by-stock issue that we are actively engaged in right now.

Audience Question: Can you comment on your current views on VIEs and whether the VIE structure is at risk due to some of the regulations and regulatory changes that have come out of China?

FR: I’ll take that one. VIEs, for those who don’t know, are variable interest entities, which are special purpose vehicles that connect US-listed stocks to domestic Chinese businesses through holding companies and some third country and equity swaps to get the returns connecting the two.

We have long viewed VIEs as a precarious legal structure and, therefore, set limits on how much each strategy could invest in VIEs. Nothing in the current imbroglio of regulatory shifts affecting the share prices of companies utilizing VIEs has made us see VIEs as more risky or less risky. In our view, the precariousness lies in the legal structure itself and our limits on VIEs are not changing.

I would say that there is debate internally about whether Chinese authorities have, in some sense, blessed the VIE structure by allowing what are called CDRs—a Chinese equivalent of ADRs whose primary listing is a VIE—to be listed in domestic exchanges in China. While that gives some comfort, it’s a regulatory rather than a legal backing, in my view, and in the view of our legal experts.

I was also troubled by statements out of the recent Politburo meeting. I only get translations, but one of the statements was that “the Politburo is going to improve overseas listing supervision.” We’ve had the phrase “rectify” applied to several of these industries where regulatory changes have occurred. I’m uncomfortable with this word “improve” because it sounds a lot like rectified, which could be damaging. Jingyi, how would you characterize that phrase? What do you think it means?

JL: Yeah, I’m really reading the tea leaves here, but my understanding of this phrase, which is very interesting, if not important, is that the policymakers still understand the necessity of a VIE structure …

FR: In order for Chinese companies to raise capital abroad?

JL: To raise capital. They fully understand the historical background going back in the early 2000s. There are long debates inside China on what to do with the VIE structure, but, after all these years, I do not think they have taken a hostile view on this.

The reason that we have a change is they are always worried that some companies may abuse the structure. And that’s why they think they need to take a more active role to supervise Chinese companies that use it to get listed. It’s fine to use that structure, but it’s not fine in their eyes to use it to circumvent some of the regulatory frameworks that are in place to prevent some companies from doing certain things. That’s my understanding.

Audience Question: Why invest in China at all?

AW: We’ve invested in a lot of risky places and we’ve made money in a lot of risky places over the decades. As we said, we don’t get paid for being comfortable. China represents roughly 10% of the international index. Our analysts have found over 50 companies that meet our pretty high standards for quality and growth.

So, we think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades. We very rarely rule out any country’s securities. As I mentioned earlier, we may require higher returns to compensate us for the risks that we take, and we are intelligent about diversifying those risks as well.

We think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades.

PC: If I may add, as a market, China is massive with huge consumption opportunities that are transforming in a significant way. But, relatively speaking, there are pockets where the risk is lesser and much more aligned with what the government is trying to achieve in terms of its national and overall social objectives.

The massive production base in China is also transforming through the increasing penetration of automation. This entire area is one where we find very, very high-quality companies which are rapidly growing. Electric vehicles and their value chain are another area related to that and one which is very well-aligned with the government’s carbon neutrality goals. China has the largest value chain as well as some of the biggest consumer demand for these cars.

So, there are those pockets that continue to be very, very high-growth and have very high-quality companies that meet our requirements and are very attractive from a long-term point of view. Especially in a country which is right now going through a massive transformation.

The pandemic meant the stands were still empty at “Theater of Greens,” the home stadium for Plymouth Argyle this year, but the ideas were plentiful as to how to harness the theories of behavioral economics to put a more competitive squad on the field.

Source: Our World In Data

Source: Bloomberg

Informational

Analytic

Separating signal from noise can provide a potent analytical edge. As Benjamin Graham wrote in The Intelligent Investor:

“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” Having a series of rules that help determine the passage of a company from the wider universe to research coverage is extremely helpful. Being structured in how to conduct research and pre-committing to the characteristics sought in a company are essential. Be objective in embracing what works from quantitative processes and systematic fundamental analysis. Structure and discipline help overcome human biases. Admit and learn from mistakes to be more objective and establish a framework to help analysts communicate with colleagues. The structure and discipline will help them focus on what’s important, and filter out what is not.

“Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.”

Decision-Making

Understand that all human beings have biases that inhibit both thorough analysis and sound decision-making. A good manager needs to set up structures to overcome these biases, and make sure that all team members stick to those structures. Overcoming our emotions and learning how to avoid cognitive errors should be at the core of any process that results in making decisions, especially decisions made under conditions of great uncertainty, which clearly includes investment decision-making. Conviction and confidence help sell ideas but may not be accurate guides to the success of those ideas.

Organizational

Incentivize analysts to get their decisions right, not to persuade portfolio managers. How an organization is structured, and how its people are incentivized and compensated, can provide the background that facilitates good decision-making and is thus a source of “organizational alpha.” For example, incentives should in part focus on long-term performance so that they’re aligned with the long-term nature of the informational and analytical edge. Moreover, individuals need to be accountable for their decisions to avoid the blame game that arises from consensus or group decisions. Finally, a good investment manager needs to communicate with clients, and, above all, set their expectations accurately.

At Harding Loevner, we think we have an edge because of what we know about decision-making and the structure and discipline of the process. Our analysts provide the necessary ingredients for successful, systematic portfolio construction. Our decision-making structure imposes individual accountability, mitigates biases, and ensures continuity, leading to better decisions and aligning each of us with our clients’ objectives.

Sitting on Our Asses

Compounding the Effect

An investment process structured around the long term, and asking questions about long-term strategy not short-term results, will focus on a few fundamental signals that show a company’s progress in creating value for its shareholders. It will focus on competitive structure of an industry, and durable competitive advantages, rather than on the outcomes of the recent past. It will take what you’ve learned and use that to forecast a company’s investments in its business and the cash flows those investments should generate over long periods of time. Only then can you make an informed guess as to what a company is worth and compare it to what the market is inviting you to pay.

A process focused on the long term also recognizes the importance of compounding—that over a long holding period, even if you did overpay, the rate at which a company continually reinvests its cash flows will be a much more important contributor to your return. In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

Humans invariably underestimate this phenomenon. Compound interest is one of the wonders of the world, yet few people understand how powerful it is. It appears our brains are designed to deal with linear, not exponential progressions.

If there was any doubt about our difficulty in intuiting the power of exponential growth rates, look at how unperturbed most people were a year or so ago when COVID-19 began spreading, first in tiny increments. People could not grasp what the impact of a very standard exponential growth curve could be until it was sloping nearly vertically upwards.

A long investment time-horizon also benefits from the long term being more predictable, despite being the sum of a series of short-terms. When some luck is involved, individual outcomes are unpredictable, but the rules of probability dominate as the number of independent trials and outcomes increase. The outcome of a single spin of a roulette wheel, a roll of dice, or draw of a card is unpredictable, but in the long run the house’s victory is as near a certainty as we can get in this world.

Our job is to turn the coins we toss into unevenly weighted ones, by being disciplined about the information we use, diligent in our research, and allowing the companies in which we invest our clients’ capital to do the heavy lifting for us.

Gold as Currency

Gold, having shed its function as a means of exchange and unit of account, is still used as a store of value. Its inflation-hedging bona fides spring from the notion that, unlike other stores of value, it cannot be debased. Central bankers have the power to conjure fiat money at the stroke of a keyboard, but they are powerless when it comes to the quantity of gold. The price of gold may vary from day to day, but with a fixed supply on the order of 250,000 tons, of which one fifth remains lodged in the earth’s crust waiting to be mined, scarcity ensures that over long time spans its purchasing power remains intact. In 1934 an ounce of gold would have set you back US$26; had you buried it in the ground only to dig it up today, 86 years later, it would be worth almost US$2,000. Not a bad return when you consider that a paper dollar lost approximately 99% of its purchasing power in the interim.

But, of course, this simple illustration is dreadfully misleading. It is true that, had you let slip a dollar bill down the back of the couch while resting after burying your gold some 86 years ago, that dollar bill would buy you far fewer goods at the cash register today. Most dollars, however, are not left lying around to gather dust; they are deposited for safekeeping and, until recently, they earned interest. Fairer would be to evaluate gold relative to what you would have earned holding cash on deposit. According to Barro and Misra¹, the long-term compounded return on cash (T-Bills), after accounting for inflation, has been 1% per year, just shy of gold’s 1.1% real return. Gold may have won by a nose, but that extra 10 basis points came at the expense of frequent eye-watering price fluctuations and the occasional sleepless decade.

Echoes of the Gold Standard

It turns out that gold’s reputation as an inflation hedge is really founded on just two episodes: the end of the gold standard and the oil shock of 1979. Between 1971 and 1975 the price of gold quadrupled as the US severed the official link between the US dollar and gold. Again between 1977 and 1980 the price of gold tripled as the inflationary impact of the second oil shock rippled through the entire energy-dependent supply chain. Outside of these two peculiar instances, the relationship between gold and inflation largely falls apart. Remove just the years of 1974, 1979, and 1980, and as we can see the positive correlation between inflation and gold disappears entirely.

Figure 1: Correlation between change in Gold price vs. Inflation 1971-2020

If inflation isn’t driving the gold price, what is? The evidence suggests that a big part of what’s moving gold prices are real interest rates—or the difference between 10-year treasury yields and inflation—whose movements up or down are an important indicator of the underlying state of an economy and its expected growth. This inverse relationship between gold and real rates is born out in the next figure, which shows yearly changes in the price of gold and real interest rates from 1971 to 2020. The large increases in the gold price in 1974, 1979, and 1980, in addition to the price spikes of 2011 and 2020, all occurred against a backdrop of negative real rates. Correspondingly, the gold price declines of the early ’80s coincided with soaring real rates, a consequence of the tight monetary policy enacted during Paul Volker’s chairmanship of the US Federal Reserve.

This relationship between real rates and gold echoes the historical linkages between gold and the US dollar. Under a gold standard, because currency values in terms of gold were fixed, trade imbalances between countries were routinely resolved by a physical flow of gold. Gold would flow into countries that exported more than they imported and had high real exchange and interest rates, and out of countries where the opposite conditions held. But under a fiat system, where currency values in terms of gold are no longer fixed, real interest rates continue to exercise their pull, except now rebalancing occurs with a change in the price of gold instead of a flow. Perhaps because of its ongoing role as a central bank reserve asset and store of value, gold behaves like a shadow currency. A currency where, absent the prospect of a future cashflow, assessing how much to own comes down to what else you could be doing with that fraying dollar bill.

Hedging Inflation: It Depends

Just because gold has kept pace with the price of goods and services does not make it an effective inflation hedge in every scenario. And that’s because the alternate sources of expected inflation—diminished supply versus excess demand—have drastically different implications for real rates and hence for hedging strategies. If you think the world is in the thick of a deflationary or stagflationary bust that will depress real interest rates, then by all means buy gold. The current pandemic, like natural disasters more broadly, can certainly fit the pattern and to the extent it continues to depress consumption could still prove to be one of those kinds of periods. But if you are concerned about monetary excess, adding gold to a portfolio may turn out to be futile and may even magnify risks. If central bankers succeed in reviving inflation by stimulating demand growth, then we should also expect real rates to increase and the gold price to weaken. In that scenario, to hedge inflation you are better off buying TIPS and selling conventional bonds.

It’s only fair to point out that any notional horse race between gold and other assets assumes a functioning financial system nested in a stable society—not an unreasonable assumption for an optimist. But you don’t have to peer too far back in history to find examples of conflict, dispossession and collapse. Beyond keeping up with the price level, part of gold’s appeal lies in its tantalizing potential to ward off financial devastation. Although, if society deteriorates and its ability to function looks dicey, the risk of confiscation also shoots up and your chances of avoiding devastation by holding onto your lump of gold decline precipitously. This makes gold a bit like owning an out-of-the-money put option on social collapse underwritten by an ultimately insolvent counterparty. There is no chance of collecting, but at least its value should rise when people are fearful.