Out of
Our Minds

Ideas, arguments, and musings from inside Harding Loevner.

The Surprising Case for Shell as a Quality-Growth Stock

By Michael Purtill, CFA, Analyst | September 17, 2025

Some sectors are packed with rapidly growing companies. Energy typically isn’t one of them—but that doesn’t mean some energy companies don’t deserve a place in a quality-growth portfolio.

It may seem like an odd fit at first blush, given that earnings in the Energy sector are notoriously volatile. Commodity prices can swing wildly, which not only affects energy producers’ revenues but also influences how much oil or gas they choose to pump out of the ground. Shell, for example, has exceeded a cash flow return on investment of 5% only once in the past 15 years, and its earnings are projected to remain flat over the next five. Even so, there are compelling reasons to own the stock. Here are a few:

1. Geopolitical risk

Energy production is concentrated in politically unstable regions, and major disruptions can quickly shake global supply. Past shocks, from shipping interruptions in the Strait of Hormuz to sanctions on Russia, offer reminders of how fragile supply can be. These events tend to hit the stocks of long-duration growth companies hardest, as investors discount their distant earnings more heavily. Therefore, holding a large energy company such as Shell helps balance the risk. As a diversified producer, Shell has less direct exposure to any single risky region, and the company benefits when wars or sanctions push oil or gas prices higher, allowing it to sell its global production at elevated prices.

2. Inflation protection

Spikes in inflation also tend to weigh on traditional quality-growth sectors such as Consumer Discretionary or Information Technology, whereas Energy stocks have historically outperformed during those periods. (Of course, higher oil prices are sometimes the very source of the inflation.) Therefore, Energy holdings can provide idiosyncratic benefits during periods of shifting inflation and favorably alter the overall risk profile of a portfolio.

3. Positioning for supply shocks

Demand for energy tends to be steadier than supply, which shifts with new discoveries and reserve depletion. For diversified producers with large reserves, that dynamic can be favorable: when supply increases, they benefit from higher volumes, and when supply tightens, they benefit from higher prices. Shell is also the largest integrated player in energy trading. As a natural consequence of the energy transition, weather volatility, and geopolitical tensions, energy volatility is likely to increase and could remain elevated. Higher volatility increases opportunities for capturing outsized margins from trading, and Shell, with its insight into global energy markets and global footprint, is well-positioned to exploit those opportunities.

4. Investment flexibility, without style compromise

Exposure to the sector can help diversify sources of return. However, many energy companies fail our quality-growth screening due to high financial and operating leverage, which create elevated risks, and a history of financial weakness caused by the cyclicality of their end markets. Shell’s diverse, cost-advantaged portfolio has enabled it to generate more durable cash flows than its rivals. Recent operational momentum is also helping to bolster its financial strength; management is working to cut costs and focus on higher-return assets while selling weaker ones. These measures should improve operating margins and lift cash flow return on investment when commodity prices are favorable.

5. Sustainable growth in LNG

Given the volatile nature of earnings in the sector, forecasts should be taken with a grain of salt. They don’t adequately reflect Shell’s unparalleled scale and expertise in liquefied natural gas (LNG) and the long-term growth opportunity it provides, as coal-dependent economies, particularly in China and Southeast Asia, shift toward cleaner energy. With limited pipeline access and declining domestic gas production across much of Asia, LNG is the most practical lower-carbon fuel available. Global demand for LNG is estimated to rise more than 50% by 2040, and most scenarios point to a global supply shortfall emerging in the 2030s. By 2030, Shell plans to grow its LNG business by 20‒30% and its LNG liquefaction volumes by 25‒30% from 2022 levels. Moreover, with global energy demand set to grow alongside rising populations and living standards, Shell looks well positioned to meet that demand while evolving with the energy transition.

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Brazil’s Market Is Thriving Amid Global Trade Shifts

By Scott Crawshaw, Analyst and Portfolio Manager | July 24, 2025

President Donald Trump’s trade wars have roiled global markets. Recently, he threatened Brazil with a 50% tariff unless the country drops an investigation into its former president. But the US trade war with the rest of the world hasn’t stopped trade. Indeed, for Brazil, its trade has increased since Trump’s first term, as seen in the chart above. Partially that is because Brazil’s exports to the US are only about 10% of its total exports and account for less than 2% of the country’s GDP.

Most of those exports are commodities such as oil, iron ore, beef, and coffee, all of which can easily be sold to other countries. And that is what has been happening. In fact, companies in Emerging Markets (EMs) around the world have responded to Trump’s trade wars by turning to other EMs as a replacement market.

All Those AI ‘Agents’ Are Going to Need Security Credentials

By Jafar Rizvi, CFA, Analyst and Portfolio Manager | July 22, 2025

One of the more immediate consequences of businesses and government entities increasingly trusting artificial intelligence (AI) with their data is security risk. An area of cybersecurity that may see greater demand because of AI is a niche known as identity and access management, which is Israel-based CyberArk’s specialty.

Humans who access an organization’s computer systems are assigned digital identities, which include their login credentials and define what parts of the system they have permission to access. Computer hardware and software also have digital identities—called “machine identities”—which must be protected. Securing human and machine identities involves managing various digital mechanisms, such as application programming interfaces (APIs), which are sets of rules that allow one piece of software to talk to another; digital certificates, which act like virtual identification cards with embedded signatures; and electronic keys that grant access to specific data or functions. CyberArk’s software platform helps organizations manage digital identities and monitor them for suspicious or unauthorized activity.

This is important because AI is creating a new class of machine identities in the form of autonomous and semi-autonomous AI “agents” capable of performing tasks and making decisions previously handled by humans. Already, the number of machine identities is on the rise: According to CyberArk, organizations on its platform had about 40 machine identities for every human identity last year—a ratio that has since doubled.

CyberArk is also poised to benefit from the proliferation of so-called containers and microservices widely used by AI developers. Containers package everything an app needs to run (code, tools, libraries), while microservices focus on discrete functions such as authentication. The company also developed a suite of AI-powered tools called CORA AI that helps its identity-security platform analyze user behavior, detect risky activity, generate audit reports, and provide its clients actionable insights. Management has been a good steward of capital, using the company’s strong balance sheet and free cash flow to invest in products and strategic partnerships that position CyberArk to meet the security challenges created by AI.

While much of the investment community has been focused on what large US companies are doing in AI, this technology may become a powerful equalizer, offering businesses of all sizes across geographies a chance to leapfrog the competition (or risk falling behind).

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Health Care Swoon Puts Sector’s Stable Profits on Discount

By Jingyi Li, Analyst and Portfolio Manager | July 17, 2025

It was a bruising quarter for global Health Care stocks, with the sector underperforming the MSCI All Country World Index by the most in more than 25 years, as fears spread over shifting US policies and the country’s cuts to funding for medical research. But Health Care has weathered storms before.

In the chart above, the gray bars are the cash flow return on investment (CFROI) of companies in the sector for each year since 1999. The gray line is the sector’s average valuation—a blend of price-to-earnings, price-to-book, and price-to-cash-flow ratios—relative to the broader index. What the data show is that despite a series of political and regulatory developments that spooked investors (the portions shaded purple) over the past two-and-a-half decades—from the roll out of the Affordable Care Act to the COVID-19 pandemic—the profitability of the underlying businesses in the sector has been remarkably stable.

Health Care stocks are now trading at some of their most attractive levels relative to the broader market in decades. And while investor sentiment can be fragile, the long-term reasons to own Health Care companies remain intact, including that aging populations with unmet medical needs continue to fuel demand for treatment options.

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The Passive Paradox: Rethinking Risk in the Age of Index Investing

By Edmund Bellord, Analyst and Portfolio Manager | May 28, 2025

After getting its start almost half a century ago when Vanguard founder John Bogle launched the first S&P 500 index fund, passive investing is now the dominant force in global equity markets. The logic behind indexing is simple. On average, active managers deliver the market return before fees and trading costs; by reducing management fees and transaction costs associated with active trading, passive funds can reliably match average market returns and thus consistently outperform the average actively managed portfolio over time.

Although conceived as an alternative to active management, passive investing ultimately depends on it. Active managers interpret new information, earnings releases, economic data, industry shifts, and incorporate it into prices. This process of price discovery helps anchor valuations to fundamentals, limits mispricings, and curbs speculative excess, all of which are essential for orderly and resilient markets. Passive investors, in contrast, simply track indices, and trade only in response to investor flows or when index compositions change. As price-takers, they rely on active investors not only to establish fair pricing but also to provide liquidity and absorb trading flows—particularly during rebalancing or redemptions.

But as passive investing continues to grow—now representing over half of global equity markets by some estimates—it may be increasing the risks faced by active investors. With a shrinking pool of active investors responsible for price discovery and liquidity provision, their role becomes more concentrated and faces more potential volatility. If less capital is available to correct mispricings or absorb large trades from passive funds, markets could become more fragile, with sharper price swings and more persistent inefficiencies. In extreme cases, active managers may be forced to take on more risk to generate returns, operating in an environment where their role is constrained yet indispensable. As passive assets swell, does the burden on active management increase, making its role more precarious?

Two recent research papers suggest the rise of passive investing is indeed reshaping market dynamics, placing greater pressure on active investors and changing the nature of liquidity and price discovery.

The first paper by Jiang, Vayanos, and Zheng, “Passive Investing and the Rise of Mega-Firms,” develops a framework in which two types of investors, “experts” (active traders) and “non-experts” (passive traders), interact in a market with growing passive flows. Experts make unconstrained investment decisions based on expected returns, while non-experts simply hold an index portfolio. The model posits that rising passive inflows disproportionately benefit the shares of the largest firms—typically those already subject to strong investor demand or overvaluation. Because large-cap stocks are a larger part of indexes, passive funds naturally allocate more capital to these stocks, inflating their prices and, paradoxically, increasing their daily volatility. Consequently, the active trading experts become increasingly hesitant to short or trim positions in overvalued large-cap stocks, as such strategies grow riskier in an environment dominated by persistent non-expert passive inflows.

The authors test these predictions using more than two decades of data on S&P 500 mutual funds and ETFs. They find that during quarters with significant passive inflows, the largest index constituents experience the biggest price gains and elevated volatility. And firms that join the S&P 500 see share price increases that are positively correlated with the size of the company, reinforcing the idea that passive investing amplifies the advantages—and fragility—of mega-cap stocks.

A separate paper by Haddad, Huebner, and Loualiche, “How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing,” investigates how competition among investors shapes stock prices, particularly when the behavior of one investor group (such as active investors) shifts toward passive strategies. Departing from traditional models of market efficiency—where reduced trading by some group of investors is assumed to be completely offset by increased trading from others, leaving prices unaffected—this study explicitly incorporates “strategic responses” into its demand framework. In the author’s approach, an active investor’s sensitivity to price (elasticity) depends not only on a stock’s valuation but also on how aggressively other investors trade.

To test their model, the authors looked at data on institutional ownership in US markets from 2001 to 2020. Because investor behavior and stock prices interact, the researchers needed a way to separate cause from effect. They achieved this by focusing on characteristics of investors—such as the overall size of their asset bases and which stocks they’re permitted to buy—that influence their trading but aren’t directly shaped by short-term price movements. Using this approach, the authors find that when those investors shift to passive strategies, active investors respond only partially, by becoming somewhat more aggressive traders. This has left markets roughly 11% more “inelastic,” meaning stock prices react more strongly to buying or selling pressures.

This decline in market elasticity has important implications. As markets become less elastic, modest changes in capital flows can trigger outsized price movements—amplifying volatility and weakening the connection between prices and fundamentals. Large-cap stocks are especially exposed: their sheer size makes them indispensable to index replication, forcing them to absorb a disproportionate share of passive flows, which dulls the influence of fundamentals.

Although some active investors do adjust their behavior in response to rising passive flows, their ability to fully offset the loss of active trading is limited by capital constraints. The notion that investor competition automatically ensures stable and efficient pricing looks increasingly outdated.

These findings make clear that passive investing has shifted the playing field for active managers. As index-driven capital increasingly influences pricing and volatility—particularly among large-cap stocks—certain portfolio traits carry heightened risk. Concentrated positions, large sector or country tilts, and risk frameworks that don’t account for this changing landscape may all be more vulnerable.

Concentrated portfolios have long been held up as a mark of investment conviction. The logic is straightforward: if a manager has a genuine edge, concentrating capital in fewer positions allows for deeper analysis and a portfolio that more precisely reflects their views. With ten or twenty holdings, it’s possible to understand each company intimately—its business model, management, financials, and strategic risks. That level of familiarity is more challenging as the number of holdings increases.

But high concentration also exposes portfolios to single points of failure. That failure might come from a specific company, a common theme or sector, or a broader market shift. And when markets are being shaped more by mechanical flows than deliberate trading, the timing and force of those failures become harder to anticipate. More diversified portfolios, by contrast, help mitigate this exposure. They don’t eliminate risk, but they spread it more widely, reducing the likelihood that any one misjudgment—or market distortion—proves catastrophic. In an environment where pricing is increasingly shaped by factors beyond fundamentals, that cushion matters more than ever.

Just as concentrated portfolios heighten exposure to individual company risk, large active country or sector weights also magnify vulnerability. When a growing share of capital flows is driven by index weights, outsized positions in major regions or sectors may deliver performance that reflects strong flows more than manager skill. This can create a false sense of confidence: managers overweighting popular areas—such as US tech or global megacaps—may benefit from flow-driven gains, only to face abrupt reversals when flows moderate or rotate.

These risks are amplified by growing price inelasticity, which weakens price signals. Fundamentals remain critical, but they increasingly compete with mechanical, valuation-insensitive flows. In this environment, large top-down sector or country exposures—whether driven by macro views or the cumulative effect of bottom-up positioning—can have less predictable results. With diminished market responsiveness, even modest sentiment shifts or index rebalancing can provoke outsized price movements. Such exposures may still have a role in active portfolios, but they require a higher bar for inclusion—not just because fundamentals change, but because the market’s response to them has become less stable.

Evolving risks means active investors must rethink not just where they look for returns, but how they manage the risks that come with pursuing them. The old playbook—making investment decisions first and applying risk controls afterward—is increasingly inadequate. When pricing is sensitive to flows, not just fundamentals, and when volatility can be caused by mechanical rebalancing rather than new information, risk management is no longer just a safeguard, it’s part of the thesis. Embedding risk considerations into position sizing, diversification, and liquidity assessments is not being cautious for its own sake—it’s recognizing that the pathways through which risk manifests have changed.

Paradoxically, a more distorted, less efficient market should in theory offer more opportunities for active managers. As Cliff Asness argued in “The Less Efficient Market Hypothesis” market inefficiencies may grow, not shrink, in a world where fewer fundamental investors are actively seeking mispricings. But capitalizing on these opportunities will likely require a different toolkit than the one that worked in a more stable, fundamentally anchored environment. Concentrated bets and implicit top-down exposures may no longer offer the same payoff they once did. Instead, active managers may need to rely more on diversification and a closer coupling of investment insight with risk awareness. In a market shaped increasingly by flows, generating alpha will depend not just on being right—but on being resilient.

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Column chart showing the difference in returns by tercile of quality in the MSCI EM index from March 2020 to March 2025.

DeepSeek, Weak Outlooks Drag on IT Companies in Emerging Markets

By Pradipta Chakrabortty, Analyst and Portfolio Manager | April 22, 2025

High-quality stocks had a very poor first quarter in Emerging Markets (EMs), primarily due to Information Technology (IT) stocks, which also tend to trade at higher valuations. Stocks in the top third of quality underperformed the lowest third by close to 15%, the kind of sharp sell-off last seen four years ago when companies were still coming out of the depths of the COVID-19 pandemic.

Within the IT sector, semiconductor and other hardware stocks linked to the AI value chain sold off sharply after Chinese AI-startup DeepSeek released a large language model that rivaled the leading models at a fraction of the training cost, raising concerns that AI-related capex spending may drop.

Additionally, shares of IT-services companies were also weak. Most reported fourth-quarter earnings in line with expectations but provided disappointing guidance for 2025, quashing hopes of an acceleration in demand this year. Of course, additional trade-related uncertainty has skyrocketed since the end of the first quarter as global markets convulsed sharply in the wake of Trump’s tariffs in early April (with North America being a large market for many EM-based IT companies).

Still, despite the short-term uncertainty, the advancement of new technologies has increased the long-term opportunities for high-quality and fast-growing EM IT companies.

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Perón’s Ghost: When Self-Reliance Becomes Self-Defeating

By Edmund Bellord, Analyst and Portfolio Manager | April 17, 2025

The following is adapted from our first-quarter report for the Global Equity strategy. Click here to read the full report.

Amid the turbulence and mixed signals of the Trump administration’s tariff strategy, a discernible tilt toward economic self-sufficiency has emerged. The stated objectives of reshoring manufacturing, reducing dependence on foreign supply chains, and projecting national strength carry political appeal for many, but undoing 50 years of globalization is fraught with risk. Argentina’s mid-20th century descent under Juan Perón offers a sobering reminder of how quickly such ambitious efforts can short-circuit, swapping prosperity for prolonged isolation and decline.

Juan Perón came to power on a wave of popular support, winning democratic elections in 1946 and 1951 with an economic agenda focused on achieving independence from foreign economic and political control. At the time, British and American investors dominated Argentina’s infrastructure, utilities, and key industries, while the nation’s reliance on imported manufactured goods and its commodity-based export economy left it vulnerable to external shocks and fluctuations in global demand.

Argentina’s mid-20th century descent under Juan Perón offers a sobering reminder of how quickly such ambitious efforts can short-circuit, swapping prosperity for prolonged isolation and decline.

In response, Perón’s government launched a program of economic nationalism centered around Import Substitution Industrialization, with high tariffs often reaching over 100% for some goods to protect fledgling domestic industries. These tariffs made foreign goods prohibitively expensive and gave local producers a captive market.

In addition to tariffs, the regime implemented strict import quotas and licensing systems, restricting both the volume and type of goods allowed into the country. These measures were designed to conserve foreign currency reserves and shield domestic firms from international competition. The government also nationalized key industries such as railroads and energy, shifting control from foreign hands to the state.

Initially, the strategy appeared to succeed as industries such as auto manufacturing, textiles, and steel expanded rapidly. But this protection led to complacency—Argentine cars grew costly and outdated, unable to compete with imports. The heavily shielded textile industry became a major employer but remained inefficient and high-cost, limiting global competitiveness. State-owned heavy industrial companies such as steelmaker Somisa faced similar issues: overstaffing, obsolete equipment, and reliance on government support.

Booming global demand for Argentina’s agricultural exports in the immediate post–World War II period had provided the foreign exchange needed to finance the country’s industrial push. But as postwar Europe recovered and commodity prices fell, Argentina’s export revenues fell sharply. With foreign currency scarce and domestic industries now dependent on protection, the limitations of the model became apparent. Production quality lagged, costs rose, and Argentina became increasingly inward-looking and uncompetitive on the global stage.

What began as a drive for economic sovereignty ultimately resulted in deep structural weaknesses—fiscal imbalances, declining productivity, and persistent inflation— and the onset of Argentina’s prolonged economic decline. Inflation escalated from 20% annually in the early 1950s to severe, chronic levels that persisted for decades, eventually culminating in hyperinflation by the late 80s. The policies introduced under Perón cast a long shadow: once one of the world’s ten wealthiest nations by GDP per capita, Argentina steadily fell behind its peers, dropping to 79th place by 2023.

While the Trump administration’s protectionist turn echoes elements of Argentina’s economic nationalism, it lacks several core features that defined the Peronist model. There is no nationalization of industry, nor a broad push to reshape the domestic economy through state planning or import substitution. Instead, Trump’s approach reflects a singular obsession with applying punitive tariffs to reduce the trade deficit—ignoring the basic accounting reality that cutting the trade deficit necessarily shrinks the capital surplus.

The flipside of the US trade deficit is its capital surplus, when the US runs a trade deficit—importing more goods and services than it exports—those dollars don’t simply vanish. Instead, they return in the form of foreign investment, with foreign capital flowing in to support equities, bonds, and the dollar.

If fewer dollars flow abroad through trade, fewer dollars will be recycled back into US assets. This shift could weaken demand for Treasuries, forcing yields higher and tightening financial conditions across the economy. US equities, long buoyed by steady foreign inflows, would face downward pressure, while a stronger dollar—resulting from tariffs or restricted trade—could further erode US export competitiveness.

The flipside of the US trade deficit is its capital surplus, when the US runs a trade deficit—importing more goods and services than it exports—those dollars don’t simply vanish. Instead, they return in the form of foreign investment, with foreign capital flowing in to support equities, bonds, and the dollar.

In short, efforts to shrink the trade deficit cannot occur in isolation; they will directly impact the capital account, reducing foreign demand for US assets and challenging the fundamental financial stability that has long underpinned US economic dominance.

Argentina’s experience vividly demonstrates how pursuing economic self-reliance can become self-defeating, as protectionist policies breed inefficiency, deter investment, and ultimately trigger spiraling inflation. Although the United States today operates in a markedly different context, its sheer economic magnitude, central position within the global economic system, and reliance on global capital flows mean that even a modest inward pivot carries outsized risks.

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Line chart tracking cumulative index performance for MSCI ACWI ex US and MSCI US, highlighting convergence in global stock performance in 1Q 2025.

First Quarter Outperformance of Non-US Stocks At 15-year High

By Andrew West, CFA, Analyst and Portfolio Manager | April 15, 2025

International markets continue to offer opportunities to own high-quality, growing businesses at levels supportive of higher future returns. Investors enjoyed a recently rare taste of that as international stocks rose in the first quarter, outperforming the US market more this quarter than it has in 15 years.

Stop Making Sense: Echoes of Emerging Markets in Today’s US Policy

April 11, 2025

I…who took the money?
Who took the money away?
…it’s always showtime
Here at the edge of the stage
I, I, I wake up and wonder
What was the place, what was the name?
We wanna wait, but here we go again…

-Talking Heads, from the film Stop Making Sense

The following is adapted from our first-quarter report for the International Equity strategy. Click here to read the full report.

This quarter, global investors have had to grapple with heightened US policy uncertainty, most overtly in the realm of trade but in many other areas as well, from military cooperation to health care to the previous administrations’ industrial policy programs. As we cautioned in our fourth quarter 2024 letter, the US political climate has featured policy volatility almost from the outset of the Trump administration. But that chaos has been greater than we imagined, and the vectors of policy shifts have expanded beyond the “tariffs, tax cuts, and deportations” list that we expected.

What hasn’t changed is our view that US policymaking in the new administration bears many of the hallmarks that we’ve come to associate over the last 35 years with emerging markets—and not the best performing ones, either. The erosion of institutional continuity and effectiveness tends to enable more erratic policymaking. This institutional disruption doesn’t just affect the regulatory stability that companies rely on to make long-term investment decisions, it also undermines predictability of enforcing contracts with suppliers, service providers, and customers. Just seven years ago, investors howled when Mexican President López Obrador unilaterally canceled the completion of an already-under-construction Mexico City Airport, leaving contracts unpaid and long-term investment plans disrupted. Now, the US government—reprising a pattern from President Trump’s business career—is terminating both employment contracts and commercial services contracted for various government agencies.

In our third quarter 2024 letter, we wrote about our potential exposure to new US tariffs and asserted—optimistically—that the risks were modest and manageable. That view was shaped by Trump campaign’s focus on China as the key malefactor behind US trade imbalances. That has proven a misjudgment on our part, as early salvos in the new trade war quickly hit China, the US’s primary geopolitical rival, but then were re-targeted at its closest neighbors, Canada and Mexico, and then at its closest allies in Europe. Before the April 2 “reciprocal tariff” shock, the most directly affected company in our International Equity portfolio was Canadian National Railway, a critical freight transport provider that, despite its name, links US states with each other, but of course also connects the US with its largest trading partner, and—no small thing—one of its top export destinations.

Another area of policy more often seen in developing countries than mature democracies is the practice of governments extracting concessions or favors from companies or individuals in exchange for letting them get on with their normal course of business. The recent case of TSMC investing a further US$100bn in the US after being threatened by targeted, ultra-high tariffs is a distasteful example of such a commitment being demanded from a company. Especially a company that had already responded voluntarily (and at large scale) to Biden-era Chips Act incentives, building a new semiconductor fab in Arizona, slated to ramp up high-volume, advanced chip production this year.

Our point here isn’t to dispute the policies¹ themselves, but rather to highlight the harm to predictability, and by extension to business confidence, from abrupt, poorly signaled shifts and their frequent reversal (and the reversal of the reversals.) This is not a business-friendly environment. When the rules of the road become increasingly arbitrary, companies—domestic and foreign alike—become less willing to commit capital. Uncertainty undermines both the appetite for investment and the demand outlook that would justify it. While TSMC’s investment commitment garnered headlines, there will be no headlines for the thousands of business projects that quietly get canceled in the US due to rising policy uncertainty. International Equity portfolio holding Air Liquide is already reversing its plans to build four hydrogen gas pipeline hubs in the US due to abrupt (if not entirely unexpected) regulatory shifts by the new administration. Meanwhile, US consumer confidence is falling as inflation expectations rise in anticipation, rationally, of the higher cost for most of the goods consumers want to buy. This does not strike us as a backdrop that supports elevated stock price valuations in the US. The relative outperformance of non-US markets this quarter—the largest quarterly lead over US stocks in fifteen years—offers a taste of how that could play out.

The world economic order that created vast wealth through open trade and cooperation now faces potentially radical disruption as the US reshapes its own role in that order. As stewards of your capital, our task is to see the world as it is, not as we might wish it to be.

From our vantage point as global investors “here at the edge of the stage,” the challenge of protecting and growing our clients’ wealth feels more daunting than usual. The world economic order that created vast wealth through open trade and cooperation now faces potentially radical disruption as the US reshapes its own role in that order. As stewards of your capital, our task is to see the world as it is, not as we might wish it to be, and anticipate the possible consequences of chaotic and self-destructive economic, business, and foreign policies, even when they stop making sense to us.

From a portfolio perspective, our investment process has always prompted us to understand the industry dynamics that affect how companies operate, to grasp and assess the source of a company’s superior profitability, and to have insight whether that source will endure or evaporate easily as foreseeable pressures arise. Thus, we’ve long harbored an aversion to companies whose profits were especially vulnerable, as we once put it, to “the whims of faceless bureaucrats and capricious politicians.” That practice has given us a leg up in parsing our portfolio holdings and potential new investments for companies situated to better avoid the fallout from a damaging trade war, regardless of its origin. That’s no small task given the size and interconnectedness of the global economy, and the central role of the US within it. Our experience of investing across emerging markets has prepared us to find resilient, growing companies that are operating well outside the line of fire of volatile or heavy-handed governments.

A process grounded in identifying and evaluating resilient companies and assessing their growth prospects feels particularly well suited to the moment.

With the entire non-US stock market as our hunting ground for the International Equity strategy, we face an ample opportunity set as we pursue sound investments. A process grounded in identifying and evaluating resilient companies and assessing their growth prospects feels particularly well suited to the moment. Many industry and societal trends transcend the political aims of any single administration, and there are products and services—indeed, entire economies—that will grow regardless of shifting policy priorities elsewhere. Moreover, due to the sustained fashionableness of US investments in recent years, investors can buy such companies at more modest prices than in many years; market volatility will afford yet more opportunities to invest in them at attractive valuations.

¹Although we have disputed the wisdom of starting trade wars. For the record, we’re also in favor of greater budget discipline in the US because we’re in favor of the US government avoiding being at the mercy of its creditors and resisting the expediency of resorting to inflation to escape its ballooning debt burden. We favor US Treasuries remaining a low-risk, benchmark investment, a feature at the center of the US’s attraction as a capital market and reserve currency provider, right up there with the trusted rule of law.

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Ex US Marks the Spot: Where future returns might be heading

March 31, 2025

Over the last 14 years, a powerful narrative around the exceptionalism of US equity markets took root. Dominant tech stocks, prolonged low interest rates, and economic stability led to higher returns for US stocks and caused many investors to question the necessity of international allocations. However, the tide has shifted in 2025; international equities have outperformed. Watch Portfolio Specialists Ray Vars, CFA, and Apurva Schwartz discuss the recent shift in market leadership and what the next decade might hold for global equity markets.

The transcript, lightly edited for clarity, follows.

Ray Vars: Amidst a lot of the market turmoil this year, I think something that stands out is non-US stocks outperforming the US. A lot of things today rhyme with the last time international embarked on an extended period of outperformance back in 2001: We had just come off the 1990s, a decade of US stocks outperforming, powered by great businesses, great innovation, the internet, all rooted here in the US. Earnings were strong.

We also saw the dollar strengthen for a decade, a couple hundred basis points per year. We saw a big valuation gap open up between US and non-US companies. I recall people saying, “Well, that’s okay. Why bother investing overseas? All the great businesses are here. The US is different.” But, of course, right when everybody decided that, the US went nowhere for a decade and international outperformed.

A lot of things today rhyme with the last time international embarked on an extended period of outperformance back in 2001.

Today, it feels very similar. We’ve had 14 years now of US outperformance driven by great businesses, innovation, and more earnings here. The dollar’s been strengthening for a decade and you see that valuation gap widen again, once again excused by US exceptionalism. Why bother with international companies? All the great businesses are here.

This peaked following the election last year. People said, “Oh wow! The US is going to continue to do well. The dollar’s going to strengthen.” Then we get to this year. Amidst the uncertainty, all of a sudden we’ve seen US stocks fall, international stocks actually go up, and we’ve seen the dollar weaken. The last time we saw the dollar weakening and US stocks falling was back in 2001. The question today is can we continue to see international stocks outperform over the next few years. Let’s walk through some of the reasons we think that might happen.

Apurva Schwartz: Maybe the first thing to talk about is tariffs. We don’t know what the policy will look like, it seems like there are changes every day, but I think tariffs are bad. Bad for companies outside the US and bad for US companies and their potential competitiveness abroad. Globalization has been such a tailwind for the US, for China, but also the world. The wealth effect and the prosperity that’s been generated by companies and countries being cooperative with each other. Interestingly enough, when you look at the last several years and the impact of the first round of tariffs we saw five or six years ago, global trade continues to do well.

Column chart comparing the amount of trade between major geopolitical blocs, showing trends and shifts through 2025.

Source: Deutsche Bank, Haver Analytics. Reproduced with permission.

Data depicted is IMF DOT export data for last twelve months ending September 2024 compared to the twelve-month period ending September 2017.

Current coverage of world trade represented herein is around 87%. Chart is from the report “Five Fresh Perspectives on Global Trade”
issued December 12, 2024.

I think the question is that as the US pursues a policy of tariffs, and you see retaliatory tariffs on top of that, what does that actually mean?

If global trade is continuing to do well, perhaps you are starting to see the US begin to squander that leading position that it has.

RV: That’s another interesting point, that the global leadership the US has shown—stability of policies, stability of institutions, driving for that change—I think is part of what underpins that idea of US exceptionalism and the premium valuation awarded to some US stocks, why the US dollar is the reserve currency for the world, and also why the dollar has been so strong.

Line chart showing the returns of the US Dollar Index increasing from March 2014 (around US$80) to March 2025 (around US$104).

To the extent that there’s some uncertainty around those things and some abdication of that leadership, it feels like that could also be a positive for non-US stocks. You can have that valuation premium evaporate a bit for the US. You could also see what we’ve been seeing today, the dollar continue to weaken.

AS: I think that’s exactly right. If you think about the enthusiasm over Europe today and the outperformance of European markets, it may be as much about people moving away from the US as it is about some changes that are happening in Europe. You have more unity, less regulation going forward, more investment as countries like Germany relax their fiscal constraints, and more monetary support.

The narrative is changing a little bit. Previously Europe was seen as slow moving, bureaucratic, and the European Central Bank behind the Federal Reserve in decision making. Now it feels that Europe is a little bit more on its front foot these days.

When you bring that to the company level, you mentioned this idea of US exceptionalism and the best businesses are found in the US, I acknowledge that earnings growth in US companies has generally been a little bit better, but The Magnificent Seven are very much a double-edged sword today. They drove the concentration of market returns in the US in 2024. But there’s certainly been a reversal of that and the pain in the markets in the US today is quite acute.

Two charts, one a line chart showing the index weight of the top seven holdings significantly increasing in the MSCI US Index vs. the MSCI ACWI ex US Index since March 2020, and the other showing the difference in MSCI US Index returns between the large contributions of the Magnificent 7 vs. all other stocks both in 2024 and January 1, 2024 through March 11, 2024.

RV: Some of that reversal, if we think back over this year, is when DeepSeek announced how strong and how efficient and effective its model was. That news was certainly a shot across the bow of US-based hyperscalers, but I think it also highlights that there is innovation beyond the US.

Even within AI, when we think about who makes all of NVIDIA’s chips, TSMC makes all of them. And what equipment do they use to make it? It’s all from ASML and their extreme ultraviolet lithography (EUV) equipment. Both are near monopolies from a Taiwanese company and a Dutch company. Even the inputs are less well known, like a company called Disco in Japan: They slice, dice, and polish the wafers that are used in making those chips, and have something like a 70% market share. This is a critical niche component to the whole infrastructure and AI supply chain. Again, these are non-US companies.

When we think about who makes all of NVIDIA’s chips, TSMC makes all of them. And what equipment do they use to make it? It’s all from ASML and their extreme ultraviolet lithography (EUV) equipment. Both are near monopolies from a Taiwanese company and a Dutch company.

Even outside of tech, you’ve got a company like Schneider Electric based in France. They do energy management equipment and services and software around that. People thought about it for green energy, but the reality is they’ve got a fantastic and fast-growing business helping build out AI infrastructure. Those AI data centers need very efficient and consistent power, and I think it’s grown to something like 20% of their business from almost nothing not too many years ago.

Health care is another area of innovation outside of the US. Anti-obesity, weight loss drugs have certainly been a focus of markets and the Health Care sector. Novo Nordisk, the Danish company, is the leader. They’re competing today with Lilly. When we look forward, what people are looking for is not just the weight loss but convenience and a better safety profile with fewer side effects.

Lilly has taken to phase three a once daily oral GLP-1 drug. That would certainly be more convenient. But interestingly, the science behind that is from Chugai, a Japanese-based company. And when we think about lower side effects, Roche recently did a deal to co-develop drugs with Zealand, a Danish-based company. It’s still an injectable, but far fewer side effects than Ozempic, Wegovy, and Mounjaro. Again, a lot of innovation for future growth is coming from non-US Health Care companies.

AS: That’s a really good point. When you look at the top 20 cash-flow return-on-investment businesses, you mentioned areas of innovation like Health Care, Information Technology, and Industrials, but there are other sectors as well. You do see a preponderance of high-quality, growing businesses in those sectors outside the US.

If you look at the ACWI benchmark, the US has a large weight, 67% in US and 33% in International. But when you slice it by market cap and look at the number companies greater than US$5 billion in that high-quality growth universe, it’s a very different skew: 73% of the companies in that high-quality growth universe are outside the US. Certainly the monopoly on innovation does not belong to the United States.

Two charts, one a line chart showing the decreasing relative valuation of MSCI ACWI ex US vs. the MSCI US Index, as well as the attractive relative price-to-earnings, price-to-book, and price-to-cash-flow of the MSCI ACWI ex US Index (15.8, 1.9, and 9.8, respectively) vs. Europe, Japan, US, and EM.

RV: Yet it’s still not reflected in valuations. You see the widest gap we’ve seen in 20 plus years, actually ever I think, but it feels like that could close. We’ve listed quite a few different potential positives. If any one of them happen, it feels like that could narrow that gap and lead to some international outperformance, hopefully within rising markets.

It can also be a powerful defense. Diversification in international, if things are going awry, that valuation can provide some support in down markets, along with the quality growth of the businesses. Outperforming in down markets is actually almost more powerful than on the way up. If you think about the magic of math, if a stock falls in half, it has to double to get back to zero.

So international markets could outperform on the way up, but there’s also a good chance that they could provide protection if markets get difficult in the coming years.

AS: That point on downside protection is a good one. I also think it’s worth mentioning, from a style perspective, that growth and value have had very different experiences outside of the US, and growth stocks in the last three years have significantly underperformed to the tune of thirty percentage points unannualized versus value stocks.

To the extent that you’re looking about at international markets and looking where to put that that marginal dollar, I think international growth stocks are pretty interesting right now.

RV: Yes, I think so, too. I think international markets definitely have the potential to perform well over the coming years.

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Column chart depicting frontier emerging markets countries' exports to the US as a percentage of their GDP: Vietnam (27%), Colombia (5%), Peru (3%), Philippines (3%), Indonesia (2%), Bangladesh (2%), Poland (2%), Saudi Arabia (2%), Pakistan (2%), Morocco (1%), Romania (1%), Kazakhstan (1%), Kenya (1%), Egypt (1%).

Surplus Surprise: Vietnam, Emerging Markets Top Global Trade with US

By Sergey Dubin, CFA, Analyst and Portfolio Manager | January 28, 2025

Frontier emerging markets (FEMs) fell in the fourth quarter after the election of Donald Trump in the US ushered in expectations that tariff hikes on a broad range of imports to the US will lead to inflationary pressure. Vietnam was one of the worst-performing FEMs, for good reason: the US is its largest export market. Its exports to the US account for more than 25% of its GDP, by far the largest percentage among FEMs. Exports to the US don’t account for more than 5% of the GDP in any other FEM country (though the US is the largest export market for the Philippines, which also weighed down FEMs in the fourth quarter).

In fact, Vietnam is the only FEM that has become one of the ten largest trading partners with the US. While there are other EM countries, such as Mexico, Taiwan, and India among the top-ten US trading partners, Vietnam has grown a significant trade surplus with the US, due in part to companies rerouting shipments through the country as supply chains have adjusted over the past several years, especially in the wake of disruptions during the COVID-19 pandemic.

Bar chart showing resilience of China's and Mexico's respective currencies compared to other global currency returns in 4Q24.

Currency Depreciation: A Rational Response to Tariffs?

By Ferrill D. Roll, CFA, Chief Investment Officer | January 16, 2025

The US dollar’s rise since September cut into international markets. Of the 7% decline in international markets in the fourth quarter, the vast majority of it can be attributed to currency depreciation against the dollar.

For countries facing harsh new tariffs from the US, weakening the currency is a highly rational response: What tariffs take away in competitive pricing from other countries, currency depreciation restores with little cost to the domestic economy, keeping products competitive in the destination market. In other words, currency depreciation negates the disinflationary effects of a strong dollar as offsets to the inflationary effects of tariffs.

If a country has few other considerations (such as high foreign debts), that trade-off is fairly painless and blunts the potency of the tariffs to alter any other policy or behavior. So far that’s not what you see in this recent spate of currency depreciation: The two countries currently facing the severest threats from additional US tariffs are China and Mexico, but neither of those currencies exhibited much weakness during the fourth quarter as seen in the above chart. However, in the longer term, we think currency depreciation may not be such a bad thing for the US’s trading partners.

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Why Own International Stocks?

By Ray Vars, CFA, Portfolio Specialist | October 02, 2024

For more than a decade, equity returns in international markets have trailed those of the US. There are various possible explanations, but a central one is that the US, after first staging a faster recovery from the global financial crisis, has tended to produce stronger earnings growth in the years since. Meanwhile, from an international perspective, everything from a strong dollar to geopolitical conflict to volatility in emerging markets to China’s economic slowdown have weighed on relative returns. It also doesn’t help that the arrival of ChatGPT, and the enthusiasm and competition it has inspired for generative artificial intelligence technology, has lately encouraged an almost singular focus on a handful of US tech stocks—out of nearly 2700 index constituents, a mere 0.2% of the companies in the MSCI ACWI Index.

Some investors look at the difference between international and US returns and, expecting that current conditions will persist, wonder what place non-US equities have in a portfolio today. But while it’s easy to fall into that line of thinking, history suggests it is likely wrong. The relative performance of US and non-US stocks has historically been a cyclical phenomenon, and as the chart below shows, their indexes have regularly swapped between leader and laggard over the past 50 years.

Chart showing the MSCI EAFE Index vs. MSCI US Index 3-year rolling returns from 1974 through June 30, 2024, highlighting how the current bout of US outperformance at 175 months is already twice as long as any prior cycle (the second longest period being 74 months).

Source: Bloomberg, MSCI Inc. Data as of June 30, 2024.

The current period of US outperformance has already lasted twice as long as any prior cycle in the past 50 years, and that fact alone would seem to flash a warning. Investors also face many large and evolving risks—everything from elections and wars to potential economic upheaval from AI and the far-reaching effects of an increasingly less cooperative, multipolar world. All of this suggests that the next decade in equity markets is unlikely to look like the past one.

We are skeptical of our, or anyone’s, ability to predict market cycles, and the Harding Loevner investment process is structured to avoid attempts at timing them. We invest globally for the long term in stocks of high-quality businesses that can grow across economic cycles, and our research is devoted to understanding the enduring characteristics of companies and the competitive structure of their industries. As bottom-up investors, although we seek to understand how changes in the economic environment might impact our companies, we don’t believe in making investment decisions solely based on macroeconomic what-ifs. Still, it’s plain to see that there are certain elements of the recent investing environment that have been broadly unfavorable for international shareholders. Here are five possible changes in market conditions that could help pave the way for international markets—especially stocks of high-quality companies—to rise again:

1. The “Magnificent Seven” Stumble

Over the past couple of years, US stock-market outperformance has been dependent on a small subset of stocks—Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla, a group known colloquially as the Magnificent Seven. These seven stocks have been responsible for a third of the gains in the MSCI ACWI Index since the end of 2022, and all of its returns in the second quarter of 2024. If these stocks were to falter, international markets might become relatively interesting again. After all, the market capitalization of the global benchmark may be heavily weighted toward the US, but the majority of the most profitable and capital-efficient businesses in most sectors—as measured by cash flow return on investment—are located outside the US:

Stacked column chart showing both the market cap. Weight of the MSCI ACWI index (37% non-us and 63% US), and the breakdown of the top 20 companies by 5-year median CFROI across GICS sectors in the US vs. non-US as of December 31, 2023 (Utilities: 90% non-US, Materials: 85% non-US, Energy: 80% non-US, Communication Services: 65% non-US, Consumer Staples: 65% non-US, Real Estate: 65% non-US, Consumer Discretionary: 50% non-US, Financials: 50% non-US, Industrials: 45% non-US, Information Technology: 35% non-US, and Health Care: 30% non-US).

Data as of December 31, 2023.
Source: Harding Loevner, FactSet, HOLT database, MSCI Inc.

In the past 50 years, there have been two periods of sustained US underperformance, both of which were preceded by US valuation bubbles. One directly followed the Nifty-Fifty era of the late 1960s and early 1970s, when a very different-looking set of companies were held up as magnificent—including bygone brands such as Sears Roebuck and Polaroid. After the subsequent crash, the MSCI EAFE Index (the MSCI ACWI didn’t exist until 1990) dramatically outperformed the US index for eight years. Later, in the early 2000s, the bursting of the dot-com bubble and the liftoff of China’s growth led to another period of international outperformance that lasted until the beginning of the financial crisis.

From a macro perspective, what investors have had in the US for the last couple of years is a good economy despite high interest rates and roaring inflation. The market is now digesting the Federal Reserve’s decision in September to aggressively cut rates to support employment levels as inflation heads in the right direction. However, with a group of largely tech-oriented stocks dictating overall market returns, perhaps a more relevant consideration for investors is whether the revenue models forming around generative AI can live up to the high expectations for profit growth that are baked into those companies’ share prices. (There is a cautionary tale in Cisco Systems and the advent of the internet.)

2. China Gets Back Up

After three decades of breakneck growth, China’s economy is now sputtering, and comparisons are being drawn to Japan’s lost decades, a period of economic stagnation that began in the 1990s and continued into the 2020s. Add in rising geopolitical tensions and how they are causing companies to alter supply chains, and there appears to be a general apprehension toward Chinese stocks. Yet, even with possible deflation and an aging population, China remains one of the most populous countries in the world and a significant source of economic activity. It accounts for nearly a quarter of the value of the MSCI Emerging Markets Index—a larger weight than any other country. Because of China’s large manufacturing base and consumer population, the health of its economy is also important to companies in other international markets, especially Europe (Atlas Copco, for example, a Swedish industrial-equipment provider that has reported weaker demand from China for compressors and vacuums used in solar, battery, and electric-vehicle manufacturing). The last time that international markets outperformed, China played a key role, and given the size of its economy and index weight today, it is easy to imagine how receptive markets would be to better news there.

Moreover, there are scores of Chinese companies that remain solid despite the overarching environment, which is why it’s important to understand not just what is happening at a country level but also at an industry and company level. High-quality companies—those with strong balance sheets and consistent free-cash-flow generation—are better equipped to withstand, or even expand, during difficult times such as China is encountering. With the share prices of so many quality growth companies in China failing to reflect the strength of the underlying businesses, valuations in China are more compelling than at any point over the past 30 years.

3. India Continues Its Ascent

As one of the world’s fastest-growing economies, India’s profile has been rising among US consumers and investors alike. A “Made in India” tag is something shoppers now encounter quite a lot, while investors increasingly wonder about India’s potential to stand as a substitute for China’s stock market. But investing in India is also full of challenges. For starters, it is the most expensive market in the world, and much of the market’s recent gains have come from cheap stocks, which tend to be those of lower quality. These include many state-owned enterprises (SOEs) benefiting from government spending. Finding companies that can deliver long-term profitable growth and whose stocks can be purchased at reasonable prices is difficult. However, as India’s market develops further, and the fundamental weakness of SOEs becomes apparent, high-quality growth businesses should be rewarded for their superior fundamentals, and more of them may emerge over time. And while it remains unclear whether India’s infrastructure, policies, and other features of its economy are built to support global manufacturing and trade on the order of China, its population and potential purchasing power can’t be ignored, and the country’s rising global competitiveness is likely to present opportunities for investors over the long run.

4. Peace Breaks Out

Between the wars in Ukraine and Gaza and the rising tensions in the Middle East and South China Sea, fears of international conflict continue to be an inescapable theme of markets, and one in which investors are at the largest information disadvantage. Although uncertainty alone can be enough to topple stock prices, companies around the world have also had to contend with the tangible effects of geopolitical instability, such as the dangerous disruptions to vital trade routes along the Red Sea, as well as, at one point in the Russia-Ukraine war, the prospect of a European winter natural-gas shortage. And while investors cannot reasonably predict the likelihood of China’s aggression toward Taiwan escalating to an invasion, it is one of the risks that complicates the picture for AI beneficiaries such as TSMC, whose factories are situated on the northern coast of Taiwan and supply the chips used by the market’s favorite semiconductor company, NVIDIA. The absence of any more significant destabilizing developments doesn’t mean that global tensions will simply fizzle; however, wars, like market cycles, generally do end, which would alleviate at least some of the pressure on international stocks and call attention to their relatively attractive valuations.

5. AI Goes International

As AI begins to ripple through the economy, investors—including us—are trying to determine which industries and companies will be disintermediated by advances in the technology and which are impervious to the coming change. But many investors seem to be certain very early on about which companies will be the biggest long-term winners from AI. The Magnificent Seven, or more specifically, the six tech and communications-services companies that are part of the Magnificent Seven, aren’t the only businesses with revenue models tied to AI. Dutch lithography machine manufacturer ASML, French energy-management solutions provider Schneider Electric, and German software provider SAP are just some of the high-quality, non-US companies playing a key role in the transition to the AI era by either supporting the chip-production process, powering AI data centers, or allowing businesses to add AI productivity tools to their digital systems.

These are all potential factors that could reverse international performance, and there are others that they could help set in motion. For example, the persistent strength of the US dollar has hindered the returns of US dollar-denominated investors in international markets, but as international risks dissipate, the dollar may also reverse. A weaker dollar would provide an additional tailwind to investing overseas—just as it did when international markets outperformed throughout the early ’00s. For all these reasons, international markets are a rich hunting ground for high-quality companies with attractive long-term growth prospects and, because of how unloved they have been lately, enticing valuations. No one can say when or how the market inflection will occur, only that history shows it is likely to do so. If that day were to arrive tomorrow, it would be too late for investors with low allocations to non-US equities to reposition their portfolios effectively. And so, for the question we are so frequently asked—“Why international?”—the most succinct answer is this: Because nothing lasts forever.

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Bar chart comparing the top five countries’ weightings in the MSCI Frontier Markets Index vs the MSCI Emerging Markets Index.

Frontier Markets Require an Active Look

By Sergey Dubin, CFA, Analyst and Portfolio Manager | July 30, 2024

At Harding Loevner, we focus on building portfolios from the bottom up, guided by our quality-growth philosophy, and rarely comment on actions of other investors or index providers. But sometimes it’s necessary to do so to highlight meaningful developments affecting the frontier emerging markets (FEM) asset class.

In June, asset manager BlackRock announced its intention to liquidate its Frontier & Select EM ETF, which once had assets exceeding US$400 million. The company cited currency liquidity challenges in several smaller frontier markets as the main reason for its decision.

BlackRock’s decision to close its passive FEM fund underscores our long-held belief that the idiosyncratic nature of frontier and small emerging markets, as well as their volatility and liquidity characteristics, make them much better suited for an active rather than passive investment strategy.

Our 2023 Letter to Shareholders

December 27, 2023

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.

Read the full letter

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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Why Own International Companies?

By Timothy Kubarych, CFA, Co-Deputy Director of Research | June 07, 2023

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.

Even if the US features most of the world’s biggest companies, it’s hardly the exclusive repository of the best ones. Using cash flow return on investment, rather than market value, as our measurement reveals that the majority of the most profitable and capital efficient businesses in just about every sector are located outside the US. The only exceptions are two areas where US companies are clearly dominant—Information Technology and Health Care.

Source: FactSet, MSCI Inc.; Harding Loevner, HOLT database.

Of course, profitability alone doesn’t define the best companies. As quality-growth investors, we examine a broader set of characteristics to determine business and management quality as well as long-term growth prospects. And still, the data show that regional diversity wins out: About three-quarters of large-cap stocks in the top two quintiles of our quality and growth rankings are non-US firms, increasingly anchored by emerging markets such as China.

Investors are naturally biased toward their home territory, which is easy to do when it is giving an electric performance. For the US, that’s been the case for more than a decade as the economy recovered from the Great Recession and smartphones, digital advertising, mobile shopping, and workplace productivity tools—areas dominated by a handful of American giants—became ingrained in daily life.

This has left international markets with more attractive share prices relative to the profitability and cash flow of their underlying businesses. We can’t predict when international markets will rise again, but we do think fundamentals and valuations ultimately drive stock performance. The valuation spread between US and international stocks today happens to mirror the gap that existed in 2001, which ushered in a period of international outperformance.

Eschewing stocks in the rest of the world not only misses out on the diversification benefits but also ignores an attractive set of companies whose valuations may be poised to rebound.

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Stylized portrait of Edmund Bellord, Analyst and Portfolio Manager at Harding Loevner.

Beauty and the Beast

By Edmund Bellord, Analyst and Portfolio Manager | January 04, 2022

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.

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.

Endnotes

¹James Seyffart, “Passive Likely Overtakes Active by 2026, Earlier If Bear Market,” Bloomberg Intelligence (March 11, 2021).

²H. Hong and J.C. Stein, “A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets,” The Journal of Finance vol. 54, pgs. 2143-2184 (1999). https://doi.org/10.1111/0022-1082.00184

³Guido Baltussen, Sjoerd van Bekkum, and Zhi Da, “Indexing and Stock Market Serial Dependence around the World,” Journal of Financial Economics vol. 132, issue 1 (2019). https://doi.org/10.1016/j.jfineco.2018.07.016

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Out of Our Minds

1. Geopolitical risk

2. Inflation protection

3. Positioning for supply shocks

4. Investment flexibility, without style compromise

5. Sustainable growth in LNG

Source: Deutsche Bank, Haver Analytics. Reproduced with permission.

Data depicted is IMF DOT export data for last twelve months ending September 2024 compared to the twelve-month period ending September 2017.

Current coverage of world trade represented herein is around 87%. Chart is from the report “Five Fresh Perspectives on Global Trade” issued December 12, 2024.

Source: Bloomberg, MSCI Inc. Data as of June 30, 2024.

1. The “Magnificent Seven” Stumble

Data as of December 31, 2023. Source: Harding Loevner, FactSet, HOLT database, MSCI Inc.

2. China Gets Back Up

3. India Continues Its Ascent

4. Peace Breaks Out

5. AI Goes International

Source: FactSet, MSCI Inc.; Harding Loevner, HOLT database.

The Beauty Contest

Source: Bloomberg, Harding Loevner

Vol of Vol

Source: Bloomberg, Harding Loevner

Endnotes

Disclosures

Out of
Our Minds

Current coverage of world trade represented herein is around 87%. Chart is from the report “Five Fresh Perspectives on Global Trade”
issued December 12, 2024.

Data as of December 31, 2023.
Source: Harding Loevner, FactSet, HOLT database, MSCI Inc.