Out of
Our Minds

Ideas, arguments, and musings from inside Harding Loevner.

Skiing in Avalanche Terrain Is a Lesson in Risk Management

February 15, 2024

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

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

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

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Experience in a “Wicked” World

By Simon Hallett, Vice-Chairman | December 20, 2023

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

In many areas of our lives, we can, in fact, learn from our experiences. Over time we start to see patterns in events and that pattern recognition enables subjective judgment, or what is often called intuition. But those patterns need to be recurrent, in environments where there is a clear and stable relationship between cause and effect, so that history really does repeat itself.

In his book Range, David Epstein described that sort of learning environment as “kind”—patterns repeat, feedback is immediate, and experience can lead to expertise. As he writes, “In golf or chess, a ball or piece is moved according to rules and within defined boundaries, a consequence is quickly apparent, and similar challenges occur repeatedly…. the player observes what happened, attempts to correct the error, tries again, and repeats for years.”

In contrast, in the sorts of learning environments that Epstein describes as “wicked” there are few (or no) clear rules and feedback is limited at best. In these kinds of environments, experience teaches you little. Indeed, it can be dangerous. Experience can lead us to over-interpret, to see patterns where there are none, and to become entrenched in our ideas.

Once we have an idea, it is extremely hard to change our minds. Confirmation bias means that we see evidence that confirms our views and ignore that which challenges them. When facts change, we should change our minds, but we rarely do. And cognitive entrenchment means that the more experience we have, the more difficult we find it to adapt to changing circumstances. With greater experience comes rigidity.

The fact that more experience can lead to these behavioral pitfalls is a good reminder that it’s important to pay attention to smart, inexperienced people. Often in organizations, seniority can lead to one’s views being accorded more weight, while more inexperienced colleagues’ views are often dismissed as lacking sufficient wisdom.

Investing, obviously, takes place in a wicked learning environment. The relationship between cause and effect on market prices is highly obscure. Few patterns repeat and, once identified, are arbitraged away and do not persist. There is no evidence, for example, that market participants can forecast the direction of markets, let alone macroeconomic or political variables.

Furthermore, for long-term investors such as us, it is hard to identify the right feedback to our decision-making. Our goal is to construct portfolios that outperform the broad markets on a risk-adjusted basis over extended periods. But returns are very time dependent, and short-term price movements are a poor guide to long-term returns, offering us poor feedback on our decisions. We must look at our investment theses and create our own feedback loops so that we can test whether the fundamental insights we are relying on to forecast outperformance of the stock of a particular company remain valid. And to overcome cognitive entrenchment, we must be prepared to update our beliefs—our forecasts—if the facts change.

This sort of learning environment is why when it comes to investing, experience doesn’t lead to expertise. It leads, simply, to experience—more opportunities to learn, more chances to understand the boundaries of our knowledge. But those chances are very, very valuable.

One of our basic beliefs about equity markets is that they are efficient, but not entirely so. There are inefficiencies that result from the biases of market participants, and to overcome our own biases and exploit those of others, we have structure and process—or rules—that govern how we do research and provide the background to the judgment required about when to buy and sell stocks.

But are there any permanent rules in investing? Rules are important for controlling cognitive biases, but they are not unchanging dogma. We should be prepared to change our rules when the environment changes or when they do not work. In an investment firm, humility about our ability to forecast accurately is important, and so is an open-mindedness about rules. More experience gives us the ability to look at our own behavior, to observe the errors that we make—usually because of our own biases—and to implement structures and processes that help mitigate the all-too-human tendency to make decisions where the results do not contribute to achieving our goals.

I know less now than I thought I did when I was new to the investment business 45 years ago. What experience has taught me is the importance of being aware of market history but not relying on it to make forecasts. It has taught me that how we behave is more important than what we know. And most importantly, experience has given me more chances to test ideas in the marketplace, receive feedback, and use that feedback for continuous improvement.

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Demolition Work in Progress

By Edmund Bellord, Asset Allocation Strategist | July 27, 2022

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

Financial markets, among other things, act as a type of sieve that screens investments. Ideally, the riskiest tradable assets pass through to the strongest balance sheets. In practice, they often end up on the balance sheets of the most accommodating investors, owned not by those most capable of bearing risks, but rather those most willing to. A well-functioning market will tend to filter out those excesses, eliminating investors who exceed their risk-bearing capacity, while helping to ensure that those who take on too little risk see their returns shrink and their share of the capital base dwindle. On balance, this sifting mechanism helps to steer capital to its most productive uses.

In extended bull markets, however, this process tends to break down, as rewards flow disproportionally to the most aggressive, over-confident, and complacent investors. This creates a powerful feedback loop, as unbridled risk-taking is rewarded with outperformance which in turn draws more capital. Once the process gets going, it is self-reinforcing as the newly attracted capital is plowed back into the same group of assets. In so doing, fragilities increase, and the longer it persists the more distorted capital allocation becomes.

By central bankers’ own admission, their goal was to spur a positive wealth effect on spending, by pushing safety-minded investors into taking more risks, thus driving up valuations. Now we will see just how difficult the unwinding will be as the wealth effect goes into reverse.

The implosion over the last six months (at least in terms of their asset prices) of profitless growth stocks, crypto assets, and other speculative creatures of the markets is emblematic of the reckoning that can occur once excessive risk taking continues for too long. In this case, it has been slowly building for over a decade. Fears of outright deflation following the global financial crisis encouraged central banks to keep pushing interest rates lower to allow over-extended borrowers to heal, and to reduce the cost of capital for new investment in the hopes of kick-starting growth. At the same time, the total absence of inflationary pressures seduced central bankers to set aside worries about the dangers of money printing and unrestrained liquidity. By their own admission, the goal of their zero-interest monetary policy was to spur a positive wealth effect on spending, by pushing fearful, safety-minded investors into taking more risks, thus driving up valuations.¹

Primary beneficiaries of this process were growth stocks, particularly the most speculative growth stocks of companies with untried business models; their multiples steadily increased, inversely with submerging interest rates. This coincided with a surge in indexation and so-called “smart beta” and factor investing, which channeled vast amounts of capital to the same group of stocks. Remarkably, for an extended period, some of these stocks were simultaneously defensive, fast growing, and relatively involatile, guaranteeing them an outsized weighting across a plethora of indices designed to track those very characteristics. Many active managers, faced with the prospect of having to beat a steadily narrowing benchmark, also piled in, overweighting these same stocks in the case of mutual funds, or owning them with leverage in the case of hedge funds. The prolonged success of these strategies encouraged yet more risk-taking, with new rafts of venture-backed startups and IPOs lacking anywhere near the prodigious free cash flows of the established tech companies. Moreover, the initial phases of the pandemic led to a late kick for tech stocks seemingly insulated from pandemic-induced disruptions to traditional commerce, which further turbocharged their valuations. The result was levitating valuations justified on the back of negative real interest rates.

The whole process was vulnerable to any shift in the macroeconomic backdrop that could prompt central banks to reverse course. The coils of that shift were arguably set by the pandemic and then sprung by the vaccine clinical trial results and rollouts which together upended consumption patterns, snarled supply chains, and reconfigured labor markets. According to the Bank for International Settlements, global growth, after cratering in 2020, accelerated to the fastest pace in almost five decades the following year.² The subsequent conflict in Ukraine exposed the fragility of an energy supply that had been undermined by a decade of underinvestment and climate-related antipathy, applying an energy supply shock to a combustible mix.

Now we will see just how difficult unwinding the unprecedented asset purchase programs and zero interest rate policies will be as central bank balance sheets shrink, interest rates rise, and the wealth effect goes into reverse. Policymakers embarked on their former policies with a clear-eyed view of the clear and present danger of deflation while the uncertain contingent costs inhabited a distant and abstract future. As that future arrives, the true costs are being revealed.

Endnotes

¹“Aiding the Economy: What the Fed Did and Why,” Ben S. Bernanke, The Washington Post (November 4, 2010).

²BIS Annual Economic Report, Bank of International Settlements (June 26, 2022).

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Russia, Risk, and Decision-Making

By Simon Hallett, Vice Chairman | March 21, 2022

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

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

The answer to the question “Could we have predicted this outcome?” is, of course, “Yes.” Hindsight makes for extremely accurate forecasts. More importantly, though, are we asking the right question by focusing on the outcome, rather than on the process by which our decisions to invest in Russian securities were made? When making decisions under conditions of uncertainty, it is not just probable, but certain, that you will sometimes be wrong. If we were to judge the quality of our decisions solely on outcomes, it would be, as former Treasury Secretary Robert Rubin once said, “a serious deterrent to taking the risks that may be necessary to making the right decision. Simply put, the way decisions are evaluated affects the way they are made.”¹

Author, cognitive psychologist, and champion poker player Annie Duke calls assessing decisions based solely on outcomes where those outcomes are a combination of luck and skill “resulting.” In supposing we made a “bad” decision to invest in Russian securities, are we guilty of resulting? Is there evidence, beyond the outcome, to suggest that the decision represents a failure of our investment process?

Author, cognitive psychologist, and champion poker player Annie Duke calls assessing decisions based solely on outcomes where those outcomes are a combination of luck and skill “resulting.”

That process is structured to reflect our investment beliefs. Those beliefs include the idea that securities markets are inefficient, but only mildly so, and that those inefficiencies stem, in large part, from flaws in investor behavior—from cognitive biases. Those biases include:

An underestimation of the power of compounding and a reluctance to take a long-term approach to investment. Rather, investors tend to suffer from a bias toward action over inaction—a bias exploited by the financial media, which gain viewers with a constant barrage of enticement to action, and by financial services companies whose revenues depend on transactions.
A tendency to extrapolate recent results into the future. As a result, stocks of companies with good results become overpriced and of those with bad results underpriced.
A love of stories and narratives in preference to facts, with the consequent overpricing of high-risk investments and underpricing of relative stability—resulting in a return premium to dullness.
Confusion of luck and skill. In activities such as sports, poker, and investing that combine luck and skill, short-term results are often dominated by luck, not skill. While skill remains constant (or, in our investing activity I would hope, modestly improves over time), luck mean reverts. Yet investors tend to extrapolate good recent results into the future, without acknowledging that those short-term results are the result of at most some skill, but at least a lot of luck.
Finally, overconfidence in the ability of investors, or anyone, to predict outcomes in the world and in securities markets. This overconfidence is carefully nurtured by investment firms that give predictions about all manner of world events ranging from the rate of inflation to the probability of war between various states. Many studies, notably by Philip Tetlock, have been carried out on this phenomenon over many years; they find little evidence that even acknowledged experts in a particular field have much skill in forecasting outcomes in that field.

Our investment process is structured to overcome these biases in our own decision-making. We are aware of our source of edge: it lies in assessing the quality of businesses, the sustainability of their cash flows, and estimating the prices at which we may invest or disinvest. We take a long-term approach to investment and try not to react to hourly or daily news cycles.

We try not to make decisions based on forecasts in which we should have little confidence. We are disciplined: adhering to a strong process, structured to be consistent with our investment beliefs, so that we should make the same decision whatever our emotional state of mind.

Importantly, we stick to our area of expertise. We try not to make decisions based on forecasts in which we should have little confidence. We are disciplined: adhering to a strong process, structured to be consistent with our investment beliefs, so that we should make the same decision whatever our emotional state of mind.

Further, we practice diversification, and we limit our permitted exposures to geographies or industries based partly on our assessment of their riskiness. In our International Equity strategy, for example, our exposure is limited to 20% in China, but also to 20% in Switzerland, obviously a much smaller market. Our limit in that strategy to Russia was 10% and 20% in the more limited universe of EM.

This is the process we trust to see ourselves through all market conditions, including when market prices are rapidly falling, whatever the reason for the crisis. When does this approach succeed? Most obviously when prices recover quickly from crises. Correlations of returns tend to increase during crises but revert to normal once they are over. We have seen quick market recoveries after, for example, the 1987 crash; Iraq’s invasion of Kuwait; the Gulf War; the Latin American debt crisis; the Long-Term Capital Management bankruptcy; the Asian financial crisis; the 9-11 attack and closure of the US financial markets; the Global Financial Crisis; and the euro debt crisis.

When does this approach fail? That’s hard to say, as it has yet to do so, at least not over any meaningful time frame. It fails in the short term when unforecastable but very negatively impactful events become more probable and there is a rapid decline in the sentiment of market participants, resulting in sharp declines in asset prices and a rise in their correlation. In the longer term, our approach would fail if there were no recovery in those asset prices. In the case of war breaking out, we note that the long history of US stock markets shows that wars have had little lasting influence on returns. Indeed, since the Great Depression, one of the most prolonged counters to the long-term upward trend in stock prices occurred during 2000–2003, a period that began with overpriced growth stocks and featured the bursting of the internet bubble. This period was also marked by 9-11 and the US invasions of Afghanistan and Iraq, yet these events had no sustained impact on markets. As investors, if not as observers of human suffering, we should perhaps worry more about observable stock prices and valuations than about armed conflicts between nations.

How did we approach decisions to invest in Russia? We identified four very strong Russian companies, with good management, strong balance sheets, and excellent growth prospects—each of them also apparently run for the benefit of shareholders with little state interference. We limited our exposure to this risky market (but one lowly correlated with other markets) and implemented our investments through securities traded on exchanges outside Russia. From a portfolio diversification perspective, we held the investments in part as an inflation hedge through the exposure to energy that two of the companies provided, and in part as an antidote to our (now proven to be well-founded) concerns about the valuation risk we saw building in many other parts of the global equity market—knowing full well that the antidote came with geopolitical risk. The trade-offs and decisions we made clearly ended badly, and we deeply regret losses that our clients have suffered. But we must not let hindsight blind us to the difficulty of forecasting such events. Unless and until it’s proven unfounded, we will adhere to a process predicated on the belief that such forecasting is not a source of edge for us (and probably not for anybody) and remain confident that the past is still a reasonable guide to the future…or certainly the best guide we have.

Endnotes

¹Remarks to the New York University Commencement, May 13, 1999.

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Culture Club

By Simon Hallett, Vice Chairman | October 06, 2021

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

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

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

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

It would be nice to be able to say that our culture at Harding Loevner emerged from a successfully executed plan, but that wasn’t really the case. Thirty-plus years ago, the few of us at the firm just wanted to be good investors and to serve clients who shared our views about what made a successful investment program. The firm’s values simply reflected the personal values of the founding generation. We all believed strongly in acting with integrity and always putting clients’ interests first. Beyond that, I don’t think you could say we particularly held the values associated today with Harding Loevner. We didn’t set out consciously to make a culture based on transparency, personal accountability, tolerance, and the importance of process. Those values only developed as we learned more about decision making, often from our mistakes.

For example, we discovered early on that sharing information with our colleagues was valuable in sharpening our views. But we soon learned that without individual accountability and very clear rules of engagement, disagreements could very easily descend into finger-pointing and personal attacks. We also came to realize that no amount of experience is a substitute for exercising judgement within the constraints of process and structure. The alternative, too often, is a culture of blame and chaos.

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.

Arsenal's (L to R) Kolo Toure, Robert Pi

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.

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From A to Xi: Regulatory Risk in China

August 12, 2021

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

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.

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

By Simon Hallett, Vice Chairman | July 09, 2021

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

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

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

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.

Richard Thaler, who won the Nobel Prize in Economics for his work in behavioral finance, has noted that 1980s basketball superstars like Larry Bird converted their three-point shot attempts at the same near-40% rate as 21st-century sharpshooters such as Steph Curry or James Harden. Yet, Bird took half as many three-point attempts as are normal today, favoring shots closer to the basket, which great players can hit roughly 50% of the time. It took 30 years for the three-point shot to become as popular as it is today or, in other words, for basketball to realize that 0.4 x 3 is greater than 0.5 x 2.

The Bill James Baseball Abstract, an annual compendium of baseball statistics that ultimately legitimized the science of baseball sabermetrics, was neglected for many years before a James disciple, Oakland Athletics General Manager Billy Beane, used the approach to identify underpriced skills for his small-market team, as popularized in Michael Lewis’s 2002 Moneyball. It was only then that James himself landed a job in the front office of the Boston Red Sox, helping the team finally overcome the “Curse of the Bambino,”¹ and win its first World Series in 86 years.

Many baseball fans complain that the influence of Moneyball has been too great—players are chosen purely for their ability to walk or jack balls over the fence; defenders are all stacked on one side of the infield because that’s where the statistics say the vast majority of a given batter’s ground balls will be hit. “It’s no fun anymore!” Clearly, those fans prefer intuition and stories to success and efficiency. They also subscribe to the great man theory, that results are driven by individual managerial genius, the wizened skipper playing a hunch.² And yet, organizations typically strive to create and adhere to processes that can improve their probability of success—to control luck.

I have been involved in two firms with many similarities, one being an investment manager and the other a football (soccer) club. An investment portfolio can, through careful construction, be more than the sum of its individual parts thanks to diversification. It may seem odd, but a football team is a portfolio. It, too, needs careful construction. You can’t simply rank order the most attractively priced available players and take the top 20 to form your squad. You would end up with a team made up only of defenders, and no goal scorers.

More than a decade after John Henry, the Red Sox owner who had hired Bill James, purchased Liverpool FC and brought Moneyball to the UK’s Premier League, systematic use of data analytics has finally worked its way throughout the ranks of English football. At my football club, Plymouth Argyle, which plays in the third tier of the leagues, we have set rules and standards to guide the decision-making of those who select the squad. Beginning with our philosophy, i.e., answering the question “What is the style of football we wish to play?,” we have defined the desired characteristics of each position. Our philosophy includes playing the ball forward from the back with quick passes along the ground to the opposition’s part of the field. Our goalkeeper must, therefore, be able to kick with both feet and play short passes while under pressure from the opposing forwards. We also prefer to play in a tactical lineup, known as a 3-5-2, with a pair of strikers at the front and a couple of fit defenders, one on each side, who dash up and down the wings depending on whether we or the opposition have the ball.

Defining the philosophy this way and defining how we will implement it enables us to search databases for players that match our criteria in each position, such as the defender we recently signed based on some impressive data around his defensive blocks, aerial duels won, and tackles per game. Then, in quantamental fashion, we can conduct research into aspects of players that can’t be quantified (yet!), such as their character, personality, or work ethic.

There are differences between assembling an optimal squad of football players and an investment portfolio. One is that securities prices are freely available, updated continuously, and can be compared with their hypothetical value generated by a model. That is not the case with football players. Transactions can only be made in two “transfer windows,” one midway through the season in January, the other during the summer before the next season starts. And no one has yet come up with a model that can assess players’ value in the way that we forecast cash flows and discount them to a present value to give an idea of what a share of stock is worth. I live in hope, though!

The market for football players is relatively efficient, but not completely so, and becomes less efficient the lower down the leagues you go. In this way, the relative inefficiencies of the market are parallel to those for, say, US large caps compared with those for emerging market small caps.

But surprisingly, perhaps, there are more similarities than differences. The market for football players is relatively efficient, but not completely so, and becomes less efficient the lower down the leagues you go. In the Premier League, the most watched football league in the world, there is a strong correlation between what you pay and the results you achieve. That is not the case lower down, so my club has a strong incentive to improve decision making, to exploit the behavioral biases and subsequent mispricing that is prevalent. In this way, the relative inefficiencies of the market are parallel to those for, say, US large caps compared with those for emerging market small caps. Similarly, though, as the potential gains to improved decision making increase, so does the resistance to replacing intuition with algorithms and process that reduces the degrees of freedom under which individuals operate. Those clubs which can overcome that resistance will generate a competitive advantage—an edge. I believe my football club has such an advantage, but I am on the alert for signs of backsliding—going along with “But that’s the way we’ve always done it!”

We have gone down this path at Plymouth Argyle because we want to spend the Club’s money wisely and compete by being smarter, not by spending more. At Harding Loevner we started down this path 25 years ago as decision making spread beyond the handful of founders to an expanded investment team. Each portfolio remained the product of two single decision makers but was now made with input from over 30 analysts. We had to learn how to structure a process that benefits from group wisdom but is not damaged by “groupthink.” The foundation of that was, and still is today, individual accountability and aggregation of individual decisions. Analysts drive the process and decide what stocks they will cover. They are free from direction by their colleagues, and free from direction by portfolio managers. They are not completely free, though. Just as Argyle’s team must recruit players who meet the objective standards we have established as being consistent with our playing philosophy, Harding Loevner analysts must confine their activities to securities of companies that they judge to conform with our investment philosophy, which focuses on growth, quality—which we have historically equated, in part, with a demonstrated track record of profitability—and price. When we look back at the last 25 years, we can see clearly that the arc of evolution of our investment process has been to define more clearly and rigorously the rules that restrict our analysts’ liberty to follow any company they chose. This has been highly effective at controlling biases and risk, and, overall has been good for returns.

Today, there are any number of voices, both internal and external, calling us away from the framework and structure that have served us well. The rise of the digital economy, and its steady proliferation of fast-growing but still-unprofitable businesses with compelling narratives, continually tests our reliance on an established track record as a guide to the future and the best indicator that a company has the culture and institutional strength to withstand cyclical downturns and shifting competitive landscape. Has the nature of growth changed? Have the kinds of characteristics that define quality shifted? Or are those merely the stories we tell ourselves to justify paying higher prices for the hot new fashion?

I don’t know the answers to those questions yet. I do know that, while it is necessary for portfolio managers to evolve along with markets, such evolution should take place deliberately and only after careful consideration. At Argyle we are at the early stages of translating our playing philosophy into a structured process for how we find players, and how they play on the field. Already, though, there have been occasions when we’ve had to adapt on the fly and adjust our typical tactical lineup. Football, like investing, is a game where the opposition can see what we do, and we must adapt to how they counter our plans. Players get injured, and replacement players may be less capable at implementing the approach. So, how we implement our philosophy must evolve, but we must be clear with ourselves that such adjustments are a change in process, not a change in philosophy. If we were to start changing our philosophy, we would surely be lost, tossed on a swirling sea of narrative.

Endnotes

¹Purportedly begun in 1920 when, after he had led the club to three World Series titles in six years, the Sox traded George Herman “Babe” Ruth to the rival Yankees for $125,000 (about $1.7 million in today’s dollars, or roughly the salary of Boston’s current backup catcher, Kevin Plawecki).

²It could be said the great man theory is also a feature of investment marketing—how often do brand name investment managers attract large amounts of client assets and then collapse in ignominy?

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Don’t Just Do Something—Stand There

By Simon Hallett, Vice Chairman | May 26, 2021

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

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

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

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

Benevento,Italy,,February,4,,2018:,Lorenzo,Insigne,Of,Napoli,Hits

At my own club, last season, we had a pair of games scheduled close together. In the first, we gave up a 1-0 lead late on and ended up with a tied game. In the second, we scored a late goal from an unexpected source to win 1-0. The narrative of the first was that “we didn’t know how to hold a lead,” and of the second that “we were gutsy and played to the end.” Same team, same players, both close games, but different outcomes drove radical differences in explanation.

As in investing, in sports a series of poor results needs a narrative to explain it, and action to reverse it. Often that action is to replace the coach. Acting to replace him when results go the wrong way attributes far too much causality to the coach. George Steinbrenner famously hired Billy Martin five times as coach of the New York Yankees. Between the Premier League and the three levels of the EFL, more than half of the 92 clubs replaced their manager this season alone. Replacing a manager tends to come at considerable cost—he (it’s always he) will have his own preferences for players and staff, and perhaps may even want to change the style of play completely—with little evidence that the players who actually kick the ball around improve their own performances as a result. Because luck occurs randomly while skill is reasonably constant, after teams are unlucky for a stretch their luck will tend to mean revert. The “manager bounce” is a well-established phenomenon whereby short-term results usually improve after a manager is replaced. It is a statistical phenomenon, though, that has little to do with on-the-pitch performance.

For asset owners, there is a similar temptation to replace a manager after a period when returns have disappointed, but, alas, unlike the fans of a soccer club, the clients of an investment manager do not enjoy the mean-reverting returns that the manager provides those who stuck with them.

For asset owners, there is a similar temptation to replace an investment manager after a period when returns have disappointed. But, alas, unlike the loyal fans of a soccer club, the former clients of an investment manager do not enjoy the mean-reverting returns that the manager provides those who stuck with them. There is plenty of evidence that investors’ urge to act is damaging to their long-term returns. In mutual funds, on average, dollar-weighted returns that shareholders receive from their funds lag the time-weighted returns that the funds generate. This “behavior gap” is directly the result of poorly timed action on the part of shareholders.

Incentives and market structures only make the bias toward action greater. One reason that English soccer coaches get changed is that, once the season starts, players may not be traded outside the month of January. A result is that during the January transfer window it’s almost non-stop activity. The period has become its own media event, with fans, players’ agents, and media pundits all calling for teams to make their moves. This, even though only a few such moves ever have significant impact on a team’s results, and despite evidence that prices paid for players tend to be higher than between seasons.

The investing industry has many incentives to transact; indeed, the revenue models of many participants depend on transactions taking place. When I started in investment management, in London in the late 1970s, our fees were not based on assets managed as is the case today. We were paid when we made a transaction in our clients’ discretionary portfolios. Why is the portfolio turnover of the average equity mutual fund so high, when doing nothing and allowing returns to compound over prolonged periods of time is often a superior way to generate market-beating returns? It’s because the investment industry exploits clients’ bias in favor of action. Managers’ actions are described in emotional terms. We read of “conviction,” of “exciting opportunities” and “story stocks.” The reality is more mundane. Successful investing is about resisting the urge and the calls to action, knowing when to sit on your hands and do absolutely zilch.

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4 Sources of Edge for Active Managers

By Simon Hallett, Vice Chairman | May 21, 2021

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

The sources of edge are often described as Informational, Analytic, Decision-making, and Organizational:

Informational

In an era of Artificial Intelligence and Big Data analysis, it’s very hard to generate an informational edge through data acquisition alone. Those who do find anomalies see them quickly arbitraged away. There is, though, the possibility of generating an edge by extending your time frame. A large segment of the market today is concerned with generating products based on dataset analysis, which generates excess returns for short periods of time, in the full knowledge that that advantage is temporary. However, no one has been able to turn the identification of companies that can generate returns over long periods of time into an algorithm. 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.

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.

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Disclosures

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

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

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

Out of Our Minds

Endnotes

Endnotes

Left to Themselves, Even Great Cultures Die

Source: ODD ANDERSEN / Staff via Getty Images

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.

Endnotes

Informational

Analytic

Decision-Making

Organizational

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