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

By Edmund Bellord, Portfolio Manager and Asset Allocation Strategist | April 12, 2022

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

Source: Federal Reserve and St. Louis Federal Reserve.

What Is the Bond Market Telling Us?

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

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

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

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

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

Equities and Inflation

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

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

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

P =	D
	r-g

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

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

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

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

High Valuations Increase Equity Market Sensitivity

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

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

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

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

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

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

Endnotes

¹By taking the first derivative of the Gordon Growth model with respect for r gives us

∆P

(r-g)²

. Then simplifying and dividing each side by

gives us an expression for duration,

∆P

r-g

, that can also be expressed as

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A Ground’s Eye View on Inflation and Its Persistence

By Edmund Bellord, Asset Allocation Strategist | December 16, 2021

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

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

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

Price Makers vs. Takers

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

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

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

Around the Sectors

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

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

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

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

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

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

Looking Ahead

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

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

Endnotes

¹“The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking.” (Former Federal Reserve Governor Daniel Tarullo speaking at the Brookings Institute, October 4, 2017.)

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Getting Real About Inflation … and Gold

By Edmund Bellord, Asset Allocation Strategist | January 08, 2021

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

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

Gold as Currency

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

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

Echoes of the Gold Standard

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

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

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

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

Hedging Inflation: It Depends

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

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

Endnotes

¹Robert Basra and Sanjay Misra, National Bureau of Economic Research, “Gold Returns,” NBER Working Paper Series (February 2013).

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Too Much Information

By Simon Hallett, Vice Chairman | March 03, 2021

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

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

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

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

The fact that filtering information is the long-term investor’s task, of course, doesn’t prevent most from feverishly pursuing every bit of information they can about the companies they follow. Egged on by the 24/7 news cycle, internet chat rooms, and by data providers to know their companies in as much depth as possible, investors often seek to become experts in every aspect of each company’s business. It’s dubious whether this helps them make better estimates of what a company’s shares are worth. Instead, the evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.

The evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.

In one unpublished study, described in Winning Decisions by J. Edward Russo and Paul J. H. Schoemaker, people who handicap horse races were asked to predict, based on increasing amounts of information, which horse would win a race. They found that, beyond a very limited amount of data, forecast accuracy did not improve with more data, but the handicappers’ confidence in their forecasts continued to grow with each extra bit of information.

Knowing more makes you feel better, in other words, but doesn’t help your decision-making. In investing, feelings and actual results arguably are even more disconnected. After all, feeling good about a decision is rarely a help in successful investing—to have a good outcome, an investment view must be different from that of most other investors, and standing apart from the herd almost always leads to discomfort.

Sitting on Our Asses

The job of an investment analyst, then, when forecasting a company’s business prospects and the price that should be paid for its stock is to distinguish between what is important—the signal—and what is useless noise. That’s what we do at Harding Loevner. Our “common language” is designed to guide investment collaboration by helping us focus on low-frequency signals that are important to a long-term investment thesis and avoid being distracted by torrents of high-frequency information that obscure the relevant underlying issues.

We recognize that our industry has an extensive tradition of emphasizing high-frequency signals to induce transacting. In the past, much of the revenue associated with financial services was transaction-based. Brokers were paid only when customers transacted (indeed, when I started my career, so were investment managers!). Unsurprisingly, brokers devoted great effort to stimulating customers to act. Customers responded as you’d expect them to—humans like action, not sitting still. Although the investment management industry has shifted in recent years to replace commissions with asset-based fees, there remains a popular expectation that a good investor will be active, including taking advantage of the most readily available and highest-frequency bits of information: stock price movements (both up and down).

Few investors, though, are able to capture any benefit from high-frequency signals. Our analysts don’t even look at stock prices until a company has been thoroughly researched and qualified as meeting our quality and growth criteria, its long-term cash flows have been forecast, and the fair value of its shares estimated.

Stock prices are much more volatile than the underlying qualities of the business they are supposed to reflect. Investors should remember the words of Charlie Munger, who said successful investing is a matter of “finding a few great companies, then you can sit on your ass.”¹ Of course, while we spend a lot of time following Mr. Munger’s advice, that doesn’t mean we are sitting still. We are constantly questioning our assumptions, testing our hypotheses, updating our information and, occasionally, as a result, changing our minds. Usually, though, ignoring the calls of those whose business model, if not entire worldview, revolves around urging you to move is the key to success.

Compounding the Effect

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

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

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

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

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

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

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

Endnotes

¹Charlie Munger, Berkshire Hathaway Annual Meeting, 2000.

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Out of Our Minds

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

Source: Federal Reserve and St. Louis Federal Reserve.

What Is the Bond Market Telling Us?

Equities and Inflation

High Valuations Increase Equity Market Sensitivity

Endnotes

A Ground’s Eye View on Inflation and Its Persistence

Price Makers vs. Takers

Around the Sectors

Looking Ahead

Endnotes

Getting Real About Inflation … and Gold

Gold as Currency

Echoes of the Gold Standard

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

Hedging Inflation: It Depends

Endnotes

Too Much Information

Sitting on Our Asses

Compounding the Effect

Endnotes

Disclosures

Out of Our Minds

Source: Federal Reserve and St. Louis Federal Reserve.

What Is the Bond Market Telling Us?

Equities and Inflation

High Valuations Increase Equity Market Sensitivity

Endnotes

A Ground’s Eye View on Inflation and Its Persistence

Price Makers vs. Takers

Around the Sectors

Looking Ahead

Endnotes

Getting Real About Inflation … and Gold

Gold as Currency

Echoes of the Gold Standard

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

Hedging Inflation: It Depends

Endnotes

Too Much Information

Sitting on Our Asses

Compounding the Effect

Endnotes

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Disclosures