Down the Rabbit Hole

By Peter Baughan, CFA | December 15, 2020

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

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

I ask myself: If I close my eyes, what do I see…in the markets? What I see is determined by my sense of what ought to be. I think of my introductory college philosophy course and Plato’s famous Forms. For Plato, everything has an absolute form, a universal ”right answer.” What we see on Earth are imperfect replicas of each thing’s true essence or Form. What would the Platonic Ideal look like for valuing a high-growth stock such as Shopify or, closer to our own portfolios, Amazon? When I close my eyes, I see a traditional multi-stage discounted cash flow model with a rapid growth period, a fade rate, and a rationally derived terminal value all discounted to the present using what I’ll call a traditionally derived cost of equity.

Other investors in the market today may see something quite different when they close their eyes. If, say, a Robinhood day trader closes his eyes, what does he see? Or if any of the numerous momentum fund managers close their eyes, what do they see? They may see relative price-to-sales driven by the second derivative of the revenue growth rate or some other relative forward 12-month or forward 3-month ratio as the key variable determining valuation. Or, perhaps today, all that many see are charts and price momentum amid the haze of Fedspeak that seems to devalue much of traditional investment thought. Perhaps investors today don’t see anything to do with ”terminal value” at all.

What do value investors see when they close their eyes? A number of us at Harding Loevner were struck by a recent Wall Street Journal article about famed value investor Ted Aronson’s decision to dissolve his longstanding $10 billion investment fund and return the cash to investors. Aronson, a previously very successful value-based quant manager, said: “It can all work for years, for decades, until or except when the not-so-invisible hand comes down and slaps you and says, ‘That’s what worked in the past, but it’s not going to work now, nope, not anymore.’”

I wonder what ways of seeing are being hard-wired into investors today. Who really speaks today of any of the valuation insights found in Benjamin Graham’s The Intelligent Investor, which was once seen as hallowed ground? I think it’s fair to say that very few market participants see the valuation structure advocated in Graham’s work when they close their eyes today. High price-to-sales seems to have replaced high price-to-earnings as the new normal. So-called modern monetary theory also looms—a new or non-standard to replace whatever fading monetary policy/interest rate standards once existed.

For Aronson, what’s up is down and what’s down is up. What he sees when he closes his eyes, what ought to be, well, it just ain’t so in the markets, and hasn’t been so for years. Aronson is a smart guy. As some of my colleagues noted in a recent client letter, there is no guarantee that what’s become true for him can’t become true one day for Harding Loevner. We don’t think we are any smarter than Aronson, or many other such value managers. We are considerably more fortunate at the moment as the global policy direction in recent years has smiled upon ”growth” while frowning upon ”value.” But further change may be coming.

All of this brings to mind a poem by Rainer Maria Rilke published in 1905:

I live my life in widening circles
that reach out across the world.
I may not ever complete the last one,
but I give myself to it.

I circle around God, that primordial tower.
I have been circling for thousands of years,
and I still don’t know: am I a falcon,
a storm, or a great song?

“I live my life in widening circles that reach out across the world”—not a bad description of investing amid ever more accommodative global monetary policy with its ripples spreading around the world. Or of investing amid a pandemic with the COVID-19 virus reaching out across the world in widening circles. I have the same ultimate question in 2020 that Rilke had in 1905. How’s all this end?

The current environment sometimes makes me think about the scene in the film Doctor Zhivago (sorry about the mixed references, but my eyes are still closed) when the good doctor returns to his family home one day to find it taken over by the workers’ committee. He is initially assigned to only one room and eventually is not allowed to enter at all. Standards changed, to say the least. More than at any time I can remember, I’d say the standards that underpin what passes for majority understanding and opinion, in the US anyway, are in flux. For example, would a proposition to reaffirm the US Constitution as written, if put to a popular vote today, win majority approval? I have my doubts. Would a proposition to reaffirm support for “free market capitalism,” if put to a popular vote today, win majority approval? I have my doubts. Would a proposition to reaffirm the principle of private ownership of land, if put to a popular vote today, win majority approval? I suspect this would still find majority support, but with a large vote against, and I’m not sure how the vote would turn out, say, five years from now. Yet the stock market has no such doubt. The best stocks in the market, by many country miles, are high-growth stocks where share prices reflect confidence in rapid earnings growth a decade or more from now—at least according to the arithmetic of discounted cash flows. Or perhaps that’s not how many investors look at it; they may only have confidence in sustained earnings momentum one to two quarters from now, not confidence in the state of things in, say, December 2030.

I did not find reading Alice’s Adventures in Wonderland and Through the Looking Glass to be a particularly satisfying experience. However, they were useful to read. As I reflect on it, the stories made me step back from my assumptions about how things should be, and left me open to considering other scenarios, in politics, in society, and in the financial markets. The meaning of the line “you must close your eyes or you won’t see anything” is not entirely clear to me. But it is perhaps the most provocative and potentially valuable investment insight I’ve come across in quite a while. While I ponder and watch, I plan to remain diversified and see just how prescient Alice’s upside-down world continues to be.

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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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When Will Life Return to Normal?

By David Glickman, CFA, Health Care Research Analyst | February 02, 2021

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

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

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Two male and one female co-workers meeting up before work and greeting each other with a kiss on the cheek and hug.

As I wrote to this analyst and the rest of the group, my honest answer is: it’s very hard to say at this point. Beyond the manufacturing and distribution challenges he references, the most troubling recent news involves the increasing prevalence of COVID-19 mutations such as the B.1.1.7 variant that first emerged in the UK and the B.1.351 that originated in South Africa. Since mid-January, there has been mounting concern that some of these variants, in addition to being more contagious, might also be more resistant to the vaccines that have already been developed. The latest study results for a pair of vaccines still awaiting approval—one from Novavax and another from our portfolio holding Johnson & Johnson (JNJ)—confirm that at least for the South African variant this is indeed the case, as both vaccines showed reduced efficacy in preventing infection in South Africa, where B.1.351 is dominant. For the Novavax trial, the reduction in infection rates in the UK was 89%, compared to just 60% in South Africa. For JNJ’s vaccine, the reduction in infection rates was 72% in the US versus just 57% in South Africa. In other words, these vaccine candidates are still capable of dramatically reducing severe COVID-19, but aren’t capable of reducing the viral load enough to lower infection rates as dramatically as we had come to expect from Pfizer and Moderna’s vaccines, whose blockbuster phase 3 trial results in late 2020 were for populations not yet exposed to B.1.351. While the follow-up data are still preliminary, expectations for how those vaccines perform against the variant probably now need to be lowered as well.

If you get a vaccine by the summer, you’ll be better protected, but my expectation is that the new and future variants will become the dominant strains in the coming months, and so you won’t be 95% protected, more like somewhere in the 50-60% protection range.

Getting much better distribution and administration of vaccines suddenly becomes more urgent. As health officials have emphasized, the more the virus is contained, the less opportunity that variants will have to replicate and gain a larger foothold in a population. Mask-wearing, handwashing, and social distancing take on similarly elevated importance in this game of viral Whack-a-Mole. It seems overly optimistic, however, to think that the variants won’t soon become more prevalent regardless, including in the US, and that we won’t just as soon need new tools to combat them. One big plus about many of the new vaccines is that they can be modified quickly, increasing manufacturers’ ability to issue booster shots specifically aimed at the variants. But can vaccine updates be issued quickly enough to prevent added waves of infection and forestall still more variants from popping up? Let’s hope.

Based on conference calls I’ve been on with the vaccine manufacturers, and research I’ve read about the nature of the virus, it is surprising, and, frankly, a bit alarming, that so many viable variants are out there this soon. The rationale given now by scientific experts is that uncontrolled spread for too long gave the virus more chances to find better ways of eluding our immune systems. RNA viruses replicate for speed and aren’t good at “checking their work,” so the vast majority of mutations are just mistakes that typically function to weaken the virus and thus immediately go extinct. However, there has always been a small probability that some of these copying errors would confer a benefit on the virus. It is akin to rolling dice and having them come up ones 10 times in a row—if you roll 1 trillion times instead of 100 billion, there’s a decently higher chance of that happening. Still, in the lifecycle of a virus such a pace of snake-eye streaks typically isn’t seen until after we apply more Darwinian pressure and the organism is forced to mutate to survive. It’s disappointing that we’re getting so many variants at this juncture, but it wouldn’t be surprising if the pattern continues. It is also possible we could have another burst of variants to contend with once the virus has finally been brought under control and feels truly cornered.

As a healthy male in my early-40s, I’m less concerned about severe disease and hospitalization once I get vaccinated, but I am concerned about the risk of being a “long hauler,” one of the estimated 10% of COVID-19 patients who experience debilitating symptoms for months or potentially years (or longer—we just don’t know) after the initial infection has run its course. I’ve met two long haulers in the last month and they are both in the 45–55 age range. We have no idea yet, for any of these vaccines, what the reduction in risk of being a long hauler is.

So, as for life returning to “2019”? I don’t think that’s going to happen this year. If you get vaccinated by the summer, you’ll be better protected, but my expectation is that the new and future variants will become the dominant strains in the coming months, and so you won’t be 95% protected, more like somewhere in the 50–60% protection range, although with much higher protection against severe disease. To me, that’s still definitely not enough to return to greeting someone outside my family with a European faux kiss on the cheek.

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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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Out of Our Minds

Down the Rabbit Hole