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Down the Rabbit Hole

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 and ordered a copy of the entire Alice in Wonderland Collection (Alice’s Adventures UndergroundAlice’s Adventures in WonderlandAlice 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.

What did you think of this piece?

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Too Much Information

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.

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When Will Life Return to Normal?

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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Getting Real About Inflation … and Gold

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?