Japan’s Mid-Quarter Market Turmoil Ends in Recovery for Fast-Growing Small Caps

By Anix Vyas, CFA, Analyst and Portfolio Manager | October 22, 2024

An unexpected interest-rate increase from the Bank of Japan helped ignite a market firestorm during the third quarter.

The central bank’s decision in late July caused a swift appreciation in the yen, a currency shift that disrupted the widely used strategy known as the yen carry trade, where investors borrowed at low Japanese rates to purchase higher-yielding foreign assets. The rapid unwinding of these positions, combined with weaker US economic data and disappointing earnings from US technology giants, culminated in a 12% drop in Japan’s Nikkei index on August 5, while expected volatility in the US equity market spiked to a level not seen outside of major crises.

Markets recovered quickly, though, and Japan ended the quarter as the second-best performing region for small-cap stocks. As the chart above shows, the yen also topped currency returns.

For several quarters, Japan has been a particularly challenging market for investors in quality growth small companies, as stocks of cheaper, low-quality businesses tended to outperform. However, another market development in Japan in the third quarter was that style patterns reversed, with stocks of faster-growing, more expensive companies leading returns. The charts below depict the spread between returns for the fastest- and slowest-growing, highest- and lowest-quality, and least and most expensive small caps by region for both the third quarter and trailing 12 months, based on Harding Loevner’s proprietary growth, quality, and value quintiles.

msci-acwi-ex-us-sc-index-return-quintile-spreads-3q24

Although it’s too soon to know whether Japan’s value rally is finally over, the third quarter provided a welcome reprieve.

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Why Own International Stocks?

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

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

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

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

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

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

1. The “Magnificent Seven” Stumble

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

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

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

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

2. China Gets Back Up

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

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

3. India Continues Its Ascent

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

4. Peace Breaks Out

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

5. AI Goes International

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

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

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Growth Is Beating Value in the US. Will International Follow?

By Apurva Schwartz, Portfolio Specialist | August 28, 2024

Non-US markets have underperformed the US for quite some time. This has been exacerbated lately by their diverging style factors.

As seen in the chart above, investors largely favored value stocks as the global economy began to reemerge from the COVID-19 pandemic following emergency-use authorization of the first vaccine in late 2020. This headwind for growth stocks has been most significant, and enduring, in international markets. For example, the MSCI All Country World ex US Growth Index lagged its value counterpart by nearly 30 percentage points in the three years through October 2023. But while the value rally has continued outside the US, 2023 saw investors reembrace US growth stocks despite their relatively high valuations.

Valuation is in the Eye of the Beholder

By Simon Hallett, Vice Chairman | August 07, 2024

The structure of sports leagues in the United States differs from those seen elsewhere in the world. Most importantly, American sports teams compete annually against pretty much the same opposition. The composition of leagues such as the NFL or NBA is largely static, with new franchises entering only rarely and with the agreement of the owners of other teams. The same holds true for various minor leagues, which operate in conjunction with the largest professional leagues, but whose teams don’t move between levels of the sport.

In UK soccer, the sport with which I am involved, in contrast, the league is composed of linked divisions arranged in a hierarchy where membership of each division changes at the end of every season—based on merit, so that the top few teams in each division move up in the hierarchy, and the bottom few clubs move down. The drama around the joy of promotion to a higher division and the misery of relegation to a lower one is part of what makes the sport so compelling; for fans (and owners) of clubs involved in the battle to win one or avoid the other, the chase can be both thrilling and terrifying.

Another significant difference, particularly in soccer, is that the frequency with which players are traded is much greater than that in most American sports. Trading of players (technically, of their contracts) takes place in two transfer windows, a long one that starts before the season begins and stays open until the season is a month old, and a short one in the middle of the season—the month of January.

Players are, of course, any club’s biggest asset, and once assets start being traded, any investment person will wonder what determines the price of those assets and how that market price relates to “true” value of the asset.

In investing, practitioners have a model that claims the value of an asset is the value of the cash flows it generates in the future, discounted back to a present value using a discount rate that is the sum of a risk-free interest rate and an equity risk premium. We all accept that the model is imperfect, but investors such as us believe that prices are more volatile than values and that they converge on value over some indeterminate time frame. Over short periods prices are set by the preponderance of buyers and sellers, but eventually, underlying values dominate prices. As Ben Graham observed, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

There is no such model that underlies prices in the market for soccer players (and I apologize to all players for considering them only as tradeable assets in this piece. They are, of course, human beings and, unlike stocks that are indifferent to ownership, have preferences about where and for whom they play). The result is that prices for soccer players are driven by the quantity of money available in the industry and often appear to have little basis in the value that is created by that player on the field (or pitch). Buyers have been attracted to rising prices for soccer clubs and more money has entered the industry in recent years, leading to a rapid increase in the price for an average player.

Prices for clubs similarly appear unrelated to their value. The discounted present value of cash flows generated by clubs in the division in which my club plays is strongly negative, with the average club losing over £25 million a year, sometimes on revenues that are less than the losses. Owners should pay to have these liabilities taken off their hands. (I hasten to add that my club operates on a cash flow breakeven basis, but still doesn’t generate cash flows that could accrue to its shareholders).

Instead, prices of clubs and players are determined, as is often the case in the real estate market, by “comparables”—buyers and sellers look at prices of similar assets and negotiate based on that. In an industry where money has been available in increasing amounts, but the numbers of clubs and players roughly fixed, that has led, unsurprisingly, to price inflation.

At my club Plymouth Argyle, we have embarked on a strategy to try to generate returns from player trading. We allocated some funds last year to buy players with the intention that they would increase in price and then be sold, generating profits to be reinvested or used to pay higher wages for more skillful players—establishing a portfolio of players, if you will. As part of that effort, we have thought about a model to determine value in the absence of associated cash flows. We could, for example, say that promotion to a higher division would increase the club’s revenues by £x million, and that an individual player could increase the probability of capturing those revenues by y%. That is possible, if not easy, and enables us to put an expected value on an individual player. The trouble is that the resulting number bears little relation to the actual market prices for players, coming up with a value that’s significantly less than actual market prices! We could also accept that the market for clubs is what it is, and that prices for clubs rise as they ascend the league’s divisions so base the expected value for a player on the contribution he makes to the probability of promotion and the value of that promotion, or to avoiding relegation. Again, this is not a true anchor in value, simply in prices for clubs.

This is, of course, quite different from investing in stocks, where, as I’ve pointed out, prices, in the long run, are determined by underlying value.

But how firm is that underpinning? Is it really so much more objective and calculable than the trading of sports stars? Investment professionals, and finance academics, like to talk about the “intrinsic value” of a stock, once the analysis has been done, the forecasts made, and the discount rate applied.

But is there really an intrinsic value that is separate from the preferences of the valuer? As my colleague Andrew West has written, “Valuation is always an estimate, and valuation always requires a valuer.”

The forecasts that analysts make of cash flows far into the future reflect subjective views about that future—not just about management’s ability to control costs, impose higher prices, gain market share or invest retained earnings successfully, but also about competitive positions in the industry in which the company operates and the industry’s competitive structure and growth rates. And all that occurs before the analyst considers the economic environment in which the company operates.

The choice of discount rates presents further opportunities for subjectivity. The risk-free rate is observable in the US Treasury market (though which Treasury should be used to approximate rates in the future is debatable) but the equity risk premium is highly contentious and perhaps is best described in terms of individual risk and return preferences and needs. In my career I’ve heard perfectly sensible people argue that the equity risk premium should be zero, and others argue that it should be 600 basis points.

Value is in the eye of the beholder and an estimate of true value is closer to an estimate of what the market is prepared to pay than fundamental investors such as us like to admit. In thinking about stock portfolios, as in thinking about the value of a squad of footballers, we cannot ignore what the market is prepared to pay when thinking about portfolio construction and even about long-term returns.

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Out of Our Minds

Japan’s Mid-Quarter Market Turmoil Ends in Recovery for Fast-Growing Small Caps