Russia, Risk, and Decision-Making

By Simon Hallett, Vice Chairman | March 21, 2022

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Endnotes

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

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Don’t Just Do Something—Stand There

By Simon Hallett, Vice Chairman | May 26, 2021

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

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

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

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

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

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

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

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

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

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

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

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4 Sources of Edge for Active Managers

By Simon Hallett, Vice Chairman | May 21, 2021

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

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

Informational

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

Analytic

Separating signal from noise can provide a potent analytical edge. As Benjamin Graham wrote in The Intelligent Investor:

“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.” Having a series of rules that help determine the passage of a company from the wider universe to research coverage is extremely helpful. Being structured in how to conduct research and pre-committing to the characteristics sought in a company are essential. Be objective in embracing what works from quantitative processes and systematic fundamental analysis. Structure and discipline help overcome human biases. Admit and learn from mistakes to be more objective and establish a framework to help analysts communicate with colleagues. The structure and discipline will help them focus on what’s important, and filter out what is not.

“Focusing on long-term industry competitive dynamics and individual companies’ own competitive advantages within their industries can lead to insights that short-term data analysis often misses.”

Decision-Making

Understand that all human beings have biases that inhibit both thorough analysis and sound decision-making. A good manager needs to set up structures to overcome these biases, and make sure that all team members stick to those structures. Overcoming our emotions and learning how to avoid cognitive errors should be at the core of any process that results in making decisions, especially decisions made under conditions of great uncertainty, which clearly includes investment decision-making. Conviction and confidence help sell ideas but may not be accurate guides to the success of those ideas.

Organizational

Incentivize analysts to get their decisions right, not to persuade portfolio managers. How an organization is structured, and how its people are incentivized and compensated, can provide the background that facilitates good decision-making and is thus a source of “organizational alpha.” For example, incentives should in part focus on long-term performance so that they’re aligned with the long-term nature of the informational and analytical edge. Moreover, individuals need to be accountable for their decisions to avoid the blame game that arises from consensus or group decisions. Finally, a good investment manager needs to communicate with clients, and, above all, set their expectations accurately.

At Harding Loevner, we think we have an edge because of what we know about decision-making and the structure and discipline of the process. Our analysts provide the necessary ingredients for successful, systematic portfolio construction. Our decision-making structure imposes individual accountability, mitigates biases, and ensures continuity, leading to better decisions and aligning each of us with our clients’ objectives.

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A Ground’s Eye View on Inflation and Its Persistence

By Edmund Bellord, Analyst and Portfolio Manager | 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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Out of Our Minds

Russia, Risk, and Decision-Making

Endnotes

Don’t Just Do Something—Stand There

4 Sources of Edge for Active Managers

Informational

Analytic

Decision-Making

Organizational

A Ground’s Eye View on Inflation and Its Persistence

Price Makers vs. Takers

Around the Sectors

Looking Ahead

Endnotes

Disclosures