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By Tim Kubarych, CFA, Co-Deputy Director of Research | June 07, 2023
When US stocks have outperformed for as long as they have—creating the world’s first trillion-dollar companies in the process—it’s easy to forget that plenty of highly profitable businesses exist a long way from Silicon Valley or Seattle.
While US companies account for just over 60% of the market capitalization of the MSCI All Country World Index, their weight is a tad misleading given that a few technology giants—Alphabet, Amazon, Apple, and Microsoft—weigh heavily on the scale. Together, those four are valued at nearly US$8 trillion, more than the next 15 largest US stocks combined.
Even if the US features most of the world’s biggest companies, it’s hardly the exclusive repository of the best ones. Using cash flow return on investment, rather than market value, as our measurement reveals that the majority of the most profitable and capital efficient businesses in just about every sector are located outside the US. The only exceptions are two areas where US companies are clearly dominant—Information Technology and Health Care.
Of course, profitability alone doesn’t define the best companies. As quality-growth investors, we examine a broader set of characteristics to determine business and management quality as well as long-term growth prospects. And still, the data show that regional diversity wins out: About three-quarters of large-cap stocks in the top two quintiles of our quality and growth rankings are non-US firms, increasingly anchored by emerging markets such as China.
Investors are naturally biased toward their home territory, which is easy to do when it is giving an electric performance. For the US, that’s been the case for more than a decade as the economy recovered from the Great Recession and smartphones, digital advertising, mobile shopping, and workplace productivity tools—areas dominated by a handful of American giants—became ingrained in daily life.
This has left international markets with more attractive share prices relative to the profitability and cash flow of their underlying businesses. We can’t predict when international markets will rise again, but we do think fundamentals and valuations ultimately drive stock performance. The valuation spread between US and international stocks today happens to mirror the gap that existed in 2001, which ushered in a period of international outperformance.
Eschewing stocks in the rest of the world not only misses out on the diversification benefits but also ignores an attractive set of companies whose valuations may be poised to rebound.
How do you begin to research a company when so little information is readily available beyond a name and a set of regulatory filings? This is the challenge that defines small-cap investing, an asset class that invariably entails an adventure in fundamental research.
The superheroes of the stock market—mainly US corporations valued at or close to a trillion dollars—tend to dominate investment news and research. And yet little-known small companies—often based outside the US—that never generate a headline remain some of the most vibrant sources of innovation. If the biggest large caps sell the finished products that investors and consumers know well, small caps often occupy a small niche along the global supply chain, providing a critical piece of technology known only to its intended audience.
Watch to learn about the little-known Swiss company that produces a critical component for Tesla vehicles.
Because small companies solving esoteric problems usually aren’t well-covered by outside analysts or journalists, building a deep understanding of their businesses requires starting from scratch. For some investment firms, this lack of information means the foray into small-cap territory demands an entirely different way of thinking and working. But for Harding Loevner, it’s why small caps are a natural fit.
Our firm’s investment philosophy is based on the premise that we cannot forecast the direction of stock prices, but that through bottom-up analysis of the more durable aspects of companies we can identify the most exceptional among them. We look for strong competitive advantages, sound finances, and capable leaders, with the belief that companies possessing these attributes can be reasonably expected to produce superior growth and weather unforeseen events better than the average company, which will eventually be reflected in their stock prices.
Because small companies solving esoteric problems usually aren’t well-covered by outside analysts or journalists, building a deep understanding of their businesses requires starting from scratch.
For small companies especially, what this research process means in a practical sense is spending a great deal of time with engineers in manufacturing and R&D facilities, seeing the guts of machinery and the software that forms the mainspring of a company’s growth and competitive advantage. At times, our team has been the first to request a meeting with a small company’s management, never mind visit its factory. We must develop our own expertise—whether it be learning the ins and outs of recycling technology (to determine TOMRA’s role in meeting European climate-change directives) or the intricacies of atmospheric sensors (to understand why customers would choose Vaisala’s for their biolabs, air-traffic control, or space missions).
One challenge of investing in small caps is trying to ascertain whether a company’s niche is one that can provide growth for a very long time. Another is that the barriers to entry are far from assured. Small companies that don’t continually innovate risk ceding their competitive advantage to rivals, particularly when larger, well-capitalized companies take an interest in the same area. Our on-site visits and discussions with suppliers and customers help us gauge R&D initiatives and product launches to make sure that our companies are investing appropriately to protect their turf.
Watch as Harding Loevner portfolio manager Jafar Rizvi discusses why small companies are the unsung heroes of the economy.
Some investment firms keep small-cap teams separate from the rest of their analysts, a potential limitation to collaborating on bottom-up research. Our small-cap strategies are instead directly supported by Harding Loevner’s global research platform in the same way as all our other strategies. This helps us to understand small companies in the context of their broader industries and develop a more complete view of their supply chains and competitive position relative to rivals of all sizes.
Getting to know businesses and their managements intimately through a systematic process can also tip off investors to disconcerting traits long before routine financial reports do. For example, when the parking lot of one company that wasn’t yet generating free cash flow looked like a Maserati dealership, we suspected management had its priorities wrong and steered clear of the stock; it’s nearly worthless today.
Throughout my ten years managing the International Small Companies (ISC) strategy, most of the entrepreneurs I have encountered didn’t have ambitions of becoming the next celebrity CEO. Or driving a supercar. They mainly want for their businesses to be the best in their niche, and because of that, they tend to face less pressure to expand beyond those core competencies than large companies do. We consider such clear focus to be a hallmark of good management.
As a result, small companies can be quite skilled at what they do. Take Uno Minda, which produces automotive components such as alternate fuel systems used in electric vehicles. Years ago, the Indian company adopted Japanese techniques such as kaizen to supercharge its manufacturing processes and growth. Now, Uno Minda’s Japanese partners visit its factories to learn how to improve their own operations.
With so little of what small companies do visible to the outside world, they aren’t well-understood by markets—and may not be for some time. It requires investors to take a long-term view, another way in which small caps are particularly suited to our firm’s philosophy. But as much as we’d like to hold onto the best small caps forever, the bittersweet reality is that those are the companies most likely to move on from the asset class. Some get acquired. Others graduate out of the portfolio because they grow too valuable to fit the definition. (In just the last year, several of our ISC holdings—including Chr. Hansen, Dechra, EMIS Group, and Network International—have received takeover offers from strategic buyers or private equity firms.)
Some people enjoy covering the superheroes. But after getting to do both, for me there is nothing like the joy of discovering the greatest small companies most investors haven’t yet heard of.
What Is a Small Cap?
Different asset managers have different answers. For some, a small cap is defined by a rigid view of market capitalizations. For example, any company less than US$2 billion may be eligible for a small-cap strategy, and any company that eventually exceeds US$3 billion in market value must be sold. The trouble with using such blunt thresholds is that they fail to take into account a general increase in markets.
Other firms may set a market-cap limit for only the initial purchase. But this is how a “small-cap portfolio” can end up rather awkwardly holding lots of companies with lofty US$25 billion market caps.
Our definition says small is relative. It starts with the parameters set by the index provider MSCI, which considers a small cap to be any investable company that falls below the 85th percentile of market caps. We then consider the market cap ranges of companies in the MSCI ACWI ex US Small Cap Index (for our international strategy) or the MSCI ACWI Small Cap Index (for our global strategy) and their weighted average market caps relative to the index. This combination ensures that we steer clear of tiny, illiquid holdings as well as companies too large to fit the small cap label.
We like this approach because it allows for different ranges for different equity markets around the world, and because the most reasonable definition of a small cap is one that changes over time. What is “small” today would’ve been considered huge 50 years ago. When the international index launched in 2007, the largest members were valued at less than US$5 billion. Today, they are more than twice as big. Don’t be surprised if in another 50 years a US$25 billion company truly is a small cap.
One of our more acid-tongued colleagues likes to observe that “just because we don’t do macro, it doesn’t mean the macro cannot do us.” The observation is a challenge to our bottom-up investment philosophy and merits a response. What does his comment really mean? Is he correct?
By “not doing macro,” he means that we try not to allow our judgments about macroeconomic variables—GDP growth, inflation, and real interest rates—or geopolitical events to dictate our views on individual companies. By “macro does us,” he means that when the market’s risk tolerance and underlying assumptions change because of unexpected shifts in the macroeconomic environment, the consequential price movements can dominate a portfolio’s periodic absolute and relative returns. Although the injury may be only temporary, it is hard to avoid getting swept up in the general fervor. That’s a problem if it leads to reflexive and hasty reactions. It is precisely to avoid getting whipsawed in this way that we devote much of our efforts to restraining our inherent behavioral biases. But even with the sturdiest of behavioral guardrails designed to curb our responsiveness, the sudden jump in portfolio volatility and tracking error feels no less jarring.
Our investment approach centers on analysis of the prospects for specific companies and the industries in which they operate. As a result, the portfolios we construct are a mosaic of company-centric views, with the final picture coming into focus only after all of the pieces are assembled. Sometimes our bottom-up investment process leads us to sidestep systemic issues. In the years before the global financial crisis, for instance, we became disenchanted with the traditional banking industry. We didn’t like how the increased price transparency that came with the migration of services online diminished banks’ bargaining power over their borrowers and depositors, or how rising levels of consumer debt portended that growth could be weaker, and rivalry and risk-taking fiercer. That was enough to lead us largely to steer clear of banking stocks. Although in hindsight our portfolio positioning appeared to anticipate the subsequent dislocations, in fact we had no overarching view on systemic financial stability.
There is no question it would be nice to have clear foresight on GDP, inflation, and real rates. Like it or not, economic growth is the lifeblood of industrial economies, and, despite its ever-shifting relationship to equity returns, is closely associated with aggregate earnings. Similarly, inflation and real rates are both barometers and agents of economic transformation that always could and frequently do alter the path of economic growth. And there is strong reason to believe that macro-level dislocations are likely to be an order of magnitude greater than the mispricings that occur at the security level. Given the periodic importance of such dislocations, this raises the question: Why don’t we attempt to shape our portfolios more explicitly by directly forecasting economic variables or geopolitical events? The question is particularly vexing given the current importance of the inflation outlook for equities.
Tetlock’s conclusion was that expert predictions about geopolitical crises were no better than guesses. The only contribution that expertise seemed consistently to confer was a perverse boost in confidence regarding one’s (ineffective) forecasts.
The standard response typically trotted out is that forecasting is exceptionally hard, or as the Danish physicist Niels Bohr is alleged to have quipped, “Prediction is very difficult, especially about the future.” Nowhere is this more true than with geopolitical events, which by all accounts appear to defy anyone’s ability to anticipate them with anything approaching consistency. The political scientist Philip Tetlock tackled this issue head-on in a multidecade study described in his 2015 book, Superforecasting: The Art and Science of Prediction. Tetlock’s conclusion was that expert predictions about geopolitical crises were no better than guesses. What’s more, the only contribution that expertise seemed consistently to confer was a perverse boost in confidence regarding one’s (ineffective) forecasts.
The record for macroeconomic forecasting is not quite as wretched; at least there are frameworks and models on which to hang one’s thinking. But it’s still one of those endeavors where you’re doing very well if you’re right a little more often than you’re wrong. Even so, it is not as though the ground-level forecasting of cashflows, business prospects, and competitive forces is easy. So perhaps the real question is why we consider the latter sensible but the former a fool’s errand, at least for fundamental equity investors such as us.
The answer in large part comes down to the size of the opportunity set, or the number of times you get to apply your investing edge. Even the most skilled forecasters, whatever their forecasting game, have but the tiniest of edges and so the surest way to increase their chances of success is to apply that minute edge as many times as possible. In a global investment universe, there are roughly 8,000 equity securities, each operating in its own industry and geography with their own sets of return drivers, compared with a relative handful of forecastable macroeconomic variables. Given equal forecasting skill, you are going to have a far higher likelihood of some overall success by applying that skill across many securities rather than over a few economic statistics. Even allowing for the fact that not every security’s return is entirely idiosyncratic, there are still far more independent and durable drivers of individual security returns than there are of macroeconomic trends, which may allow you to get the micro right without so much as taking a swing at the macro.
Even if you were one of the few hyper-skilled and hyper-accurate macro forecasters, a portfolio of stocks would be a poor way to capitalize on views about inflation or economic growth. Although there’s a relationship between the macroeconomy and stock returns, that relationship is neither simple nor determinate. In practical terms, stocks are a terribly inefficient way to express a view on macroeconomic variables. Better to bet on currencies, yields curves, and commodity prices directly, all of which are far more closely tethered to the outlook for growth, inflation, and real rates.
It’s not just that there are better, more precise, and more levered ways to express macroeconomic views. It’s also that trying to do so with stocks risks erasing the hard-won company-level insights that are the linchpin of our portfolios.
And it’s not just that there are better, more precise, and more levered ways to express such views. It’s also that trying to do so with stocks risks erasing the hard-won company-level insights that are the linchpin of our portfolios. All the companies in which we invest have track records of successfully generating cash and reinvesting it wisely. In many cases these companies have survived wars, recessions, pandemics, inflation, deflation, and geopolitical shocks. Sacrificing those financially valuable fundamental attributes in a most likely vain attempt to time a particular economic cycle not only presupposes a preternatural ability to tie economic outcomes to individual security returns but also risks the long-term health of the portfolio.
We don’t do macro, so by default we allow macro to do us. There are, though, ways in which we can protect against developments that result in sudden changes in risk aversion. One is to diversify—events that damage the outlook in one industry or part of the world may have no impact, or even a beneficial one, on stock prices elsewhere. That said, diversification cannot work during times of systemic crisis, when correlations between geographies, industries, sectors, and individual securities converge. That’s where our reliance on a company’s strength comes in. Two hallmarks of a company’s quality are the ability of its management to prepare for a wide range of outcomes and whether it has the financial strength to survive the worst possible operating conditions.
Although we can’t estimate the probability of market-moving events, we can think about the magnitude and range of potential outcomes so we may more fully understand our exposures and ensure we are sufficiently diversified to protect against them. For example, before Russia’s invasion of Ukraine, many people thought about a range of outcomes that included war versus no war or disruption to energy supplies. But, given prior Western responses, few considered the potential for sanctions that would freeze all Russian assets and render them worthless, at least for the time being. Now, as we think about the financial market implications if China were to invade Taiwan, we must consider the possibility that Chinese assets could be similarly impaired.
So, what do we do about it? We certainly aren’t going to try to parse Chinese troop movements or overturn our investment theses on the dozens of companies, not only in China but also throughout the global supply chain, that could be impacted by what at this point must still be considered a very low-probability event. On the other hand, thinking long and hard about the potential risks to supply lines, revenues, or the corporate structures of portfolio companies and what further levels of diversification might be in order is very much in our wheelhouse.
By Edmund Bellord, Portfolio Manager and Asset Allocation Strategist | April 12, 2022
Despite recent volatility the bond market has yet to lose its composure over the multi-decade high in inflation. In the US, ten-year Treasury yields have risen, but only to levels they reached prior to the pandemic, and, while ten-year real yields have been a little perkier, they are still below zero. As a result, the longer-term inflation expectations baked into today’s bond prices remain bunched up around 2% despite headline inflation running at over three times that rate. Short-term yields anticipate a series of hikes in the federal funds rate, the central bank’s standard response to persistent inflation, but even forward curves expect short-term yields to top out at only around 2.5%, within spitting distance of where they peaked back in 2018 when inflation was slumbering at 2%.
Source: Federal Reserve and St. Louis Federal Reserve.
What Is the Bond Market Telling Us?
What are we to make of such an acquiescent yield curve in the face of the highest inflation in a generation? Are investors so convinced of central banks’ inflation-fighting credibility that they are willing to forego any compensation for the risk that things might not turn out exactly as planned? Or have successive efforts by central banks to prop up asset prices at the first sign of trouble by generously spraying markets with liquidity scrubbed away any vestigial memories of inflation and left investors in a state of learned passivity? Or perhaps there’s a simpler explanation: the information contained in bond prices must be taken with a large pinch of salt.
There are plenty of reasons for not taking bond prices at face value, and they bear repeating, if only to remind ourselves of the profound distortions bedeviling sovereign yield curves. The biggest culprits are the quantitative easing programs undertaken by central banks following the Global Financial Crisis (and extended or revived during the pandemic) to push down long-term interest rates and thereby spur economic growth. Despite plans to wind them down, these asset-purchasing programs continue to hoover up much of the sovereign bond supply in the US, the eurozone, and Japan. The rate-dampening effects of these programs are augmented by the ongoing bond purchases by other central banks, notably in Asia, whose recurrent need to prevent large current account surpluses from sending their currencies spiraling higher compels them to keep adding to their towering foreign reserves.
The increased adoption of risk-parity strategies has cemented the role of bonds as foremost an insurance asset. If instead of demanding compensation for bearing inflation risk, investors are willing to pay a premium to protect their portfolios, inflation expectations derived from bond prices will be understated.
But while central banks, along with other non-profit-maximizing participants, have always been a feature of bond markets, what’s new today is the rise of a class of investor for whom default-free government bonds are a hedge first and a return-seeking investment a distant second. The increased adoption of risk-parity strategies, along with various permutations that fall under the umbrella of volatility-targeting strategies, has cemented the role of bonds as foremost an insurance asset. In these strategies, as equity market volatility rises or falls, exposure to bonds is dialed up or down to equalize the contribution to total portfolio volatility coming from each asset class. The inherent assumption is that bonds will be a hedge when the rest of the portfolio heads south. And that’s a problem because the inflation expectations that are backed out from bond prices assume that investors demand a reward for bearing inflation risk. But if instead of demanding compensation for bearing inflation risk, investors are willing to pay a premium to protect their portfolios, inflation expectations derived from bond prices will be understated.
What this means from a practical perspective is that bond prices are likely to be far less reactive to nascent inflation concerns than in the past, and equity prices may be the better guide for those concerned about what’s brewing with inflation. Moreover, today’s strained equity valuations magnify the markets’ sensitivity to prospective increases in inflation. Ominously, high valuations not only make equities more sensitive but also more vulnerable, as we shall see.
Equities and Inflation
Whenever inflation and equities are mentioned in the same breath there is always someone who will reflexively insist that, because equities are a claim on real assets, holders can safely ignore inflation. There is a kernel of truth to this. Equities are a claim on real assets and so over the very long term should be more resilient than, say, nominal bonds, but that doesn’t mean inflation can be ignored. Far from it. Because inflation has knock-on effects to cash flows and discount rates, the impact of higher inflation on equity valuations can be dramatic. The hit to cash-flow expectations comes from the combined effects of a squeeze on company profits from rising input costs and the demand destruction that typically follows the policy response—an increase in tax levels or interest rates—needed to bring inflation back under control. Moreover, because monetary instability also strikes at the heart of the economic compact between labor and capital, it can have a dramatic effect on equity discount rates beyond its mechanical effect on borrowing costs.
Assuming companies can pass on their costs one-to-one with inflation, they should be able to pay higher dividends and their share prices should go up. What this simple story leaves out, of course, is the colossal bun fight that inevitably breaks out as everyone flails around trying to dodge the inflation hit to profits, wages, and pocketbooks.
A simple model for equity returns can help to elucidate the mechanics. One workhorse model for equity returns is the Gordon Growth model, a variant of the dividend discount model that assumes the current dividend D grows at some constant rate g in perpetuity and that investors discount those future expected cashflows at a fixed rate r. The price P for such an asset is the present value of the entire stream of future cash flows, which can be expressed as follows:
P =
D
r-g
What’s clear from this simplified model is that, assuming companies can pass on ballooning input costs by raising prices for their goods one-to-one with inflation, the resulting increase in nominal dividends will be matched by a corresponding increase in nominal share prices. If that were the only thing going on, then inflation could indeed be safely ignored. What this simple story leaves out, of course, is the colossal bun fight that inevitably breaks out as everyone flails around trying to dodge the inflation hit to profits, wages, and pocketbooks.
The precise contours of the conflict depend on the source of the inflation shock and the relative bargaining power of the various stakeholders. But the broad outlines tend to follow the same pattern, with a shock to living standards sparking a demand for higher wages that gets passed on through higher prices as businesses try and defend their margins. Because each step is contentious, none of it unfolds smoothly, which lowers productivity and interferes with resource allocation and ultimately is manifested in slower earnings growth.
Eventually, a central coordinator like a central bank or fiscal authority steps in to try and break this dynamic. The standard cure involves them reining in economic activity with some combination of higher interest rates or increased taxation, which does eventually bring the inflationary cycle to a shuddering halt but at the cost of lower profits and wages. These interventions typically produce additional unintended consequences—see the miners’ strike in Great Britain during Margaret Thatcher’s early years—which further increase frictions.
Given that backdrop, it’s hardly surprising that consistently rising prices tend to also push up the required rate of return for risky assets. This reflects the real sense that elevated inflation embodies the unraveling of the social contract in the economic sphere. And that’s because inflation is not so much a rise in the price of goods as it is a decline in the value of money. This erosion in the unit of account ripples through balance sheets, blunting price signals, and makes it harder for businesses and households to plan for the future. The longer inflation persists, the more debilitating the harm.
High Valuations Increase Equity Market Sensitivity
The Gordon Growth model also has a role to play in explaining why the confluence of elevated valuations and inflation is so toxic. To understand how that works, we need to introduce another concept known as modified duration. The notion of modified duration is central to bond analysis, but it’s rarely applied in the context of equities. And that’s a shame because equity market duration has a lot to tell us about the stock market’s current sensitivity to inflation.
Duration is the average maturity of the expected future cash flows for any security. Purely speculative assets that have no expected cash flows, such as gold or Bitcoin, have infinite duration. The duration for a zero-coupon bond with a single known cash flow at expiry is simply the number of years to maturity. If you divide the duration of an asset by its discount rate, you have a measure of its sensitivity to changes in that discount rate, which is called modified duration. For bonds, modified duration is the sensitivity of its price to changes in its yield to maturity, or, said otherwise, the percent change in price for a given percent change in yield. For equities, modified duration tells you how much of a share price change you should anticipate for a given small change in the discount rate, r.
Although in the case of equities the cash flows are uncertain, we can still use the Gordon Growth model to approximate a measure of modified duration for the broad market. I’ll leave the tedious math for the footnote1 but suffice to say that a few manipulations reveal that the modified duration of the equity market is simply the inverse of the market’s dividend yield. With a dividend yield of 1.43%, the S&P 500 is currently sporting a modified duration of around 70 years (100/1.43 = ~70).
It’s quite possible that the recent ruckus in the market for growth stocks—those securities with cash flows furthest out into the future and therefore with an even more extended duration—is exactly what we’d expect as the first tremors in the discount rate reverberate through the amplifier of high valuations.
Over the past 20 years, already a period of elevated valuations relative to long-term history, the average modified duration for the S&P 500 has been 50 years. A current modified duration of 70 implies a 40% increase over the historical average in the sensitivity of share prices to small changes in the discount rate. In practice, at a modified duration of 50 years, a 50 bps increase in the discount rate would translate to roughly a 20% decline in prices. This decline is somewhat less than the 25% we would expect from modified duration alone (.05% x -50 = -25%) because, for larger changes in the discount rate, we need to also account for a bit of arcana known as convexity. Even so, today, with a modified duration of 70, the effect of a 50 bps increase in the discount rate at a modified duration of 70 years is a 27% drop.
It’s quite possible that the recent ruckus in the market for growth stocks—those securities with cash flows furthest out into the future and therefore with an even more extended duration—is exactly what we’d expect as the first tremors in the discount rate reverberate through the amplifier of high valuations. Meanwhile, the resilience of the broader market might indicate that so far, at the aggregate level at least, this rise in the discount rate has been partly offset by rude economic health and no indications of an unravelling of the social fabric caused by inflation. If only such an assessment wasn’t directly at odds with the recent inversion of the US yield curve pregnant with recessionary portents. Let us hope that the bond market’s distortions that scramble its inflation signaling are also adding to its inutility as a predictor of economic slowdowns.
Endnotes
1By taking the first derivative of the Gordon Growth model with respect for r gives us
∆P
dr
=
D
(r-g)2
. Then simplifying and dividing each side by
1
P
gives us an expression for duration,
∆P
P
dr
=
1
r-g
, that can also be expressed as
P
D
.
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Disclosures
“Out of Our Minds” presents the individual viewpoints of members of Harding Loevner on a range of investment topics. For more detailed information regarding particular investment strategies, please visit our website, www.hardingloevner.com. Any views expressed by employees of Harding Loevner are solely their own.
Any discussion of specific securities is not a recommendation to purchase or sell a particular security. Non-performance based criteria have been used to select the securities discussed. It should not be assumed that investment in the securities discussed has been or will be profitable. To request a complete list of holdings for the past year, please contact Harding Loevner.
There is no guarantee that any investment strategy will meet its objective. Past performance does not guarantee future results.
