CHARTING THE DEVASTATION: US EV Sales Q1 2025: Tesla Dominates, Legacy Automakers EVs SWIRLING THE DRAIN

Agent001 submitted on 4/12/2025 Auto Spies Photos Timestamp: 12:32:54 AM
Views : 608 | Category: Auto Sales | Source: www.autospies.com
In Q1 2025, US electric vehicle (EV) sales reached nearly 300,000 units, up 11.4% year-over-year, per Cox Automotive. Tesla’s Model Y led with approximately 80,000 units sold, followed by the Model 3 at around 55,000. Despite a 13% sales dip to 336,681 vehicles, Tesla held a 44% market share. Ford’s Mustang Mach-E ranked third with 11,607 units, up 21%, while Hyundai’s Ioniq 5 sold 10,200 units, up 26%. General Motors saw a 94% EV sales surge to 31,887, driven by the Chevrolet Equinox EV and Blazer EV. However, legacy automakers like Nissan, Stellantis, and Volvo lagged, with flat or declining sales. Rivian’s deliveries fell 36% to 8,640 units. Honda’s Prologue showed promise, but overall, non-Tesla EVs struggled against Tesla’s pricing power and brand loyalty. EV market share hit 7.5%, inching toward a projected 10% for 2025, fueled by incentives and new models. Yet, legacy automakers face inventory issues and uneven demand. With legacy auto EVs so weak, why are they even bothering anymore with electrification? US EV sales by model for the last quarter. ???? https://t.co/qG0at8N6z2 pic.twitter.com/QHEAKBQUqy— Roland Pircher (@piloly) April 11, 2025
US EV sales by model for the last quarter. ???? https://t.co/qG0at8N6z2 pic.twitter.com/QHEAKBQUqy
„They are being watched. We work in secret. They’ll never find us.”
— Agent001 (View Profile)
More photo galleries
More latest news

Reddit and its partners use cookies and similar technologies to provide you with a better experience. By accepting all cookies, you agree to our use of cookies to deliver and maintain our services and site, improve the quality of Reddit, personalize Reddit content and advertising, and measure the effectiveness of advertising. By rejecting non-essential cookies, Reddit may still use certain cookies to ensure the proper functionality of our platform.
For more information, please see our
Cookie Notice
and our
Privacy Policy.
the home of Tesla discussion for those who haven’t drank the Elon-Ade
We have all seen the Tesla cars piling up at alternate lots. This includes Cybertrucks which are supposedly all pre-sold. So what is really going on? Are they in big trouble, because they are not selling their vehicles and over producing? They said that they put the Cybertrucks there until they are able to take care of the various recalls, and manufacturing issues, but that still doesn’t explain the multitude of Model 3’s and Model Y’s.
Create your account and connect with a world of communities.
Anyone can view, post, and comment to this community

Click “Continue” to visit the pages for Harding, Loevner Funds, Inc., a family
of mutual funds for US investors.
Continue
Click “Continue” to visit the pages for Harding, Loevner Funds, Inc., a family
of mutual funds for US investors.
Continue
Unfortunately, this investment is not available for the investor type and location you have selected. Please consider the alternative funds or contact us to explore all your options.
Terms & Conditions
Please confirm that you have read and understand the following terms of use of this website.
You are about to access the pages of Harding Loevner Funds plc, an Irish umbrella type open-ended investment company (the “Company”), which contains information about the Company and its sub-funds (each a “Fund”). These pages are for informational purposes only. It is not investment advice, nor is it intended to be relied on as a forecast or research and does not constitute an offer, recommendation or solicitation to buy or sell shares in any Fund. Access to and the information contained in these pages are restricted to persons who are residents of jurisdictions in which the distribution of the information herein is permitted. Please consult your professional advisers if you have questions about a particular investment or are unsure of the laws and regulations applicable to you.
Investment in any Fund may only be made in accordance with the terms of the relevant offering documents, and subject to the laws and regulations applicable in which the offering documents are distributed. Please further note that not all Funds are available for distribution in all or the same jurisdictions. No information regarding the offering of shares of the Funds is intended for, nor will offers or sales of such shares generally be made to, residents of the United States of America, its territories or possessions. In particular, neither the Funds nor any shares are or will be registered under the U.S. Securities Act of 1933, as amended, the U.S. Investment Company Act of 1940, as amended, or otherwise in the U.S. and may not, except in a transaction which does not violate U.S. securities laws, be directly or indirectly offered or sold in the U.S. or to any U.S. persons.
By clicking on the “I Agree” button below, you acknowledge that you have read and understood this disclaimer and wish to proceed to these pages.
I Agree
Harding Loevner is not responsible for the content, accuracy, or timeliness and does not make any warranties, expressed or implied, with regard to the information obtained from other websites. These links are provided for your convenience and for navigational purposes only. They should not be considered a recommendation to buy or sell any securities. It should not be assumed that investment in the securities identified has been or will be profitable.
By clicking on the „I Agree” button, you acknowledge that you have read and understood this disclaimer and wish to proceed.
I Agree
Harding Loevner is not responsible for the content, accuracy, or timeliness and does not make any warranties, expressed or implied, with regard to the information obtained from other websites. These links are provided for your convenience and for navigational purposes only. They should not be considered a recommendation to buy or sell any securities. It should not be assumed that investment in the securities identified has been or will be profitable.
By clicking on the „I Agree” button, you acknowledge that you have read and understood this disclaimer and wish to proceed.
I Agree
Advanced Search
Harding Loevner > Insights > Out of Our Minds
Active Management
-Talking Heads, from the film Stop Making Sense
The following is adapted from our first-quarter report for the International Equity strategy. Click here to read the full report.
This quarter, global investors have had to grapple with heightened US policy uncertainty, most overtly in the realm of trade but in many other areas as well, from military cooperation to health care to the previous administrations’ industrial policy programs. As we cautioned in our fourth quarter 2024 letter, the US political climate has featured policy volatility almost from the outset of the Trump administration. But that chaos has been greater than we imagined, and the vectors of policy shifts have expanded beyond the “tariffs, tax cuts, and deportations” list that we expected.
What hasn’t changed is our view that US policymaking in the new administration bears many of the hallmarks that we’ve come to associate over the last 35 years with emerging markets—and not the best performing ones, either. The erosion of institutional continuity and effectiveness tends to enable more erratic policymaking. This institutional disruption doesn’t just affect the regulatory stability that companies rely on to make long-term investment decisions, it also undermines predictability of enforcing contracts with suppliers, service providers, and customers. Just seven years ago, investors howled when Mexican President López Obrador unilaterally canceled the completion of an already-under-construction Mexico City Airport, leaving contracts unpaid and long-term investment plans disrupted. Now, the US government—reprising a pattern from President Trump’s business career—is terminating both employment contracts and commercial services contracted for various government agencies.
In our third quarter 2024 letter, we wrote about our potential exposure to new US tariffs and asserted—optimistically—that the risks were modest and manageable. That view was shaped by Trump campaign’s focus on China as the key malefactor behind US trade imbalances. That has proven a misjudgment on our part, as early salvos in the new trade war quickly hit China, the US’s primary geopolitical rival, but then were re-targeted at its closest neighbors, Canada and Mexico, and then at its closest allies in Europe. Before the April 2 “reciprocal tariff” shock, the most directly affected company in our International Equity portfolio was Canadian National Railway, a critical freight transport provider that, despite its name, links US states with each other, but of course also connects the US with its largest trading partner, and—no small thing—one of its top export destinations.
Another area of policy more often seen in developing countries than mature democracies is the practice of governments extracting concessions or favors from companies or individuals in exchange for letting them get on with their normal course of business. The recent case of TSMC investing a further US$100bn in the US after being threatened by targeted, ultra-high tariffs is a distasteful example of such a commitment being demanded from a company. Especially a company that had already responded voluntarily (and at large scale) to Biden-era Chips Act incentives, building a new semiconductor fab in Arizona, slated to ramp up high-volume, advanced chip production this year.
Our point here isn’t to dispute the policies1 themselves, but rather to highlight the harm to predictability, and by extension to business confidence, from abrupt, poorly signaled shifts and their frequent reversal (and the reversal of the reversals.) This is not a business-friendly environment. When the rules of the road become increasingly arbitrary, companies—domestic and foreign alike—become less willing to commit capital. Uncertainty undermines both the appetite for investment and the demand outlook that would justify it. While TSMC’s investment commitment garnered headlines, there will be no headlines for the thousands of business projects that quietly get canceled in the US due to rising policy uncertainty. International Equity portfolio holding Air Liquide is already reversing its plans to build four hydrogen gas pipeline hubs in the US due to abrupt (if not entirely unexpected) regulatory shifts by the new administration. Meanwhile, US consumer confidence is falling as inflation expectations rise in anticipation, rationally, of the higher cost for most of the goods consumers want to buy. This does not strike us as a backdrop that supports elevated stock price valuations in the US. The relative outperformance of non-US markets this quarter—the largest quarterly lead over US stocks in fifteen years—offers a taste of how that could play out.
The world economic order that created vast wealth through open trade and cooperation now faces potentially radical disruption as the US reshapes its own role in that order. As stewards of your capital, our task is to see the world as it is, not as we might wish it to be.
From our vantage point as global investors “here at the edge of the stage,” the challenge of protecting and growing our clients’ wealth feels more daunting than usual. The world economic order that created vast wealth through open trade and cooperation now faces potentially radical disruption as the US reshapes its own role in that order. As stewards of your capital, our task is to see the world as it is, not as we might wish it to be, and anticipate the possible consequences of chaotic and self-destructive economic, business, and foreign policies, even when they stop making sense to us.
From a portfolio perspective, our investment process has always prompted us to understand the industry dynamics that affect how companies operate, to grasp and assess the source of a company’s superior profitability, and to have insight whether that source will endure or evaporate easily as foreseeable pressures arise. Thus, we’ve long harbored an aversion to companies whose profits were especially vulnerable, as we once put it, to “the whims of faceless bureaucrats and capricious politicians.” That practice has given us a leg up in parsing our portfolio holdings and potential new investments for companies situated to better avoid the fallout from a damaging trade war, regardless of its origin. That’s no small task given the size and interconnectedness of the global economy, and the central role of the US within it. Our experience of investing across emerging markets has prepared us to find resilient, growing companies that are operating well outside the line of fire of volatile or heavy-handed governments.
A process grounded in identifying and evaluating resilient companies and assessing their growth prospects feels particularly well suited to the moment.
With the entire non-US stock market as our hunting ground for the International Equity strategy, we face an ample opportunity set as we pursue sound investments. A process grounded in identifying and evaluating resilient companies and assessing their growth prospects feels particularly well suited to the moment. Many industry and societal trends transcend the political aims of any single administration, and there are products and services—indeed, entire economies—that will grow regardless of shifting policy priorities elsewhere. Moreover, due to the sustained fashionableness of US investments in recent years, investors can buy such companies at more modest prices than in many years; market volatility will afford yet more opportunities to invest in them at attractive valuations.
1Although we have disputed the wisdom of starting trade wars. For the record, we’re also in favor of greater budget discipline in the US because we’re in favor of the US government avoiding being at the mercy of its creditors and resisting the expediency of resorting to inflation to escape its ballooning debt burden. We favor US Treasuries remaining a low-risk, benchmark investment, a feature at the center of the US’s attraction as a capital market and reserve currency provider, right up there with the trusted rule of law.
1Although we have disputed the wisdom of starting trade wars. For the record, we’re also in favor of greater budget discipline in the US because we’re in favor of the US government avoiding being at the mercy of its creditors and resisting the expediency of resorting to inflation to escape its ballooning debt burden. We favor US Treasuries remaining a low-risk, benchmark investment, a feature at the center of the US’s attraction as a capital market and reserve currency provider, right up there with the trusted rule of law.
What did you think of this piece?
Fundamental Analysis
But the idea that PayPal lost its relevance isn’t true for the millions of people and merchants who do rely on it, especially for online purchases. More than 430 million PayPal accounts made a transaction through the platform in the past year, and it remains the leading digital wallet provider and the one accepted by the most retailers. The company also owns Venmo, a money-transfer app with social-media-like features that is popular with 18-to-29-year-olds, a slightly younger demographic than the PayPal brand targets.
Your perception of who is winning the battle to control your digital wallet is in some way dependent on which smartphone you use and what websites you shop at. Beyond PayPal and Apple Pay, there are Amazon.com’s Amazon Pay, Alphabet’s Google Pay, and Shopify’s Shop Pay, among others, each one fighting for your business. Smartphone ecosystems tend to limit awareness of alternatives to their baked-in services, making it hard for third-party apps that fade in popularity to claw their way back. However, PayPal still has key competitive advantages that may allow the company to reposition its platform as the default choice for more people.
The digital-payments industry is a broad umbrella, comprising everything from consumer services such as digital wallets and peer-to-peer payments to merchant-facing technology that forms the backbone of online shopping, such as merchant acquiring, payment gateways, and payment processing. On the consumer side, digital wallets securely store the same cards found in your physical wallet, while peer-to-peer payment apps such as Venmo are the kind you might use to settle a tab with a friend by wiring them your portion. On the merchant side, a merchant acquirer is an institution that enables retailers to accept credit-card payments. Retailers also need a payment gateway to securely transmit payment information, and a payment processor to authorize and confirm the funds transfer between the cardholder’s issuing bank and the retailer. PayPal is unique because it does all of those things—and nothing else.
Focus is crucial for industries in which consumer habits determine growth. Products and services that become easy routines for people generally see greater usage, resulting in higher revenues; they also have a better chance of holding onto their users even when other good options become available. But for a company to achieve this level of customer loyalty, it must understand its users’ needs and be able to anticipate how those needs might change. The odds of success are likely higher if the product or service is an area of strategic focus. It’s why Spotify, for example, has been able to out-innovate and build a more user-friendly service than Apple Music. Much like music streaming, payments are a small extension of Apple’s core business, while at PayPal, it is the core business. Chief Executive Officer Alex Chriss, who started in late 2023, said at a recent investor presentation that the company is focused on product improvements that should help differentiate PayPal and build habituation among users.
For example, it is applying artificial intelligence to the data it collects from merchants and a shopper’s financial institutions so it can flag which card in their digital wallet would provide the most rewards points or largest discount. PayPal can do this because it is a two-sided network, with both consumers and merchants on its platform. Apple Pay and Google Pay don’t directly partner with merchants or track purchases at the individual product level, so they’re more limited in their ability to offer personalized rewards.
Last year, PayPal also introduced Fastlane, which significantly speeds up the online checkout process by allowing a shopper to skip several steps. No password is needed—Fastlane uses other authentication methods—and the shopper’s billing and shipping information is already securely stored. They can go to their cart and complete the transaction in one click. This is similar to Shopify’s handy Shop Pay functionality. PayPal said in February that 25% of the shoppers using Fastlane were new to PayPal, and more than 50% were PayPal users whose accounts had been inactive.
PayPal is trying to catch up in NFC payments, too. In September, the company began airing a commercial in which Will Ferrell discovers PayPal’s tap-and-go and cash-back features while singing “I want to pay with you everywhere” to the tune of Fleetwood Mac’s “Everywhere.”

Credit: PayPal

The growth that investors would like to see from this push will take some time. By 2027, PayPal aims to have more than 80% of customers globally using its new checkout options, such as Fastlane, Buy Now Pay Later, and Pay with Venmo, up from just 30% in the US currently. Therefore, it expects transaction margin dollars—the percentage the business earns on its gross merchandise value, the total value of goods and services sold through its platform—to grow by more than 10% after 2027, up from the low-single-digit rate that’s estimated for this year.
Whether PayPal can deliver on its long-term promise largely hinges on continued improvements to the convenience of its products and more consumers gaining a sense that PayPal really is everywhere. So far, it appears to be on the right track.
The growth that investors would like to see from this push will take some time. By 2027, PayPal aims to have more than 80% of customers globally using its new checkout options, such as Fastlane, Buy Now Pay Later, and Pay with Venmo, up from just 30% in the US currently. Therefore, it expects transaction margin dollars—the percentage the business earns on its gross merchandise value, the total value of goods and services sold through its platform—to grow by more than 10% after 2027, up from the low-single-digit rate that’s estimated for this year.
Whether PayPal can deliver on its long-term promise largely hinges on continued improvements to the convenience of its products and more consumers gaining a sense that PayPal really is everywhere. So far, it appears to be on the right track.
What did you think of this piece?
Active Management
The transcript, lightly edited for clarity, follows.
Ray Vars: Amidst a lot of the market turmoil this year, I think something that stands out is non-US stocks outperforming the US. A lot of things today rhyme with the last time international embarked on an extended period of outperformance back in 2001: We had just come off the 1990s, a decade of US stocks outperforming, powered by great businesses, great innovation, the internet, all rooted here in the US. Earnings were strong.
We also saw the dollar strengthen for a decade, a couple hundred basis points per year. We saw a big valuation gap open up between US and non-US companies. I recall people saying, “Well, that’s okay. Why bother investing overseas? All the great businesses are here. The US is different.” But, of course, right when everybody decided that, the US went nowhere for a decade and international outperformed.

A lot of things today rhyme with the last time international embarked on an extended period of outperformance back in 2001.

Today, it feels very similar. We’ve had 14 years now of US outperformance driven by great businesses, innovation, and more earnings here. The dollar’s been strengthening for a decade and you see that valuation gap widen again, once again excused by US exceptionalism. Why bother with international companies? All the great businesses are here.
This peaked following the election last year. People said, “Oh wow! The US is going to continue to do well. The dollar’s going to strengthen.” Then we get to this year. Amidst the uncertainty, all of a sudden we’ve seen US stocks fall, international stocks actually go up, and we’ve seen the dollar weaken. The last time we saw the dollar weakening and US stocks falling was back in 2001. The question today is can we continue to see international stocks outperform over the next few years. Let’s walk through some of the reasons we think that might happen.
Apurva Schwartz: Maybe the first thing to talk about is tariffs. We don’t know what the policy will look like, it seems like there are changes every day, but I think tariffs are bad. Bad for companies outside the US and bad for US companies and their potential competitiveness abroad. Globalization has been such a tailwind for the US, for China, but also the world. The wealth effect and the prosperity that’s been generated by companies and countries being cooperative with each other. Interestingly enough, when you look at the last several years and the impact of the first round of tariffs we saw five or six years ago, global trade continues to do well.

Source: Deutsche Bank, Haver Analytics. Reproduced with permission.
Data depicted is IMF DOT export data for last twelve months ending September 2024 compared to the twelve-month period ending September 2017.
Current coverage of world trade represented herein is around 87%. Chart is from the report “Five Fresh Perspectives on Global Trade”
issued December 12, 2024.

I think the question is that as the US pursues a policy of tariffs, and you see retaliatory tariffs on top of that, what does that actually mean?
If global trade is continuing to do well, perhaps you are starting to see the US begin to squander that leading position that it has.
RV: That’s another interesting point, that the global leadership the US has shown—stability of policies, stability of institutions, driving for that change—I think is part of what underpins that idea of US exceptionalism and the premium valuation awarded to some US stocks, why the US dollar is the reserve currency for the world, and also why the dollar has been so strong.

To the extent that there’s some uncertainty around those things and some abdication of that leadership, it feels like that could also be a positive for non-US stocks. You can have that valuation premium evaporate a bit for the US. You could also see what we’ve been seeing today, the dollar continue to weaken.
AS: I think that’s exactly right. If you think about the enthusiasm over Europe today and the outperformance of European markets, it may be as much about people moving away from the US as it is about some changes that are happening in Europe. You have more unity, less regulation going forward, more investment as countries like Germany relax their fiscal constraints, and more monetary support.
The narrative is changing a little bit. Previously Europe was seen as slow moving, bureaucratic, and the European Central Bank behind the Federal Reserve in decision making. Now it feels that Europe is a little bit more on its front foot these days.
When you bring that to the company level, you mentioned this idea of US exceptionalism and the best businesses are found in the US, I acknowledge that earnings growth in US companies has generally been a little bit better, but The Magnificent Seven are very much a double-edged sword today. They drove the concentration of market returns in the US in 2024. But there’s certainly been a reversal of that and the pain in the markets in the US today is quite acute.

RV: Some of that reversal, if we think back over this year, is when DeepSeek announced how strong and how efficient and effective its model was. That news was certainly a shot across the bow of US-based hyperscalers, but I think it also highlights that there is innovation beyond the US.
Even within AI, when we think about who makes all of NVIDIA’s chips, TSMC makes all of them. And what equipment do they use to make it? It’s all from ASML and their extreme ultraviolet lithography (EUV) equipment. Both are near monopolies from a Taiwanese company and a Dutch company. Even the inputs are less well known, like a company called Disco in Japan: They slice, dice, and polish the wafers that are used in making those chips, and have something like a 70% market share. This is a critical niche component to the whole infrastructure and AI supply chain. Again, these are non-US companies.

When we think about who makes all of NVIDIA’s chips, TSMC makes all of them. And what equipment do they use to make it? It’s all from ASML and their extreme ultraviolet lithography (EUV) equipment. Both are near monopolies from a Taiwanese company and a Dutch company.

Even outside of tech, you’ve got a company like Schneider Electric based in France. They do energy management equipment and services and software around that. People thought about it for green energy, but the reality is they’ve got a fantastic and fast-growing business helping build out AI infrastructure. Those AI data centers need very efficient and consistent power, and I think it’s grown to something like 20% of their business from almost nothing not too many years ago.
Health care is another area of innovation outside of the US. Anti-obesity, weight loss drugs have certainly been a focus of markets and the Health Care sector. Novo Nordisk, the Danish company, is the leader. They’re competing today with Lilly. When we look forward, what people are looking for is not just the weight loss but convenience and a better safety profile with fewer side effects.
Lilly has taken to phase three a once daily oral GLP-1 drug. That would certainly be more convenient. But interestingly, the science behind that is from Chugai, a Japanese-based company. And when we think about lower side effects, Roche recently did a deal to co-develop drugs with Zealand, a Danish-based company. It’s still an injectable, but far fewer side effects than Ozempic, Wegovy, and Mounjaro. Again, a lot of innovation for future growth is coming from non-US Health Care companies.
AS: That’s a really good point. When you look at the top 20 cash-flow return-on-investment businesses, you mentioned areas of innovation like Health Care, Information Technology, and Industrials, but there are other sectors as well. You do see a preponderance of high-quality, growing businesses in those sectors outside the US.
If you look at the ACWI benchmark, the US has a large weight, 67% in US and 33% in International. But when you slice it by market cap and look at the number companies greater than US$5 billion in that high-quality growth universe, it’s a very different skew: 73% of the companies in that high-quality growth universe are outside the US. Certainly the monopoly on innovation does not belong to the United States.

RV: Yet it’s still not reflected in valuations. You see the widest gap we’ve seen in 20 plus years, actually ever I think, but it feels like that could close. We’ve listed quite a few different potential positives. If any one of them happen, it feels like that could narrow that gap and lead to some international outperformance, hopefully within rising markets.
It can also be a powerful defense. Diversification in international, if things are going awry, that valuation can provide some support in down markets, along with the quality growth of the businesses. Outperforming in down markets is actually almost more powerful than on the way up. If you think about the magic of math, if a stock falls in half, it has to double to get back to zero.
So international markets could outperform on the way up, but there’s also a good chance that they could provide protection if markets get difficult in the coming years.
AS: That point on downside protection is a good one. I also think it’s worth mentioning, from a style perspective, that growth and value have had very different experiences outside of the US, and growth stocks in the last three years have significantly underperformed to the tune of thirty percentage points unannualized versus value stocks.
To the extent that you’re looking about at international markets and looking where to put that that marginal dollar, I think international growth stocks are pretty interesting right now.
RV: Yes, I think so, too. I think international markets definitely have the potential to perform well over the coming years.
Ray Vars: Amidst a lot of the market turmoil this year, I think something that stands out is non-US stocks outperforming the US. A lot of things today rhyme with the last time international embarked on an extended period of outperformance back in 2001: We had just come off the 1990s, a decade of US stocks outperforming, powered by great businesses, great innovation, the internet, all rooted here in the US. Earnings were strong.
We also saw the dollar strengthen for a decade, a couple hundred basis points per year. We saw a big valuation gap open up between US and non-US companies. I recall people saying, “Well, that’s okay. Why bother investing overseas? All the great businesses are here. The US is different.” But, of course, right when everybody decided that, the US went nowhere for a decade and international outperformed.
A lot of things today rhyme with the last time international embarked on an extended period of outperformance back in 2001.
Today, it feels very similar. We’ve had 14 years now of US outperformance driven by great businesses, innovation, and more earnings here. The dollar’s been strengthening for a decade and you see that valuation gap widen again, once again excused by US exceptionalism. Why bother with international companies? All the great businesses are here.
This peaked following the election last year. People said, “Oh wow! The US is going to continue to do well. The dollar’s going to strengthen.” Then we get to this year. Amidst the uncertainty, all of a sudden we’ve seen US stocks fall, international stocks actually go up, and we’ve seen the dollar weaken. The last time we saw the dollar weakening and US stocks falling was back in 2001. The question today is can we continue to see international stocks outperform over the next few years. Let’s walk through some of the reasons we think that might happen.
Apurva Schwartz: Maybe the first thing to talk about is tariffs. We don’t know what the policy will look like, it seems like there are changes every day, but I think tariffs are bad. Bad for companies outside the US and bad for US companies and their potential competitiveness abroad. Globalization has been such a tailwind for the US, for China, but also the world. The wealth effect and the prosperity that’s been generated by companies and countries being cooperative with each other. Interestingly enough, when you look at the last several years and the impact of the first round of tariffs we saw five or six years ago, global trade continues to do well.
I think the question is that as the US pursues a policy of tariffs, and you see retaliatory tariffs on top of that, what does that actually mean?
If global trade is continuing to do well, perhaps you are starting to see the US begin to squander that leading position that it has.
RV: That’s another interesting point, that the global leadership the US has shown—stability of policies, stability of institutions, driving for that change—I think is part of what underpins that idea of US exceptionalism and the premium valuation awarded to some US stocks, why the US dollar is the reserve currency for the world, and also why the dollar has been so strong.
To the extent that there’s some uncertainty around those things and some abdication of that leadership, it feels like that could also be a positive for non-US stocks. You can have that valuation premium evaporate a bit for the US. You could also see what we’ve been seeing today, the dollar continue to weaken.
AS: I think that’s exactly right. If you think about the enthusiasm over Europe today and the outperformance of European markets, it may be as much about people moving away from the US as it is about some changes that are happening in Europe. You have more unity, less regulation going forward, more investment as countries like Germany relax their fiscal constraints, and more monetary support.
The narrative is changing a little bit. Previously Europe was seen as slow moving, bureaucratic, and the European Central Bank behind the Federal Reserve in decision making. Now it feels that Europe is a little bit more on its front foot these days.
When you bring that to the company level, you mentioned this idea of US exceptionalism and the best businesses are found in the US, I acknowledge that earnings growth in US companies has generally been a little bit better, but The Magnificent Seven are very much a double-edged sword today. They drove the concentration of market returns in the US in 2024. But there’s certainly been a reversal of that and the pain in the markets in the US today is quite acute.
RV: Some of that reversal, if we think back over this year, is when DeepSeek announced how strong and how efficient and effective its model was. That news was certainly a shot across the bow of US-based hyperscalers, but I think it also highlights that there is innovation beyond the US.
Even within AI, when we think about who makes all of NVIDIA’s chips, TSMC makes all of them. And what equipment do they use to make it? It’s all from ASML and their extreme ultraviolet lithography (EUV) equipment. Both are near monopolies from a Taiwanese company and a Dutch company. Even the inputs are less well known, like a company called Disco in Japan: They slice, dice, and polish the wafers that are used in making those chips, and have something like a 70% market share. This is a critical niche component to the whole infrastructure and AI supply chain. Again, these are non-US companies.
When we think about who makes all of NVIDIA’s chips, TSMC makes all of them. And what equipment do they use to make it? It’s all from ASML and their extreme ultraviolet lithography (EUV) equipment. Both are near monopolies from a Taiwanese company and a Dutch company.
Even outside of tech, you’ve got a company like Schneider Electric based in France. They do energy management equipment and services and software around that. People thought about it for green energy, but the reality is they’ve got a fantastic and fast-growing business helping build out AI infrastructure. Those AI data centers need very efficient and consistent power, and I think it’s grown to something like 20% of their business from almost nothing not too many years ago.
Health care is another area of innovation outside of the US. Anti-obesity, weight loss drugs have certainly been a focus of markets and the Health Care sector. Novo Nordisk, the Danish company, is the leader. They’re competing today with Lilly. When we look forward, what people are looking for is not just the weight loss but convenience and a better safety profile with fewer side effects.
Lilly has taken to phase three a once daily oral GLP-1 drug. That would certainly be more convenient. But interestingly, the science behind that is from Chugai, a Japanese-based company. And when we think about lower side effects, Roche recently did a deal to co-develop drugs with Zealand, a Danish-based company. It’s still an injectable, but far fewer side effects than Ozempic, Wegovy, and Mounjaro. Again, a lot of innovation for future growth is coming from non-US Health Care companies.
AS: That’s a really good point. When you look at the top 20 cash-flow return-on-investment businesses, you mentioned areas of innovation like Health Care, Information Technology, and Industrials, but there are other sectors as well. You do see a preponderance of high-quality, growing businesses in those sectors outside the US.
If you look at the ACWI benchmark, the US has a large weight, 67% in US and 33% in International. But when you slice it by market cap and look at the number companies greater than US$5 billion in that high-quality growth universe, it’s a very different skew: 73% of the companies in that high-quality growth universe are outside the US. Certainly the monopoly on innovation does not belong to the United States.
RV: Yet it’s still not reflected in valuations. You see the widest gap we’ve seen in 20 plus years, actually ever I think, but it feels like that could close. We’ve listed quite a few different potential positives. If any one of them happen, it feels like that could narrow that gap and lead to some international outperformance, hopefully within rising markets.
It can also be a powerful defense. Diversification in international, if things are going awry, that valuation can provide some support in down markets, along with the quality growth of the businesses. Outperforming in down markets is actually almost more powerful than on the way up. If you think about the magic of math, if a stock falls in half, it has to double to get back to zero.
So international markets could outperform on the way up, but there’s also a good chance that they could provide protection if markets get difficult in the coming years.
AS: That point on downside protection is a good one. I also think it’s worth mentioning, from a style perspective, that growth and value have had very different experiences outside of the US, and growth stocks in the last three years have significantly underperformed to the tune of thirty percentage points unannualized versus value stocks.
To the extent that you’re looking about at international markets and looking where to put that that marginal dollar, I think international growth stocks are pretty interesting right now.
RV: Yes, I think so, too. I think international markets definitely have the potential to perform well over the coming years.
What did you think of this piece?
Fundamental Analysis
L’Oréal, based in France, is the world’s largest maker of cosmetics, with about a 13% share of the global market. Some of the century-old company’s best years were just before the COVID-19 pandemic, as demand soared for luxury skincare products, particularly among young consumers in China. But growth in the beauty industry has slowed since the pandemic, and the main reason for that slowdown is China, where economic struggles have weighed on consumer spending. While nearly 30% of L’Oréal’s sales came from North Asia in 2021, that figure shrank to 24% last year.
L’Oréal also benefited from a subdued competitive environment during the pandemic. Virus-related disruptions resulted in fewer new brands entering the market, and its rivals held off on new product launches. These conditions enabled L’Oréal to increase its sales at 1.7 times the rate of the industry. Now, its growth is settling back to its pre-pandemic level of around 1.2–1.3 times the industry rate.
But global beauty sales are still expected to increase 4.5% this year, compared with a rate of 5% for the years leading up to the pandemic. And L’Oréal is still outpacing the industry—the company’s sales climbed 5.1% in 2024.
Shares of L’Oréal command a sizable premium over other European Consumer Staples stocks, and that gap has widened in recent quarters. For example, Bloomberg data show that L’Oréal’s forward price-to-earnings ratio is more than 50% higher than the average for European staples. Some analysts focused on the European sector thus view L’Oréal’s valuation as relatively expensive and have turned bearish on its stock.
However, that narrow lens is less relevant to a global investor. When you expand an analysis of L’Oréal’s valuation to include US companies, it starts to look more interesting.
For a long time, the average price-to-earnings ratios for US and European Consumer Staples stocks tended to trace each other—until the end of 2023, when their valuations began to diverge. US Consumer Staples are now much more expensive than their European counterparts.

Source: FactSet.

Consider now that the most significant contributors to the orange line above are companies focused on food and household products. Those are slower-growing markets that, unlike beauty, haven’t yet resumed their pre-pandemic pace.
Therefore, five years after the COVID-19 virus shut down the global economy, L’Oréal’s benchmark is looking worse, but its own business appears to be unchanged from before the pandemic. No wonder it trades at a premium.
Consider now that the most significant contributors to the orange line above are companies focused on food and household products. Those are slower-growing markets that, unlike beauty, haven’t yet resumed their pre-pandemic pace.
Therefore, five years after the COVID-19 virus shut down the global economy, L’Oréal’s benchmark is looking worse, but its own business appears to be unchanged from before the pandemic. No wonder it trades at a premium.
What did you think of this piece?
Fundamental Analysis
The equinox is just one of the myriad holidays that shut down the capital markets in Japan. There are national holidays to celebrate the young, the old, the mountains, the sea, emperors, equinoxes, culture, and trees. The Tokyo Stock Exchange will close for 18 different holidays in 2025. No other major exchange closes for as many individual holidays.
The pan-Europe Euronext exchanges will close for only six holidays. Stock exchanges in London and Frankfurt are closing for eight. The New York Stock Exchange is closed for ten holidays. Each of those holidays comprise only one trading day. The Shanghai Stock Exchange closes for seven national holidays, but is closed for 18 trading days, including six for Chinese New Year in January and February and five for National Day in October. The Hong Kong Stock Exchange closes for 13 holidays that stretch across 15 trading days.
Japan’s holidays reflect the nation’s traditional cultural history and, in particular, its indigenous religion, Shinto, in which nature is a large focus. But the heavy schedule of holidays is also in some ways a counter-balance against Japan’s business culture. Japanese workers are so driven that they tend to not take paid vacation days. Last year, the average Japanese worker left seven of 19 paid vacation days unused, according to a report from Expedia. In France and Germany, it was only two. In the US and Canada, it was one. The Japanese work so much, in fact, they even have a word for it: karoshi, which translates as “overwork death.” The numerous holidays are a forced protection against karoshi.
There are holidays that are also celebrated globally such as New Year’s Day, and Japan has its own version of Labor Day and Thanksgiving called Labor Thanksgiving Day (essentially combining the two holidays into one). But there are many holidays that are unique to Japan. Here’s a list of them, and the dates that they fall on in 2025:

January 13: Coming of Age Day, which is set aside to congratulate and encourage people as they reach adulthood.
February 11: National Foundation Day celebrates the mythological founding of Japan and the accession of its first emperor in 660 BCE. The 2025 edition, therefore, celebrated the 2,685th anniversary of Japan’s founding.
April 29: Showa Day is set aside to honor the Emperor Showa (Hirohito), Japan’s longest serving emperor, who ruled from 1926 to 1989.
May 5: The very young get their own day, Children’s Day.
July 21: On Marine Day, the island nation takes a day to show appreciation for the ocean.
August 11: Mountain Day is set aside to honor the archipelago’s mountains. Fully 80% of Japan is made up of mountains, which means most of its 124 million citizens live in small, tiny flat areas such as Tokyo and Osaka, making them among the most crowded metropolitan areas in the world.
September 15: As children and children coming of age get their own day, Respect for the Aged Day is set aside to honor the nation’s elderly.
September 23: The exchange closes for the Autumnal Equinox, but this holiday has an interesting history. Before World War II, it was a Shinto holiday to honor and respect family ancestors. The post-war era saw the holiday split from its religious background, just as the state and religion were separated, but some families still pay a visit to family graves, clean them up, offer flowers, burn incense, and pray.
October 13: Sports Day commemorates the opening of the 1964 Summer Olympics, held in Tokyo.
November 3: Culture Day is celebrated with 300,000 different matsuri, or festivals, focused on the nation’s arts and culture. Top-ranking matsuri are known to mobilize several million people and contribute up to 1% of GDP for some the country’s regional prefectures. Almost every shrine holds its own festival, many of them going as far back as several hundred years.
Japan’s holidays reflect the nation’s traditional cultural history and, in particular, its indigenous religion, Shinto, in which nature is a large focus. But the heavy schedule of holidays is also in some ways a counter-balance against Japan’s business culture. Japanese workers are so driven that they tend to not take paid vacation days. Last year, the average Japanese worker left seven of 19 paid vacation days unused, according to a report from Expedia. In France and Germany, it was only two. In the US and Canada, it was one. The Japanese work so much, in fact, they even have a word for it: karoshi, which translates as “overwork death.” The numerous holidays are a forced protection against karoshi.
There are holidays that are also celebrated globally such as New Year’s Day, and Japan has its own version of Labor Day and Thanksgiving called Labor Thanksgiving Day (essentially combining the two holidays into one). But there are many holidays that are unique to Japan. Here’s a list of them, and the dates that they fall on in 2025:
What did you think of this piece?
Fundamental Analysis
But Novo Nordisk isn’t the only company in the neighborhood that uses the alchemy of fermentation science to turn microbes into high-demand products. It isn’t even the only Novo.
Just around the corner from the cauldrons of Ozempic is another facility, where three-story fermentation tanks are similarly filled with bacteria and fungi multiplying by the millions in a nutrient-rich broth. The enzymes that get secreted are eventually used by dozens of industries to make everything from food and laundry detergents to biofuel and medicines. The Novo that produces and sells these enzymes is Novonesis.
The similarity in the names isn’t a coincidence. That’s because, until 2000, the two Novos were one company. More than two decades after their corporate breakup, their headquarters, some labs, and production plants remain near one another (and both businesses continue to be controlled by a holding company for the Novo Nordisk Foundation).
“Novo” is Latin for new, and that’s what industrial enzymes were in the 1940s, when the original company introduced its first enzymatic products—one used to clean leather hides before they are tanned, and another for textile desizing, in which amylase breaks down starch agents to prepare fabrics for dyeing. The company was also a pioneer in synthetic biology, launching its first enzyme derived from genetically engineered microorganisms in 1987; lipase is still used today in detergents to help remove stains deposited by a greasy burger or pizza, and some of Novonesis’s biggest customers are Procter & Gamble and Unilever.
Enzymes are proteins that act as catalysts to speed up chemical reactions. For example, they are naturally found in the stomach and help break down food into tiny particles that can be converted into energy. In industrial settings, they are used as a substitute for harsh chemicals, which tend to require higher temperatures and pressure to carry out the necessary reactions. The use of enzymes also prevents unwanted reactions, as each type of enzyme binds only to specific molecules, thus leaving behind less waste than traditional chemicals that could give off hazardous byproducts. And industrial enzymes are a good business: While they comprise a small portion of a manufacturer’s overall cost of goods sold, the switching costs can be high, which gives enzyme suppliers pricing power over their customers. This is especially true for Novonesis, given that it is the dominant player in the oligopolistic niche market.
Another source of strength for Novonesis is its research-and-development strategy. The company has historically spent much more on R&D as a percentage of sales than competitors such as DuPont, DSM, and BASF, and that investment has produced a number of important products and thousands of patents over time. In 2024 alone, Novonesis introduced 45 new products, and 30% of its revenue comes from products launched in the past five years.
Novonesis recently acquired its Danish competitor, Chr. Hansen, which supplies bacteria cultures and probiotics used in products such as yogurts. (The US$12.3 billion deal closed last year.) There are product-level advantages to putting the companies together. For example, adding protein to yogurt changes the texture and taste, but Novonesis can now combine products to better address those issues. Management has said it sees similar synergistic opportunities around food preservation for baked goods.
Revenue growth had been bumpy for Novonesis over the past decade, but recently it has gained positive momentum. Pro-forma sales climbed 5% in 2024 (8% when excluding the negative effects of currencies and acquisitions), and the company projects organic sales growth of 5% to 8% this year. The long-term outlook also looks attractive because there remains a significant opportunity for enzymes to displace chemical additives in industrial production processes. The clearest example is detergents, as producers emphasize products that are more water efficient, enable washing machines to run at lower temperatures, and use fewer harsh chemicals. An expanding middle class in emerging markets could also increase the demand for better household-cleaning products.
It’s also at lower US tariff risk than some other European companies, given that Novonesis has R&D and production facilities in the US, and most of its demand there is fulfilled by local production.
It may not be one of the companies shaking up the splashy market for weight-loss solutions, but Novonesis happens to possess a lot of the traits that investors admire about its better-known sibling: cutting-edge research that allows it to succeed in high-growth markets. For Novonesis, that growth strategy is beginning to bear fruit.
What did you think of this piece?
Fundamental Analysis
This is helpful to society because it allows that capital to be recycled and put to productive use by consumers and businesses. But lending borrowed money comes with several different kinds of risk. Most notably, there is credit risk, where borrowers fail to pay back loans to the bank. Duration risk comes when long-term interest rates on the loans and securities are low but short-term rates are rising; the banks therefore can sell assets only at a loss (i.e., the assets are “underwater”) and cannot afford to pay the new, higher rate of interest that depositors demand. And liquidity risk hits when a bank’s assets are still worth more than its liabilities, but the depositors want their money right now and the loans won’t be paid back for some time. In other words, the money is tied up. As George Bailey explained in the famous bank-run scene in It’s a Wonderful Life, “The money’s not here. Well your money’s in Joe’s house, that’s right next to yours, and in the Kennedy house and Mrs. Mayklin’s house and a hundred others.”
Each of these risks have sunk banks in recent years. During the 2008 financial crisis, many banks failed because of credit risk when borrowers defaulted on their mortgages. In 2023, Silicon Valley Bank, Signature Bank, and then First Republic Bank all collapsed when duration risk fears sparked bank runs (to be clear, they were not the only banks with underwater assets, they were the only banks to suffer a run). And liquidity risks often come up when there are already other problems, such as the bank run at Washington Mutual that turned long-term issues into an immediate crisis and the largest bank failure in US history.
Regulators create rules to keep banks and their management teams from taking too much risk, but it is only a partial solution. No amount of regulation can force banks to make only good loans. So, one idea that’s been getting some attention recently is that maybe banks shouldn’t make loans at all. A “narrow bank” would take in deposits and provide payment services but wouldn’t make loans or take credit risk. Instead, it would hold all the cash it brought in as deposits at the central bank or buy short-term government bonds, meaning that there is basically no credit risk. There is almost no duration risk because the assets are short term or even overnight, like the deposits. And there is no liquidity risk because the assets are cash (or as liquid as non-cash assets can be).
To my knowledge, none of the tens of thousands of banks around the world operate this way. In part, that is because the regulators who are supposed to keep the current banking system safe don’t seem to trust the idea. In February 2024, for example, the Fed rejected the application of a bank called The Narrow Bank, which had been trying to secure a banking license for nearly a decade. Indeed, some have even argued that narrow banks actually make the system less secure. Because a narrow bank would be so secure, depositors, during a panic, might move their money away from conventional, risk-taking banks to narrow banks, exacerbating the crisis.

Today, the closest company to a narrow bank anywhere in the world isn’t even a bank. Wise is a financial-services firm with more than 11 million customers that started as an international money transfer service. Wise lets customers leave their money inside of the service as a pseudo deposit, similar to keeping money in Venmo or Cash App. Many customers who travelled frequently or did a lot of international business realized it was more convenient to leave their money with Wise than constantly shift it in and out of local banks. Today, Wise holds about £16 billion in deposits on behalf of its customers, investing the money in government bonds and other low-risk assets (see chart). And in fiscal 2024, it made £360 million in net interest income on those deposits, compared to £1 billion from its main business.
For large depositors, Wise could be safer than a traditional FDIC-insured bank even though it is not one itself. A small business in the US with US$5 million deposited at a bank is insured only up to US$250,000 by the FDIC.

Unlike banks, Wise does not lend out its customers’ money but instead holds it in cash or cash-like, safe assets.

Source: Wise PLC. and Harding Loevner analysis.

The other US$4.75 million is at risk in a bank failure. So, what is really safer, a regulated bank taking on credit, duration, and liquidity risks, or a less-regulated payments company that just holds onto cash? Its customers have decided that Wise’s approach is at least good enough for them.
But Wise also highlights some of the weaknesses of narrow banks. Without taking on any risk, it is difficult to generate any kind of return. Until interest rates started rising in 2022, it made effectively no money on its deposit-taking operation. It was just for customer convenience so that Wise could make more money on fees from its other services. Commercial banks don’t rely on fees; most of them are primarily lenders that make most of their revenue from net interest income and offer some services on the side. Rates could fall to zero again, and that revenue stream of hundreds of millions of pounds per year could disappear—Wise cannot rely on it.
As ever, there are some wrinkles. Wise doesn’t claim to be a narrow bank. Someday, it could get a banking license and start making loans. And its international business adds a new currency risk because its assets do not perfectly match its liabilities’ currencies. A kibitzer could also point out that it doesn’t hold only cash at central banks and short-term government debt. Wise doesn’t disclose exactly what is in its securities portfolio, so some of it could be corporate debt. And it deposits money at commercial banks that puts them in the same fractional reserve banking system that narrow banks are supposed to avoid. But these are molehills. Ninety percent of the deposits are in US dollar, British pounds, and euros, and they are closely matched. Banks can fail, but that is much less common than borrowers failing to repay a loan, and even if there are a few corporate bonds in there, a sliver of the funds being lent to investment-grade corporate borrowers is much lower risk than any conventional commercial bank.
On the whole, Wise is the narrowest and one of the safest banks in the world. Without being a bank at all.
Today, the closest company to a narrow bank anywhere in the world isn’t even a bank. Wise is a financial-services firm with more than 11 million customers that started as an international money transfer service. Wise lets customers leave their money inside of the service as a pseudo deposit, similar to keeping money in Venmo or Cash App. Many customers who travelled frequently or did a lot of international business realized it was more convenient to leave their money with Wise than constantly shift it in and out of local banks. Today, Wise holds about £16 billion in deposits on behalf of its customers, investing the money in government bonds and other low-risk assets (see chart). And in fiscal 2024, it made £360 million in net interest income on those deposits, compared to £1 billion from its main business.
For large depositors, Wise could be safer than a traditional FDIC-insured bank even though it is not one itself. A small business in the US with US$5 million deposited at a bank is insured only up to US$250,000 by the FDIC.
The other US$4.75 million is at risk in a bank failure. So, what is really safer, a regulated bank taking on credit, duration, and liquidity risks, or a less-regulated payments company that just holds onto cash? Its customers have decided that Wise’s approach is at least good enough for them.
But Wise also highlights some of the weaknesses of narrow banks. Without taking on any risk, it is difficult to generate any kind of return. Until interest rates started rising in 2022, it made effectively no money on its deposit-taking operation. It was just for customer convenience so that Wise could make more money on fees from its other services. Commercial banks don’t rely on fees; most of them are primarily lenders that make most of their revenue from net interest income and offer some services on the side. Rates could fall to zero again, and that revenue stream of hundreds of millions of pounds per year could disappear—Wise cannot rely on it.
As ever, there are some wrinkles. Wise doesn’t claim to be a narrow bank. Someday, it could get a banking license and start making loans. And its international business adds a new currency risk because its assets do not perfectly match its liabilities’ currencies. A kibitzer could also point out that it doesn’t hold only cash at central banks and short-term government debt. Wise doesn’t disclose exactly what is in its securities portfolio, so some of it could be corporate debt. And it deposits money at commercial banks that puts them in the same fractional reserve banking system that narrow banks are supposed to avoid. But these are molehills. Ninety percent of the deposits are in US dollar, British pounds, and euros, and they are closely matched. Banks can fail, but that is much less common than borrowers failing to repay a loan, and even if there are a few corporate bonds in there, a sliver of the funds being lent to investment-grade corporate borrowers is much lower risk than any conventional commercial bank.
On the whole, Wise is the narrowest and one of the safest banks in the world. Without being a bank at all.
What did you think of this piece?
Fundamental Analysis
At Harding Loevner, we believe the best investment decisions are informed by firsthand research, direct conversations with managers and engineering teams, and understanding how industries evolve in real time. That’s why Portfolio Manager and Communication Services Analyst Uday Cheruvu, CFA, recently traveled across Western Europe to attend a series of events including the Semicon Europa trade show and the Morgan Stanley Technology, Media, and Telecom conference. Over two weeks, he engaged with industry executives, engineers, suppliers, and other experts to gain deeper insight into how innovative companies differentiate their products.
From learning how SAP’s software is perceived by its IT-services partners, to seeing the unique technology that forms Keyence’s competitive advantage in automation, Uday shares his key takeaways from the trip.
What did you think of this piece?
Fundamental Analysis
And yet, Walmex plans to appeal the verdict by Mexico’s antitrust watchdog, the Federal Economic Competition Commission, or Cofece. To understand why the company wasn’t happy with a minor financial burden—Walmex earned US$657 million in the third quarter of 2024 alone—you need to understand how retailers such as Walmex make their money.
The investigation began after Chedraui, the third-largest retail chain in Mexico, accused Walmex of abusing its market power, using its size to coerce suppliers into giving it better prices and terms than they could to competitors, especially smaller ones. A Reuters story amplified the claims of pressuring suppliers, finding that some of those suppliers removed their products from Amazon as a result of Walmex’s pressure. Cofece’s investigation concluded that Walmex abused its position over the course of 13 years and broke anti-monopoly laws in the process.
The common assumption with big retailers such as Walmex is that their power and profits are a result of their scale and ability to lower prices on products that will attract and keep customers. And that is true and well understood. But what is not well understood is how its scale gives the company that power. Retailers don’t make their money on consumers. They make it on suppliers.
There is an intricate game between retailers, suppliers, and customers. Customers have bargaining power with retailers, because they will go wherever prices are the best. Therefore retailers have little bargaining power with their customers—but can have a lot of bargaining power with suppliers. Successful retailers become the conduit to customers and therefore gain an advantage over their suppliers. Retailers use that bargaining power to force terms from suppliers that advantage the retailers, and offset the retailers’ weak bargaining power against fickle buyers. What Cofece concluded was that Walmex was abusing that power.
The Cofece ruling imposed a ban against some of Walmex’s practices, such as retaliating against suppliers based on their contracts with other retailers. That should raise the bargaining power of suppliers against Walmex. The impact, though, is hard to predict. If the ruling stands, it would effectively reduce Walmex’s competitive advantages, which would hurt the bottom line. That won’t be an issue if it wins on appeal, though it will likely be several years for that to play out.
In the meantime, there are two wrinkles. For one thing, Cofece, in its oversight role, will determine whether the company is violating the ruling. For example, the ruling does not appear to ban volume-based discounts. But if Walmex demands a 50% discount from a supplier on, say, 10 million units of an item, will that constitute a violation? For now, only Cofece gets to answer that question. Moreover, the ruling applies specifically and only to Walmex. In effect, Cofece is raising the bargaining power of suppliers…against Walmex only.
That is the real reason Walmex is appealing the ruling rather than just paying the small fine and moving on. Because ultimately what makes a retailer successful is the leverage it holds over its suppliers, not its customers.
What did you think of this piece?
Fundamental Analysis
R1, as the model is called, is an open-source, advanced-reasoning model—the kind that is designed to mimic the way humans think through problems. It was developed by DeepSeek, whose founder, Liang Wenfeng, reportedly accumulated 10,000 of NVIDIA’s graphics processing units (GPUs) while at his quantitative hedge fund, which relied on machine-learning investment strategies. The kicker: DeepSeek says it spent less than US$6 million to train the model that was used as a base for R1—a fraction of the billions of dollars that Western companies such as OpenAI have spent on their foundational models. This detail stunned the market and walloped the share prices of large tech companies and other parts of the burgeoning AI industry on January 27.
The knee-jerk reactions are a reminder that we are still in the early stages of a potential AI revolution, and that no matter the conviction some insiders and onlookers may seem to have, no one knows with certainty where the path will lead, let alone how many twists and turns the industry will encounter along the way. As more details become available, companies and investors will be able to better assess the broader implications of DeepSeek’s achievement, which may reveal that the initial market reaction was overdone in some cases. However, should DeepSeek’s claims that its methods lead to dramatic improvements in cost efficiency be substantiated, it may actually bode well for the adoption of AI tools over time.
Although the techniques employed by DeepSeek are not entirely new, the company’s execution is considered extraordinary for how it significantly reduced training and inference costs. The company reportedly not only used fewer and less-powerful chips but also trained its model in a matter of weeks. There is considerable debate regarding the accuracy of the roughly US$6 million training cost figure that has been reported as well as speculation that DeepSeek may have utilized rival models such as Meta Platforms’ Llama, Alibaba’s Qwen, and OpenAI’s GPT-4 in a process known as distillation to create a student model. Therefore, it may be that the true training cost of DeepSeek’s model is understated.
There is the risk that more efficient AI models may reduce the growth rate of demand for computing power and, in turn, the pace of investment in AI infrastructure. But while investors seem to have equated improved efficiency with a diminished need for AI infrastructure, the history of technology shows that better performance and lower costs typically lead to wider adoption and faster growth over time. AI could follow the same trajectory.
Among the likely beneficiaries of cheaper, more efficient AI are the software providers building applications on top of these models. As more users discover the advantages of AI, increased demand for user-facing software also helps the cloud-services companies that provide the computing power and data storage. However, the commoditization of large language models may negatively affect creators of these models, particularly those that have eschewed open-source technology.
Also, greater computing efficiency may lead to higher volumes of cloud data and thus the need for more data centers and electrical power over time. This would benefit infrastructure providers on the condition that higher demand more than offsets price declines.
The field of AI is still evolving, and further advances in the technology and the methods for developing it are likely. Innovation is always disruptive, but on the whole, DeepSeek’s breakthrough would seem to be a good sign for the industry.
What did you think of this piece?
Active Management
In fact, Vietnam is the only FEM that has become one of the ten largest trading partners with the US. While there are other EM countries, such as Mexico, Taiwan, and India among the top-ten US trading partners, Vietnam has grown a significant trade surplus with the US, due in part to companies rerouting shipments through the country as supply chains have adjusted over the past several years, especially in the wake of disruptions during the COVID-19 pandemic.
The chart above also shows China’s outsized trade surplus with the US and underscores how global trade has not stopped due to shifts in US policy since the first Trump election in 2016. What has happened is that global trade has evolved over the last eight years, especially with respect to emerging markets, despite tariffs under both the Trump and Biden administrations.

China, one of the primary targets of US tariffs, has simply rerouted its exports. Some of the biggest growth in global trade volumes has come from both the US’s and China’s increase in trade with EMs. Trade between EMs is growing as well. And the current account balances of important export-oriented EMs such as Mexico, Taiwan, South Africa, and Indonesia are significantly better than they were eight years ago, providing these economies with a larger cushion against volatility in global trade.
The chart above also shows China’s outsized trade surplus with the US and underscores how global trade has not stopped due to shifts in US policy since the first Trump election in 2016. What has happened is that global trade has evolved over the last eight years, especially with respect to emerging markets, despite tariffs under both the Trump and Biden administrations.
China, one of the primary targets of US tariffs, has simply rerouted its exports. Some of the biggest growth in global trade volumes has come from both the US’s and China’s increase in trade with EMs. Trade between EMs is growing as well. And the current account balances of important export-oriented EMs such as Mexico, Taiwan, South Africa, and Indonesia are significantly better than they were eight years ago, providing these economies with a larger cushion against volatility in global trade.
What did you think of this piece?
Fundamental Analysis
Momentum strategies were a powerful force for global equities in 2024, primarily ones that followed artificial intelligence (AI) and its extended value chain. The trend was particularly acute in emerging markets (EMs).
For the calendar year, virtually all of the returns in the MSCI EM Index could be traced to just five stocks, led by TSMC, which on its own contributed nearly half of the index’s return. The dominance of these stocks was most evident in the fourth quarter. Every sector except Information Technology fell, and the only regions that rose were the Middle East, which eked out a small gain, and Taiwan, home to a number of prominent tech stocks including TSMC (the “T” stands for Taiwan.)
TSMC rocketed on surging demand for AI-related chips and a seemingly unassailable leadership position in the industry following failed attempts by competitors to take market share in advanced process technologies. The company has more than 80% market share in leading-edge semiconductors globally and fabricates almost all of the chips designed by NVIDIA. TSMC expects AI-related revenue to grow at a cumulative rate of 50% over the next five years.
Hon Hai Precision, the giant Taiwanese electronics contract manufacturer, also saw its shares soar as growth prospects have been boosted by the demand for AI servers. The other top-five contributors, however, came from China and outside the AI-momentum trade: Tencent, Meituan, and Xiaomi.
What did you think of this piece?
Active Management
The US dollar’s rise since September cut into international markets. Of the 7% decline in international markets in the fourth quarter, the vast majority of it can be attributed to currency depreciation against the dollar.
For countries facing harsh new tariffs from the US, weakening the currency is a highly rational response: What tariffs take away in competitive pricing from other countries, currency depreciation restores with little cost to the domestic economy, keeping products competitive in the destination market. In other words, currency depreciation negates the disinflationary effects of a strong dollar as offsets to the inflationary effects of tariffs.
If a country has few other considerations (such as high foreign debts), that trade-off is fairly painless and blunts the potency of the tariffs to alter any other policy or behavior. So far that’s not what you see in this recent spate of currency depreciation: The two countries currently facing the severest threats from additional US tariffs are China and Mexico, but neither of those currencies exhibited much weakness during the fourth quarter as seen in the above chart. However, in the longer term, we think currency depreciation may not be such a bad thing for the US’s trading partners.
What did you think of this piece?
Fundamental Analysis
By now, it is clear to most investors that the companies benefiting from the move to artificial intelligence (AI) include more than just a couple of chipmakers. One analogy for the increasing size and breadth of the AI industry is a tsunami: As the wave of corporate investment in AI builds, and the underlying hardware, foundational machine-learning models, and early-stage software applications all continue to improve, a broader set of tech providers has been able to benefit from the associated demand.
For example, Alphabet and Meta are among large cloud-services companies—also known as “hyperscalers”—that are building both the physical infrastructure and large-language models that are needed for AI technologies to be adopted by corporations more broadly. While the servers in their data centers continue to require powerful graphics processing units designed by NVIDIA and manufactured by TSMC, these hyperscalers are also designing their own custom chips, called application-specific integrated circuits (ASICs), which they are developing in partnership with chipmaker Broadcom, boosting that company’s growth outlook as well.
Advances in AI technology are also benefiting enterprise-software providers, as the rise of agentic AI in the fourth quarter brought the long-term promise of computers with human-like problem-solving capabilities into sharper focus. Agentic AI is capable of sophisticated reasoning and can automatically come up with ways to solve complex, multi-step problems—a significant step forward by models such as OpenAI’s o3 and Google’s Gemini 2 as compared to the more limited tasks performed by the previous generation of AI technology. Therefore, agentic AI is likely to be more broadly useful in business software, with companies such as Salesforce and ServiceNow well positioned to offer powerful tools based on this technology. At a recent event in San Francisco, Salesforce Chief Executive Officer Mark Benioff said the company is focused on its agentic-AI platform, Agentforce, adding, “The only thing we’re going to do at Salesforce is Agentforce.”
What did you think of this piece?
Fundamental Analysis
Chinese consumers have, through necessity, become very price conscious. Pingti, which translates literally to “horizontal replacement,” refers to a consumer buying a cheaper product that does the same thing as a more expensive one. Trading down, as we might say in the US. In the language of Porter forces that we use to analyze industry dynamics at Harding Loevner, it is new entrants matching the functionality of incumbents such as Adidas at better prices, leading to a more intense rivalry between companies.
And pingti is easy to do. There are websites, such as 1688.com (part of Alibaba) or Made-in-China.com, originally set up for manufacturers and exporters to do business with their wholesale buyers. Since most of the manufacturer supply chains are in China, it is therefore relatively easy for consumers to find cheaper versions of products from retailers such as Adidas, Li Ning, and others. All a consumer needs do is find an item they like in a store, look at the label to see who manufactured it, and go find the lower-priced, off-brand versions online.
“Customer mindsets have changed considerably in Mainland China in the post-COVID era,” Pan Ning, the chief executive of the Chinese division of Japan’s Uniqlo, said in July. “We are seeing a new set of consumer values centered on pingti.” The trend has been especially sharp among the younger generations, he said. Given its focus on low-priced goods, Uniqlo could also be seen as a beneficiary of the trend, which would help explain why its performance held up better in China than some other retailers.
Adidas has been adapting. The company has been expanding aggressively into lower-tier cities, where it is selling more-affordable versions of its products. It has also, as much as possible, tried to organize its Chinese operation as if it was a local company. The company has teams that are focused on discerning what local buyers want, and building products based on those insights. Once they come up with those ideas, the product designs are approved by the China team, not the home office back in Germany. The efforts appear to be yielding results. Its sales in China rose 9% in the third quarter of 2024, to about US$1 billion, its best quarter since the beginning of 2022.
While pingti was sparked by the economic downturn, it may outlast the eventual recovery. Chinese consumers have become more sophisticated. They no longer view price and brand as the sole markers of quality. Increasingly, they are seeing that lower-cost products can have the same essential quality. A good example of this is the Japanese brand Mont-bell, which has been opening new stores and expanding its presence in China. Mont-bell is a well-known replacement for Arc’teryx, the premium brand owned by Anta.
This dynamic doesn’t have a catchy name in the US, but pingti has been visible here: off-price retail stores operated by TJX such as TJ Maxx and Marshalls saw sales rise after the 2008 financial crisis. Even as the economy recovered after the crisis, those new customers stayed loyal and that outcome may hold in China, too. For that reason, manufacturers and retailers in China may have to account for the trend even after the economy eventually rebounds.
What did you think of this piece?
Fundamental Analysis
It’s tempting to think that a new CEO can reshape a business overnight. Yet investors often overlook how the timing of a CEO’s appointment is a factor in that person’s ability to steer the company in a new direction. While a CEO controls key decisions—pertaining to hiring, spending, corporate strategy, and workplace culture—those efforts can only gain traction if the company is one in which change is possible. And that isn’t meant to be an abstract observation. Rather, a company’s susceptibility to change is partly reflected in a quantifiable metric found in every 10-K filing: its asset life.
Asset life is the estimated duration over which a company’s assets remain useful to the business. Assets can be physical structures, such as property, plants, and equipment, but they can also be intangible, such as investments in research and development. By examining average asset life, investors can gauge how long capital expenditures made in the past will continue to shape the company’s capabilities and cash flows. Shorter asset lives allow new leadership to shift investment priorities relatively quickly. Conversely, longer asset lives mean that earlier investments remain in place for years or even decades, limiting the new CEO’s ability to quickly implement large-scale changes.
A related metric is the ratio of net property, plant, and equipment (PPE) to gross PPE. A high ratio indicates the outgoing CEO heavily invested in the company’s facilities and equipment. A declining ratio suggests that the outgoing CEO invested little to maintain or upgrade them—or as some might say, management was “sweating the assets.” The latter scenario constrains the next CEO’s ability to implement significant changes. Think of it as the difference between buying a well-maintained house and one needing extensive repairs: The same renovation budget would achieve far more in the well-maintained house, while at the fixer-upper the money would need to be used for necessary but less exciting projects.
Take Intel as an example. Once the leading chip designer and manufacturer, the US company has fallen behind rivals such as NVIDIA and TSMC. Its CEO was pushed out in December, and shareholders are hopeful that his replacement can restore Intel to its prominence. The challenge is that Intel is not easily changeable. Chipmaking is intricate and capital intensive, and the process relies on specialized tools, machinery, and facilities that last for many years. According to its filings, Intel’s manufacturing assets can remain in service for up to eight years, with some facilities lasting over two decades. Despite recent capital investments, the net-to-gross PPE ratio hasn’t dramatically improved, suggesting legacy infrastructure still defines the firm’s capabilities. A quick pivot is tough.
The other question to ask about an incoming CEO is whether change at the company would be a good or bad thing. Generally speaking, change is more welcome for a business that is in a position of weakness, such as Intel, than one that is in a position of strength, such as Schneider Electric. Schneider’s competitive edge in providing electrical solutions continues to be a source of sustained profitable growth, particularly as it sees heightened demand from data-center customers. While the industrials company replaced its CEO in November, investors are unlikely to want drastic changes. Fortunately, with Schneider’s long-lived assets providing operational consistency, the new CEO has limited room—or need—to meaningfully change things.
Consider the potentially very different implications of a new CEO for a company such as Intel compared with a company such as Schneider:

The quadrant to steer clear of is the bottom right, because a weak company that is difficult to change doesn’t leave a lot of options for a CEO, no matter how skilled they may be. It all comes back to something Warren Buffett once said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
The quadrant to steer clear of is the bottom right, because a weak company that is difficult to change doesn’t leave a lot of options for a CEO, no matter how skilled they may be. It all comes back to something Warren Buffett once said: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
What did you think of this piece?
Behavioral Finance
In our annual letter to shareholders, we examine the phenomena of momentum investing and the fear of missing out (FOMO). We also articulate pre-commitments we’ve made to mitigate these behavioral pitfalls.
Inevitably, we face pressure to bend or break our risk guideline pre-commitments when FOMO is greatest. But our long experience with these absolute limits—such as the benefits of maximum weights when there were downturns in China (2020), in Brazil (2006-7), in Emerging Market banks (2012), in the IT sector (back in 1999-2000), and minimum weights during upturns in the US (2004-5) and in Japan (1998)—serves as positive reinforcement for such discipline.
Read the full letter
Investments involve risk and loss is possible.
The Portfolio’s investment objectives, risks, charges and expenses must be read and considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company. They may be obtained by calling toll free (877) 435-8105, or visiting hardingloevnerfunds.com.
The Portfolio is distributed by Quasar Distributors, LLC.
What did you think of this piece?
Fundamental Analysis
The Industrials sector encompasses a wide range of businesses with unique growth prospects and challenges. From commercial aerospace and machinery to industrial distribution and the auto supply chain, companies within this sector operate in distinct competitive environments where scale, adaptability, and innovation are crucial for success. In this series, Harding Loevner Industrials Analyst and Global Portfolio Manager Sean Contant, CFA, discusses some of the key growth opportunities he sees in the sector. Using the Porter Five Forces framework —central to Harding Loevner’s investment strategy—Sean explains how select companies in certain industries within the sector are using their competitive strengths to address complex challenges, increase market share, and provide innovative solutions to meet customer demands.
What did you think of this piece?
Fundamental Analysis
Alphabet’s Waymo, General Motors’ Cruise, Tesla, Baidu, and others are all in a competition to perfect and dominate the market for AVs. The winner of this new competition won’t be the one that builds the best vehicle, though. The heart of an autonomous vehicle is not the car. It’s the operating system.
The concept behind autonomous vehicles is simple—cars that are controlled by onboard computers and sensors rather than a human driver—but the technologies behind making them work are far more complex. Autonomous vehicles replace the human driver with a highly advanced system of hardware and software. The most promising ones incorporate a system called LiDAR (Light Detection and Ranging). LiDAR systems flash a laser and record the time it takes that light to hit an object and return to measure distance and the shapes of objects (very similar to radar, which uses radio waves in the same way). A LiDAR system can measure data points down to the centimeter. An AV’s operating system takes the information provided by the LiDAR system to map out the car’s path and then control the steering, acceleration, and braking.
The concept of self-driving cars has been around for a long time. A man named Francis Houdina experimented with a radio-controlled car all the way back in 1925, driving it down New York’s Fifth Avenue. In the 1950s, a famous one-off concept car called the Golden Sahara utilized a rudimentary, LiDAR-like self-driving system. A team at Carnegie Mellon built its first autonomous vehicle, dubbed Navlab, in 1986. Much like humanoid robots, the problem wasn’t the technology but the cost; it was too expensive to be commercially feasible. Recent advances in hardware and software have driven the costs down and given these companies a real chance at making and selling AVs at scale and profitably.
They’re not there quite yet. Israeli company Mobileye has dominated the market for driver-assisted software, but has struggled to sell to auto makers more advanced systems that enable higher levels of autonomous driving. Tesla earlier this year delayed the initial launch of its robotaxis (the company dubbed them “cybercabs”) from July to October, and the October “launch” was just the reveal of a prototype. Production vehicles won’t be available for sale until the first half of 2025 at the earliest (and Elon Musk is notorious for his unmet timelines). Just getting the cars onto the road is not sign of success, either. A Cruise robotaxi hit and dragged a pedestrian in San Francisco last year; subsequently California regulators rescinded the test permit they’d given the company just months earlier. Stories like that highlight what could end up being a material obstacle: regulators who will need to be convinced these cars are safe before they approve any more of them for public roads, or suspend ones that have already been approved.
The AV competition splits pretty cleanly between two kinds of companies, auto and software companies, and in this competition, experience making cars is less important than experience making software. Because the key part of the vehicle is the autonomous operating system, companies such as Baidu and Alphabet are on equal footing with Tesla and GM.
The fact that software companies such as Alphabet and Baidu are already such prominent players in this market proves the point. The ”picks and shovels” of the AV industry won’t be the car makers, we think, it will be the software makers. Whoever builds the best operating system—which means one that can both be completely effective and pass muster with the regulators who will allow it on the roads—will be able to sell it to any auto maker. The car itself will almost become a commodity while the operating system will be the key differentiator. It will be analogous to mobile phones. There are really only two operating systems: Apple’s iOS and Alphabet’s Android. Autonomous vehicles are likely to repeat that development. We imagine the landscape for AV operating systems will end up looking like the landscape for mobile-phone operating systems. Which means this competition is virtually all or nothing, where only one or two companies will end up with the dominant system that everybody else is forced to use.
What did you think of this piece?
Fundamental Analysis
CATL is the world’s largest maker of batteries, which are by far the highest-value component of EVs. In recent years, the company has gained considerable share globally and now accounts for nearly 40% of global EV-battery shipments, more than its three closest competitors combined. Over time, we have seen CATL’s brand emerging as an asset in itself, as its technology and quality differentiate its products from what were largely seen as commodity items.
EV makers are beginning to highlight their use of CATL batteries as a way to differentiate their cars from the competition. Companies such as Zeekr have been advertising their use of CATL batteries, much like PC makers used to do with “Intel Inside” stickers to differentiate themselves in a crowded, intensely competitive market. Like Intel’s chips in the 1990s, CATL’s batteries have consistently pushed the envelope in technological advances, including industry-leading charging speed and density, which enable total ranges of more than 600 miles. These advanced batteries, called Shenxing and Qilin, now account for roughly a third of its EV battery shipments. Earlier this year, CATL started offering special service stations exclusively for owners of cars with the Shenxing batteries.
In August, CATL took that idea—that the battery in your car matters, more than you think—one step further. It opened a showroom in Chengdu, in Sichuan province, displaying nearly 100 models of EVs from 50 different car brands that use CATL batteries. The only major car maker not featured is BYD, a vertically integrated EV maker that has insisted on producing its own batteries, effectively becoming CATL’s main competitor.
As if to illustrate just how important an EV battery really can be, a Mercedes EV caught fire in Incheon, South Korea, just a week before CATL’s showroom launched. Thankfully no one was hurt, but the fire ended up damaging or destroying dozens of cars in an underground garage. After that, Korean regulators started requesting automakers disclose their battery suppliers.
The car in question had a battery from Farasis, a Chinese semi-captive supplier to Mercedes and one of a long tail of unprofitable, substandard rivals to CATL, which has the best safety record in the industry among major makers. CATL sets aside the most reserves for quality/warranty payouts (a conservative accounting approach), yet uses the least amount of those reserves in practice.
Batteries are not as commoditized as many think. These recent events could lead more consumers, and investors, to that conclusion.
What did you think of this piece?
Fundamental Analysis
Video games, much like movies, are a lumpy business. Every so often a hit comes along upon which a publisher can build a long-running franchise—Activision Blizzard’s Call of Duty, for example, just released a well-received 21st installment. Other times, you can find gamers and investors alike grumbling over the industry delays, bugs, and titles that completely flop.
Still, for a lumpy business, the gaming industry is consistently very profitable. Just look at how it stacks up against the Consumer Staples sector, which is arguably the definition of consistency due to the reliability of demand for basic goods. Economic returns, as measured by cash flow return on investment, have not been as stable for video-game companies over the past 30 years as they have been for consumer staples, but their averages are closer than you might expect—and gaming companies have grown faster:
Additionally, in September, Sony pulled its shooter game Concord off the market two weeks after it was released, saying the game “didn’t land the way we’d intended.” Like Ubisoft, the Japanese conglomerate issued refunds. There is also speculation that Grand Theft Auto VI, which has long been in development at Take-Two Interactive, may get delayed until 2026—13 years after the previous installment in the series was released.
News such as this tends to restart the debate over whether gaming is just a bad industry for investors. In fact, the industry structure seems challenging. The barriers to entry are somewhat low, and the number of substitutes and competitors—including new entrants in China and South Korea—are both high, factors that generally limit a company’s ability to generate sustainably high profits. But the charts above do not depict such a terrible situation. Rather, there may be some weak players, but there are clearly others that have managed to become more profitable and stable over time.
One way some publishers have done this is by building diversified franchises, which leaves them less prone to revenue lulls and limits the impact that a failed release has on the company’s overall finances. Electronic Arts, for example, has a number of successful franchises, including FIFA, Madden, Apex Legends, and The Sims. Activision Blizzard, in addition to Call of Duty, has World of Warcraft, Candy Crush, and Overwatch, among others—a collection Microsoft found so attractive that it acquired the company for about US$70 billion last year (Microsoft owns Xbox). Other diversified players include Tencent and NetEase, both based in China.
Another way that some in the industry have generated more consistent revenue and profits is through add-on digital content. Twenty years ago, video-game publishers were essentially consumer-goods companies. Their games were a physical product, and manufacturing, shipping, and selling these discs carried a significant cost. Playing them was also a one-off experience. Digital technology changed all this, with players increasingly downloading games rather than purchasing new or used discs. This has allowed game developers and publishers to boost the revenue generated by a game after it’s released by offering so-called expansion packs for online purchase, as well as virtual cosmetics to enhance a player’s avatar and virtual currencies. For example, Call of Duty: Black Ops 6 was released October 25, but you can almost guarantee that at some point, perhaps in six months or so, an expansion pack with additional content will become available. Extending the useful life of each game in this way relieves the pressure on developers to quickly crank out the next one. In the second quarter of 2023, Activision Blizzard’s last earnings report before its sale to Microsoft was completed, the company said that downloadable content and micro-transactions accounted for 63% of its net bookings.
The industry’s earnings consistency also has to do with the other types of companies involved in gaming: console makers, such as Microsoft and Sony, as well as businesses that sell tools and services to developers and publishers. One example is Keywords Studios, a provider of game-ready art and quality-assurance testing. Gaming platforms and toolmakers capture a portion of the industry’s revenues, which means they benefit from the overall growth without taking on the risk of any single game.
The recent challenges at Ubisoft and other companies reflect two industry trends that are worth watching. One is that game development has slowed. It’s unclear whether this is due to increased remote work, developers missing deadlines because they’re trying pack more interactive features into a game, pushback against the industry’s overtime habits, or perhaps all the above. In any case, these would seem to be temporary challenges.
Another is that some gamers seem to be spending less money on the hobby, which describes a change in user habits that could be more permanent. However, there’s not enough data to know if that’s the case. Instead, what we can gather from 30 years of financial data is that some gaming companies are built to ride out the rough patches, and so it would be a mistake for investors to write off the whole industry.
What did you think of this piece?
Factor Investing
You can see Morocco from Europe, nine miles away from southernmost Spain across the Strait of Gibraltar, yet the African nation flies under the radar for many global investors. Nevertheless, Morocco’s US$150 billion economy is one of the most developed in Africa, featuring advanced infrastructure that has improved the quality of life for its 38 million inhabitants, facilitated trade, and encouraged private investment. Now the country is embarking on an ambitious program to boost growth even more over the next decade.
The government is focused on a “new development model” agenda that aims for a cumulative annual growth rate in income-per-capita of 6% through 2035. It plans to spend about US$100 billion between now and 2030 on infrastructure, covering everything from improving irrigation to reducing carbon emissions to rebuilding housing after last year’s earthquake.
Over the past two decades, Morocco has achieved remarkable macroeconomic stability compared to other frontier markets, a result of prudent monetary and fiscal policies. The country has more than 1,100 miles of highways, one of the largest container ports in Africa, Tanger Med, and the first high-speed trains in Africa. The kingdom spends 5.5% of GDP on education, and is turning out 24,000 engineers annually from its nearly 200 technology-focused universities and institutes. The country also offers investment incentives to industries such as autos and pharmaceuticals, and has established free-trade agreements with more than 50 partners.
Morocco has been consciously trying to shift its economy away from more volatile sectors such as agriculture via a deliberate industrialization strategy that’s resulted in a more diversified economy. Sectors such as automotive and aeronautics have been growing at a faster rate than traditional sectors. As a result, the contribution of those traditional sectors to total exports has fallen from 44% in 2010 to 25% in 2023.
By the time the soccer World Cup arrives in 2030—the country is co-hosting alongside Spain and Portugal—Morocco expects to show off a vibrant, growing country that will attract both tourists and foreign investors and can be a lasting bridge between Africa and Europe.
What did you think of this piece?
Factor Investing
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.

Although it’s too soon to know whether Japan’s value rally is finally over, the third quarter provided a welcome reprieve.
Although it’s too soon to know whether Japan’s value rally is finally over, the third quarter provided a welcome reprieve.
What did you think of this piece?
Factor Investing
There were additional measures aimed at boosting the real-estate sector, which rebounded by about 50% in late September, as seen in the chart below. The policy announcements included cutting mortgage rates for existing homeowners by as much as 50 basis points and cutting the down payment requirement for second home purchases by 15%.
For the equity market, there are now 500 billion renminbi swap facilities for brokers and asset managers to fund stock purchases, with regulators announcing another 300 billion renminbi relending facilities to fund share buybacks. This led to a wide rally across most Chinese stocks, but the gains were more prominent in brokers and insurance companies that benefit most directly from these announcements.
For the equity market, there are now 500 billion renminbi swap facilities for brokers and asset managers to fund stock purchases, with regulators announcing another 300 billion renminbi relending facilities to fund share buybacks. This led to a wide rally across most Chinese stocks, but the gains were more prominent in brokers and insurance companies that benefit most directly from these announcements.
What did you think of this piece?
Factor Investing
Over the last 18 months, disciplined fundamental investors have been challenged by an episode of price momentum concentrated in a few of the largest stocks in the market. Price momentum refers to a phenomenon where securities whose prices have risen are more likely to keep rising in the short run, while those that have fallen are more likely to experience further declines. The concept of momentum has garnered sufficient adherents to secure its place in the pantheon of portfolio analytics and inspire the creation of numerous indices and ETFs designed to exploit it.
We have deliberately resisted incorporating the momentum factor into our investment process for several reasons. First, simple price momentum does not provide a fundamental basis for making investment decisions. Serial correlation of share price changes has, at best, a weak connection to the underlying business you’re investing in, and nothing to do with what it is worth. Second, momentum investing is literally “chasing” stocks that have already gone up or outperformed (or selling those that already went down or underperformed). This approach leads to higher turnover and trading costs. Lastly, although momentum investing has shown net positive returns over very long periods, there is considerable volatility in its return path. Momentum works until it doesn’t, and when it doesn’t, all the gains you made can be reversed more quickly than you can exit the market. This whipsaw effect makes momentum investing much harder to stomach in practice than it appears in theory.
Of course, there are cases when stock price momentum is linked to company fundamentals. Apple is an example where a profound and structural change is harnessed by a company over a long period, leading to sustained profit growth and extended share price appreciation. Such dynamics are possibly at play in the recent fever for companies linked to the development of artificial intelligence or weight-loss drugs. But such cases are rare and most of the time investors tend to overestimate the number of transformative changes that will actually materialize.
Momentum in the markets is often driven less by fundamentals and more by the fear of missing out (FOMO). In our experience, the FOMO response is most acute when it’s most dangerous—near the peak of market trends, or worse, an investment bubble. Investors who hold the winning stocks are happy to hold on, while those who don’t quickly feel the pressure of “missing out,” amplified by the constant media coverage that acts as free advertising for these market leaders. Passive investors inadvertently pour more capital into these heavyweight stocks in ever-increasing percentages, further amplifying their impact. As a result, the momentum behind these stocks grows ever stronger, and they come to dominate index returns. All (human) investors who measure themselves against a benchmark index feel drawn to jump on the bandwagon. We suspect that FOMO has been a significant element contributing to some of the most damaging drawdowns in the performance record of momentum investing, and we expect it will likely feature in some doozies to come.
We are well aware of the behavioral pitfalls in investing and use a variety of tools to promote objectivity in decision-making. But we can be just as susceptible as other investors to the temptations of momentum. To stiffen our resolve, we’ve made pre-commitments in the form of absolute limits in our risk guidelines, which are primarily aimed at enforcing diversification in our portfolios, but secondarily act as brakes to curb our enthusiasm.
What did you think of this piece?
Fundamental Analysis
Compass Group, a new holding in the Harding Loevner Global Equity strategy, is the largest food-catering company in the world. Based in Chertsey, England, the business provides everything from corporate dining to stadium concessions—including at Stamford Bridge, home of Chelsea Football Club—to food services for hospitals, retirement homes, universities such as Texas A&M, and even offshore oil rigs.
While some of its rivals have recognizable names—Aramark, Sodexo—the global food-service industry is still so fragmented that Compass’s 15% market share is 2.5 times that of the next-largest player. This scale is a key competitive advantage because it allows Compass to earn attractive margins while providing better service at better prices than competitors, and lower than the cost of a business managing its food needs in-house (which many still do). Customers that outsource their catering to Compass tend to be loyal—96% renew their contracts. This high retention rate along with Compass’s demonstrated ability to pass on inflationary cost increases to customers are evidence of its strong bargaining power over buyers.
Food service isn’t a particularly fast-growing industry, but Compass has plenty of room to increase its market share by converting more self-operators to customers as well as by using its strong balance sheet to acquire smaller competitors. The company has been a serial acquirer but also a smart one. Its sales have continued to grow at a high-single-digit rate through a combination of M&A and winning new business, and the stock has risen at a compound annual rate of 9% (in US dollars) over the past decade.
What did you think of this piece?
Active Management
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.
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:
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:
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.)
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.
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.
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.
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.
What did you think of this piece?
Fundamental Analysis
In the pre-streaming era, cable companies wielded enormous pricing power over consumers by building regional monopolies with few substitutes. Today, Netflix, Disney, and others are attempting to capture the same profit pool that was once controlled by those cable providers. To do so, scale is crucial.
But achieving scale isn’t as easy as loading up an app with as many good shows and movies as possible. Content is expensive, and the formula for profitability is simple: number of subscribers multiplied by average revenue per user minus content costs. Disney overspent on content during the pandemic years in a race to add subscribers. Because of this, the frenzied spending on content has abated. According to Harding Loevner analysts Uday Cheruvu, CFA, and Igor Tishin, PhD, Netflix has shown that to achieve scale and remain profitable, a service needs to offer a sufficient breadth and depth of content so that every person in a household finds the service useful and there is no incentive to cancel—but not so much that it becomes too costly to produce. Watch the videos above for highlights from their discussion at the Harding Loevner 2024 Investor Forum.
What did you think of this piece?
Fundamental Analysis
After being rebuffed on its US$12.9 billion “friendly” offer at the beginning of May—a 30% premium to Sabadell’s market cap at the time—BBVA came back with a US$13.1 billion offer that it plans to present directly to Sabadell shareholders, bypassing management. This kind of hostile merger is a rarity among banks. Mergers are risky enough on their own. Hostile mergers amplify those risks, and hostile mergers in the highly regulated world of banking amplify them even further.
Analyst Isaac May presents a few of the biggest reasons why hostile mergers for banks can be risky, and portfolio manager Moon Surana presents counterarguments for why BBVA might be able to overcome those risks.
The Regulators

May

The challenge: Spain’s stock-market supervisor, the National Securities Market Commission, began its review of the proposal in June. BBVA will have to convince regulators of the deal’s merits before it can bring it to Sabadell’s shareholders. That could be tough. The Spanish government has already come out against the deal, and an acquisition would also require the approval of Spain’s antitrust watchdog, the CNMC, as well as the European Central Bank and even regulators in the UK and Mexico, where the banks have operations.
Those hurdles illustrate the first problem with a bank trying to orchestrate a hostile merger. Every industry is regulated, but banking is more regulated than most, and those government overseers have a lot of leverage. The regulator can block the deal outright or add conditions that make the deal very expensive. Regulators have a lot of power that they can use to discourage actions they don’t strictly have control over.

Surana

The answer: BBVA needs regulatory approval before it can take the tender offer to Sabadell shareholders (its own shareholders have already approved the offer). The offer has been authorized by the ECB and several other countries, but not yet by Spanish regulators. And there is a chance that it gets approval from both companies’ shareholders and regulators, but is still blocked by the Spanish government. In that scenario, the parent company would own two banks but couldn’t combine them, leaving them to nominally compete against each other.
BBVA management claimed the deal would be worth doing even if it has to operate the banks separately, though it would be a very unusual construction that makes it harder to realize the originally expected cost savings. Ultimately, though, the downside risk seems limited. If Sabadell shareholders reject the offer, or if regulators block it, BBVA moves on. There is little damage for BBVA at this point in making one last attempt to get a deal done. Even in the worst-case scenario the upside—BBVA gets bigger in its home market—still outweighs the downside.

The Employees

May

The challenge: One of the common reasons to merge companies is so managements can cut costs, which generally means employees. Therefore, every merger affects the staff at both the acquirer and the target to some degree. Hostile mergers by their nature can amplify the very natural resentment some employees might feel after an acquisition. But within the world of banking, issues with a company’s employees can have a more pronounced effect.
In a bank, many employees are important contacts with the customers, and in some cases they can leave and take the customers with them. Think of wealth managers who generate fee income and have personal relationships with clients. If senior managers leave, normal business may get disrupted. Loans stop getting processed, new sales leads go quiet. Even tellers leaving can be a problem that helps push customers to a competitor.
Many of these kinds of problems can be partially solved with money, but it can cost a lot, and isn’t sustainable. A takeover’s economics often depend on layoffs or branch closures, so employees know that their job security is under threat. If the acquirer has to give some employees a big raise to keep them at the job and happy, it likely exacerbates whatever the company had to overpay by going hostile in the first place.

Surana

The answer: The deal is actually less hostile than it seems. In its announcement of the offer, BBVA pledged to keep “the best talent and culture of both entities.” And BBVA made “friendly” offers, such as having an integration committee with members from both banks, keeping the management team at Sabadell’s SME (small and medium enterprises) business, and maintaining the Sabadell brand. BBVA also has a track record of successfully integrating companies through mergers across geographies. That experience should help here.

The Loan Book

May

The challenge: When two banks negotiate a friendly merger, at some point the acquiring bank will get to look at the loan book of the target bank. If not the entire book, they will at least see some of the bigger loans. This is critical, because it tells the acquirer if there are problems looming that wouldn’t be visible to an outside party. In a hostile merger, the acquiring bank is an outside party. It will not get that inside look at the bank’s true balance sheet. If there are any problematic loans or brewing issues, the acquirer will find out about them only after it has bought the company.

Surana

The answer: These companies are already very familiar with each other. BBVA held merger talks with Sabadell in 2020 and has long mulled the benefits of integrating the two companies. They were close to a friendly deal in 2020, and close this year, too, until the merger talks leaked.

Taking a merger offer hostile adds extra risks to what is already an inherently risky maneuver. Add up all the extra costs that come with a hostile transaction and the odds of it adding value for shareholders get very long. BBVA has enough levers and cushions to offset those risks and still make this deal work, if it can maintain its discipline on price and focus on execution.
The Regulators
May
The challenge: Spain’s stock-market supervisor, the National Securities Market Commission, began its review of the proposal in June. BBVA will have to convince regulators of the deal’s merits before it can bring it to Sabadell’s shareholders. That could be tough. The Spanish government has already come out against the deal, and an acquisition would also require the approval of Spain’s antitrust watchdog, the CNMC, as well as the European Central Bank and even regulators in the UK and Mexico, where the banks have operations.
Those hurdles illustrate the first problem with a bank trying to orchestrate a hostile merger. Every industry is regulated, but banking is more regulated than most, and those government overseers have a lot of leverage. The regulator can block the deal outright or add conditions that make the deal very expensive. Regulators have a lot of power that they can use to discourage actions they don’t strictly have control over.
Surana
The answer: BBVA needs regulatory approval before it can take the tender offer to Sabadell shareholders (its own shareholders have already approved the offer). The offer has been authorized by the ECB and several other countries, but not yet by Spanish regulators. And there is a chance that it gets approval from both companies’ shareholders and regulators, but is still blocked by the Spanish government. In that scenario, the parent company would own two banks but couldn’t combine them, leaving them to nominally compete against each other.
BBVA management claimed the deal would be worth doing even if it has to operate the banks separately, though it would be a very unusual construction that makes it harder to realize the originally expected cost savings. Ultimately, though, the downside risk seems limited. If Sabadell shareholders reject the offer, or if regulators block it, BBVA moves on. There is little damage for BBVA at this point in making one last attempt to get a deal done. Even in the worst-case scenario the upside—BBVA gets bigger in its home market—still outweighs the downside.
The Employees
May
The challenge: One of the common reasons to merge companies is so managements can cut costs, which generally means employees. Therefore, every merger affects the staff at both the acquirer and the target to some degree. Hostile mergers by their nature can amplify the very natural resentment some employees might feel after an acquisition. But within the world of banking, issues with a company’s employees can have a more pronounced effect.
In a bank, many employees are important contacts with the customers, and in some cases they can leave and take the customers with them. Think of wealth managers who generate fee income and have personal relationships with clients. If senior managers leave, normal business may get disrupted. Loans stop getting processed, new sales leads go quiet. Even tellers leaving can be a problem that helps push customers to a competitor.
Many of these kinds of problems can be partially solved with money, but it can cost a lot, and isn’t sustainable. A takeover’s economics often depend on layoffs or branch closures, so employees know that their job security is under threat. If the acquirer has to give some employees a big raise to keep them at the job and happy, it likely exacerbates whatever the company had to overpay by going hostile in the first place.
Surana
The answer: The deal is actually less hostile than it seems. In its announcement of the offer, BBVA pledged to keep “the best talent and culture of both entities.” And BBVA made “friendly” offers, such as having an integration committee with members from both banks, keeping the management team at Sabadell’s SME (small and medium enterprises) business, and maintaining the Sabadell brand. BBVA also has a track record of successfully integrating companies through mergers across geographies. That experience should help here.
The Loan Book
May
The challenge: When two banks negotiate a friendly merger, at some point the acquiring bank will get to look at the loan book of the target bank. If not the entire book, they will at least see some of the bigger loans. This is critical, because it tells the acquirer if there are problems looming that wouldn’t be visible to an outside party. In a hostile merger, the acquiring bank is an outside party. It will not get that inside look at the bank’s true balance sheet. If there are any problematic loans or brewing issues, the acquirer will find out about them only after it has bought the company.
Surana
The answer: These companies are already very familiar with each other. BBVA held merger talks with Sabadell in 2020 and has long mulled the benefits of integrating the two companies. They were close to a friendly deal in 2020, and close this year, too, until the merger talks leaked.
Taking a merger offer hostile adds extra risks to what is already an inherently risky maneuver. Add up all the extra costs that come with a hostile transaction and the odds of it adding value for shareholders get very long. BBVA has enough levers and cushions to offset those risks and still make this deal work, if it can maintain its discipline on price and focus on execution.
What did you think of this piece?
Factor Investing
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.
For international quality growth investors, the hope, of course, was that resurgent performance for US growth stocks would herald a similar trend elsewhere. Although this has yet to be the case, the variability in the performance of growth stocks in recent months may suggest a reversal in style trends is approaching. For example, the return spread between international value stocks and international growth stocks does appear to be flattening.
There is also reason to question the underpinnings of a rally characterized by companies with weak profits. In many cases, the catalysts for the rise in their shares have been speculative or one-off developments, such as the announcement of share buybacks, a short-lived valuation opportunity, or takeover chatter. A clear example is the broad rotation toward stocks of low-quality, cyclical companies in Japan on anticipation that a flurry of reforms may, eventually, improve corporate governance and shareholder returns in the country.
The idea that highly profitable, growing companies outside the US will continue to perform the way they have over the last three and a half years isn’t supported by their earnings outlook. Therefore, a rotation back into growth may not be far off in the future.
What did you think of this piece?
Fundamental Analysis
In semiconductor manufacturing, a single speck of dust poses a threat to production. It’s why cleanrooms, the sterile labs where silicon wafers get etched and cut into pieces, and then packaged as finished chips—with thousands of steps in between—contain few humans. To reduce the risk of contamination and defects, materials are largely transported by automated monorail systems that travel along the ceiling.
Daifuku, based in Japan, is a leading provider of cleanroom-automation solutions such as the monorail described above, which TSMC, Samsung, Intel, and others depend on to keep chip production on track. Each monorail extends 10 kilometers (6.2 miles) and is equipped with about 1,000 autonomous vehicles, called front opening unified pods (FOUPs). Typically, multiple cleanrooms operate together, with several monorail systems connected to one another. Each FOUP can travel 200 meters (656 feet) per minute. This speed is important because the photoresist light-sensitive polymers will degrade if the process takes too long. Dynamic routing, or the ability of the FOUPs to find the best path depending on the wafer’s condition while avoiding collision with other vehicles, is one of Daifuku’s key competitive strengths.
Because the company has only one significant rival, Murata Machinery, Daifuku enjoys strong bargaining power over buyers. (Samsung has a subsidiary that also does some of this work, but exclusively for its parent company.) And although the broader cleanroom-automation market is largely split between Daifuku and Murata, fabrication facilities, or fabs, working on the most cutting-edge technology—chips with features two and three nanometers small that are highly sensitive to contamination and degradation and require more precision—primarily turn to Daifuku. To create smaller transistors and other components, fabs not only must limit airborne and aerosol particles but also minimize machine vibrations and have other critical environmental controls. Daifuku is distinguished by its ability to engineer large, sophisticated projects such as these. Rather than focus on manufacturing all the disparate parts that go into an automation system, the company’s core competency is designing ways for various solutions to work together to address each customer’s increasingly complex needs.
Cleanroom automation isn’t Daifuku’s only business, although it may soon be its biggest. For much of the company’s 87-year history, its largest source of revenue has been factory and warehouse conveyor systems, including those used today by Amazon.com, Home Depot, and Walmart to swiftly transport boxes around facilities that can span several football fields. Its elevator-like systems of storage racks can also organize and retrieve crates stacked multiple stories high (a common setup in Asia, where land is limited, and warehouses tend to be tall rather than wide). Daifuku’s systems are also used in automotive plants to hoist cars through assembly lines, and in airports to move baggage.

Source: Daifuku. Data as of March 31, 2024.

In 2023, cleanroom-automation solutions grew to account for about a third of Daifuku’s sales—nearly on par with the intralogistics division that serves warehouses. But by 2025, cleanrooms will likely be the largest part of Daifuku’s business. The growth is being fueled by the changing production needs of its chipmaking customers, both in how and where they assemble their devices.
First, the how. This requires a brief tour through the physics of chipmaking as well as Moore’s Law, which is the observation that the number of transistors on an integrated circuit doubles every two years with a minimal rise in cost. As these devices get smaller, more can be added to the chips, giving them more processing power. However, innovations in transistor size have slowed in recent years, which is leading chipmakers to explore other solutions in a paradigm shift known as “More than Moore.” For instance, TSMC Chairman Mark Liu projects that within a decade, a graphics processing unit (GPU), a type of chip used for AI, will contain 1 trillion transistors, up from about 100 billion today, but the current pace of transistor miniaturization won’t allow such density. Unable to shrink transistors much further so that they fit side by side, chipmakers are instead stacking them in vertical layers, which saves space and improves processing efficiency by shortening the distance that signals must travel.
What does this mean for Daifuku? More of chipmakers’ budgets may be set to flow its way, as priorities shift from the front end of the production process, where the sizes of the chips and components are determined, to the back end, where transistor stacking and packaging takes place. In 2021, global semiconductor capital expenditures totaled nearly US$100 billion. About 80% of this went to the front end, as the focus on chip miniaturization over the past decade required foundries such as TSMC to make large outlays for expensive lithography machines that print the chips. Now, as stacking and packaging become more technical and important to increasing performance, greater investment will be needed to automate that stage of the process. By 2027, back-end solutions should account for 20% to 30% of Daifuku’s cleanroom sales. If back-end production becomes fully automated, it may be just as profitable for Daifuku as the front end, with operating margins of 10% and higher.
The other source of growth for Daifuku is a shift in where chip production takes place, as governments such as the US and Japan try to bring key tech manufacturing closer to home. The Semiconductor Industry Association (SIA) projects that wafer starts per month in the US will more than triple by 2032, taking the country’s share of global chip-fabrication capacity from 10% to 14%. Consequently, manufacturers will have to contend with higher labor costs and a shortage of skilled workers. This increases the need for automation, including at the back end as the focus shifts to packaging.

*Others include Malaysia, Singapore, India, and the rest of the world.
All values shown in 12-inch equivalents.
Source: Semiconductor Industry Association, BCG.

The US currently has only a small share of the US$95 billion assembly, test, and packaging market. But it wouldn’t make much sense to bring front-end chip-production work to the US only to have to ship components to Asia for the final steps. Therefore, the CHIPS and Science Act, passed in 2022, includes US$3 billion to build the country’s capabilities in advanced packaging. According to the SIA, companies such as Amkor Technology, Intel, Samsung, and SK Hynix are already planning packaging-related investments for facilities in Arizona, New Mexico, Indiana, and Texas.
These changes to the supply chain and chipmaking process, along with the broader advances being made in computing, are all favorable long-term trends for Daifuku.
In 2023, cleanroom-automation solutions grew to account for about a third of Daifuku’s sales—nearly on par with the intralogistics division that serves warehouses. But by 2025, cleanrooms will likely be the largest part of Daifuku’s business. The growth is being fueled by the changing production needs of its chipmaking customers, both in how and where they assemble their devices.
First, the how. This requires a brief tour through the physics of chipmaking as well as Moore’s Law, which is the observation that the number of transistors on an integrated circuit doubles every two years with a minimal rise in cost. As these devices get smaller, more can be added to the chips, giving them more processing power. However, innovations in transistor size have slowed in recent years, which is leading chipmakers to explore other solutions in a paradigm shift known as “More than Moore.” For instance, TSMC Chairman Mark Liu projects that within a decade, a graphics processing unit (GPU), a type of chip used for AI, will contain 1 trillion transistors, up from about 100 billion today, but the current pace of transistor miniaturization won’t allow such density. Unable to shrink transistors much further so that they fit side by side, chipmakers are instead stacking them in vertical layers, which saves space and improves processing efficiency by shortening the distance that signals must travel.
What does this mean for Daifuku? More of chipmakers’ budgets may be set to flow its way, as priorities shift from the front end of the production process, where the sizes of the chips and components are determined, to the back end, where transistor stacking and packaging takes place. In 2021, global semiconductor capital expenditures totaled nearly US$100 billion. About 80% of this went to the front end, as the focus on chip miniaturization over the past decade required foundries such as TSMC to make large outlays for expensive lithography machines that print the chips. Now, as stacking and packaging become more technical and important to increasing performance, greater investment will be needed to automate that stage of the process. By 2027, back-end solutions should account for 20% to 30% of Daifuku’s cleanroom sales. If back-end production becomes fully automated, it may be just as profitable for Daifuku as the front end, with operating margins of 10% and higher.
The other source of growth for Daifuku is a shift in where chip production takes place, as governments such as the US and Japan try to bring key tech manufacturing closer to home. The Semiconductor Industry Association (SIA) projects that wafer starts per month in the US will more than triple by 2032, taking the country’s share of global chip-fabrication capacity from 10% to 14%. Consequently, manufacturers will have to contend with higher labor costs and a shortage of skilled workers. This increases the need for automation, including at the back end as the focus shifts to packaging.
The US currently has only a small share of the US$95 billion assembly, test, and packaging market. But it wouldn’t make much sense to bring front-end chip-production work to the US only to have to ship components to Asia for the final steps. Therefore, the CHIPS and Science Act, passed in 2022, includes US$3 billion to build the country’s capabilities in advanced packaging. According to the SIA, companies such as Amkor Technology, Intel, Samsung, and SK Hynix are already planning packaging-related investments for facilities in Arizona, New Mexico, Indiana, and Texas.
These changes to the supply chain and chipmaking process, along with the broader advances being made in computing, are all favorable long-term trends for Daifuku.
What did you think of this piece?
Fundamental Analysis
TOMRA has a dominant business position. The company’s scale, brand, and service network are difficult to match for smaller competitors or new entrants. It has a 70% global market share in reverse vending machines, and roughly 50% of the market for sorting machines. A third division focuses on adapting its sorting technology for production and processing in the food industry.
Given the strength of its main businesses, and the increasing interest among companies, consumers, and regulators for more recycled material in products, TOMRA seemed primed for profitable growth as the go-to equipment supplier in this “circular economy.” From 2017 through 2021, the company compounded its earnings at a 13% rate. At a capital markets day in 2022 it promised more of the same—to boost revenues 15% per year while expanding margins.
But since that capital markets day, which coincided with turnover in the executive team, the company’s execution has faltered. Earnings this year are expected to be lower than they were three years ago. TOMRA was hurt by inflation, as existing contracts prevented the company from increasing prices to offset rising costs. The company was also the victim of a severe cyberattack, which cost US$20 million to remediate. In the food division, the company had to undergo a drastic restructuring after a series of acquisitions led to a disjointed operation.
World-class industrial businesses often have an ethos that focuses their work force and strategy on what’s most important—think Danaher’s famous Danaher Business System, Parker Hannifin’s Win Strategy, or Honeywell’s Accelerator program. The companies attribute their historical success to these systems because they focus decision makers on organic growth, profitability, and return on invested capital. We’d like to see TOMRA’s management take a similar approach and pay more attention to concrete financial metrics as opposed to buzzwords like “circular economy” or “food security.” Talking about cash-flow return on investment and other hard numbers with investors often encourages a more dedicated focus on them.
In the first quarter of this year, two of TOMRA’s three divisions lost money, yet on its earnings call with investors, the management team hardly referenced the dismal results. In fact, in the opening 30 minutes of the one-hour call, the CEO made scant reference to TOMRA’s lackluster financial results. The second-quarter results showed some promise; revenue for its reverse-vending machines rose 15%, an encouraging sign. Earnings, however, for the first six months fell from 2023’s levels.
While TOMRA has endured a challenging period, it still has a dominant position in a growing market, and some mid- to long-term drivers of growth are still intact. Jurisdictions from Quebec to Tasmania are planning to launch deposit programs this year and next, albeit others are rethinking plans; France for instance cancelled a planned bottle-recycling program. But Austria, Poland, Hungary, and Romania have also emerged as new markets. Additionally, the technology the company has developed for sorting recyclables can be leveraged for other uses; the company expanded into metal recycling in 2006 and mining in 2008 as well as food sorting.
The company says its machines collect more than 46 billion used beverage containers every year, and that collection rates in markets with deposit programs are higher than those with curbside-collection plans. TOMRA has managed to boost revenues steadily over the past decade, which points to a degree of stability. The new management’s missteps combined with the changing interest-rate environment and countries altering recycling plans have sown doubt. There is still a business and environmental case to be made for TOMRA. What we’re looking for are signs that the new management team is balancing those two things more effectively.
What did you think of this piece?
Behavioral Finance
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.
What did you think of this piece?
Active Management
In June, asset manager BlackRock announced its intention to liquidate its Frontier & Select EM ETF, which once had assets exceeding US$400 million. The company cited currency liquidity challenges in several smaller frontier markets as the main reason for its decision.
BlackRock’s decision to close its passive FEM fund underscores our long-held belief that the idiosyncratic nature of frontier and small emerging markets, as well as their volatility and liquidity characteristics, make them much better suited for an active rather than passive investment strategy.
Markets such as Egypt and Nigeria have indeed faced challenges with repatriation due to unsustainable currency pegs, which both countries abandoned earlier this year. Since then, Nigeria was eliminated from the benchmark by index provider MSCI in February. Also, Egypt has attracted US$35 billion from a consortium led by Abu Dhabi’s ADQ investment company and an additional US$5 billion from the IMF, easing liquidity pressure there.
We also note that BlackRock shuttered its fund as the FEM Index has actually become more balanced. From 2023 through the first half of 2024, MSCI added about 125 stocks to the MSCI FEM Index, resulting in lower country concentration for the benchmark. The Philippines, once the largest market with more than 30% weight, is now 20%.

In fact, the MSCI FEM Index is now more diversified than the MSCI EM Index. The five largest markets in FEM—the Philippines, Vietnam, Peru, Romania, and Morocco—constitute less than two-thirds of the index weight while the five largest markets in EM—China, India, Taiwan, South Korea, and Brazil—account for more than three-quarters of the index weight. Not only is the FEM Index more diversified, the exposure that investors can achieve is markedly different than the MSCI EM Index.
In fact, the MSCI FEM Index is now more diversified than the MSCI EM Index. The five largest markets in FEM—the Philippines, Vietnam, Peru, Romania, and Morocco—constitute less than two-thirds of the index weight while the five largest markets in EM—China, India, Taiwan, South Korea, and Brazil—account for more than three-quarters of the index weight. Not only is the FEM Index more diversified, the exposure that investors can achieve is markedly different than the MSCI EM Index.
What did you think of this piece?
Factor Investing
International small caps continue to trade near their cheapest valuations relative to international large caps since the 2009 global recession. Although they are also valued at a discount to US small caps, the spread hasn’t changed much over the last two decades.
Even relative to their own historical valuation multiples, international small caps look cheap, with the MSCI All Country World ex US Small Cap Index trading at a price-to-earnings ratio of 14.8, 19% below its 2021 peak. This indicates there is an attractive valuation opportunity for small-cap investors, especially with respect to some high-quality, fast-growing international small companies.
What did you think of this piece?
Factor Investing
One way to understand valuations is the required rate of return, which measures the minimum return for which investors will be willing to allocate capital. An outside view that we refer to is a valuation framework from UBS’ data-analytics platform HOLT that backs out the implied required rate of return investors are demanding from securities in the market, referred to as the market implied yield. At a country level, India’s median market-implied yield of 1.4% is at an all-time low for India and an all-time high premium relative to the broader EM index.
This is underscored when we look at the valuation across sectors. Current valuations are at the extreme point of the five-year range in all sectors, with the sole exception of Financials.

While India’s stock valuations remain high, regulators have highlighted a potential bubble, particularly in the mid-cap segment, and have attempted to limit further domestic flows into these stocks. And with regards to SOEs, we suspect the fundamental weakness of these companies will become apparent over time and that the superior fundamentals of high-quality, fast-growing businesses will once again be reflected in stronger stock prices.
While India’s stock valuations remain high, regulators have highlighted a potential bubble, particularly in the mid-cap segment, and have attempted to limit further domestic flows into these stocks. And with regards to SOEs, we suspect the fundamental weakness of these companies will become apparent over time and that the superior fundamentals of high-quality, fast-growing businesses will once again be reflected in stronger stock prices.
What did you think of this piece?
Factor Investing
As we’ve explored previously, the performance of certain factors can shift markedly in just a few years. Time will tell if this value rally gives way to better performance for more expensive, higher-quality, faster-growing companies in Japan.
Outside of Japan, there didn’t appear to be strongly defined style patterns. The heatmap above shows that there weren’t consistent headwinds or tailwinds when examining performance by measures of quality, growth, and value. There did, however, appear to be a style divergence between regions.
In the Eurozone, the fastest-growing stocks performed in line with the slowest-growing stocks. In emerging markets, the concentration effect of heavyweight stocks, including TSMC and Tencent, flattered the returns of the highest-quality, fastest-growing cohorts, even while cheaper stocks outperformed. In Asian markets excluding Japan, the most expensive stocks only modestly outperformed the least expensive this past quarter.
What did you think of this piece?
Fundamental Analysis
A small group of US stocks, dubbed the Magnificent Seven, continues to dominate returns in global markets. As seen in the chart above, nearly half of the gains in the MSCI All Country World Index for the first six months of 2024, and all of the gains in the second quarter, came from just these seven stocks.
The phenomenon is not new, although it has become more extreme this year. The Magnificent Seven has accounted for about a third of the index’s return since the end of 2022:
The chart above shows that when looking at these seven stocks in isolation, growth clearly outperforms: The fastest-growing members of the Magnificent Seven—those represented by the first quintile in the gray bar to the left—rose nearly 12% in the second quarter, an 875-basis-point (bp) lead over the second growth quintile, and a 1,200-bp lead over the slowest-growing quintile on the far right of the chart. Now, let’s look at the MSCI ACWI Index without the impact of the Magnificent Seven. As the orange bars show, growth still outperforms, but not by much. When stripping out those seven stocks, the index’s top quintile of growth gained just 4%, compared to a 3% overall return across all quintiles.
The chart above shows that when looking at these seven stocks in isolation, growth clearly outperforms: The fastest-growing members of the Magnificent Seven—those represented by the first quintile in the gray bar to the left—rose nearly 12% in the second quarter, an 875-basis-point (bp) lead over the second growth quintile, and a 1,200-bp lead over the slowest-growing quintile on the far right of the chart. Now, let’s look at the MSCI ACWI Index without the impact of the Magnificent Seven. As the orange bars show, growth still outperforms, but not by much. When stripping out those seven stocks, the index’s top quintile of growth gained just 4%, compared to a 3% overall return across all quintiles.
What did you think of this piece?
Fundamental Analysis
The three most important considerations for companies in the retail industry are product, price, and place. This is because a retailer generally differentiates itself through what it sells, how much it charges, or how convenient it is for customers to shop there. Therefore, when new rivals enter the industry, they tend to target perceived shortcomings in one or more of these areas.
The clearest example of how these dynamics can play out has been the rise of e-commerce over the past two decades. Websites such as Amazon.com were able to take market share from store-based retailers by providing shoppers a greater assortment, price transparency and savings, and the ability to shop from their homes.
Now, a new class of online retailers is finding room to further disrupt the 3Ps of retail by offering deep discounts on trendy apparel and other impulse purchases. They include Shein, a company that is aiming to go public soon, Temu, a subsidiary of China’s PDD Holdings, as well as TikTok Shop, a shopping feature that was added to the namesake social-media app owned by China’s ByteDance. (While Shein has moved its headquarters to Singapore, its operations are also primarily in China.) All three cross-border operators are bringing specific competitive advantages to large retail markets such as the US and Brazil.
Perhaps because consumers in the US and elsewhere are accustomed to seeing “made in China” tags on their clothing, there is a misconception that China was always the domain of fast fashion—cheap, rapidly produced apparel that mimics catwalk trends. Traditionally, though, production and shipping lead times were longer in China, making it a more suitable supplier for brands such as Nike than retailers trying to quickly recreate viral looks. Leading fast-fashion retailers such as Inditex, the Spanish parent of Zara, and the British e-ecommerce site ASOS source only about 30% to 40% of their merchandise from China and often turn to countries such as Spain, Portugal, Morocco, and Turkey for styles requiring a quicker turnaround.
Shein and Temu, however, mostly rely on Chinese suppliers, and they’re able to offer low prices in part because of the method they use to get their products from those suppliers to shoppers. By shipping individual orders directly to customers, they avoid US import duties, which are waived if a shipment’s value is less than US$800. US lawmakers have called this an unfair advantage over American retailers, many of which do pay import duties to bring in inventory made overseas. Duties, particularly in countries with high duties, can be a meaningful component of costs, although their avoidance isn’t the only reason Shein and Temu can offer low prices. Another is the efficiency of their supply chains and logistics operations.
But while these relative newcomers have been popular with some consumers, there doesn’t appear to be much risk to high-quality retail companies. One reason is that the retail market pie is so large, which means the rivalry dynamics are such that many different strategies can succeed at the same time. For example, even after getting off to a gangbuster start in the US, Temu’s gross merchandise value represents just 1% of the US e-commerce market, putting it significantly behind Amazon at 38% and even Walmart at 6%. Its customer retention rate is also lower, suggesting that some shoppers may be drawn to the novelty of scoring a deal but aren’t becoming repeat customers. The Sensor Tower data below shows the proportion of Apple iPhone users who open the Temu app at least once a month after downloading and how that compares to other retail apps; the large drop-off in Temu visitors is true among Android users as well:

Source: Sensor Tower

To offer such low prices, Shein and Temu also can’t provide the speedy shipping that American shoppers have come to expect from companies with robust local distribution infrastructure, such as Amazon and Walmart. Instead, the packages can take a week or longer to arrive from China. This is one reason that the risk to sales of large, easily accessible US discounters such as Amazon and Walmart, which has over 4,600 stores in the US—more than one for every US county—appears to be low.
Where Shein has somewhat differentiated itself is in its use of artificial intelligence (AI), which helps it quickly respond to fashion trends and accelerate production of items that are expected to be in high demand. It’s a strategy that other retailers with high financial resources can replicate. AI may prove particularly advantageous for online marketplaces because of the tremendous amount of data that is captured by a company’s relationship with a large mix of buyers, sellers, and goods. So far, though, most of what the retail industry has done with AI doesn’t appear to be game-changing. In fact, there are cautionary tales in which brands have put too much emphasis on technology and the product suffered as a result. For example, Adidas said in 2019 that it over-invested in digital advertising and focused too much on the number of shoppers clicking its ads rather than its overall brand perception.
The category of retailers that would seem to be most at risk from competition from Shein and Temu are dollar stores given the similarities in product selection and prices. But even dollar stores have some differentiating characteristics. For example, many sell items that the Chinese apps don’t, such as consumables. They also offer convenience for shoppers in need of an item quickly and the ability to inspect a product in person rather than scrolling through a long list of options. So far, new online challengers haven’t had a material impact on the dollar-store industry.
Overall, high-quality specialist companies have continued to grow despite the success of new challengers such as Shein and Temu. It’s because of their differing strategies around product, price, and place that the barriers to entry in retail are higher than most might assume. However, it is possible that market-share gains by Shein and Temu will shake the stock-price sentiment for even some high-quality retailers, which may produce more attractive valuations and potential buying opportunities.
To offer such low prices, Shein and Temu also can’t provide the speedy shipping that American shoppers have come to expect from companies with robust local distribution infrastructure, such as Amazon and Walmart. Instead, the packages can take a week or longer to arrive from China. This is one reason that the risk to sales of large, easily accessible US discounters such as Amazon and Walmart, which has over 4,600 stores in the US—more than one for every US county—appears to be low.
Where Shein has somewhat differentiated itself is in its use of artificial intelligence (AI), which helps it quickly respond to fashion trends and accelerate production of items that are expected to be in high demand. It’s a strategy that other retailers with high financial resources can replicate. AI may prove particularly advantageous for online marketplaces because of the tremendous amount of data that is captured by a company’s relationship with a large mix of buyers, sellers, and goods. So far, though, most of what the retail industry has done with AI doesn’t appear to be game-changing. In fact, there are cautionary tales in which brands have put too much emphasis on technology and the product suffered as a result. For example, Adidas said in 2019 that it over-invested in digital advertising and focused too much on the number of shoppers clicking its ads rather than its overall brand perception.
The category of retailers that would seem to be most at risk from competition from Shein and Temu are dollar stores given the similarities in product selection and prices. But even dollar stores have some differentiating characteristics. For example, many sell items that the Chinese apps don’t, such as consumables. They also offer convenience for shoppers in need of an item quickly and the ability to inspect a product in person rather than scrolling through a long list of options. So far, new online challengers haven’t had a material impact on the dollar-store industry.
Overall, high-quality specialist companies have continued to grow despite the success of new challengers such as Shein and Temu. It’s because of their differing strategies around product, price, and place that the barriers to entry in retail are higher than most might assume. However, it is possible that market-share gains by Shein and Temu will shake the stock-price sentiment for even some high-quality retailers, which may produce more attractive valuations and potential buying opportunities.
What did you think of this piece?
Factor Investing
It has been our long-standing belief that high-quality businesses will weather difficult or shifting economic environments better than most. This, in part, is due to their operational resilience that allows us to hold on to our investments in their shares during periods of stock market turmoil.
In our semi-annual letter to shareholders, we examine the conundrum of the high-quality return premium, and its possible explanation based in behavioral finance. And we emphasize our dedication to our rigorous investment process in considering companies fueling the recent artificial intelligence boom.
Our long experience may not be a guarantee of skill or prescience. But it does afford us perspective on the ways technological advances affect a wide variety of industries, and the companies operating within them globally. We’re optimistic that our thoughtful and evolving process to analyze those businesses, will, with dedicated effort, yield good long-term investment results.
Read the full letter
Investments involve risk and loss is possible.
The Portfolio’s investment objectives, risks, charges and expenses must be read and considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company. They may be obtained by calling toll free (877) 435-8105, or visiting hardingloevnerfunds.com.
The Portfolio is distributed by Quasar Distributors, LLC.
What did you think of this piece?
Fundamental Analysis
Since last year’s election of former Lagos governor Bola Tinubu to the presidency, Nigeria has implemented a series of economic reforms designed to stabilize the country after a decade of mismanagement and allow it to profit from its own potential. What we as investors are looking for is the proverbial inflection point, a time when the reforms start producing tangible economic benefits. That would be good for the nation in general, and it would also be particularly good for Zenith Bank, Guaranty Trust Bank, and other large, high-quality Nigerian banks.
Tinubu had success turning around the economy in Lagos as its governor, and he wasted no time in tackling the country’s sclerotic economy. On the day of his inauguration, he abruptly ended a decades-old subsidy paid to oil companies to keep fuel prices low that cost the government US$10 billion a year, more than it spent on education or health care. He reorganized the county’s foreign-exchange system and abandoned the naira’s currency peg—it has fallen about 70% against the dollar since—and took other steps geared toward improving the economy and boosting tax revenue.
Since ending the subsidy, the price of oil (which is a strong source of revenue in Nigeria) has stabilized and credit-quality issues that plagued the energy sector have improved. Credit trends, for now at least, are stable. Two currency devaluations have removed a lot of the concerns about the previous monetary regime. So far, the reforms seem to be well received by outside observers. In early May, the ratings agency Fitch upgraded the country’s outlook to positive from stable, based on the initial success of Tinubu’s reform package.
There is good reason for investors to pay attention. Nigeria’s demographics are compelling: it has the sixth-largest global population, one that is young and fast-growing. Demographic tailwinds can be powerful over longer periods of time as penetration of banking and insurance services naturally expand as countries develop. Even amid the travails of recent years the country’s high-quality banks have fared well. Zenith and Guaranty Trust consistently post a return on assets north of 3%, compared to the more typical 1-2% earned by most banks around the globe.
Recent earnings might seem to indicate the hoped-for inflection point has arrived, and investors may also be enticed by the fact that Zenith and Guaranty Trust trade well below book value. But the earnings are somewhat misleading since both banks posted large and unsustainable hedging gains due to the naira devaluation. Nevertheless, their operating performance demonstrates their relative stability amid the volatility induced by the reform package.
A larger argument against the idea that an inflection point’s been reached is the reality that unwinding the mistakes of the past 8 to 10 years is going to be extremely difficult. Tinubu’s reforms, while necessary, have caused lots of pain and economic hardship. The currency devaluation feeds straight into inflation, which is running north of 30%. That, combined with the removal of the fuel subsidy and later an electricity subsidy as well, was too hard a pill for the majority of the mostly poor population to swallow. It seems likely that the next couple of years will be rocky and there may be credit-quality issues for the banks since credit stresses typically lag economic shocks.
Whatever the short-term pain, though, we do believe that the long-term picture is still positive, which is why we remain resolutely interested in Nigerian companies, not just the banks. The policy changes this new government has made will hopefully put the economy on a better growth trajectory and make the society more prosperous. In fact, we’d go so far as to say that Nigeria is lucky to have elected President Tinubu at this critical time. He appears to be the right man to have taken over the country given its precarious economic state. After his success in Lagos, it’s reasonable to have hope for his administration’s ability to turn the country around. But the path to better days ahead will likely be turbulent.
What did you think of this piece?
Fundamental Analysis
Fossil fuels are the lifeblood of modern society, used for everything from heating homes to powering cars and planes to generating the electricity that keeps the internet running. Crude oil, natural gas, and coal currently meet about 80% of our energy needs globally, but 75% of carbon dioxide emissions come from finding and burning these fossil fuels. There is a consensus about transitioning away from those sources of energy, given how much they contribute to climate change, but there is not a consensus on how much our reliance upon them can be cut or what will replace them. There does not appear to be one clear replacement and there will likely be multiple pathways to decarbonizing the global economy. To understand our energy future, it is helpful to have a perspective on past efforts to develop new energy sources. In this excerpt from the 2024 Harding Loevner Investor Forum, our analysts offer some perspective on the history of energy transition.
What did you think of this piece?
Fundamental Analysis
When most people think of automation in driving, they think of cars that could operate anywhere without a human driver, or what the Society of Automotive Engineers calls “Level 5 automation.” But many cars on the road today offer some level of automation, whether it’s lane centering features or adaptive cruise control, or both. The key distinction in these so-called Level 1 and Level 2 systems is that these features support the driver, rather than replacing the driver as the higher levels would.
The market for the driver-assistance technology is currently dominated by the Israeli company Mobileye. The company’s EyeQ system analyzes the input from a camera and sensors to alert drivers to dangerous traffic conditions and can initiate maneuvers such as evasive steering when a collision is imminent. As of last year, the company has captured about 70% of the private vehicle market with its basic driver assistance tools, with more than 50 automaker clients including Volkswagen, Ford, Toyota, and Chinese electric vehicle maker Geely.
Mobileye now hopes to leverage its success in basic driver assistance solutions to allow it to have similar success in more advanced levels of automated driving. Mobileye rolled out SuperVision, its Level 2+ driving assistance solution, in 2021. The system requires drivers to keep their eyes on the road, but they can let go of the steering wheel and let the automated system take over in specific circumstances such as on “all regular road types at up to 80 miles per hour,” according to the company.
In 2026, the company plans to release a true Level 3 autonomy system it calls Mobileye Chauffeur. That system would enable motorists to take their eyes off the road and their hands off the steering wheel in a wider array of traffic conditions, another step toward fully autonomous cars.
These more advanced systems come with extra risks for the company. If a car is involved in an accident while the automated systems are engaged, the manufacturer of the driver assistance tools can be held legally responsible for the incident. The added liability risk and the regulatory certification process, especially for Level 3 cars and above, are two of the reasons why few companies have ventured to bring advanced self-driving cars to market.
There is also strong competition in the market. The biggest threat is from large automakers that can afford to produce technologies for self-driving cars that could replace, or surpass, Mobileye’s offerings. An example is Mercedes-Benz, which in 2023 introduced the first Level 3 automation system approved for use in the United States. Chipmakers such as NVIDIA and Qualcomm also make competitive products.
One of Mobileye’s competitive advantages so far has been the low cost of its systems. Since they are mass produced and compatible with over 800 car models, the company has economies of scale that reduces the per unit cost of its products. The company’s basic driver’s assistance package sells to manufacturers for about US$50 per EyeQ unit, while the SuperVision product is sold for between US$1,000 and US$2,000 per system. Last year, most SuperVision units were sold to the electric vehicle maker Geely.
The cost of Mobileye’s automation systems for consumers depends on the manufacturer’s suggested retail price. For example, Ford recommends car dealerships charge consumers a US$600 to US$700 markup for the Ford Escape Active SUV, with Level 2 automation features.
This is compared with Tesla’s Level 2 offerings. While most Tesla car models are manufactured with the basic autopilot features pre-installed, consumers can upgrade to the enhanced Autopilot function for US$6,000 or the Full Self Driving package for US$12,000.
So far, orders for Mobileye’s advanced offerings have been below market expectations for 2024 as the company initially expected to ship 175,000 to 195,000 SuperVision units to a handful of large automakers including Porsche, China’s FAW group, Geely, and India’s Mahindra. But Mobileye’s stock edged up in late March after Volkswagen Group announced it would use SuperVision and Chauffeur in the future production of car brands such as Audi, Bentley, and Lamborghini, and also unveiled a partnership with Mobileye to rollout a robot taxi fleet in 2026.
Despite the positive update, investors would like to see more large Western automakers join the ranks of customers for the company’s new system. Mobileye says it’s in talks with 11 manufacturers who make 37% of global light vehicles. If the company wins more deals with automotive companies that essentially give up on their in-house autonomous vehicle systems, Mobileye could create a competitive moat to defend its long-term profits and market share.
The market for the driver-assistance technology is currently dominated by the Israeli company Mobileye. The company’s EyeQ system analyzes the input from a camera and sensors to alert drivers to dangerous traffic conditions and can initiate maneuvers such as evasive steering when a collision is imminent. As of last year, the company has captured about 70% of the private vehicle market with its basic driver assistance tools, with more than 50 automaker clients including Volkswagen, Ford, Toyota, and Chinese electric vehicle maker Geely.
Mobileye now hopes to leverage its success in basic driver assistance solutions to allow it to have similar success in more advanced levels of automated driving. Mobileye rolled out SuperVision, its Level 2+ driving assistance solution, in 2021. The system requires drivers to keep their eyes on the road, but they can let go of the steering wheel and let the automated system take over in specific circumstances such as on “all regular road types at up to 80 miles per hour,” according to the company.
In 2026, the company plans to release a true Level 3 autonomy system it calls Mobileye Chauffeur. That system would enable motorists to take their eyes off the road and their hands off the steering wheel in a wider array of traffic conditions, another step toward fully autonomous cars.
These more advanced systems come with extra risks for the company. If a car is involved in an accident while the automated systems are engaged, the manufacturer of the driver assistance tools can be held legally responsible for the incident. The added liability risk and the regulatory certification process, especially for Level 3 cars and above, are two of the reasons why few companies have ventured to bring advanced self-driving cars to market.
There is also strong competition in the market. The biggest threat is from large automakers that can afford to produce technologies for self-driving cars that could replace, or surpass, Mobileye’s offerings. An example is Mercedes-Benz, which in 2023 introduced the first Level 3 automation system approved for use in the United States. Chipmakers such as NVIDIA and Qualcomm also make competitive products.
One of Mobileye’s competitive advantages so far has been the low cost of its systems. Since they are mass produced and compatible with over 800 car models, the company has economies of scale that reduces the per unit cost of its products. The company’s basic driver’s assistance package sells to manufacturers for about US$50 per EyeQ unit, while the SuperVision product is sold for between US$1,000 and US$2,000 per system. Last year, most SuperVision units were sold to the electric vehicle maker Geely.
The cost of Mobileye’s automation systems for consumers depends on the manufacturer’s suggested retail price. For example, Ford recommends car dealerships charge consumers a US$600 to US$700 markup for the Ford Escape Active SUV, with Level 2 automation features.
This is compared with Tesla’s Level 2 offerings. While most Tesla car models are manufactured with the basic autopilot features pre-installed, consumers can upgrade to the enhanced Autopilot function for US$6,000 or the Full Self Driving package for US$12,000.
So far, orders for Mobileye’s advanced offerings have been below market expectations for 2024 as the company initially expected to ship 175,000 to 195,000 SuperVision units to a handful of large automakers including Porsche, China’s FAW group, Geely, and India’s Mahindra. But Mobileye’s stock edged up in late March after Volkswagen Group announced it would use SuperVision and Chauffeur in the future production of car brands such as Audi, Bentley, and Lamborghini, and also unveiled a partnership with Mobileye to rollout a robot taxi fleet in 2026.
Despite the positive update, investors would like to see more large Western automakers join the ranks of customers for the company’s new system. Mobileye says it’s in talks with 11 manufacturers who make 37% of global light vehicles. If the company wins more deals with automotive companies that essentially give up on their in-house autonomous vehicle systems, Mobileye could create a competitive moat to defend its long-term profits and market share.
What did you think of this piece?
Fundamental Analysis
The lower house of France’s Parliament passed a bill in February that would impose a “sin tax” of up to 10 euros or 50% of the selling price on fast-fashion clothing, a severe penalty given that many of these products cost less than €10. The bill would also ban advertising and demands that companies in the industry disclose the environmental impact of their businesses. The bill was approved unanimously and moved to the upper house of Parliament. If it becomes law, it will make France one of the first countries to impose this type of penalty on fast-fashion companies.
Fast fashion has become a roughly US$120 billion industry and is projected to grow to US$185 billion by 2027. Shein, H&M, Temu, Zara, and others have built worldwide businesses by creating cheap clothing in bulk as quickly as possible to respond to changing fashion trends, especially for a growing global middle class with more disposable income. The crux of the problem is that fast fashion tends to encourage what many consider an excessive amount of consumption. Traditional clothing companies might release new lines four times a year; fast-fashion companies do so weekly or even daily. The clothes are designed to be relatively cheap and worn for a short period of time before being discarded, sometimes after only seven or eight wears. Consumers are then expected to buy the next hot thing. The result? People are buying more clothes, an estimated 60% more, but keeping them only half as long as they would a more durable, higher-quality piece of clothing.
Those dynamics exacerbate the environmental impacts of an industry that is inherently polluting to begin with. Conventional textile mills generate about one-fifth of the world’s industrial water pollution. About 20-35% of all the microplastics in the world’s oceans come from microfibers shed by clothes as they are washed. The industry also produces veritable mountains of unsold clothing, which get burned or thrown into landfills strewn around the Global South. (Shein, for one, has argued that its business model better matches supply with demand and produces less unsold clothing).

The photograph above was taken by Maria Lernerman, who came across the Shein-labeled piece of plastic while on vacation.

Businesses with a high-volume, low-price model, such as Shein and Temu, would be the most vulnerable to a tax like the one France is contemplating, given higher prices would test consumer demand. The effects would also depend on how the French regulation ends up defining “fast fashion.” It may cover only the “fastest” companies, such as Shein and Temu, or it could include older, more established players like Zara and H&M. An advertising ban would severely limit companies’ ability to grow, and the tax would cut into both growth and profits. While it would be a competitive benefit for “slower” fashion companies, placing severe costs and restrictions on even part of the industry could cement the image of fashion as “sinful,” making it easier for other governments to levy taxes or fees on all players over time. Lastly, a bill such as this could be politically divisive, opposed by consumers who are already facing economic strains.
On one level, France’s bill is aimed directly at the environmental impact of fast-fashion companies, but there is another motive behind the bill. This bill would give a competitive advantage to France’s domestic fashion and retail industry and protect it from upstarts. But lawmakers in other jurisdictions are also looking at the industry. The EU’s European Commission has been working for four years on regulations for the industry that should enter into force by 2030. In the US, state lawmakers in New York and California have introduced bills that address the fast-fashion industry’s environmental effects. And in 2022, Massachusetts banned textiles being thrown out in the garbage, mandating they be recycled.
Businesses with a high-volume, low-price model, such as Shein and Temu, would be the most vulnerable to a tax like the one France is contemplating, given higher prices would test consumer demand. The effects would also depend on how the French regulation ends up defining “fast fashion.” It may cover only the “fastest” companies, such as Shein and Temu, or it could include older, more established players like Zara and H&M. An advertising ban would severely limit companies’ ability to grow, and the tax would cut into both growth and profits. While it would be a competitive benefit for “slower” fashion companies, placing severe costs and restrictions on even part of the industry could cement the image of fashion as “sinful,” making it easier for other governments to levy taxes or fees on all players over time. Lastly, a bill such as this could be politically divisive, opposed by consumers who are already facing economic strains.
On one level, France’s bill is aimed directly at the environmental impact of fast-fashion companies, but there is another motive behind the bill. This bill would give a competitive advantage to France’s domestic fashion and retail industry and protect it from upstarts. But lawmakers in other jurisdictions are also looking at the industry. The EU’s European Commission has been working for four years on regulations for the industry that should enter into force by 2030. In the US, state lawmakers in New York and California have introduced bills that address the fast-fashion industry’s environmental effects. And in 2022, Massachusetts banned textiles being thrown out in the garbage, mandating they be recycled.
What did you think of this piece?
Factor Investing
The difficulty in pinning down exactly what’s behind such canonical factors as quality, value, and momentum shouldn’t be a surprise. Factors can only be observed after the fact, but the underlying mechanisms that produce them are hidden. They are birthed from the complex interplay of buying and selling against a backdrop of economic and geopolitical shifts, all woven together by intricate feedback loops. Because they emerge as properties of a complex system, and because their returns wax and wane over decades, pinpointing a definitive root cause is quite the challenge.
Among factors, perhaps the biggest puzzle, however, is what lies behind the excess returns that have accrued to companies with strong balance sheets, consistent profitability, and operational excellence, typically referred to as the quality factor. Investors should be willing to pay up for such enviable characteristics, and they do, but not as much as they should and therein lies the puzzle. Narratives about risk can shed light on the performance of value stocks, and the idea of slow-spreading information can account for momentum, but what exactly is behind the outperformance of high-quality stocks remains elusive.
For behavioralists, often mistakenly criticized as viewing every market inefficiency as proof of human imperfection, the quality factor is a reflection of rational, yet imperfect, heuristics that sometimes lead to less-than-optimal outcomes. For strictly orthodox economists who hold fast to the notion of a perfectly rational human agent, every excess return must be a manifestation of some as yet unrecognized risk. And a more unconventional viewpoint turns the traditional understanding of the quality factor on its head, suggesting instead that what we’re observing is not a premium for high quality so much as discount applied to everything else.

A Question of Behavior

An argument that resonates with us, given our interest in decision-making, is that the quality premium is a strange brew that is cooked up in a cauldron of behavioral biases.
One such bias is our species’ attraction to novelty which isn’t just a quirk, but a survival mechanism with deep evolutionary roots, aiding in resource discovery, adaptation, learning, and fostering genetic diversity. However, in the realm of investing, this penchant for the new and thrilling—such as groundbreaking companies or industries believed to hold unparalleled growth potential—can be a double-edged sword. While novelty propels us toward innovation, it may also detract from investment performance as the inclination towards novelty can distract us from well-established, dependable companies, causing these reliable (but perhaps less flashy) businesses to trade at undemanding valuations.
Investing in the latest hot stocks or jumping on board the next big thing also comes with perks that aren’t just about money. Being able to dazzle friends and colleagues with tales of daring portfolio moves might not do much for your bank balance but may well boost your social standing. A desire for non-financial psychic returns, a feature of gambling and other negative expected value pastimes, can prompt investors to pursue the latest speculative ventures over more reliable, high-quality firms, even though the latter may offer superior financial gains in the long run.
Overconfidence and the illusion of knowledge are additional behavioral hurdles for investors, leading them to overestimate their ability to spot the next big thing or accurately forecast market movements. Such overconfidence often diverts attention away from companies with a history of reliable performance towards those that appear to be future market leaders. Overconfidence can also lead investors to underestimate risks and overlook red flags in highly volatile stocks or sectors, fostering a false sense of security about their ability to navigate market turbulence unscathed.
By favoring novelty, seeking social status, or falling prey to overconfidence, investors might overlook the superior long-term performance potential of high-quality companies, thus contributing to the observed excess returns.

By favoring novelty, seeking social status, or falling prey to overconfidence, investors might overlook the superior long-term performance potential of high-quality companies, thus contributing to the observed excess returns.

A Better Beta?

While the idea that behavioral biases divert investors away from high-quality stocks provides a credible rationale for the excess return to high-quality companies, it flies in the face of notions of market efficiency. After all, if these biases are evident, why haven’t they been competed away by savvy arbitrageurs? An alternative perspective that coheres with behavioral explanations yet also aligns with notions of investor rationality is encapsulated by the low beta anomaly or beta puzzle. This refers to the empirical finding that low beta stocks (stocks that have lower sensitivity to overall index returns) on average tend to deliver higher risk-adjusted returns, in direct contradiction of what is predicted by the Capital Asset Pricing Model (CAPM).
High-quality companies, in addition to their strong fundamentals, typically have stocks with low betas. According to the CAPM, the expected return on a stock is directly related to its beta, which measures its sensitivity to market movements. Higher beta stocks are expected to have higher returns to compensate for their higher risk and vice versa. However, in practice the opposite holds true, with lower beta stocks on average yielding higher returns than would be expected and vice versa.

Higher beta stocks are expected to have higher returns to compensate for their higher risk and vice versa. However, in practice the opposite holds true, with lower beta stocks on average yielding higher returns than would be expected and vice versa.

Fisher Black, famously known for co-developing the Black-Scholes option pricing model, was among the first to spotlight the beta puzzle. In the early 1970s, Black posited that borrowing limitations might be a key factor behind the low beta anomaly. The CAPM presupposes that investors can freely borrow and lend at the risk-free rate, allowing them to adjust their leverage to meet their preferred risk levels. Black noted that in practice, investors faced restrictions on leverage, preventing them from achieving their desired beta through leverage adjustments alone. Consequently, they had to alter their portfolio composition to reach their beta objectives, resulting in the low beta anomaly.
Black’s theory was plausible at the time, considering the high trading costs and assorted frictions which made it hard for investors to access leverage. Yet, half a century later, after an explosion of innovation in financial derivatives and an extended period of ultra-easy borrowing conditions, the notion that investors are leverage-constrained seems almost quaint.
More likely the beta puzzle stems from the inherent limitations of the CAPM itself. As a static model that assumes market equilibrium and provides only a momentary glimpse of how a stock’s expected returns correlate with market returns, it fails to consider the evolution of this relationship over time.
This shortcoming of the CAPM is particularly acute in the model’s failure to account for the tendency of betas to converge during periods of market distress. The phrase “all betas go to one in a crisis” succinctly captures this phenomenon, where individual stock behaviors become increasingly synchronized under severe market conditions. This convergence is largely caused by a widespread rush for liquidity and a collective retreat from risk, as leveraged investors indiscriminately divest assets in their dash for cash. In such times, the unique attributes that typically differentiate stock performances become overshadowed by systemic risk, which exerts a uniform pressure across the market. Consequently, the usual factors that contribute to diverse performance fade into the background, and the collective retreat from risk catalyzes a comprehensive market downturn. This scenario sees individual stocks’ returns align closely with the market average, effectively normalizing betas to one, a shift that CAPM does not anticipate.
This dynamic has the effect of disadvantaging low-beta stocks while benefiting high-beta stocks during crises. High-beta portfolios, which are inherently riskier under normal conditions, experience a relative decline in beta during a crisis, providing a form of wealth protection not accounted for if beta remained unchanged. In contrast, investors with low-beta portfolios find themselves at a disadvantage as their stocks, previously less sensitive to market movements, start mirroring the broader market. Technically, the high-beta portfolio exhibits positive convexity, meaning that losses diminish in relative terms during a crisis, while the low-beta portfolio shows negative convexity, with losses accelerating. Positive convexity is desirable, something investors are willing to pay a premium for, whereas negative convexity, representing increased risk, is something investors expect compensation to endure. And, as market pricing incorporates the convexity associated with different portfolios, the premium attached to low-beta, or high-quality, stocks emerges as a form of compensation for the negative convexity they bear during times of crisis.
But while convexity may well be a piece of the quality puzzle, its impact is likely peripheral, affecting primarily those stocks where low beta coincides with high quality. Moreover, attributing all the excess return to convexity adjustments alone is hard to square with its overall magnitude, which typically ranges from 1% to 3% annually across global equity markets. Even staunch proponents of rational expectations struggle to justify such a rich premium for convexity alone, suggesting that additional drivers must be at play.

A Capital Question

One possible explanation, albeit one that is perhaps a little far-fetched, turns the whole notion of a quality factor on its head by proposing that the phenomenon is less about higher-quality companies generating superior returns and more about lower-quality companies consistently eroding shareholder value. And while this may seem like a distinction without a difference, leading to the same outcome, it shifts the locus of investigation and suggests that one key to understanding the excess returns from high-quality stocks lies in understanding this erosion of shareholder value.
A clue lies buried in the arcana of equity index valuation. Given that stocks are ultimately a claim on future cash flows, a common heuristic for stock expected returns is the inverse of the price to earnings (PE) ratio, known as the earnings yield. Building on this concept, Robert Shiller, in an influential 1988 paper co-authored with John Campbell exploring long-term mean reversion in stock prices, proposed a refinement. He recognized that since earnings fluctuate with the business cycle, a simple PE analysis based on the last year’s earnings would distort expected returns. To mitigate this, Shiller proposed using a ten-year average of real earnings instead of a single year’s earnings in the calculation. This adjustment, known as the cyclically adjusted earnings yield (CAPE), by removing the year-to-year volatility in earnings, offered a more reliable view on long-term stock expected returns by smoothing or removing the effects of business cycles.
Shiller’s research attracted attention for its implications on mean reversion, challenging the dominant idea that stock markets follow a random walk. A less-noticed aspect of his work is how it highlighted the systematic overstatement of earnings. Specifically, his findings showed that, on average in the US since 1870, expected returns as reflected by the CAPE have consistently exceeded realized real returns.
The discrepancy between the expected returns calculated using CAPE and the actual returns achieved by investors, often called earnings slippage, is a puzzle. While this gap exists, it’s relatively small—under 50 basis points (bps) when assessed over the same ten-year period horizon as the CAPE. Interestingly, this gap has been diminishing since the turn of the century, but not because of accelerating earnings growth but rather due to surging market valuations. Given that Shiller’s premise is that valuations mean revert, adjusting for this recent expansion in valuations nudges an estimate of earnings slippage closer to 100bps. While this figure is similar to the excess returns seen from high-quality companies, it doesn’t equate earnings slippage with the excess return to quality directly. However, earnings slippage does suggest an intriguing possibility: perhaps high-quality companies are indeed delivering the true expected equity risk premium, with the broader market persistently falling short.
While it’s nigh on impossible to pinpoint the exact causes of earnings slippage, potential culprits include aggressive pension accounting, the omission of stock option expenses, and good old-fashioned featherbedding and fraud. But the biggest culprit is most likely poor allocation of capital by those responsible for managing the business on behalf of its owners. The connection between bad investments and inflated earnings might not be immediately intuitive, as poor capital allocation decisions typically lead to losses, not inflated earnings. However, the mechanism through which bad investments can contribute to apparent earnings slippage involves the timing of investment gains and losses, along with accounting practices that can obscure the true financial impact of these investments. Investments in corporate jets ostensibly to maximize the efficiency of senior executives come to mind as does the asymmetric nature of stock options that have an uncanny tendency to be reset when things go awry.
The phenomenon of earnings slippage offers another possible explanation for the quality factor. Rather than a reward for superior management and profitability, it might be more accurately seen as a penalty on the rest of the market for its capital allocation failures.

The phenomenon of earnings slippage offers another possible explanation for the quality factor. Rather than a reward for superior management and profitability, it might be more accurately seen as a penalty on the rest of the market for its capital allocation failures.

A Quality Conundrum

The excess returns to shares of high-quality companies almost certainly don’t emanate from a single source. Instead, it likely emerges from a nexus of influences—behavioral biases that divert attention away from solid, albeit less-exciting, investments; a market structure that rewards low-beta stocks, contrary to classical models; and the tangible effect of companies’ capital allocation decisions on their long-term value.
The lack of a single cause for these excess returns to quality means that it cannot be fully automated or left to simple rules-based strategies to be harvested. While these approaches may succeed in catching broad trends, they lack the discernment necessary to differentiate between genuine quality and superficial indicators of performance. This understanding of high quality as a reflection of the wider market’s capital allocation failures naturally leads us to the pivotal role of bottom-up, stock-by-stock fundamental analysis.
A meticulous, bottom-up approach allows investors to peel back the layers of each potential investment, assessing the quality of its management, the efficacy of its capital allocation, and the sustainability of its business model. This granular analysis is crucial to identify companies that not only exemplify the traits associated with high quality in the past but are also positioned to sustain these traits in the face of market volatility and economic shifts going forward. Such an approach recognizes that high quality is not merely the product of a few, easily quantifiable metrics but the outcome of numerous, interrelated elements that require careful consideration. By investing the time and effort into understanding each company’s unique context and fundamentals, investors can more dependably pursue the superior equity risk premium that high-quality companies offer while resisting the myriad temptations to do otherwise. In essence, the pursuit of the excess return to high-quality companies through fundamental analysis is not just a matter of preference but a strategic imperative.
An argument that resonates with us, given our interest in decision-making, is that the quality premium is a strange brew that is cooked up in a cauldron of behavioral biases.
One such bias is our species’ attraction to novelty which isn’t just a quirk, but a survival mechanism with deep evolutionary roots, aiding in resource discovery, adaptation, learning, and fostering genetic diversity. However, in the realm of investing, this penchant for the new and thrilling—such as groundbreaking companies or industries believed to hold unparalleled growth potential—can be a double-edged sword. While novelty propels us toward innovation, it may also detract from investment performance as the inclination towards novelty can distract us from well-established, dependable companies, causing these reliable (but perhaps less flashy) businesses to trade at undemanding valuations.
Investing in the latest hot stocks or jumping on board the next big thing also comes with perks that aren’t just about money. Being able to dazzle friends and colleagues with tales of daring portfolio moves might not do much for your bank balance but may well boost your social standing. A desire for non-financial psychic returns, a feature of gambling and other negative expected value pastimes, can prompt investors to pursue the latest speculative ventures over more reliable, high-quality firms, even though the latter may offer superior financial gains in the long run.
Overconfidence and the illusion of knowledge are additional behavioral hurdles for investors, leading them to overestimate their ability to spot the next big thing or accurately forecast market movements. Such overconfidence often diverts attention away from companies with a history of reliable performance towards those that appear to be future market leaders. Overconfidence can also lead investors to underestimate risks and overlook red flags in highly volatile stocks or sectors, fostering a false sense of security about their ability to navigate market turbulence unscathed.
By favoring novelty, seeking social status, or falling prey to overconfidence, investors might overlook the superior long-term performance potential of high-quality companies, thus contributing to the observed excess returns.
By favoring novelty, seeking social status, or falling prey to overconfidence, investors might overlook the superior long-term performance potential of high-quality companies, thus contributing to the observed excess returns.
While the idea that behavioral biases divert investors away from high-quality stocks provides a credible rationale for the excess return to high-quality companies, it flies in the face of notions of market efficiency. After all, if these biases are evident, why haven’t they been competed away by savvy arbitrageurs? An alternative perspective that coheres with behavioral explanations yet also aligns with notions of investor rationality is encapsulated by the low beta anomaly or beta puzzle. This refers to the empirical finding that low beta stocks (stocks that have lower sensitivity to overall index returns) on average tend to deliver higher risk-adjusted returns, in direct contradiction of what is predicted by the Capital Asset Pricing Model (CAPM).
High-quality companies, in addition to their strong fundamentals, typically have stocks with low betas. According to the CAPM, the expected return on a stock is directly related to its beta, which measures its sensitivity to market movements. Higher beta stocks are expected to have higher returns to compensate for their higher risk and vice versa. However, in practice the opposite holds true, with lower beta stocks on average yielding higher returns than would be expected and vice versa.
Higher beta stocks are expected to have higher returns to compensate for their higher risk and vice versa. However, in practice the opposite holds true, with lower beta stocks on average yielding higher returns than would be expected and vice versa.
Fisher Black, famously known for co-developing the Black-Scholes option pricing model, was among the first to spotlight the beta puzzle. In the early 1970s, Black posited that borrowing limitations might be a key factor behind the low beta anomaly. The CAPM presupposes that investors can freely borrow and lend at the risk-free rate, allowing them to adjust their leverage to meet their preferred risk levels. Black noted that in practice, investors faced restrictions on leverage, preventing them from achieving their desired beta through leverage adjustments alone. Consequently, they had to alter their portfolio composition to reach their beta objectives, resulting in the low beta anomaly.
Black’s theory was plausible at the time, considering the high trading costs and assorted frictions which made it hard for investors to access leverage. Yet, half a century later, after an explosion of innovation in financial derivatives and an extended period of ultra-easy borrowing conditions, the notion that investors are leverage-constrained seems almost quaint.
More likely the beta puzzle stems from the inherent limitations of the CAPM itself. As a static model that assumes market equilibrium and provides only a momentary glimpse of how a stock’s expected returns correlate with market returns, it fails to consider the evolution of this relationship over time.
This shortcoming of the CAPM is particularly acute in the model’s failure to account for the tendency of betas to converge during periods of market distress. The phrase “all betas go to one in a crisis” succinctly captures this phenomenon, where individual stock behaviors become increasingly synchronized under severe market conditions. This convergence is largely caused by a widespread rush for liquidity and a collective retreat from risk, as leveraged investors indiscriminately divest assets in their dash for cash. In such times, the unique attributes that typically differentiate stock performances become overshadowed by systemic risk, which exerts a uniform pressure across the market. Consequently, the usual factors that contribute to diverse performance fade into the background, and the collective retreat from risk catalyzes a comprehensive market downturn. This scenario sees individual stocks’ returns align closely with the market average, effectively normalizing betas to one, a shift that CAPM does not anticipate.
This dynamic has the effect of disadvantaging low-beta stocks while benefiting high-beta stocks during crises. High-beta portfolios, which are inherently riskier under normal conditions, experience a relative decline in beta during a crisis, providing a form of wealth protection not accounted for if beta remained unchanged. In contrast, investors with low-beta portfolios find themselves at a disadvantage as their stocks, previously less sensitive to market movements, start mirroring the broader market. Technically, the high-beta portfolio exhibits positive convexity, meaning that losses diminish in relative terms during a crisis, while the low-beta portfolio shows negative convexity, with losses accelerating. Positive convexity is desirable, something investors are willing to pay a premium for, whereas negative convexity, representing increased risk, is something investors expect compensation to endure. And, as market pricing incorporates the convexity associated with different portfolios, the premium attached to low-beta, or high-quality, stocks emerges as a form of compensation for the negative convexity they bear during times of crisis.
But while convexity may well be a piece of the quality puzzle, its impact is likely peripheral, affecting primarily those stocks where low beta coincides with high quality. Moreover, attributing all the excess return to convexity adjustments alone is hard to square with its overall magnitude, which typically ranges from 1% to 3% annually across global equity markets. Even staunch proponents of rational expectations struggle to justify such a rich premium for convexity alone, suggesting that additional drivers must be at play.
One possible explanation, albeit one that is perhaps a little far-fetched, turns the whole notion of a quality factor on its head by proposing that the phenomenon is less about higher-quality companies generating superior returns and more about lower-quality companies consistently eroding shareholder value. And while this may seem like a distinction without a difference, leading to the same outcome, it shifts the locus of investigation and suggests that one key to understanding the excess returns from high-quality stocks lies in understanding this erosion of shareholder value.
A clue lies buried in the arcana of equity index valuation. Given that stocks are ultimately a claim on future cash flows, a common heuristic for stock expected returns is the inverse of the price to earnings (PE) ratio, known as the earnings yield. Building on this concept, Robert Shiller, in an influential 1988 paper co-authored with John Campbell exploring long-term mean reversion in stock prices, proposed a refinement. He recognized that since earnings fluctuate with the business cycle, a simple PE analysis based on the last year’s earnings would distort expected returns. To mitigate this, Shiller proposed using a ten-year average of real earnings instead of a single year’s earnings in the calculation. This adjustment, known as the cyclically adjusted earnings yield (CAPE), by removing the year-to-year volatility in earnings, offered a more reliable view on long-term stock expected returns by smoothing or removing the effects of business cycles.
Shiller’s research attracted attention for its implications on mean reversion, challenging the dominant idea that stock markets follow a random walk. A less-noticed aspect of his work is how it highlighted the systematic overstatement of earnings. Specifically, his findings showed that, on average in the US since 1870, expected returns as reflected by the CAPE have consistently exceeded realized real returns.
The discrepancy between the expected returns calculated using CAPE and the actual returns achieved by investors, often called earnings slippage, is a puzzle. While this gap exists, it’s relatively small—under 50 basis points (bps) when assessed over the same ten-year period horizon as the CAPE. Interestingly, this gap has been diminishing since the turn of the century, but not because of accelerating earnings growth but rather due to surging market valuations. Given that Shiller’s premise is that valuations mean revert, adjusting for this recent expansion in valuations nudges an estimate of earnings slippage closer to 100bps. While this figure is similar to the excess returns seen from high-quality companies, it doesn’t equate earnings slippage with the excess return to quality directly. However, earnings slippage does suggest an intriguing possibility: perhaps high-quality companies are indeed delivering the true expected equity risk premium, with the broader market persistently falling short.
While it’s nigh on impossible to pinpoint the exact causes of earnings slippage, potential culprits include aggressive pension accounting, the omission of stock option expenses, and good old-fashioned featherbedding and fraud. But the biggest culprit is most likely poor allocation of capital by those responsible for managing the business on behalf of its owners. The connection between bad investments and inflated earnings might not be immediately intuitive, as poor capital allocation decisions typically lead to losses, not inflated earnings. However, the mechanism through which bad investments can contribute to apparent earnings slippage involves the timing of investment gains and losses, along with accounting practices that can obscure the true financial impact of these investments. Investments in corporate jets ostensibly to maximize the efficiency of senior executives come to mind as does the asymmetric nature of stock options that have an uncanny tendency to be reset when things go awry.
The phenomenon of earnings slippage offers another possible explanation for the quality factor. Rather than a reward for superior management and profitability, it might be more accurately seen as a penalty on the rest of the market for its capital allocation failures.
The phenomenon of earnings slippage offers another possible explanation for the quality factor. Rather than a reward for superior management and profitability, it might be more accurately seen as a penalty on the rest of the market for its capital allocation failures.
The excess returns to shares of high-quality companies almost certainly don’t emanate from a single source. Instead, it likely emerges from a nexus of influences—behavioral biases that divert attention away from solid, albeit less-exciting, investments; a market structure that rewards low-beta stocks, contrary to classical models; and the tangible effect of companies’ capital allocation decisions on their long-term value.
The lack of a single cause for these excess returns to quality means that it cannot be fully automated or left to simple rules-based strategies to be harvested. While these approaches may succeed in catching broad trends, they lack the discernment necessary to differentiate between genuine quality and superficial indicators of performance. This understanding of high quality as a reflection of the wider market’s capital allocation failures naturally leads us to the pivotal role of bottom-up, stock-by-stock fundamental analysis.
A meticulous, bottom-up approach allows investors to peel back the layers of each potential investment, assessing the quality of its management, the efficacy of its capital allocation, and the sustainability of its business model. This granular analysis is crucial to identify companies that not only exemplify the traits associated with high quality in the past but are also positioned to sustain these traits in the face of market volatility and economic shifts going forward. Such an approach recognizes that high quality is not merely the product of a few, easily quantifiable metrics but the outcome of numerous, interrelated elements that require careful consideration. By investing the time and effort into understanding each company’s unique context and fundamentals, investors can more dependably pursue the superior equity risk premium that high-quality companies offer while resisting the myriad temptations to do otherwise. In essence, the pursuit of the excess return to high-quality companies through fundamental analysis is not just a matter of preference but a strategic imperative.
What did you think of this piece?
Fundamental Analysis
Maria Lernerman, CFA, portfolio manager for our Global Paris-Aligned and International Carbon Transition Equity strategies, recently traveled to India to observe the country’s emission reduction initiatives first-hand. In this video, she shares thoughts from her trip and highlights hurdles that the country must overcome to progress toward net-zero status.
What did you think of this piece?
Fundamental Analysis
Sparkling water isn’t the only product looking cheaper at Costco these days. During a quarterly earnings call in March, Chief Financial Officer Richard Galanti seemed to signal an inflection point when he rattled off a variety of goods for which prices were being lowered: Kirkland batteries (from US$17.99 down to US$15.99) and reading glasses (US$18.99 to US$16.99), as well as sporting goods and lawn-care products. A bag of frozen fruit was even reduced by US$4. Plus, there was a more subtle clue about the direction of retail pricing: inflation was mentioned just seven times on the call, compared with 35 times during the March 2023 earnings call. (As for the recent trade disruptions in the Panama Canal and Red Sea, management said this hadn’t pushed up prices because of the long-term nature of shipping contracts.)
Costco’s results for the quarter were healthy, but they also contained signs that industry dynamics are beginning to shift. For example, given that overall inflation was flat across the retailer’s product categories, growth in same-store sales was dependent on increased customer traffic.

Shifting Dynamics

As inflation moderated in early 2024, increased traffic to Costco’s stores was the source of same-store sales growth

Source: Company filings

To be sure, the US Federal Reserve’s battle with inflation is continuing. A Commerce Department report last week showed that the central bank’s preferred inflation gauge unexpectedly reaccelerated in March, throwing into question the interest-rate cuts that were projected for later in the year, as well as providing a more complicated backdrop for Costco’s pricing strategy.
As consumer prices surged the last few years, Costco thrived by offering relative discounts. Its Kirkland Signature private-label products tend to be at least 20% cheaper than national brands, and at the height of inflation, Kirkland’s market penetration increased by 2%. One item in particular has become a symbol of Costco savings: its iconic food court hot dog. Even after inflation on food set multidecade records in 2022, the hot-dog-and-soda combo still costs just US$1.50, the same price it’s been since 1985.
Costco has an advantage in setting prices because of its limited assortment of products. Each store carries only about 4,000 stock-keeping units, or SKUs—the scannable barcodes assigned to each type of product. In contrast, SKUs at other big-box retailers, such as Target and Walmart, can number in the tens of thousands. By purchasing fewer products in enormous quantities, Costco’s purchasing power often exceeds that of its rivals, which enables it to set lower prices than the market.
“We always want to be the first out there trying to lower prices,” Galanti said in March. But if the economic environment is such that other retailers begin to lower prices, competition may increase.
The prospect of rising competition leaves investors to wonder if that’s why Costco seems hesitant to raise membership fees. Only members can shop at Costco’s warehouses, and the fee to be a member has traditionally gone up every five to six years. However, the last increase was nearly seven years ago in June 2017, suggesting the retailer is overdue for another bump. Currently, the two membership options cost US$60 and US$120 a year.
Last May, Galanti said that he felt “very good” about the ability to increase membership fees without hurting renewal rates or signups. But it’s easier to raise prices when prices in general are going up, and harder to do if inflation moderates. During the recent earnings call, Galanti was vague about the company’s plans, adding only that the decision for when to raise fees doesn’t involve “some big analytical formula.”
In the meantime, other retailers have introduced optional membership programs to encourage shoppers to spend more money with them. In 2020, Walmart launched Walmart+, a plan that costs US$98 a year and includes free shipping and delivery, fuel savings, and access to the Paramount+ streaming-TV service. In April, Target introduced a similar program called Target Circle 360; for US$99 a year, users save on speedy shipping and are given an extra 30 days to make returns. There’s also Amazon Prime, a US$139-a-year subscription with shipping and digital-entertainment perks. For shoppers looking to buy in bulk, one of Costco’s closest rivals is BJ’s Wholesale Club, which similarly requires customers to become members and pay either US$55 or US$110 a year.
Despite the myriad in-store and online shopping competitors, Costco members remain especially loyal. About 93% in the US and Canada, and 90.5% worldwide, renewed as of the latest quarter, with both rates essentially unchanged from a year ago.

Loyal Shoppers

As Costco’s membership base has grown, the proportion renewing their plans has remained consistent

Source: Company filings

Over time, international renewal rates should also build to near North America’s levels. That’s because many of its locations abroad are still new. In China alone, the company has opened six stores since 2019 to much initial fanfare (the grand opening of the first location drew such large crowds that it had to close early for the day). New stores initially attract consumers who are curious about Costco but don’t necessarily live nearby or plan to remain members. Therefore, it can take time for the customer base to stabilize.
While Costco remains a high-quality company, the stock’s rally this year—partly due to high expectations for its expansion in China—has caused the valuation to become stretched relative to its growth prospects. The business is a steady grower, with revenue set to climb by mid-to-high single digits over the long term, yet as it grows it passes on savings to customers, which means margins shouldn’t change much. As competition increases and the company prepares to raise membership fees, investors will watch closely for any change to its membership growth.
As inflation moderated in early 2024, increased traffic to Costco’s stores was the source of same-store sales growth
To be sure, the US Federal Reserve’s battle with inflation is continuing. A Commerce Department report last week showed that the central bank’s preferred inflation gauge unexpectedly reaccelerated in March, throwing into question the interest-rate cuts that were projected for later in the year, as well as providing a more complicated backdrop for Costco’s pricing strategy.
As consumer prices surged the last few years, Costco thrived by offering relative discounts. Its Kirkland Signature private-label products tend to be at least 20% cheaper than national brands, and at the height of inflation, Kirkland’s market penetration increased by 2%. One item in particular has become a symbol of Costco savings: its iconic food court hot dog. Even after inflation on food set multidecade records in 2022, the hot-dog-and-soda combo still costs just US$1.50, the same price it’s been since 1985.
Costco has an advantage in setting prices because of its limited assortment of products. Each store carries only about 4,000 stock-keeping units, or SKUs—the scannable barcodes assigned to each type of product. In contrast, SKUs at other big-box retailers, such as Target and Walmart, can number in the tens of thousands. By purchasing fewer products in enormous quantities, Costco’s purchasing power often exceeds that of its rivals, which enables it to set lower prices than the market.
“We always want to be the first out there trying to lower prices,” Galanti said in March. But if the economic environment is such that other retailers begin to lower prices, competition may increase.
The prospect of rising competition leaves investors to wonder if that’s why Costco seems hesitant to raise membership fees. Only members can shop at Costco’s warehouses, and the fee to be a member has traditionally gone up every five to six years. However, the last increase was nearly seven years ago in June 2017, suggesting the retailer is overdue for another bump. Currently, the two membership options cost US$60 and US$120 a year.
Last May, Galanti said that he felt “very good” about the ability to increase membership fees without hurting renewal rates or signups. But it’s easier to raise prices when prices in general are going up, and harder to do if inflation moderates. During the recent earnings call, Galanti was vague about the company’s plans, adding only that the decision for when to raise fees doesn’t involve “some big analytical formula.”
In the meantime, other retailers have introduced optional membership programs to encourage shoppers to spend more money with them. In 2020, Walmart launched Walmart+, a plan that costs US$98 a year and includes free shipping and delivery, fuel savings, and access to the Paramount+ streaming-TV service. In April, Target introduced a similar program called Target Circle 360; for US$99 a year, users save on speedy shipping and are given an extra 30 days to make returns. There’s also Amazon Prime, a US$139-a-year subscription with shipping and digital-entertainment perks. For shoppers looking to buy in bulk, one of Costco’s closest rivals is BJ’s Wholesale Club, which similarly requires customers to become members and pay either US$55 or US$110 a year.
Despite the myriad in-store and online shopping competitors, Costco members remain especially loyal. About 93% in the US and Canada, and 90.5% worldwide, renewed as of the latest quarter, with both rates essentially unchanged from a year ago.
As Costco’s membership base has grown, the proportion renewing their plans has remained consistent
Over time, international renewal rates should also build to near North America’s levels. That’s because many of its locations abroad are still new. In China alone, the company has opened six stores since 2019 to much initial fanfare (the grand opening of the first location drew such large crowds that it had to close early for the day). New stores initially attract consumers who are curious about Costco but don’t necessarily live nearby or plan to remain members. Therefore, it can take time for the customer base to stabilize.
While Costco remains a high-quality company, the stock’s rally this year—partly due to high expectations for its expansion in China—has caused the valuation to become stretched relative to its growth prospects. The business is a steady grower, with revenue set to climb by mid-to-high single digits over the long term, yet as it grows it passes on savings to customers, which means margins shouldn’t change much. As competition increases and the company prepares to raise membership fees, investors will watch closely for any change to its membership growth.
What did you think of this piece?
Factor Investing
Japan remains the single-largest country weight in the MSCI All Country World ex US Small Cap Index. However, the country’s weak economic growth, aging population, tight labor conditions, and chronic deflation have long made it a challenge to find high-quality, growing companies there.
Government regulators and the Tokyo Stock Exchange recently introduced a flurry of reforms aimed at improving corporate governance and shareholder returns. As discussed in our fourth quarter 2023 report, these actions have primarily benefited the cheapest stocks, given that they are typically associated with the least-profitable and slowest-growing companies. Additionally, the Bank of Japan has raised short-term interest rates, ending its decade-long era of negative rates. This landmark move boosted Japanese value stocks in the first quarter, further exacerbating the region’s style headwinds.
As the chart above to the right shows, the cheapest stocks in Japan outperformed the most expensive by nearly 1,600 basis points in the first quarter. For the trailing 12-month period, it’s worse: The spread between the most expensive and cheapest quintile was nearly 46%. The left and center charts show that investors also have favored slower-growing and lower-quality companies.
We don’t know how long this value rally will persist. In the short run, some of the changes have clearly exacerbated, and could prolong, style headwinds for higher-quality, faster-growing companies. But over the long term, the changes in Japanese business policy and mindset are positive developments. As more businesses raise their standards, the number of high-quality companies in Japan may increase.
What did you think of this piece?
Fundamental Analysis
At Harding Loevner, we believe that whether a business thrives largely depends on the competitive structure of its industry, which we evaluate using Michael Porter’s Five Forces framework. NVIDIA has an estimated 95% share of the market for AI chips. Its graphics processing units (GPUs), which were originally used to power video games, have been adapted to become the key engine of AI computation. The customer base for these chips is highly concentrated and primarily consists of “hyperscalers”—companies such as Alphabet, Amazon.com, Meta, and Microsoft that operate large networks of data centers with immense computing power and storage needs. More than half of NVIDIA’s data-center revenue for its fiscal quarter that ended in January came from large cloud-services providers, and one company alone accounted for 19% of last year’s total company revenue.
From the Porter perspective, a key factor in the bargaining power of buyers is their ability to backward integrate. All of the aforementioned customers have this capability, which threatens to diminish their reliance on NVIDIA. In our view, it’s only a matter of time before this manifests. In fact, Amazon, Google, and Microsoft each have unveiled custom data-center chips as potential substitutes for NVIDIA’s general-purpose GPUs. Because each server in a data center performs only a few specific functions that are repeated over and over, these custom chips, called application-specific integrated circuits (ASICs), are tailored to just the tasks the companies need them to perform.
Industry rivalry is also likely to increase. As the frenzied pace of spending on AI infrastructure eventually eases, companies will begin to look for less expensive options from new suppliers, which may include NVIDIA’s own customers.
NVIDIA is a high-quality company led by skillful managers. Its revenue more than doubled over the past fiscal year, and net profit rose fivefold. But the high potential for increased rivalry and backward integration among key customers suggest that it is unlikely NVIDIA can continue growing at these rates with these margins while maintaining its grip on 95% of the AI-chip market. The fragility of its competitive structure limits our valuation tolerance, which is why we exited the stock in the first quarter after holding it for more than five years.
While it is possible that NVIDIA will continue to exceed increasingly aggressive consensus earnings forecasts for some time, we own other more attractively priced businesses that allow us to invest in AI’s potential. For example, Microsoft and other providers of software and services have the advantage of being able to monetize generative-AI technology without regard for whose GPUs or ASICs are used in the future. Microsoft’s customers also don’t appear to have the ability or interest to try to backward integrate; in fact, AI functionality such as its Copilot chatbot are helping to lock in users. In general, as the applications for AI evolve, value is likely to shift from hardware, such as NVIDIA’s GPUs, to the software and services built upon this infrastructure.
Read more about our software and services holdings in the first quarter Global Equity report.
What did you think of this piece?
Fundamental Analysis
While challenges in China persist, Chinese companies look better than China’s economy.
Some key parts of the Chinese economy continue to stabilize. Manufacturing activities expanded in March for the first time in six months, led by new orders from domestic customers as well as by export orders. The government is pushing for more domestic production in strategic industries such as green technology and advanced manufacturing. Growth in services activities has remained good, with travel and tourism continuing to rebound. We are also seeing increasing localization as Chinese companies prefer Chinese suppliers over multinational corporations to de-risk their own supply chain. This is leading to domestic market-share gains for many companies. Finally, valuations for some high-quality companies look compelling at these levels.
Quality growth stocks in China have derated significantly since 2019 and are now trading at a nearly 40% discount to developed-market counterparts and emerging markets (EMs) as a whole. Conversely, while valuations of Indian companies have moderated slightly over the past year, they continue to be expensive relative to the rising valuations in developed markets. Quality growth stocks in India still trade at a significant premium to other EMs.
India’s evolving economy is promising, as witnessed by our analysts on a recent trip to the country; however, the stock market rally in response has probably gone too far, especially with regards to small and mid-cap stocks. Today, valuations remain stretched across most sectors.
Note: Top QG quadrant is defined as companies with a QR score > 0.5 and a GR score > 0.5. VR Score based on weighted average.
What did you think of this piece?
Fundamental Analysis
Expectations are that semiconductor industry revenue growth will accelerate to annualized double-digit levels this decade, spurred by demand for AI chips. This would be a growth rate well above levels that we’ve seen since the mid-1990s, with predictions that the roughly US$50 billion dollars of AI chips sold in 2023 could rise to US$400 billion dollars of sales before the end of the decade.
While US chip designer NVIDIA gets most of the AI press, TSMC manufactures virtually all of the high-performance AI chips designed by NVIDIA. The Taiwan-based company uses some of its most sophisticated manufacturing technologies for these chips, enabling them to be at the forefront of transistor density, speed, and energy efficiency. AI chip customers also increasingly depend on TSMC’s innovative capabilities in integrating and packaging the logic, memory, and input/output components involved. TSMC’s CEO recently projected that in four years about 20% of this company’s total revenue would come from AI-specific chips.
Samsung Electronics has received less attention from investors but is also carving out a niche for itself in AI-related semiconductor manufacturing. Samsung anticipates a rebound in their memory chip prices in 2024, in part due to the expected proliferation of on-device AI, a memory-hungry implementation, and is investing for longer term in the next generation of high-bandwidth memory chips integral to AI applications, promising to leapfrog competitors in performance. Samsung Electronics is also positioning itself to compete with TSMC in manufacturing advanced logic chips, using its capability of designing and manufacturing memory, logic, and chip packaging to unlock new opportunities for its foundry business.
Infineon, widely recognized for its strength in automotive and power semiconductors, is less directly exposed to AI themes but does have products supporting growth data centers and AI computing whose high-power demands is a good match for Infineon’s switched mode power supplies and voltage regulator designs that power high performance systems.

Image source: Synopsys as of 2024. 1Global Semiconductor Sales – Sources: SIA/WSTS (historicals); forecasts based on Gartner, TechInsights, IBS, SIA/WSTS and consensus analyst forecasts for leading semiconductor companies. 2Explosion in Demand for AI Chips – Sources: Gartner, AMD, NVIDIA, Intel, Goldman Sachs.
Image source: Synopsys as of 2024. 1Global Semiconductor Sales – Sources: SIA/WSTS (historicals); forecasts based on Gartner, TechInsights, IBS, SIA/WSTS and consensus analyst forecasts for leading semiconductor companies. 2Explosion in Demand for AI Chips – Sources: Gartner, AMD, NVIDIA, Intel, Goldman Sachs.
What did you think of this piece?
Fundamental Analysis
But with so much focus on AI, what is perhaps under-appreciated is that Amazon’s e-commerce business recently underwent a transformation of its own—a rethinking of how it gets customers’ packages from point A to point B. Because of this new strategy, the business, where profitability has been low and erratic, may be on the cusp of a new era in which margins finally reach—and sustain—an attractive level.
During 2023, Amazon overhauled the sprawling US logistics network that supports its online-retail operations, switching from a national system for filling and routing orders to a regional setup. The core change was to partition the US into eight main regions, assigning each region dedicated fulfillment warehouses, sorting centers, last-mile delivery hubs, and vehicles. By limiting the area each facility serves, the company doesn’t need as many connecting points along its distribution routes, and trucks are filled closer to their capacity and travel shorter distances. This helps Amazon save money on fuel, fleet upkeep, labor, and other overhead, as well as potentially reduce its environmental impact.
Amazon’s latest financial report in February revealed that fulfillment costs, which had soared to 16.4% of net sales in 2022, shrank to 15.8% of net sales in 2023 as the new system was implemented. As the chart below shows, it was only the second time in 14 years that this metric’s long ascension was interrupted. This time, we view it as an inflection point, and so the downward trend should continue.

Source: Amazon filings

The company’s filings don’t separate fulfillment-center square footage from the company’s data centers and other owned and leased properties, but according to the commercial real-estate database CoStar, Amazon reduced its distribution space by more than 14 million square feet between July 2022 and October 2023. In September 2023 and October 2023 alone, it listed roughly 2 million square feet of industrial space for sublease, including large facilities in the Atlanta area, as well as San Antonio and Fort Worth.
In the early days of the COVID-19 pandemic, to keep up with a surge in consumer demand, Amazon aggressively added fulfillment centers—some the size of a dozen or more football fields. Since then, however, e-commerce growth has slowed, and as Chief Executive Officer Andy Jassy looked to slash costs throughout the company, overhauling the distribution system became a top priority. A particular inefficiency in the old system had also gnawed at the company’s leaders; the problem would arise when a customer’s order couldn’t be completed by nearby warehouses, at which point the fulfillment method would turn scattershot. It meant that something as inconsequential as a storage basket or phone case could travel long distances from a random warehouse in a half-empty truck.
The new approach helps avoid that costly conundrum by enabling most orders to be filled by warehouses in the same region as the recipient. By the middle of last year, more than three-quarters of orders were being handled this way, up from 62% previously. Additionally, with fewer warehouses feeding into each region, the company is reducing its use of intermediate sorting centers and able to send more packages directly to delivery hubs, where they get loaded onto delivery vehicles. The efficiency gains not only facilitate faster shipping but also the ability to offer lower-priced goods. That combination may further incentivize shoppers to turn to Amazon more often.
While Jassy has said that the company has more room to fine-tune its distribution system, margins are already moving in the right direction. The North America e-commerce operation generated an operating margin of 6.1% in the final period of 2023, the widest since the first quarter of 2019—although that period was itself an outlier. (For the past decade, the North America operation has earned, on average, just three cents of operating profit for every dollar of sales.) We estimate that the operating margin in North America could climb to 8% or higher over the next few years and, most importantly, sustain high single digits over the long term.
Meanwhile, Amazon’s international e-commerce operations, which are still in early stages in many countries, are operating at a loss as the company uses Prime benefits to entice local shoppers. But as Amazon achieves distribution scale abroad and implements what it has learned in the US, we expect the international business to become profitable, with its operating margin rising toward 5% over the next few years.
Our investment thesis about Amazon largely rests on three factors. One is AWS maintaining its strong margins and industry leadership, which we expect because it operates in a favorable industry structure. Another is Amazon capitalizing on the unique data it captures on shoppers’ intentions to support the continued rapid growth of its US$50 billion digital-advertising division. The last key piece is whether the alchemy of running such a sprawling e-commerce business can be managed in such a way that it produces sustainably high margins while retaining its leading global market share. There are now signs that it can, in which case, investors are about to see a different Amazon.
Investment insights contributed by Peter Baughan, CFA, Analyst and Portfolio Manager

Image source: Chad Robertson – stock.adobe.com.
The company’s filings don’t separate fulfillment-center square footage from the company’s data centers and other owned and leased properties, but according to the commercial real-estate database CoStar, Amazon reduced its distribution space by more than 14 million square feet between July 2022 and October 2023. In September 2023 and October 2023 alone, it listed roughly 2 million square feet of industrial space for sublease, including large facilities in the Atlanta area, as well as San Antonio and Fort Worth.
In the early days of the COVID-19 pandemic, to keep up with a surge in consumer demand, Amazon aggressively added fulfillment centers—some the size of a dozen or more football fields. Since then, however, e-commerce growth has slowed, and as Chief Executive Officer Andy Jassy looked to slash costs throughout the company, overhauling the distribution system became a top priority. A particular inefficiency in the old system had also gnawed at the company’s leaders; the problem would arise when a customer’s order couldn’t be completed by nearby warehouses, at which point the fulfillment method would turn scattershot. It meant that something as inconsequential as a storage basket or phone case could travel long distances from a random warehouse in a half-empty truck.
The new approach helps avoid that costly conundrum by enabling most orders to be filled by warehouses in the same region as the recipient. By the middle of last year, more than three-quarters of orders were being handled this way, up from 62% previously. Additionally, with fewer warehouses feeding into each region, the company is reducing its use of intermediate sorting centers and able to send more packages directly to delivery hubs, where they get loaded onto delivery vehicles. The efficiency gains not only facilitate faster shipping but also the ability to offer lower-priced goods. That combination may further incentivize shoppers to turn to Amazon more often.
While Jassy has said that the company has more room to fine-tune its distribution system, margins are already moving in the right direction. The North America e-commerce operation generated an operating margin of 6.1% in the final period of 2023, the widest since the first quarter of 2019—although that period was itself an outlier. (For the past decade, the North America operation has earned, on average, just three cents of operating profit for every dollar of sales.) We estimate that the operating margin in North America could climb to 8% or higher over the next few years and, most importantly, sustain high single digits over the long term.
Meanwhile, Amazon’s international e-commerce operations, which are still in early stages in many countries, are operating at a loss as the company uses Prime benefits to entice local shoppers. But as Amazon achieves distribution scale abroad and implements what it has learned in the US, we expect the international business to become profitable, with its operating margin rising toward 5% over the next few years.
Our investment thesis about Amazon largely rests on three factors. One is AWS maintaining its strong margins and industry leadership, which we expect because it operates in a favorable industry structure. Another is Amazon capitalizing on the unique data it captures on shoppers’ intentions to support the continued rapid growth of its US$50 billion digital-advertising division. The last key piece is whether the alchemy of running such a sprawling e-commerce business can be managed in such a way that it produces sustainably high margins while retaining its leading global market share. There are now signs that it can, in which case, investors are about to see a different Amazon.
Investment insights contributed by Peter Baughan, CFA, Analyst and Portfolio Manager
Image source: Chad Robertson – stock.adobe.com.
What did you think of this piece?
Fundamental Analysis
Given the opaque relationship between the Chinese government and private companies, the exact terms of the exchange are unknown; Baidu’s move could result in the US putting the company on the restricted list that blocks US investments in companies that could be supporting China’s military. However, there is a plausible market-based reason for the donation: the quantum computer was expensive to build and maintain and the effort wasn’t profitable.
At a meeting with analysts in January, Baidu’s chief financial officer, Rong Luo, explained that the kind of “moonshot research” the quantum computer represented was too expensive and didn’t add to the company’s bottom line. Donating it helped cut costs and foster goodwill with the government. It was the kind of pragmatic move that the company had gotten away from in recent years.
Like their global peers, Chinese internet companies enjoyed years of growth and strong cash flows. That allowed them to expand beyond their core operations to invest in new business formats and technologies, such as Alibaba in offline retail and Tencent in fintech. They usually focused on creating scale even if the business itself was initially unprofitable. That goal depressed margins in the sector. But as growth has slowed, Baidu, Alibaba, Tencent, Netease, and other Chinese tech companies have been refocusing their operations on turning a profit.
At Baidu, this included bringing in Luo, who has a PhD in management science from Peking University and had been the CFO at TAL Education Group. During his tenure there, Luo played an important role in TAL’s transformation from operation-driven to data- and technology-driven, and from offline to online.
When Luo arrived at Baidu two years ago, some senior management didn’t recognize the importance of return-focused performance metrics. That has changed. Expenses have been cut. Research and development spending as a percentage of sales, which had been about 20% (and more than its peers), has been reduced. The company was making investments in innovative technologies, such as quantum computing, but there wasn’t likely to be a return on these investments in the foreseeable future. The effectiveness of projects is now measured on the return on investment and efficiency. Thus, the decision to give away the computer.
Now the company is focused on the parts of its business that are or can be profitable: its core ad business, cloud computing, and AI. In the highly competitive business of search, Baidu released an AI-based advertising platform called QingGe. The new platform essentially examines a users’ interactions with a chatbot and generates a new ad specifically tailored to them. The goal is to create a better advertising platform, with the goal of improving the click-through rate by 10x. Hitting that goal would add several billion in incremental RMB in 2024, the company said.
That’s one example of how management is employing AI, a crucial test. In 2017, Baidu was the leader among its peers in AI. It had Andrew Ng, the former head of Google Brain, as its chief scientist and signaled its intentions with its slogan “All in AI.” But Ng left the company in 2017.
Despite his departure, Baidu was the first among Chinese companies to launch a chatbot in 2019, shortly after OpenAI released ChatGPT. That chatbot, called Ernie, is not as advanced as ChatGPT 4.0 but is more advanced than its Chinese peers and many Chinese companies are using it to train their own more specialized models. In December, Baidu reported Ernie had more than 100 million users.
Even with a technological lead over its peers, Baidu hasn’t yet shown it can make AI a profit center the way some US-based companies have. It is testing monetization models, such as a subscription service, and fusing it into its search business, but neither investors nor Baidu itself can be certain how the AI efforts will affect the company’s profits (the company does not provide revenue projections for its AI business). What investors do know is that the company’s criteria for the success of that effort and everything else it does will be measured on the bottom line.

Image source: Ascannio – stock.adobe.com
Image source: Ascannio – stock.adobe.com
What did you think of this piece?
Fundamental Analysis
The holy month of Ramadan affects companies and products differently each year, and it is essential for investors in Muslim-majority countries to understand these effects. The holiday, during which Muslims fast from dawn to dusk, starts 10-12 days earlier each year, unlike fixed holidays such as Christmas. This year, Ramadan starts at sunset on March 10 and lasts until April 9.
The fact that the holy month moves each year means that the effects of Ramadan on businesses change over time. Recently, when Ramadan was during the summer, it was a significant headwind for companies such as brewers, as the fast suppressed demand for beer during what would otherwise be a peak month. But now as Ramadan is moving earlier in the year, that headwind will lessen.
Learn more about Ramadan’s effect on businesses in Muslim-majority countries, or those with significant Muslim populations, in our extended analysis.
What did you think of this piece?
Factor Investing
How companies perform on those measures can change over time. Industry dynamics evolve, which can lead to a shift in competitive positioning. Macroeconomic cycles and deviations in management strategy can also alter the long-term outlook. Even companies that consistently rank highly for quality and growth must be continuously assessed for signs of deterioration in their financial health, competitive advantages, and other factors. The challenge isn’t just determining the businesses that meet our criteria today, but also which businesses will sustain their quality and growth characteristics over the long run.
The charts below illustrate how variable those characteristics are. The bubbles represent the roughly 2,700 stocks that were in the MSCI All Country World Index (ACWI) at the end of 2018. In the tab for 2018, they’re split down the middle such that the top half of stocks (the orange portion) were considered high quality, based on their Harding Loevner quality scores at the time. But over the next five years, the characteristics of the companies changed. Now click the tab for 2023. It shows that only 25% of index members were also above the threshold that was set in 2018.

201820232018

2023

HOLT, FactSet, MSCI, data as of December 31, 2023

In fact, in any five-year period only about a quarter of companies were in the top half of quality at the start and the end of the period:

HOLT, FactSet, MSCI, data as of December 31, 2023

Identifying a persistently high-quality and fast-growing company is even more difficult, as the following charts show. Clicking the tab for 2023 reveals that only 10% of companies in the index remained above the threshold for quality and growth that was set in 2018. This means investors can expect that the majority of high-quality, growing businesses today will not score as high-quality, fast growers in five years.

201820232018

2023

HOLT, FactSet, MSCI, data as of December 31, 2023

TSMC and France-based Dassault Systèmes are among companies that, because of their strong competitive advantages, have managed to sustain their quality and growth rankings in our measurements. TSMC is one of the few reliable, high-volume global manufacturers of advanced and specialty semiconductor chips, a strength that stems from decades of proprietary technology development and disciplined execution. Dassault is a provider of software for virtual product design that has one of the broadest offerings in the space, able to be used by customers in multiple industries. Its high proportion of recurring revenue from software subscriptions and a loyal customer base have insulated the business from economic downturns. In fact, both TSMC and Dassault have remained in the top quadrant of quality and growth every year for the past 15 years (and have been owned in Harding Loevner’s International Equity model portfolio for that entire time). But as the data show, such companies are the outliers.
Quality growth investing also isn’t as simple as buying and holding companies that score in the top quadrant of our rankings—or immediately discarding the stock of a company that has strayed from that territory. These scores are merely proxies that attempt to capture each company’s financial strength, competitive advantage, and the projected trajectory of their growth. Indeed, fundamental analysis can sometimes lead us to identify companies that meet our investment criteria even if they don’t, at the moment, score in the top quadrant. Therefore, it’s better to analyze and monitor a business’s quality and growth through the fundamental research that informs these scores rather than speculate on potential movements in the scores themselves.
At Harding Loevner, this process begins with an analyst examining a company’s competitive position within its industry using the framework of Porter’s Five Forces, which is based on Harvard University professor Michael Porter’s book, Competitive Strategy: Techniques for Analyzing Industries and Competitors. Once a company is affirmed to meet our investment criteria, analysts continue to track and debate the strength of its fundamentals and growth potential, communicating with colleagues when these factors are at risk of deterioration. It’s because we know quality and growth may not always persist that our research process to evaluate these characteristics must.
In fact, in any five-year period only about a quarter of companies were in the top half of quality at the start and the end of the period:
Identifying a persistently high-quality and fast-growing company is even more difficult, as the following charts show. Clicking the tab for 2023 reveals that only 10% of companies in the index remained above the threshold for quality and growth that was set in 2018. This means investors can expect that the majority of high-quality, growing businesses today will not score as high-quality, fast growers in five years.
TSMC and France-based Dassault Systèmes are among companies that, because of their strong competitive advantages, have managed to sustain their quality and growth rankings in our measurements. TSMC is one of the few reliable, high-volume global manufacturers of advanced and specialty semiconductor chips, a strength that stems from decades of proprietary technology development and disciplined execution. Dassault is a provider of software for virtual product design that has one of the broadest offerings in the space, able to be used by customers in multiple industries. Its high proportion of recurring revenue from software subscriptions and a loyal customer base have insulated the business from economic downturns. In fact, both TSMC and Dassault have remained in the top quadrant of quality and growth every year for the past 15 years (and have been owned in Harding Loevner’s International Equity model portfolio for that entire time). But as the data show, such companies are the outliers.
Quality growth investing also isn’t as simple as buying and holding companies that score in the top quadrant of our rankings—or immediately discarding the stock of a company that has strayed from that territory. These scores are merely proxies that attempt to capture each company’s financial strength, competitive advantage, and the projected trajectory of their growth. Indeed, fundamental analysis can sometimes lead us to identify companies that meet our investment criteria even if they don’t, at the moment, score in the top quadrant. Therefore, it’s better to analyze and monitor a business’s quality and growth through the fundamental research that informs these scores rather than speculate on potential movements in the scores themselves.
At Harding Loevner, this process begins with an analyst examining a company’s competitive position within its industry using the framework of Porter’s Five Forces, which is based on Harvard University professor Michael Porter’s book, Competitive Strategy: Techniques for Analyzing Industries and Competitors. Once a company is affirmed to meet our investment criteria, analysts continue to track and debate the strength of its fundamentals and growth potential, communicating with colleagues when these factors are at risk of deterioration. It’s because we know quality and growth may not always persist that our research process to evaluate these characteristics must.
What did you think of this piece?
Fundamental Analysis
Japan has been undergoing a baby bust for decades. In the early 1970s, there were years where more than 2 million babies were born in Japan, but since then, those numbers have declined steadily. By the 1990s, there were about 1.2 million babies born each year in Japan, while in 2022, births fell below 800,000 for the first time.
One might expect that a decrease in the number of babies would be a major problem for a company like Unicharm, which dominates the Japanese market for disposable diapers. But by taking advantage of other demographic trends that have opened new markets for the company, Unicharm has seen its overall business grow, even as its core market shrinks.
Unicharm was founded in 1961 as an insulation and building materials supplier and later began manufacturing feminine sanitary pads. In the following decades, Unicharm relied on its expertise in processing non-woven fabrics and absorbent materials made from petroleum-based polymers to expand into other markets beyond feminine care, especially diapers.
Unicharm grew to dominate the market for baby diapers in Japan, with an estimated 41% retail market share in 2023. But the product segment has become a challenging, low-margin business, partly because consumers have not been swayed to pay a premium for baby diapers with special features, and the decreasing number of babies being born has meant that Unicharm is fighting for its portion of a shrinking pie. Meanwhile in neighboring China, once a key market for the company’s baby diapers, stiff competition from local manufacturers has driven down retail prices.
While Unicharm says it will continue to make baby diapers, because of the positive and happy associations consumers attach to baby products, the company has increasingly focused on market segments that offer higher margins (if not the same positive feelings) such as adult incontinence products.
Japan now has the highest proportion of elderly citizens of any country in the world. About 29% of Japanese are over age 65, while more than 10% are 80 or older. As the population has gotten older, Unicharm’s adult products have become a larger part of its business. Adult diapers constitute about 33% of the company’s net sales in Japan today, up from an estimated 25% in 2018. Overall, the company derived one-third of its sales and 40% of its profits from Japan last year.
Adult incontinence products are a high-margin business because consumers are willing to pay a premium for products with special features, such as improved fit to prevent leakage. Furthermore, the company’s marketing campaigns have been successful at creating demand for its light and mini-incontinence pads by associating them with an active lifestyle.
The sort of quality companies that we look to invest in have, among other characteristics, strong management teams who can respond to changing market and industry dynamics. Unicharm’s ability to leverage its core competency in absorbent materials in different markets is an example of how managing change can help a business thrive over time. And Unicharm might even find a way to help address Japan’s aging demographics—it’s recently introduced a new feminine hygiene product that monitors ovulation to help women plan their pregnancies.
What did you think of this piece?
Behavioral Finance
Cognitive biases can wreak havoc on decision making. That’s why the Harding Loevner investment process is structured to help avoid errors in thinking that can lead investors to make irrational decisions. By identifying a strict set of criteria for the companies we hold and the method by which we track and debate these requisite characteristics, there’s less room for human behavioral flaws to influence our actions.
Backcountry skiers—who routinely navigate avalanche-prone terrain—seek to avoid danger in much the same way, says Patrick Todd, CFA, a portfolio manager and analyst at Harding Loevner. For example, every trip to the backcountry involves scrutinizing the snow conditions beforehand and making a pre-commitment that outlines the actions he and his group will take should the conditions differ once they ascend the mountain. Sometimes, the best decision is to turn back despite the time, effort, and money that already went into the trip. When skiers wrestle with this decision, it’s the sunk-cost fallacy at play, one of the many cognitive biases that can rear its ugly head in backcountry skiing—and investing.
In the video above, Patrick discusses more of the parallels between the risks in investing and backcountry skiing and how a thoughtful process can mitigate both.
What did you think of this piece?
Factor Investing
Portfolio manager Andrew West, CFA, explains how selecting companies with strong balance sheets and low debt safeguards against the potential erosion of the value when interest rates are elevated.
What did you think of this piece?
Fundamental Analysis
It’s an expansive deal, beginning in January 2025 and running for ten years. Netflix will air Raw in the US and internationally, and will have the rights to all WWE shows outside the US. It also may be a harbinger of what’s to come in the world of streaming services and sports. Over the next several years, the contracts for broadcast rights to the NBA, NFL, NHL, and MLB in the US will come up for renewal, as well as the domestic and US rights to top soccer leagues such as the Premier League (UK), La Liga (Spain), Seria A (Italy) and Bundesliga (Germany). The streaming services will be serious contenders in the bidding for all of them.
Netflix has previously declined to jump into sports. “We’re not anti-sports, we’re pro-profits,” co-CEO Ted Sarandos said last year. Making a major foray into sports, even if it’s a scripted one, may be a signal that Netflix is seeing—or at least planning for—a ceiling in terms of how many new subscribers it can attract without sports.
The biggest problem with sports programming is that while it does the things a broadcaster wants it to—steadily bring in dedicated viewers—over time the rights can become addictive for companies. If a sport increases in popularity, that improves profitability and hopefully leads to good returns on the investment for the rights holder. However, those attractive returns also lead to a higher renewal contract, which resets profitability at a lower level even when competitive dynamics are benign.
The problem for Netflix is that the sports-rights competition is not benign. Netflix will be competing with Paramount, Peacock, and Disney, as well as big-tech companies that have completely different strategic goals. For tech companies like Amazon and Apple, for example, “success” in terms of sports programming is more about e-commerce or hardware sales than subscriber profitability.
Netflix has spent roughly US$17 billion a year on content since 2021, a level it plans to maintain for the foreseeable future. The company said that the WWE deal would not add to its content budget, meaning it expects to spend less elsewhere. On one level, then, this is not an expensive bet. WWE already has a fanatical global audience and NBC is paying nearly US$300 million annually just for the US rights. Maybe US$500 million a year for global rights is a bargain.
Given Netflix doesn’t have any legacy networks to protect like some of its competitors do, it sidesteps a lot of the messy problems in the industry. But Netflix has its own set of pressures with which to contend. In 2023, Netflix’s subscriber base rose to 260 million, which was a record. Its growth rate, however, is slowing. In the past two years, the subscriber base is up 17%. In the two years prior to that, it rose 33%. Netflix used to be valued and treated like a tech stock. These days it is valued and treated more like a media company.

Shaded area represents the pandemic and post-pandemic period.

Source: Statista

With this 10-year deal, the company has now locked in billions of costs, and it will have to prove over the next decade that Roman Reigns, Rhea Ripley, and Finn Bálor will be enough of a draw to make the deal profitable. If WWE programming can help Netflix both bring in new subscribers and keep churn at current levels or lower, then the deal is absolutely worth it.
Netflix is being ambitious by entering into the sports rights rat race, but it won’t be clear for some time whether it’s being ambitious and opportunistic or ambitious and foolhardy. Last year Netflix earned US$5.5 billion, up from US$4.5 billion the year before. In streaming, any profits are rare, so Netflix is looking better than its peers. But like its subscriber-base growth, its earnings growth rate has been decelerating, too. With earnings growth in mind, it will be important to keep an even closer eye on Netflix’s content spending from now on.
With this 10-year deal, the company has now locked in billions of costs, and it will have to prove over the next decade that Roman Reigns, Rhea Ripley, and Finn Bálor will be enough of a draw to make the deal profitable. If WWE programming can help Netflix both bring in new subscribers and keep churn at current levels or lower, then the deal is absolutely worth it.
Netflix is being ambitious by entering into the sports rights rat race, but it won’t be clear for some time whether it’s being ambitious and opportunistic or ambitious and foolhardy. Last year Netflix earned US$5.5 billion, up from US$4.5 billion the year before. In streaming, any profits are rare, so Netflix is looking better than its peers. But like its subscriber-base growth, its earnings growth rate has been decelerating, too. With earnings growth in mind, it will be important to keep an even closer eye on Netflix’s content spending from now on.
What did you think of this piece?
Fundamental Analysis
But one Japanese company in the Information Technology (IT) sector has taken an unusual approach to reinvigorating the labor market. SHIFT, which provides software-testing services, is poaching and re-training workers from other industries, turning them into IT pros. As Prime Minister Fumio Kishida advocates for the reskilling of workers and for companies to increase wages, SHIFT’s system is an example of how companies could help put a dent in Japan’s entrenched model of lifetime employment, helping the country dig out of a decades-long deflationary environment.
Among its labor-market challenges, Japan faces a major shortage of IT engineers. Of the 75 million people in the country’s working population, only about one million are IT professionals. That’s a lower proportion than in other developed countries such as the US and Germany. But SHIFT estimates that 10% of Japan’s non-IT workers aspire to join the space.
Software testing is also one of the most labor-intensive processes in software development, as it entails the time-consuming work of manually looking for bugs within code and making sure an application works as intended. For firms that struggle to find experienced programmers to begin with, having those expensive programmers do testing doesn’t make sense. Some of SHIFT’s biggest customers are consulting firms that would rather have their own high-paid employees focus on their main business of consulting while outsourcing something like software testing to save money. For example, the average salary at Nomura Research Institute (NRI), an IT-consulting firm, is double the average at SHIFT:

Source: Company filings

Even though it’s lower than at other IT-related firms, compensation is a big part of the draw of making a career change to work at SHIFT. Candidates seeking to become software testers start by taking a recruitment exam, known as CAT, that filters applicants for certain skills and traits—comprehension, attention to detail, and judgment, for example—rather than computer-programming knowledge or IT experience. As of December, nearly 103,000 people have taken the CAT exam and about 16% have passed, according to SHIFT.
For the people SHIFT hires, it provides training and certification programs as well as performance-based compensation as incentives for continued learning and advancement. That sort of pay structure means that many of SHIFT’s personnel costs are variable, but the compensation scheme—and the fact that these workers were likely earning lower wages in their previous jobs—helps SHIFT attract and retain talent, which is important for the company to sustain growth. According to SHIFT’s filings, the average monthly unit price for its engineers is 818,000 yen (US$5,600). Engineer compensation accounts for about 60% of those sales, which implies an annual salary of about 6 million yen (US$41,000), higher than the average pay in Japan of 4.6 million yen (US$31,000).
By encouraging worker mobility and development of new skills, SHIFT is driving up Japan’s stagnant worker pay.
Even though it’s lower than at other IT-related firms, compensation is a big part of the draw of making a career change to work at SHIFT. Candidates seeking to become software testers start by taking a recruitment exam, known as CAT, that filters applicants for certain skills and traits—comprehension, attention to detail, and judgment, for example—rather than computer-programming knowledge or IT experience. As of December, nearly 103,000 people have taken the CAT exam and about 16% have passed, according to SHIFT.
For the people SHIFT hires, it provides training and certification programs as well as performance-based compensation as incentives for continued learning and advancement. That sort of pay structure means that many of SHIFT’s personnel costs are variable, but the compensation scheme—and the fact that these workers were likely earning lower wages in their previous jobs—helps SHIFT attract and retain talent, which is important for the company to sustain growth. According to SHIFT’s filings, the average monthly unit price for its engineers is 818,000 yen (US$5,600). Engineer compensation accounts for about 60% of those sales, which implies an annual salary of about 6 million yen (US$41,000), higher than the average pay in Japan of 4.6 million yen (US$31,000).
By encouraging worker mobility and development of new skills, SHIFT is driving up Japan’s stagnant worker pay.
What did you think of this piece?
Active Management
Three years since the first COVID-19 vaccine was approved, growth investors have felt the pain of a relative bear market compared to their value peers. In our annual letter to shareholders, we examine the current economic climate, and discuss why we believe that the types of companies in which we invest are well-positioned to navigate the challenges ahead.
In sum, this time is no different from similar periods in the past in which our taste for high-quality, rapidly growing companies has been out of step with market fashion. We foresee an eventual return of investor focus on such fundamental factors in the face of uncertain and slower economic and corporate profit growth. We therefore remain committed to our favored targets, while reinforcing our attention to the price we are asked to pay for them.
Read the full letter
Investments involve risk and loss is possible.
The Portfolio’s investment objectives, risks, charges and expenses must be read and considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company. They may be obtained by calling toll free (877) 435-8105, or visiting hardingloevnerfunds.com.
The Portfolio is distributed by Quasar Distributors, LLC.
What did you think of this piece?
Behavioral Finance
In many areas of our lives, we can, in fact, learn from our experiences. Over time we start to see patterns in events and that pattern recognition enables subjective judgment, or what is often called intuition. But those patterns need to be recurrent, in environments where there is a clear and stable relationship between cause and effect, so that history really does repeat itself.
In his book Range, David Epstein described that sort of learning environment as “kind”—patterns repeat, feedback is immediate, and experience can lead to expertise. As he writes, “In golf or chess, a ball or piece is moved according to rules and within defined boundaries, a consequence is quickly apparent, and similar challenges occur repeatedly…. the player observes what happened, attempts to correct the error, tries again, and repeats for years.”
In contrast, in the sorts of learning environments that Epstein describes as “wicked” there are few (or no) clear rules and feedback is limited at best. In these kinds of environments, experience teaches you little. Indeed, it can be dangerous. Experience can lead us to over-interpret, to see patterns where there are none, and to become entrenched in our ideas.
Once we have an idea, it is extremely hard to change our minds. Confirmation bias means that we see evidence that confirms our views and ignore that which challenges them. When facts change, we should change our minds, but we rarely do. And cognitive entrenchment means that the more experience we have, the more difficult we find it to adapt to changing circumstances. With greater experience comes rigidity.
The fact that more experience can lead to these behavioral pitfalls is a good reminder that it’s important to pay attention to smart, inexperienced people. Often in organizations, seniority can lead to one’s views being accorded more weight, while more inexperienced colleagues’ views are often dismissed as lacking sufficient wisdom.
Investing, obviously, takes place in a wicked learning environment. The relationship between cause and effect on market prices is highly obscure. Few patterns repeat and, once identified, are arbitraged away and do not persist. There is no evidence, for example, that market participants can forecast the direction of markets, let alone macroeconomic or political variables.
Furthermore, for long-term investors such as us, it is hard to identify the right feedback to our decision-making. Our goal is to construct portfolios that outperform the broad markets on a risk-adjusted basis over extended periods. But returns are very time dependent, and short-term price movements are a poor guide to long-term returns, offering us poor feedback on our decisions. We must look at our investment theses and create our own feedback loops so that we can test whether the fundamental insights we are relying on to forecast outperformance of the stock of a particular company remain valid. And to overcome cognitive entrenchment, we must be prepared to update our beliefs—our forecasts—if the facts change.
This sort of learning environment is why when it comes to investing, experience doesn’t lead to expertise. It leads, simply, to experience—more opportunities to learn, more chances to understand the boundaries of our knowledge. But those chances are very, very valuable.
One of our basic beliefs about equity markets is that they are efficient, but not entirely so. There are inefficiencies that result from the biases of market participants, and to overcome our own biases and exploit those of others, we have structure and process—or rules—that govern how we do research and provide the background to the judgment required about when to buy and sell stocks.
But are there any permanent rules in investing? Rules are important for controlling cognitive biases, but they are not unchanging dogma. We should be prepared to change our rules when the environment changes or when they do not work. In an investment firm, humility about our ability to forecast accurately is important, and so is an open-mindedness about rules. More experience gives us the ability to look at our own behavior, to observe the errors that we make—usually because of our own biases—and to implement structures and processes that help mitigate the all-too-human tendency to make decisions where the results do not contribute to achieving our goals.
I know less now than I thought I did when I was new to the investment business 45 years ago. What experience has taught me is the importance of being aware of market history but not relying on it to make forecasts. It has taught me that how we behave is more important than what we know. And most importantly, experience has given me more chances to test ideas in the marketplace, receive feedback, and use that feedback for continuous improvement.
What did you think of this piece?
Fundamental Analysis
As bottom-up investors, we aim to invest in high-quality growth businesses at reasonable prices to provide superior risk-adjusted returns over the long term. To determine what constitutes a high-quality growth business, we research a company’s management, financial strength, growth prospects, and we closely examine the industry in which it operates to determine the company’s competitive advantage.
It’s as important to examine a company’s industry as it is to examine the fundamentals of a company. An analysis of industry structure can inform how well-positioned a company is relative to competitors, as well as the profit potential for the company.
Our analysis is guided by Harvard University professor Michael Porter’s Five Forces, which were first introduced in a 1979 issue of Harvard Business Review and later detailed in his 1980 book, Competitive Strategy: Techniques for Analyzing Industries and Competitors.
In this six-part video series, we examine each Porter Force and discuss how we use them to analyze industries. Watch the series introduction below and click through to see how we leverage Michael Porter’s Five Forces framework for industry analysis.
Porter’s Five Forces: A Framework for Competitive Analysis
What did you think of this piece?
Fundamental Analysis
China faces a demographic shift similar to Japan three decades ago. Portfolio manager Jingyi Li explains how that comparison can help guide investors looking at China today.
What did you think of this piece?
Fundamental Analysis
Perhaps most intriguingly, NVIDIA is a leading company in the biggest tech-driven trend to come along in years, artificial intelligence. It makes the chips that power AI-based computer systems, and it sells the software and services companies need to operate their own AI programs. And NVIDIA was a big company before AI took off.
As if to emphasize the point, this week the company posted third-quarter revenue of US$18.1 billion—tripling from a year ago and setting a company record. Earnings were also a record at US$10 billion.
NVIDIA meets all our core criteria for a quality growth company: It has a sustainable business and a competitive advantage, solid management, and financial strength. Over the last six years, its revenue has grown from nearly US$7 billion in fiscal 2017 to just under US$27 billion in fiscal 2022.
But as NVIDIA reaches dizzying valuations—it currently trades at 118 times earnings—we can’t help thinking of another good technology company whose stock once commanded nose-bleed premiums: Cisco Systems.
Cisco makes the networking equipment that enables much of the internet. As the World Wide Web was taking off in the mid-1990s, Cisco Chief Executive John Chambers was telling people a new era of computing was coming, and the company’s hardware played a big part in making that new era real. Between 1995 and 2000, its revenue surged 850%, from about US$2 billion to US$19 billion.
Cisco stock did even better, growing an incredible 3,800%, from US$2 in January 1995 to US$79 in March 2000. The title of its 1999 annual report exhorted investors to “Capture the Momentum.” Many took that advice. In March 2000, at the height of the dot-com bubble, Cisco became the most valuable company in the world, with a market capitalization of more than US$500 billion.
Then the dot-com bubble burst. Cisco shares fell 88%, dropping from US$79 to a low of US$9.50 two years later. That drop wasn’t the result of any large change in the company’s performance. Revenue was nearly US$19 billion in fiscal 2000, US$22 billion in 2001, and about US$19 billion in 2002. But the premium that investors were willing to pay for the company disappeared as the hype around the web faded.
Over the next two decades, Cisco kept growing. Its sales in 2022 were nearly US$52 billion, more than double the US$19 billion it hit in 2000. Yet its stock has never traded as high as it did on March 1, 2000. Today it’s at roughly US$53. On a total return basis, it took 20 years for Cisco stock to recover from the dot-com crash.
So, are there lessons we can learn from Cisco as we look at NVIDIA? Just as Chambers argued 25 years ago that a new era of computing was at hand, Huang has been talking up AI. Just this month he said “In the last 40 years, nothing has been this big. It’s bigger than PC, it’s bigger than mobile, and it’s gonna be bigger than the internet, by far.” The enthusiasm for AI’s future has led to very high valuation multiples for NVIDIA, although not as high as Cisco reached in 2000.

Source: YCharts

By all accounts, NVIDIA is strong—in its last full fiscal year (2022), it earned US$9.8 billion on US$27 billion in revenue—and in an enviable position. Semiconductors are the oil of the 21st century, an essential component for the tech-fueled modern world. The company produces chips that allow for the most advanced computing, expanding from its core gaming prowess into related lucrative areas like data centers, autos, and of course AI.
But as Cisco shows, the success of a company and the performance of its stock aren’t the same thing, and as valuations increase, it’s more and more difficult for a stock to outperform. Over the past 50 years, 231 companies have reached a similar multiple. Only 20% of the stocks trading with a price/sales ratio between 30 and 40 outperformed the market over the next 12 months. The more you extend your time horizon, the worse the results get. Over a 10-year period, that number drops down to 6%.1
NVIDIA is a good company with all the quality and growth prospects we look for in an investment. The critical question is how much one is willing to pay for those prospects. As Cisco showed in the waning days of the dot-com boom, overpaying for a good company is a bad choice.

Endnotes

1 Siegel, Jeremy with Schwartz, Jeremy. Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, Sixth edition. McGraw-Hill Companies, 2022
By all accounts, NVIDIA is strong—in its last full fiscal year (2022), it earned US$9.8 billion on US$27 billion in revenue—and in an enviable position. Semiconductors are the oil of the 21st century, an essential component for the tech-fueled modern world. The company produces chips that allow for the most advanced computing, expanding from its core gaming prowess into related lucrative areas like data centers, autos, and of course AI.
But as Cisco shows, the success of a company and the performance of its stock aren’t the same thing, and as valuations increase, it’s more and more difficult for a stock to outperform. Over the past 50 years, 231 companies have reached a similar multiple. Only 20% of the stocks trading with a price/sales ratio between 30 and 40 outperformed the market over the next 12 months. The more you extend your time horizon, the worse the results get. Over a 10-year period, that number drops down to 6%.1
NVIDIA is a good company with all the quality and growth prospects we look for in an investment. The critical question is how much one is willing to pay for those prospects. As Cisco showed in the waning days of the dot-com boom, overpaying for a good company is a bad choice.
1 Siegel, Jeremy with Schwartz, Jeremy. Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies, Sixth edition. McGraw-Hill Companies, 2022
What did you think of this piece?
Fundamental Analysis
Portfolio manager Jingyi Li discusses how several Global Equities portfolio companies are using their pricing power to navigate through this period of higher interest rates and higher inflation.
What did you think of this piece?
Fundamental Analysis
The possibilities are mind-blowing. The DRC, with a population of 112 million and situated almost precisely in the middle of the continent, is the second-largest country in Africa by landmass and the 11th largest in the world. The Congo River, which winds through the country and is the second largest in the world by discharge volume, has the potential to produce 100 gigawatts of clean electricity, of which less than 3% is currently being harnessed.
With the river and its tributaries coursing through the countryside, the DRC has an estimated 80 million hectares of arable land, enough to produce food for two billion people. The DRC also has abundant mineral resources. A recent UN study estimated its untapped mineral reserves were worth US$24 trillion. The DRC holds 46% of the world’s cobalt reserves, 23% of the world’s lithium reserves, and 4% of the world’s copper reserves. These are all commodities essential in the effort to enable the global transition to green energy.

Portfolio Manager and Analyst Babatunde Ojo, CFA, at a Somika mine in Lubumbashi Katanga, Democratic Republic of the Congo.

That potential is attracting companies like Equity Bank, the largest bank in Kenya. The company has acquired two DRC-based banks in recent years, which now comprise 30% of its total assets. Equity Bank is early to the DRC, but we expect to see more investments flow to the country in the coming years. It is barely scratching the surface of what it could become.
Decades of autocratic rule and corruption have kept the country from tapping its potential. Beginning with Mobutu Sese Seko in 1965, the DRC was marred by wars and political instability under a series of dictators. Because of that, the country’s economic development has been weak, even by African standards. Ranked by GDP per capita, it is one of the poorest nations in the world. The entire country produces only about 3,000 megawatts of power, leading to constant shortages. Less than 10% of the country’s arable land is currently being farmed, making the country dependent on others for food. Only 6% of the population have bank accounts.
The DRC’s financial infrastructure is bare bones. Equity Bank’s DRC-based subsidiary, Equity Banque Commerciale du Congo (BCDC), is the largest bank in the country in terms of bank accounts but has only 1.9 million clients. And the DRC effectively has no capital market; there aren’t markets for government or corporate equities or bonds, which results in a low savings rate, deters economic growth, and makes the economy less efficient.
The physical infrastructure isn’t much further along. Simply generating power is a challenge; energy shortages are regular and severe. Somika, a mining company in Lubumbashi, the DRC’s second-largest city, provides its own electricity with diesel-powered generators, making energy and logistics the areas of some of its biggest challenges and costs. The result is that, despite having some of the highest grades of copper and cobalt in the world, local mines are not cost-competitive compared to mines in Australia.
Today, the DRC is addressing those and other issues. There’s been political stability since the 2018 election of current President Felix Tshisekedi. Working with developmental partners such as the United Nations, the World Bank, and the International Monetary Fund, his government enacted key political, judicial, and economic reforms that are beginning to unlock the country’s potential. Tshisekedi has attempted to weed out corruption and bring transparency to the government and the markets; these efforts resulted in a US$750 million World Bank financing package in 2022. His administration has proposed nearly 70 reforms focused on boosting business creation, facilitating property transfers, improving international trade, and more. The DRC’s entry into the East African Community trade bloc, also in 2022, opened access to neighboring markets with a combined 300 million residents and a combined GDP of US$285 billion.
Today, the DRC is Africa’s third-fastest-growing economy. Add its vast natural potential to that fact and you can see why companies like Equity Bank are moving there. That makes it enticing for forward-thinking investors.
That potential is attracting companies like Equity Bank, the largest bank in Kenya. The company has acquired two DRC-based banks in recent years, which now comprise 30% of its total assets. Equity Bank is early to the DRC, but we expect to see more investments flow to the country in the coming years. It is barely scratching the surface of what it could become.
Decades of autocratic rule and corruption have kept the country from tapping its potential. Beginning with Mobutu Sese Seko in 1965, the DRC was marred by wars and political instability under a series of dictators. Because of that, the country’s economic development has been weak, even by African standards. Ranked by GDP per capita, it is one of the poorest nations in the world. The entire country produces only about 3,000 megawatts of power, leading to constant shortages. Less than 10% of the country’s arable land is currently being farmed, making the country dependent on others for food. Only 6% of the population have bank accounts.
The DRC’s financial infrastructure is bare bones. Equity Bank’s DRC-based subsidiary, Equity Banque Commerciale du Congo (BCDC), is the largest bank in the country in terms of bank accounts but has only 1.9 million clients. And the DRC effectively has no capital market; there aren’t markets for government or corporate equities or bonds, which results in a low savings rate, deters economic growth, and makes the economy less efficient.
The physical infrastructure isn’t much further along. Simply generating power is a challenge; energy shortages are regular and severe. Somika, a mining company in Lubumbashi, the DRC’s second-largest city, provides its own electricity with diesel-powered generators, making energy and logistics the areas of some of its biggest challenges and costs. The result is that, despite having some of the highest grades of copper and cobalt in the world, local mines are not cost-competitive compared to mines in Australia.
Today, the DRC is addressing those and other issues. There’s been political stability since the 2018 election of current President Felix Tshisekedi. Working with developmental partners such as the United Nations, the World Bank, and the International Monetary Fund, his government enacted key political, judicial, and economic reforms that are beginning to unlock the country’s potential. Tshisekedi has attempted to weed out corruption and bring transparency to the government and the markets; these efforts resulted in a US$750 million World Bank financing package in 2022. His administration has proposed nearly 70 reforms focused on boosting business creation, facilitating property transfers, improving international trade, and more. The DRC’s entry into the East African Community trade bloc, also in 2022, opened access to neighboring markets with a combined 300 million residents and a combined GDP of US$285 billion.
Today, the DRC is Africa’s third-fastest-growing economy. Add its vast natural potential to that fact and you can see why companies like Equity Bank are moving there. That makes it enticing for forward-thinking investors.
What did you think of this piece?
Fundamental Analysis
Portfolio manager Anix Vyas, CFA, discusses how the current conflict in the Middle East is affecting International Small Companies portfolio holding CyberArk.
What did you think of this piece?
Fundamental Analysis
In 2023, Chinese markets have been roiled by continued trade tensions, slowing economic growth, and deleveraging in the property sector. Despite this difficult backdrop, there are reasons to be optimistic about the growth prospects of some Chinese companies. Portfolio Managers Andrew West, CFA, and Lee Gao discuss their current perspectives on China with Portfolio Specialist Apurva Schwartz, including how they weigh the opportunities and risks of investing in the market.
Real estate, the biggest source of wealth for Chinese consumers, was in bubble territory and has been slowing for a while. This has negatively affected consumer confidence and household consumption.
Two-thirds of private developers cannot service their debt. Deleveraging may continue but Beijing has plenty of policy options available to help revive growth.

Investment Rewards vs. Risk

Quality growth companies are doing well, and valuations look better now than at any point over the last 30 years, suggesting prospective returns could be high. We maintain diversified portfolios and carefully monitor risks to try and take advantage of the opportunities that we see.

Impact On Our Investments

China is a big place; different things happen in different sectors. Despite the broad market slowdown, many of our holdings, which are in globally competitive industries such as solar, electric vehicles, and industrial components, are still growing rapidly.
Two-thirds of private developers cannot service their debt. Deleveraging may continue but Beijing has plenty of policy options available to help revive growth.
Quality growth companies are doing well, and valuations look better now than at any point over the last 30 years, suggesting prospective returns could be high. We maintain diversified portfolios and carefully monitor risks to try and take advantage of the opportunities that we see.
China is a big place; different things happen in different sectors. Despite the broad market slowdown, many of our holdings, which are in globally competitive industries such as solar, electric vehicles, and industrial components, are still growing rapidly.
What did you think of this piece?
Fundamental Analysis
I see it differently. Viewed through the lens of Michael Porter’s competitive forces, which we use at Harding Loevner to analyze industry dynamics, the dispute was a clear example of a change in the bargaining power of buyers amid the changing economics of streaming services.
Disney and Charter clashed over a new cable agreement. Charter complained about the high fees it paid for ESPN, FX, and other Disney channels while Disney was funneling premium content to its own Disney+ streaming service. Eventually, Disney’s channels disappeared from Charter’s Spectrum TV service, and Spectrum stood firm: it was prepared to give up Disney’s networks, seemingly forever.
It didn’t come to that, though, and the terms of the agreement don’t sound monumental: Disney+ will now be an option for Charter subscribers for an additional fee. Disney gets new eyeballs, but hands over a chunk of its fees to Charter, which had faced a seemingly inevitable revenue decline from its cable business due to the rise of streaming. The agreement offers a reprieve from that.
However, the terms of the resolution show that Disney as a supplier had far less bargaining power with its customer than it had assumed. It was forced to make material concessions that will affect its transition to a full-streaming model. Make no mistake, Disney backed down, and that loss is going to hurt its bottom line in the long run. Moreover, if the world’s largest entertainment company couldn’t use its muscle to get what it wants, then all the other networks are going to face the same dilemma when their carriage agreements come up for renewal. Disney’s capitulation could signal a major shift in the entertainment industry.
For decades, “content is king” was the mantra of the media industry. While cable companies were the primary distributor of content made by studios, the ultimate pricing power was always in the hands of the studios, especially studios like Disney that owned must-see kids, sports, and movie content. A cable provider could not attract subscribers without these must-have channels. As a result, even though there would be heated negotiations over fees, ultimately cable providers would yield to the studios’ demands.
The studios’ leverage has been weakened by the very thing they are focused on: streaming. Streaming subscribers often cherry pick services, signing up for a short time if there’s a must-see program and then canceling. For Disney and the others, there is a fundamental mismatch between costs and revenue duration. Streaming platforms need a constant flow of new programming to limit subscriber churn, but that pushes operating costs up into the billions. Not all of them can afford it.
It’s possible Charter perceived this, or just felt like it had nothing to lose. It was willing to take a loss of subscribers upfront by terminating its Disney arrangement rather than bleed subscribers over a number of years if it didn’t challenge Disney, given either course would likely lead to the same terminal point, just in different time frames. Charter’s hard stand showed the flaw in the Disney plan.
The content king may not be dead but it definitely seems like he holds less power.
What did you think of this piece?
Fundamental Analysis
The twist is that Ozempic, a trade name for semaglutide, is a diabetes drug, not an obesity drug. Semaglutide is however effective in inducing weight loss; its creator Novo Nordisk markets a separate version called Wegovy specifically for obesity. Wegovy became so popular there were shortages of it, so doctors began prescribing Ozempic “off label” for a condition other than its intended use. That popularity fueled Novo Nordisk shares and this month it pushed past LVMH as Europe’s most valuable company.
Ozempic being used as a substitute for a different medical treatment goes beyond Novo Nordisk selling the same drug under different names. Ozempic could also serve as a replacement for people contemplating bariatric surgery, since it stands to reason that anybody considering surgery would likely be willing to try a less-invasive treatment. Recently, Intuitive Surgical noted a slowdown in the growth of bariatric surgical procedures because of the increasing use of drugs such as Ozempic. “Some customers have indicated that they are seeing increased patient interest in weight-loss drugs,” Intuitive chief financial officer Jamie Samath said in July.
Given that obesity is the most important reversible factor contributing to sleep apnea, there’s a chance Ozempic and similar drugs could become a treatment for that, too. Eli Lilly, for instance, is running a study of its type 2 diabetes medication Mounjaro, which is in the same drug class as Ozempic/Wegovy, as a possible treatment for sleep apnea. Results are due in March 2024.
That could be a problem for a company like ResMed, which makes sleep-apnea treatments with its CPAP (continuous positive airway pressure) therapy. These are machines that force air through the patient’s nasal passages, enabling better sleep. For patients, the issue may go beyond just which treatment is more effective.
Cost will be a big factor. Medicare and private insurers cover Ozempic for its commercially approved use, diabetes, but not for weight loss or other off-label uses. That could be important because the cost of Ozempic can be considerable (without insurance, it can cost about $1,000 a month). For sleep apnea patients, ResMed products may end up delivering the same or better results at a much lower price.
ResMed CEO Michael Ferrell in fact seems to welcome the new attention, since sleep apnea tends to be an underdiagnosed condition. Ozempic and similar drugs could bring potential patients “into the funnel,” he said on a conference call, while issues like cost and side effects will limit any hit to sales caused by the drugs. “That’s good for us, too,” he said.
What did you think of this piece?
Fundamental Analysis
Portfolio manager Scott Crawshaw highlights several companies in our Emerging Markets portfolio that are poised to benefit from increasing electrical power demand.
What did you think of this piece?
Fundamental Analysis
In its second-quarter earnings conference call, Meta founder and CEO Mark Zuckerberg detailed how AI permeates the company. For example, nearly all of Meta’s advertisers now use at least one AI-based product, allowing them, for instance, to personalize and customize ads. He also touted an increase of 7% in time spent on Facebook after launching AI-recommended content from accounts that users don’t follow.
Now the company plans an aggressive push of its own version of generative AI, the kinds of large language models that have gotten so much attention lately. In July, the company released an open-source—i.e., free for even commercial use—generative AI platform called Llama 2, which Meta hopes will emerge as a competitor to OpenAI’s GPT-4. Meta is betting its platform will unleash users’ creative potential and result in a flood of content. If that occurs, Meta’s powerful algorithms for matching content with users—4 billion of them across all of its platforms—will become indispensable as a content-discovery tool with a rich set of monetization options from advertising to ecommerce to subscriptions.
The big-picture view suggests that Meta is building a hub for user-generated content (UGC) discovery and distribution that aims to go head-to-head with the likes of YouTube and TikTok. In the world of unlimited content, the power shifts from creators to distributors and curators. In this scenario, the ultimate constraint on demand for content is the totality of leisure man-hours; Meta’s goal is to optimize how to fill those hours with the most compelling content.
Generative AI could also help transform Meta’s main money-maker, its advertising business. The digital-ad market comprises roughly 70% of the overall advertising market, and is dominated by two firms, Meta and Alphabet. Finding a way to expand its market share has been a stumbling block for Meta. However, with these new AI tools, Meta may have found a way around that constraint. It may not be able to take much more share of the advertising market, but it could start taking share of the advertising-creation market. On the call, Zuckerberg specifically mentioned the strides made by its Advantage+ generative AI tools that allows advertisers to supply just an image, from which the AI will then develop an entire ad campaign. For small companies that can’t afford to hire an advertising agency, this could be a powerful alternative and a lucrative market for Meta. Its Advantage+ ad program has the potential to take share from creatives and even advertising agencies by customizing, altering, or outright creating content for advertising, rather than just targeting or measuring it.

Source: Statista

Meta’s embrace of AI is one of several efforts the company’s made over the past year to reverse the slump that followed its 2021 shift into the metaverse. Zuckerberg showed common sense on reining in spending, the company executed on its new identifier for advertisers (IDFA) independent ad-targeting model, and it ramped up new initiatives like Reels, Advantage+, and most recently Threads. Meta has also delivered robust recoveries in free cash flow and revenue, with free cash flows for 2023 now forecast at approximately US$30 billion, a big increase from the US$10 billion forecast at the end of 2022. Even critical media coverage about privacy concerns and Facebook’s effects on democracy have waned and regulatory pressures have eased (except in the EU).
All this doesn’t mean Meta’s out of the woods, though. While impressive, the turnaround only just got the company back to where it was a year ago, when it was facing hard questions on rising costs, large infrastructure investments, and its incredibly audacious spending on the metaverse. Reality Labs—the division of the company building the metaverse that has already burned through US$30 billion since 2020—is losing a further US$15 billion per year, and Meta expects those losses to increase meaningfully in fiscal year 2024. Meta has yet to provide an explanation about how this is going to pay off. Even with its recent good fortune and AI potential, Zuckerberg will have to provide some real clarity soon to avoid another investor rebuke.

Image source: Romain TALON – stock.adobe.com.
Meta’s embrace of AI is one of several efforts the company’s made over the past year to reverse the slump that followed its 2021 shift into the metaverse. Zuckerberg showed common sense on reining in spending, the company executed on its new identifier for advertisers (IDFA) independent ad-targeting model, and it ramped up new initiatives like Reels, Advantage+, and most recently Threads. Meta has also delivered robust recoveries in free cash flow and revenue, with free cash flows for 2023 now forecast at approximately US$30 billion, a big increase from the US$10 billion forecast at the end of 2022. Even critical media coverage about privacy concerns and Facebook’s effects on democracy have waned and regulatory pressures have eased (except in the EU).
All this doesn’t mean Meta’s out of the woods, though. While impressive, the turnaround only just got the company back to where it was a year ago, when it was facing hard questions on rising costs, large infrastructure investments, and its incredibly audacious spending on the metaverse. Reality Labs—the division of the company building the metaverse that has already burned through US$30 billion since 2020—is losing a further US$15 billion per year, and Meta expects those losses to increase meaningfully in fiscal year 2024. Meta has yet to provide an explanation about how this is going to pay off. Even with its recent good fortune and AI potential, Zuckerberg will have to provide some real clarity soon to avoid another investor rebuke.
Image source: Romain TALON – stock.adobe.com.
What did you think of this piece?
Fundamental Analysis
Anyone who has interacted with popular AI models—asked them about the mysteries of life and the cosmos or created convincing Van Gogh replicas using AI-enabled image generators—can sense that we may be in the midst of a technological revolution. That prospect has consumed equity markets lately, with seven US tech-related stocks responsible for most of the market appreciation in the second quarter.
As an investor in high-quality, growing businesses, we have always tried to position this portfolio to benefit from secular trends, the kind that transcend economic cycles and are driven by fundamental changes in key areas such as tech. Still, it is incredibly difficult for anyone to predict how such trends will unfold; the vicissitudes of cryptocurrency are a sobering reminder of this. Furthermore, as seen with the rise of the internet and, later, mobile connectivity, technology is merely a platform; it’s the applications of the technology that eventually determine many of the winners and losers. In the case of generative AI, some of the future applications may not yet be conceivable, although many companies, even outside the tech field, are now pondering the possibilities.
ChatGPT, the chatbot that helped spark the market’s AI enthusiasm, is an important innovation because it can digest large amounts of text (hence the term large language model), communicate in natural (human) language, and generate sophisticated responses. Based on the Transformer architecture, a technique first introduced by Google in 2017, ChatGPT demonstrates the advances that have been made in AI that open the door to a wider set of business uses. But while natural language models recently produced epiphanies among lay chief executives and investors regarding AI, some tech companies were already investing in such capabilities and are being rewarded for that foresight. NVIDIA has been the biggest beneficiary this year in terms of its stock run and projected revenue gains; however, our other holdings, such as Adobe, Microsoft, Salesforce, ServiceNow, Synopsys, and TSMC, also appear among the possible beneficiaries. More companies—including, perhaps, some not yet in existence—will certainly join the ranks over time.
While it is still early, it’s evident that these companies see generative AI as transformative to their businesses and something upon which they can build new revenue models. Additionally, they are turning to AI to boost internal productivity, enhance existing customer offerings, and improve the quality and efficiency of customer interactions.
Most notably, Microsoft was able to gain an immediate leadership position in generative AI by making a US$10 billion investment in OpenAI, the company behind ChatGPT, earlier this year. Microsoft’s Bing search engine has since introduced ChatGPT into its web index data—a collection so large that it is rivaled by the dataset of only one other business in the world, Alphabet’s Google. Data are the feedstock of AI models, and an AI-enhanced search engine trained on so much data may attract more users to Bing, allowing Microsoft to sell more ads on the service. Microsoft is also adding generative AI to other products, including the Azure cloud service, enabling business customers who use Azure to easily integrate OpenAI models to glean more insights from their data and automate functions such as certain IT tasks. These added capabilities should motivate more businesses to migrate their data to the cloud and make Azure more competitive with Amazon.com’s AWS and Google Cloud.
The beneficiaries of demand for generative AI aren’t limited to traditional IT-sector companies. Data centers used to train AI models require up to ten times more power than typical data centers, thus requiring more-powerful equipment and backup power. Given the amount of heat they generate, new liquid-cooling solutions will be needed as well. This creates an opportunity for Schneider Electric, which has been developing innovative data-center equipment solutions for many years.
In the meantime, NVIDIA has emerged as the unrivaled global leader in providing the technologies at the center of the AI arms race. Due to an explosion of demand related to generative AI and LLMs from across its customer base, NVIDIA projects that data-center revenue for its fiscal second quarter ending in July will surge to US$11 billion. Not only is that more than double last quarter’s total, but the forecast also shattered the average analyst estimate that called for about US$7 billion.
Our investments in NVIDIA and Schneider are reflective of how we are thinking through the many unknowns and approaching portfolio structure in this environment. Through our fundamental framework, we can appreciate the broad excitement for AI, but we also remain conscious of valuations and thoughtful about diversification, recognizing that it’s unlikely anyone can predict today the biggest long-term winners.
What did you think of this piece?
Fundamental Analysis
Economic Advances and Hurdles

People haven’t been this bullish about India for 20 years, although there are reasons to question that enthusiasm.

Government’s Role

Governmental efforts to support industry and the country’s geopolitical positioning are boosting India’s attractiveness to companies.

Unique Spending Habits

Some of what makes India attractive are the unexpected or underappreciated investment opportunities.

Prices Warrant Patience

Investor patience will be required to purchase shares of high-quality companies at appropriate valuations.
People haven’t been this bullish about India for 20 years, although there are reasons to question that enthusiasm.
Governmental efforts to support industry and the country’s geopolitical positioning are boosting India’s attractiveness to companies.
Some of what makes India attractive are the unexpected or underappreciated investment opportunities.
Investor patience will be required to purchase shares of high-quality companies at appropriate valuations.
What did you think of this piece?
Fundamental Analysis
Portfolio Manager Wenting Shen, CFA, and Portfolio Specialist Apurva Schwartz discuss why Chinese companies are relocating production facilities to Southeast Asia. Watch the rest of their conversation.
What did you think of this piece?
Fundamental Analysis
As the world’s largest consumer-goods company, Procter & Gamble provides insight into what’s driving the pricing decisions at big brands.
In the first three months of 2023, P&G raised prices a whopping 10% year over year, following a series of large price hikes implemented throughout 2022:

Best known for brands such as Cascade, Gillette, Pampers, and Tide, P&G sells items typically found in the bathroom cabinet or under the kitchen sink. They aren’t the sort of hot items consumers blithely splurge on—but they are necessities. Despite P&G’s brands being among the most expensive in their categories, customers are loyal partly because the premium price and name recognition suggest they can expect consistent quality. Family and home care are areas “where the consumer doesn’t want to risk failure,” Andre Schulten, P&G’s chief financial officer, said during an April earnings call. “You don’t want to wash your clothes twice, and you certainly don’t want to deal with a diaper failure.”
With the latest round of price increases, P&G sold just 3% fewer items during the quarter (with the company’s decision to scale back operations in Russia responsible for one percentage point of this decline). This tells us that P&G may be losing some customers to sticker shock, but most are still coughing up the extra money. In fact, shoppers were entirely undeterred in the US, where the company’s sales volumes were up.
P&G is starting to see pushback in Europe, where the problem of stubbornly high inflation is worse due to the conflict in Ukraine and resulting energy crisis. P&G’s private-label rivals, which sell cheaper alternatives to brand-name goods, have been slow to raise prices in those markets as European consumers opt for the more affordable choice. This contrasts with the US, where consumers aren’t trading down and market share for private-label brands remains stable at about 16%, according to P&G. Rather than cut prices in Europe, though, P&G is spending on product and packaging enhancements as well as marketing to boost its brand prestige. For example, it’s promoting Ariel and Tide laundry detergents for use in cold water for consumers wanting to reduce their environmental impact or energy costs.
One reason P&G continues to raise prices for consumers is that the company is feeling the pinch of inflation, too. While higher prices benefited its gross profit margin last quarter by 470 basis points, much of that was offset by higher input expenses. Even as freight and transportation costs have come down, certain commodities and materials, such as ammonia and caustic soda, have gotten more expensive as P&G’s suppliers look to cover their own increased labor costs. Meanwhile, as the company reinvests in its brands to entice shoppers through means other than competitive prices, its operating margin widened by just 40 basis points, an improvement nonetheless.
Inflation isn’t in the rearview mirror, even if it is starting to ease. The companies with the greatest pricing power are taking advantage while they still can.
Best known for brands such as Cascade, Gillette, Pampers, and Tide, P&G sells items typically found in the bathroom cabinet or under the kitchen sink. They aren’t the sort of hot items consumers blithely splurge on—but they are necessities. Despite P&G’s brands being among the most expensive in their categories, customers are loyal partly because the premium price and name recognition suggest they can expect consistent quality. Family and home care are areas “where the consumer doesn’t want to risk failure,” Andre Schulten, P&G’s chief financial officer, said during an April earnings call. “You don’t want to wash your clothes twice, and you certainly don’t want to deal with a diaper failure.”
With the latest round of price increases, P&G sold just 3% fewer items during the quarter (with the company’s decision to scale back operations in Russia responsible for one percentage point of this decline). This tells us that P&G may be losing some customers to sticker shock, but most are still coughing up the extra money. In fact, shoppers were entirely undeterred in the US, where the company’s sales volumes were up.
P&G is starting to see pushback in Europe, where the problem of stubbornly high inflation is worse due to the conflict in Ukraine and resulting energy crisis. P&G’s private-label rivals, which sell cheaper alternatives to brand-name goods, have been slow to raise prices in those markets as European consumers opt for the more affordable choice. This contrasts with the US, where consumers aren’t trading down and market share for private-label brands remains stable at about 16%, according to P&G. Rather than cut prices in Europe, though, P&G is spending on product and packaging enhancements as well as marketing to boost its brand prestige. For example, it’s promoting Ariel and Tide laundry detergents for use in cold water for consumers wanting to reduce their environmental impact or energy costs.
One reason P&G continues to raise prices for consumers is that the company is feeling the pinch of inflation, too. While higher prices benefited its gross profit margin last quarter by 470 basis points, much of that was offset by higher input expenses. Even as freight and transportation costs have come down, certain commodities and materials, such as ammonia and caustic soda, have gotten more expensive as P&G’s suppliers look to cover their own increased labor costs. Meanwhile, as the company reinvests in its brands to entice shoppers through means other than competitive prices, its operating margin widened by just 40 basis points, an improvement nonetheless.
Inflation isn’t in the rearview mirror, even if it is starting to ease. The companies with the greatest pricing power are taking advantage while they still can.
What did you think of this piece?
Fundamental Analysis
Portfolio manager Pradipta Chakrabortty discusses the earnings bright spots within emerging markets regions and sectors.
What did you think of this piece?
Active Management
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.

Source: FactSet, MSCI Inc.; Harding Loevner, HOLT database.

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.
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.
What did you think of this piece?
Fundamental Analysis
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.
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.
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.
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.
What did you think of this piece?
Fundamental Analysis
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.
What did you think of this piece?
Behavioral Finance
Financial markets, among other things, act as a type of sieve that screens investments. Ideally, the riskiest tradable assets pass through to the strongest balance sheets. In practice, they often end up on the balance sheets of the most accommodating investors, owned not by those most capable of bearing risks, but rather those most willing to. A well-functioning market will tend to filter out those excesses, eliminating investors who exceed their risk-bearing capacity, while helping to ensure that those who take on too little risk see their returns shrink and their share of the capital base dwindle. On balance, this sifting mechanism helps to steer capital to its most productive uses.
In extended bull markets, however, this process tends to break down, as rewards flow disproportionally to the most aggressive, over-confident, and complacent investors. This creates a powerful feedback loop, as unbridled risk-taking is rewarded with outperformance which in turn draws more capital. Once the process gets going, it is self-reinforcing as the newly attracted capital is plowed back into the same group of assets. In so doing, fragilities increase, and the longer it persists the more distorted capital allocation becomes.
By central bankers’ own admission, their goal was to spur a positive wealth effect on spending, by pushing safety-minded investors into taking more risks, thus driving up valuations. Now we will see just how difficult the unwinding will be as the wealth effect goes into reverse.
The implosion over the last six months (at least in terms of their asset prices) of profitless growth stocks, crypto assets, and other speculative creatures of the markets is emblematic of the reckoning that can occur once excessive risk taking continues for too long. In this case, it has been slowly building for over a decade. Fears of outright deflation following the global financial crisis encouraged central banks to keep pushing interest rates lower to allow over-extended borrowers to heal, and to reduce the cost of capital for new investment in the hopes of kick-starting growth. At the same time, the total absence of inflationary pressures seduced central bankers to set aside worries about the dangers of money printing and unrestrained liquidity. By their own admission, the goal of their zero-interest monetary policy was to spur a positive wealth effect on spending, by pushing fearful, safety-minded investors into taking more risks, thus driving up valuations.1
Primary beneficiaries of this process were growth stocks, particularly the most speculative growth stocks of companies with untried business models; their multiples steadily increased, inversely with submerging interest rates. This coincided with a surge in indexation and so-called “smart beta” and factor investing, which channeled vast amounts of capital to the same group of stocks. Remarkably, for an extended period, some of these stocks were simultaneously defensive, fast growing, and relatively involatile, guaranteeing them an outsized weighting across a plethora of indices designed to track those very characteristics. Many active managers, faced with the prospect of having to beat a steadily narrowing benchmark, also piled in, overweighting these same stocks in the case of mutual funds, or owning them with leverage in the case of hedge funds. The prolonged success of these strategies encouraged yet more risk-taking, with new rafts of venture-backed startups and IPOs lacking anywhere near the prodigious free cash flows of the established tech companies. Moreover, the initial phases of the pandemic led to a late kick for tech stocks seemingly insulated from pandemic-induced disruptions to traditional commerce, which further turbocharged their valuations. The result was levitating valuations justified on the back of negative real interest rates.
The whole process was vulnerable to any shift in the macroeconomic backdrop that could prompt central banks to reverse course. The coils of that shift were arguably set by the pandemic and then sprung by the vaccine clinical trial results and rollouts which together upended consumption patterns, snarled supply chains, and reconfigured labor markets. According to the Bank for International Settlements, global growth, after cratering in 2020, accelerated to the fastest pace in almost five decades the following year.2 The subsequent conflict in Ukraine exposed the fragility of an energy supply that had been undermined by a decade of underinvestment and climate-related antipathy, applying an energy supply shock to a combustible mix.
Now we will see just how difficult unwinding the unprecedented asset purchase programs and zero interest rate policies will be as central bank balance sheets shrink, interest rates rise, and the wealth effect goes into reverse. Policymakers embarked on their former policies with a clear-eyed view of the clear and present danger of deflation while the uncertain contingent costs inhabited a distant and abstract future. As that future arrives, the true costs are being revealed.
Endnotes

1“Aiding the Economy: What the Fed Did and Why,” Ben S. Bernanke, The Washington Post (November 4, 2010).
2BIS Annual Economic Report, Bank of International Settlements (June 26, 2022).
1“Aiding the Economy: What the Fed Did and Why,” Ben S. Bernanke, The Washington Post (November 4, 2010).
2BIS Annual Economic Report, Bank of International Settlements (June 26, 2022).
What did you think of this piece?
Fundamental Analysis
But days before Shen’s departure, new complications arose: outbreaks of the Omicron variant in several Chinese cities, including Shanghai, were prompting citywide lockdowns. The flight was still due to depart, but had been rerouted to Fuzhou, a coastal city across the strait from Taiwan, 450 miles to the Southwest.
The natural—some would say, prudent—decision at this point might have been to postpone her trip. But Shen, worried she might not easily get another ticket, pressed ahead. Here are her travel bulletins.
4 p.m. GMT March 31, 10,000 feet above Siberia

Quite frankly, it is a miracle we are still enroute to China. In recent months, many other flights were canceled minutes before departure, and some were turned around in the air midway. One woman I spoke with during my pre-flight COVID testing told me her ticket was cancelled eight times!
Assuming we make it (looking around now for wood to knock on—the plane is mostly carbon fiber), ours will be the first plane from the East Coast of the United States to land in China in weeks. When I booked my flight in January, my seat was one of the last available; a few days later all were gone from any airport between Boston and DC until the end of July.

I’m still amazed so many other people are intent on going to China right now, even though so many people in China are under mobility restrictions. The pandemic has occupied nearly every conversation I’ve had in recent days—with other travelers at the testing facility in Queens, at the airport, here on the plane with the friendly flight attendants smiling from behind their full hazmat garb. On the Chinese social media apps, there is furious debate between the “zero-COVIDers” and the “open-uppers,” just like the culture wars in the States. People in each camp are so busy arguing with and unfriending those from the other camp that a much-needed third voice is being drowned out—one that argues for hurrying more, and, if needed, better jabs into arms, especially for China’s under-vaccinated elderly, which might lower the severe costs of the pandemic to society.

4 a.m. local time, April 1, Fuzhou Changle Airport

The arrival process has been pretty orderly. After touching down, we were deplaned in groups of 15 so each of us could undergo testing and temperature checks. Everyone’s luggage was sanitized. We filled out forms capturing our identification information and phone numbers, which took several hours. Now we’re just waiting for a bus to take us to a quarantine hotel. Still don’t know the name and location due to rolling availability.

5:30 a.m. April 1, Phase 1, Day 1 of 15 in Room 919 at the Shiji Jinyuan Hotel, Fuzhou

We are settled in the quarantine hotel in Fuzhou, otherwise known as the City of Banyans because of all the beautiful banyan trees. The largest tree is said to date back to the Song era, about 900 years ago. It’s hard to make them out from my hotel room window, and I have no glimpse of the sea or Taiwan. I can see a little bit of the Min River, though, and the mountains to the north.
So far, the room is homey enough. I have plenty of space. The internet connectivity is subpar but functional. I have been staying in touch with my colleagues and talked to many people to update them on my arrival.

Temperatures are checked twice a day with COVID tests every few days. Thankfully, no one on my flight has tested positive. If that happens, our two-week quarantine will be extended even longer.
I received a call from the office in Beijing where my government ID is associated, since that’s where I went to college and spent my first job. The woman asked me a few questions about my plans and was pleasant, although I was a little taken aback by how happy she sounded when she learned I would not be frequenting her city after my quarantine. For a moment there, I felt like we were in the Black Plague!

7:30 a.m., Room 919, Day 2 of 15

Obligatory food review: The chefs are cooking for some 400 people, so the quality varies. At times the food is overcooked, presumably to kill any COVID floating around. But the delivery person has been exceptionally kind to me, usually leaving one or even two extra meals for me since I think my room, which is at the end of the corridor, might be the last one on his route. So, I save some choices that I enjoy. The meals are delivered to our door three times a day. No outside food is allowed, but online orders of daily necessities are permitted. For me, that’s a yoga mat, which I ordered from Taobao. Hoping that yoga will help me restore my circadian rhythm.

11 a.m., Room 919, Day 6 of 15

My fellow passengers and I (we are all in a WeChat group together) have been scrambling this morning to figure out the next leg of our travel. April 16th now appears to be our release date from Phase 1 of the quarantine period, which still seems very far away. What is not clear is the latest policy for Phase 2 in Shanghai, which many of us have listed as our final destinations. I don’t know yet whether I will be at a central government-operated quarantine hotel as I am now, or self-quarantining at another location, which would be strictly monitored. The situation is very fluid.

9:30 a.m., Room 919, Day 8 of 15

Half of my Phase 1 quarantine time has passed, and it looks like spring has arrived here in Fuzhou—the views are pretty, and I wish I could go outside to explore. Unfortunately, the bright sun doesn’t lift the spirits of the passengers from Flight MU588. As time grinds on, people have become a bit more anxious and exhausted. On WeChat, there are complaints about the hotel rooms and services. A few people feel the meals are unpalatable and would rather have cup noodles. Others grumble about the brain-stir-style COVID tests or the internet service, which has degraded with a new influx of passengers at the hotel. I’ve stayed out of it (maybe the yoga helps) and appreciate how tough it must be to keep 400 quarantined people happy. I have been able to stay connected to the internet most of the time but am having to use my phone hot spot more.

Our biggest worry is what will happen to us after Phase 1. The barriers seem more insurmountable by the day for those who were headed to Shanghai. Apparently, most flights and trains to the city have been canceled, so some people may have to stay several more days, or even weeks in Fuzhou. There were stories of people turned away at the Fuzhou airport for departure—but then rejected entry back to the city, so they have no choice but to sleep at the Fuzhou airport (which might be apocryphal since I didn’t see anyone camping out when we were there). The same struggle is shared by those trying to make the trip the other way—those who landed in Shanghai but are trying to get to other cities outside. A friend of mine has been trapped in Shanghai for three weeks. He has spent the first two weeks in quarantine, and the hotel where he is staying has just announced the food is running short. At least I have other options, including heading straight on to my hometown Xi’an.

2 p.m., Room 919, Day 9 of 15

We are the lucky ones. None of our little headaches here in Fuzhou come close to what people in Shanghai are experiencing, who have now been in lockdown for weeks. They are panicking about food, and more and more items are under shortages. I know from my conversations with our portfolio companies that much of this has to do with logistics—countless restrictions have been placed on truckers and drivers, who cannot come into the city because of the fears they will bring in or carry out the virus. At times, this feels like the country is living backwards, plopped right back at the start of the pandemic two years ago. I spoke with one of our companies, the travel booking site Trip.com Group. They think more cities will enter lockdowns in Q2 because of the appearance of Omicron everywhere.

10 a.m., Room 919, Day 11 of 15

I’ve spent the last couple days speaking to more companies and hearing more difficult news from friends and family throughout China. A friend was placed in quarantine simply because someone else in his testing batch was positive, and they wouldn’t readminister tests to find out whose sample it was.
When I put my analyst hat on, all this makes me think that the current wave could leave worse marks on the economy than 2020. If cities have recurring lockdowns, multinationals might re-evaluate China’s comparative supply chain advantages. And orders have been lukewarm anyway, as more of the world resumes normality and moves more aggressively to insulate itself from any potential disruption.

11 a.m., Room 919, Day 12 of 15

Out of everything gloomy, a piece of positive news! Some cities are finally pushing more seriously for vaccines for the elderly. In Beijing, a generous gift credit of Rmb500 (US$75) is being handed out to those above 60 years old who get a shot, along with additional coupons for those who bring in their friends.
My 88-year-old grandparents finally got their first shots a couple of weeks ago. Like any good granddaughter, I had bombarded them for several weeks with severity and death data from the unvaccinated elderly in Hong Kong. Now, they’re waiting for their second shot. Already, it gives me some peace of mind—and hope they are a representative indicator!

10 p.m., Room 919, Day 15 of 15

My two weeks of quarantining in Fuzhou are nearly up—at times it has been slow, but the days have been very busy for me—earnings season, talking to companies to let them know I am here, comparing notes with colleagues. It’s nice to be able to attend so many of my company discussions without a time zone difference, although none seem to be doing in-person meetings just yet.
I can’t say this is the finest hotel I have ever stayed at, but it is sure to be the most memorable. For one, I won’t forget the silent humor of the staff. One fellow passenger complained that her meals were too bland and asked the hotel to cook with more soy sauce. The next thing she knows, she gets a bottle of soy sauce delivered to her door, a sly invitation to douse her own food all she wants. It’s the amusing moments like these that have made this time a little easier.
Now, only nine hours to go before my release from Phase 1. Medical assistants dressed in white protection gear (nicknamed “Big White” on Chinese social media) come to test my hotel room. Swabs are taken from my pillows, my jacket, and my toothbrush.
As lockdowns dragged on in Shanghai and spread to my other intended destination, I have decided to head straight home to Xi’an after all. The only downside is that none of the six people in my family will be allowed to leave the apartment for the first seven days I am there. After a week, they will be granted freedom to move around, but I’ll have to stay inside for another seven days. Hopefully my grandpa’s snoring won’t disrupt our firm’s quarterly webcast, which we are filming a couple days after I arrive.

9 a.m. Xi’an time, April 17, Phase 2, Day 2 of 14

Home at last! I left my quarantine facility on Saturday as planned—the trip to Xi’an took twelve hours. The climax was the ambulance ride to my parents’ from the airport (that’s me again to the left, mildly offended no sirens are blaring). When I finally reached home, a local officer in Big White was waiting for me. She was carrying a seal for the front door and an electronic lock that will send an alarm to the local police if any of us ventures outside more than three times a day for more than the few minutes it takes to carry out the trash or get tested.
Ours is a kind of double lockdown—one protecting Xi’an from me due to my arrival from abroad, the other a citywide lockdown protecting us from the virus now loose on the streets of Xi’an.

Evening, April 23, Day 8 of 14

I continue to have daily calls with companies. From my conversations, logistics and travel seem to be front-and-center in their concerns. Since logistics companies are often faulted as carriers of the virus, the new default is to suspend deliveries as soon as a lockdown is commenced.
Consumer sentiment is weak now too, which may scar the consumer and retail sector even after the peaks have passed. Staples like dairy should be doing fine. People are still trying to eat and would like to buy!
Industrial disruptions are occurring throughout the supply chain, which could do long-term damage to China’s status as the world’s factory. So ironic after China was the first country to get back up and running during the first wave, and so sad since it seems like so much of the damage could have been controlled.

Noon, May 1, Reflection and release

During this entire trip, I have felt extremely privileged. For the duration of my quarantine, I have always had more than enough to eat, unlike all those many isolated and hungry in Shanghai. I also feel a little guilty about the inconvenience my return has caused others. I learned the hotel staff was in their own parallel lockdown with us, working at the hotel for up to a month and then quarantining for 14 days after each shift. The flight attendants have been quarantining for 14 days after each flight.
I’ve started to wonder how the country’s near-term growth targets can possibly be met now absent a relaxation of Zero- Covid and/or massive additional government support. I understand that they wanted to both protect the elderly and other vulnerable people and give the local biotechs a chance to finish developing their own mRNA vaccines before letting in the Western versions. But couldn’t there be a more sustainable way to handle the situation?
One thing is certain—the government is at war with the virus, but there’s also a war underway within public opinion. In the chat groups and social media sites where I’ve spent so many of my waking hours these past five weeks, it is constant debate. This lack of solidarity and wavering of confidence that we will get through this is a stark contrast to China’s fast emergence from the pandemic in 2020 and has undoubtedly contributed to the difficulties. On the other hand, there is also something refreshing about it—a sign of civic sanity, perhaps, in the face of lockdowns on top of lockdowns.

According to reports a few days ago, another 1,100 companies in Shanghai have been cleared to reopen. That’s on top of the 600 that were previously announced. The latest estimates are the whole city might be out of lockdown within two weeks. We’ll see. Here in Xi’an, meanwhile, we have gotten off easy. I was finally sprung right before China’s five-day “May First” (Labor Day) holiday. The last week actually worked out pretty well for me, because April 30 is the deadline of the super reporting season for A-share companies, who usually report both annual and Q1 results simultaneously and hold their annual investor meetings, the vast majority online. I managed to attend as many as seven meetings per day. I hope my boss doesn’t get any ideas about putting me in quarantine every earnings season now.

During the holiday, I was able to catch up with a handful of schoolmates since nobody could really travel outside the province. Interestingly, most have ended up working for state-owned enterprises or institutes. The recurring complaints seem to be around compensation and the rigidity of the system. Otherwise, people still worry about the same things as before: housing prices and kids’ education. There still seems fierce competition to get into a good school to test well for the college entrance exam.
Over this past weekend, I took my first long walk in Xi’an in several years. The city has transformed from the historical city I remember into a cosmopolitan metropolis with thousands of high rises and dozens of brand-new shopping malls. As I walked around the new South Lake that was being built when I left for college, early risers were doing their morning exercises. Life was remarkably calm and peaceful. Nobody seemed to care about politics so long as it is leading them to a brighter future—and hopefully a future that doesn’t have to involve repeated lockdowns.
4 p.m. GMT March 31, 10,000 feet above Siberia
Quite frankly, it is a miracle we are still enroute to China. In recent months, many other flights were canceled minutes before departure, and some were turned around in the air midway. One woman I spoke with during my pre-flight COVID testing told me her ticket was cancelled eight times!
Assuming we make it (looking around now for wood to knock on—the plane is mostly carbon fiber), ours will be the first plane from the East Coast of the United States to land in China in weeks. When I booked my flight in January, my seat was one of the last available; a few days later all were gone from any airport between Boston and DC until the end of July.
I’m still amazed so many other people are intent on going to China right now, even though so many people in China are under mobility restrictions. The pandemic has occupied nearly every conversation I’ve had in recent days—with other travelers at the testing facility in Queens, at the airport, here on the plane with the friendly flight attendants smiling from behind their full hazmat garb. On the Chinese social media apps, there is furious debate between the “zero-COVIDers” and the “open-uppers,” just like the culture wars in the States. People in each camp are so busy arguing with and unfriending those from the other camp that a much-needed third voice is being drowned out—one that argues for hurrying more, and, if needed, better jabs into arms, especially for China’s under-vaccinated elderly, which might lower the severe costs of the pandemic to society.
4 a.m. local time, April 1, Fuzhou Changle Airport
The arrival process has been pretty orderly. After touching down, we were deplaned in groups of 15 so each of us could undergo testing and temperature checks. Everyone’s luggage was sanitized. We filled out forms capturing our identification information and phone numbers, which took several hours. Now we’re just waiting for a bus to take us to a quarantine hotel. Still don’t know the name and location due to rolling availability.
5:30 a.m. April 1, Phase 1, Day 1 of 15 in Room 919 at the Shiji Jinyuan Hotel, Fuzhou
We are settled in the quarantine hotel in Fuzhou, otherwise known as the City of Banyans because of all the beautiful banyan trees. The largest tree is said to date back to the Song era, about 900 years ago. It’s hard to make them out from my hotel room window, and I have no glimpse of the sea or Taiwan. I can see a little bit of the Min River, though, and the mountains to the north.
So far, the room is homey enough. I have plenty of space. The internet connectivity is subpar but functional. I have been staying in touch with my colleagues and talked to many people to update them on my arrival.
Temperatures are checked twice a day with COVID tests every few days. Thankfully, no one on my flight has tested positive. If that happens, our two-week quarantine will be extended even longer.
I received a call from the office in Beijing where my government ID is associated, since that’s where I went to college and spent my first job. The woman asked me a few questions about my plans and was pleasant, although I was a little taken aback by how happy she sounded when she learned I would not be frequenting her city after my quarantine. For a moment there, I felt like we were in the Black Plague!
7:30 a.m., Room 919, Day 2 of 15
Obligatory food review: The chefs are cooking for some 400 people, so the quality varies. At times the food is overcooked, presumably to kill any COVID floating around. But the delivery person has been exceptionally kind to me, usually leaving one or even two extra meals for me since I think my room, which is at the end of the corridor, might be the last one on his route. So, I save some choices that I enjoy. The meals are delivered to our door three times a day. No outside food is allowed, but online orders of daily necessities are permitted. For me, that’s a yoga mat, which I ordered from Taobao. Hoping that yoga will help me restore my circadian rhythm.
11 a.m., Room 919, Day 6 of 15
My fellow passengers and I (we are all in a WeChat group together) have been scrambling this morning to figure out the next leg of our travel. April 16th now appears to be our release date from Phase 1 of the quarantine period, which still seems very far away. What is not clear is the latest policy for Phase 2 in Shanghai, which many of us have listed as our final destinations. I don’t know yet whether I will be at a central government-operated quarantine hotel as I am now, or self-quarantining at another location, which would be strictly monitored. The situation is very fluid.
9:30 a.m., Room 919, Day 8 of 15
Half of my Phase 1 quarantine time has passed, and it looks like spring has arrived here in Fuzhou—the views are pretty, and I wish I could go outside to explore. Unfortunately, the bright sun doesn’t lift the spirits of the passengers from Flight MU588. As time grinds on, people have become a bit more anxious and exhausted. On WeChat, there are complaints about the hotel rooms and services. A few people feel the meals are unpalatable and would rather have cup noodles. Others grumble about the brain-stir-style COVID tests or the internet service, which has degraded with a new influx of passengers at the hotel. I’ve stayed out of it (maybe the yoga helps) and appreciate how tough it must be to keep 400 quarantined people happy. I have been able to stay connected to the internet most of the time but am having to use my phone hot spot more.
Our biggest worry is what will happen to us after Phase 1. The barriers seem more insurmountable by the day for those who were headed to Shanghai. Apparently, most flights and trains to the city have been canceled, so some people may have to stay several more days, or even weeks in Fuzhou. There were stories of people turned away at the Fuzhou airport for departure—but then rejected entry back to the city, so they have no choice but to sleep at the Fuzhou airport (which might be apocryphal since I didn’t see anyone camping out when we were there). The same struggle is shared by those trying to make the trip the other way—those who landed in Shanghai but are trying to get to other cities outside. A friend of mine has been trapped in Shanghai for three weeks. He has spent the first two weeks in quarantine, and the hotel where he is staying has just announced the food is running short. At least I have other options, including heading straight on to my hometown Xi’an.
2 p.m., Room 919, Day 9 of 15
We are the lucky ones. None of our little headaches here in Fuzhou come close to what people in Shanghai are experiencing, who have now been in lockdown for weeks. They are panicking about food, and more and more items are under shortages. I know from my conversations with our portfolio companies that much of this has to do with logistics—countless restrictions have been placed on truckers and drivers, who cannot come into the city because of the fears they will bring in or carry out the virus. At times, this feels like the country is living backwards, plopped right back at the start of the pandemic two years ago. I spoke with one of our companies, the travel booking site Trip.com Group. They think more cities will enter lockdowns in Q2 because of the appearance of Omicron everywhere.
10 a.m., Room 919, Day 11 of 15
I’ve spent the last couple days speaking to more companies and hearing more difficult news from friends and family throughout China. A friend was placed in quarantine simply because someone else in his testing batch was positive, and they wouldn’t readminister tests to find out whose sample it was.
When I put my analyst hat on, all this makes me think that the current wave could leave worse marks on the economy than 2020. If cities have recurring lockdowns, multinationals might re-evaluate China’s comparative supply chain advantages. And orders have been lukewarm anyway, as more of the world resumes normality and moves more aggressively to insulate itself from any potential disruption.
11 a.m., Room 919, Day 12 of 15
Out of everything gloomy, a piece of positive news! Some cities are finally pushing more seriously for vaccines for the elderly. In Beijing, a generous gift credit of Rmb500 (US$75) is being handed out to those above 60 years old who get a shot, along with additional coupons for those who bring in their friends.
My 88-year-old grandparents finally got their first shots a couple of weeks ago. Like any good granddaughter, I had bombarded them for several weeks with severity and death data from the unvaccinated elderly in Hong Kong. Now, they’re waiting for their second shot. Already, it gives me some peace of mind—and hope they are a representative indicator!
10 p.m., Room 919, Day 15 of 15
My two weeks of quarantining in Fuzhou are nearly up—at times it has been slow, but the days have been very busy for me—earnings season, talking to companies to let them know I am here, comparing notes with colleagues. It’s nice to be able to attend so many of my company discussions without a time zone difference, although none seem to be doing in-person meetings just yet.
I can’t say this is the finest hotel I have ever stayed at, but it is sure to be the most memorable. For one, I won’t forget the silent humor of the staff. One fellow passenger complained that her meals were too bland and asked the hotel to cook with more soy sauce. The next thing she knows, she gets a bottle of soy sauce delivered to her door, a sly invitation to douse her own food all she wants. It’s the amusing moments like these that have made this time a little easier.
Now, only nine hours to go before my release from Phase 1. Medical assistants dressed in white protection gear (nicknamed “Big White” on Chinese social media) come to test my hotel room. Swabs are taken from my pillows, my jacket, and my toothbrush.
As lockdowns dragged on in Shanghai and spread to my other intended destination, I have decided to head straight home to Xi’an after all. The only downside is that none of the six people in my family will be allowed to leave the apartment for the first seven days I am there. After a week, they will be granted freedom to move around, but I’ll have to stay inside for another seven days. Hopefully my grandpa’s snoring won’t disrupt our firm’s quarterly webcast, which we are filming a couple days after I arrive.
9 a.m. Xi’an time, April 17, Phase 2, Day 2 of 14
Home at last! I left my quarantine facility on Saturday as planned—the trip to Xi’an took twelve hours. The climax was the ambulance ride to my parents’ from the airport (that’s me again to the left, mildly offended no sirens are blaring). When I finally reached home, a local officer in Big White was waiting for me. She was carrying a seal for the front door and an electronic lock that will send an alarm to the local police if any of us ventures outside more than three times a day for more than the few minutes it takes to carry out the trash or get tested.
Ours is a kind of double lockdown—one protecting Xi’an from me due to my arrival from abroad, the other a citywide lockdown protecting us from the virus now loose on the streets of Xi’an.
Evening, April 23, Day 8 of 14
I continue to have daily calls with companies. From my conversations, logistics and travel seem to be front-and-center in their concerns. Since logistics companies are often faulted as carriers of the virus, the new default is to suspend deliveries as soon as a lockdown is commenced.
Consumer sentiment is weak now too, which may scar the consumer and retail sector even after the peaks have passed. Staples like dairy should be doing fine. People are still trying to eat and would like to buy!
Industrial disruptions are occurring throughout the supply chain, which could do long-term damage to China’s status as the world’s factory. So ironic after China was the first country to get back up and running during the first wave, and so sad since it seems like so much of the damage could have been controlled.
Noon, May 1, Reflection and release
During this entire trip, I have felt extremely privileged. For the duration of my quarantine, I have always had more than enough to eat, unlike all those many isolated and hungry in Shanghai. I also feel a little guilty about the inconvenience my return has caused others. I learned the hotel staff was in their own parallel lockdown with us, working at the hotel for up to a month and then quarantining for 14 days after each shift. The flight attendants have been quarantining for 14 days after each flight.
I’ve started to wonder how the country’s near-term growth targets can possibly be met now absent a relaxation of Zero- Covid and/or massive additional government support. I understand that they wanted to both protect the elderly and other vulnerable people and give the local biotechs a chance to finish developing their own mRNA vaccines before letting in the Western versions. But couldn’t there be a more sustainable way to handle the situation?
One thing is certain—the government is at war with the virus, but there’s also a war underway within public opinion. In the chat groups and social media sites where I’ve spent so many of my waking hours these past five weeks, it is constant debate. This lack of solidarity and wavering of confidence that we will get through this is a stark contrast to China’s fast emergence from the pandemic in 2020 and has undoubtedly contributed to the difficulties. On the other hand, there is also something refreshing about it—a sign of civic sanity, perhaps, in the face of lockdowns on top of lockdowns.
According to reports a few days ago, another 1,100 companies in Shanghai have been cleared to reopen. That’s on top of the 600 that were previously announced. The latest estimates are the whole city might be out of lockdown within two weeks. We’ll see. Here in Xi’an, meanwhile, we have gotten off easy. I was finally sprung right before China’s five-day “May First” (Labor Day) holiday. The last week actually worked out pretty well for me, because April 30 is the deadline of the super reporting season for A-share companies, who usually report both annual and Q1 results simultaneously and hold their annual investor meetings, the vast majority online. I managed to attend as many as seven meetings per day. I hope my boss doesn’t get any ideas about putting me in quarantine every earnings season now.
During the holiday, I was able to catch up with a handful of schoolmates since nobody could really travel outside the province. Interestingly, most have ended up working for state-owned enterprises or institutes. The recurring complaints seem to be around compensation and the rigidity of the system. Otherwise, people still worry about the same things as before: housing prices and kids’ education. There still seems fierce competition to get into a good school to test well for the college entrance exam.
Over this past weekend, I took my first long walk in Xi’an in several years. The city has transformed from the historical city I remember into a cosmopolitan metropolis with thousands of high rises and dozens of brand-new shopping malls. As I walked around the new South Lake that was being built when I left for college, early risers were doing their morning exercises. Life was remarkably calm and peaceful. Nobody seemed to care about politics so long as it is leading them to a brighter future—and hopefully a future that doesn’t have to involve repeated lockdowns.
What did you think of this piece?
Multi-Asset
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.
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.
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:
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.
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.
What did you think of this piece?
Behavioral Finance
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:
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.
1Remarks to the New York University Commencement, May 13, 1999.
What did you think of this piece?
Active Management
Much of the debate surrounding indexing centers on the relative merits of taking an active versus passive investment approach. But the question of how indexing might be reshaping market structure is largely unexplored. The standing assumption is that, since passive investment flows mirror the prevailing distribution of capital, index trades are bereft of information and therefore have no effect on the pricing of the underlying securities; hence the overall scale of indexing is irrelevant. But this assumption becomes more tenuous as the share of passively managed assets grows. What if passive increased to, say, 100% of all equity assets? Would those investments still have no effect on prices?
It’s unclear how the widespread use of indexing may be affecting market structure; that is, at what point the sheer quantity of assets mimicking market behavior could start to change the behavior. Maybe it already has.
The Beauty Contest

To its advocates, the virtues of indexing are beyond reproach. With low fees and high transparency, index funds offer a cheap and straightforward way for an investor to earn average returns. This perspective is buttressed by mounds of academic research that have characterized passive investing as a stable equilibrium, meaning that even were everyone to index their investments, it would make no difference to either prices or the cost of capital.
Underlying this claim is an assumption that markets are populated by rational beings, whose collective behavior delivers market prices that always perfectly reflect all available information. But markets don’t work that way, and grubby reality is a world away from this frictionless ideal.

“We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
—John Maynard Keynes

The early 20th-century British economist John Maynard Keynes understood this only too well, famously comparing investors to participants in newspaper beauty contests. A popular feature in the London press of his time, these contests asked readers to choose the six prettiest faces out of a collection of a hundred photographs. The winner was the entry that came closest to the average selection. Although nominally about personal aesthetics, winning the contest meant successfully anticipating the anticipations of others. “It is not a case of choosing those which…are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes wrote. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
Investors tasked with choosing which stocks to own face the same quandary as players in the beauty contest. Should they expend time and energy to understand companies’ long-term business prospects and to project cashflows decades out? Or, given limited resources, is it wiser to try and figure out which stocks are likely to be popular six months hence? Writing seven years after the great crash of ’29 and attempting to make sense of the devastation left in its wake, it was clear to Keynes that only the former had any merit, but that most investors favored the latter, trying to “beat the gun, […] to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” A slight shift in mood is enough to set off cascading price changes as investors react en masse. The inherent instability spawned by this recursive guessing game is why prices are far more volatile than what is known of underlying fundamentals, and why life for investors struggling to get a purchase on cash flows and discount rates, in Keynes’s view, can be so forbidding.
But what happens when most investors opt out of selecting individual stocks? When beauty contestant judges pick the same pretty faces week after week?
The question is relevant because the answer would go some ways toward explaining today’s higher-than-average valuations. An end to the beauty contest would equate to a permanent decline in undiversifiable risk, which all else being equal, would justify paying a higher multiple for uncertain future cash flows. It might even make life a little less unpleasant for those relying on their projections of long-term fundamentals. After all, with fewer active traders whacking prices around, shouldn’t the signal be a little easier to unscramble from the noise?
The evidence on the ground, however, suggests a more complicated picture. The beauty contest hasn’t ended so much as shifted its locus of speculation from individual securities to trading vehicles that clump together groups of securities based on mechanical trading rules.
One indication that this is happening is the puzzling reversal in the positive serial dependence of short-term index returns. Serial dependence, or autocorrelation, refers to the degree of correlation between two observations of the same variable at different points in time. A random variable, the flip of a coin say, has an autocorrelation of zero, each flip independent of the one before. Historically, short-term index returns have had a small (but consistent) positive serial dependence, meaning that, on average, a positive return one day will be followed by a return in the same direction the next day and vice versa. One possible explanation for this phenomenon held that stocks reacted with a lag to non-fundamental shocks.2
But in 2000, this relationship turned negative, and it has remained so ever since. The chart below shows correlation between daily returns for the S&P 500 averaged over a ten-year window going back to 1949. Positive serial dependence increased steadily throughout the 1960s and ’70s, peaked shortly before the introduction of index futures in the ’80s, then declined steadily for two decades before falling consistently below zero at the start of this century.

Source: Bloomberg, Harding Loevner

According to a new study3 by researchers at Erasmus University and the University of Notre Dame, the explanation for this reversal can be laid squarely at the feet of indexing and the seismograph-like movements of mechanical trading rules amplifying the daily response to new information. The research considered 20 equity indices across 15 countries and found an identical change in the behavior of short-term returns. Moreover, they found a direct causal relationship between these patterns and the combined increase in index products including futures, ETFs, and mutual funds. According to the authors, “introducing indexing products seems to change the behavior of the underlying stock market across indexes and over time,” and more critically a higher level of indexing leads to “a more negative serial dependence.” It is unclear what the full consequences of the new pattern will be, but we may be seeing it on display at the far right of the graph above, in the sharply negative one-day autocorrelation in March 2020 at the onset of the pandemic. In plain language, it used to be that uncertainty about the future flowed from individual stock prices into indices; now, the tide has been reversed and uncertainty propagates from indices to individual stocks.

Vol of Vol

Another unsettling sign of change is the rise in the level of implied volatility of volatility (vol of vol), a measure of the market’s capacity for registering unexpected shocks. Roughly speaking, implied volatility—the volatility that is backed out from the price of options—reflects the market’s expectation for the range of potential outcomes for an asset over a specific period. When implied volatility is high, markets expect larger price moves (in either direction), or when it’s low, smaller moves. The most well-known measure of these signals is the VIX, which is calculated from the price of short-dated index options on the S&P 500 and is frequently referred to as the “investor fear gauge.”
Despite its notoriety, the VIX is a measure of disorder and quite distinct from a measure of potential disorder. For that we need to consider volatility of volatility, the true measure of market entropy. To measure that entropy, we use VVIX. Just as the VIX is calculated from the price of options on the S&P 500, the VVIX is based on the price of options on the VIX. Future returns are unknown, but the VIX tells us something about the range of returns we should expect. The VVIX, on the other hand, indicates how uncertain we are about the variability of that range.
Intuitively there are strong reasons to believe that while this vol of vol itself should vary day-to-day as the market digests unexpected shocks, like the VIX it should be stable around some long-term average. But, as can be seen in the chart below, since 2006, a period coinciding with the boom in passive investing, volatility of volatility has shown a consistent upward trend—a sign that the range of potential disorder is expanding.

Source: Bloomberg, Harding Loevner

Doubtless there is more than one culprit behind the increase in vol of vol. Low real interest rates driving down risk premiums probably figure in, as does the growth in systemwide leverage which magnifies fragility by accelerating the interdependence of financial flows. But we would be remiss to ignore the effects of ballooning index flows. Index replication relies on a well-behaved and liquid market for the underlying securities, a presupposition that is paradoxically undermined by the expanding share of index flows. Keynes’s insight was understanding the role of psychology in fueling the tussle between long-term investors and short-term speculators. But things are different at the asset class level. Strategic allocations are typically set in stone, which leaves precious little capital to take the other side of the trade and lean against speculative flows, and a tussle can turn into a rout.

“When you invent the ship, you invent the shipwreck.”
—Paul Virilio

The cultural theorist Paul Virilio asserted that every new technology embeds the potential for new unanticipated accidents. As he put it: “When you invent the ship, you also invent the shipwreck.” Indexing is an invaluable new vessel, which has ushered in a new era for many types of investors. And yet, as indexing has mushroomed over the past two decades, the switch in serial dependence to an amplification as opposed to dampening of short-term shocks and the increased probability of tail-risk events with the rise in vol of vol are ominous signs that we’ve yet to reckon with the consequences of a market swamped by passive flows. Shoals may await just over the horizon.

Endnotes

1James Seyffart, “Passive Likely Overtakes Active by 2026, Earlier If Bear Market,” Bloomberg Intelligence (March 11, 2021).
2H. Hong and J.C. Stein, “A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets,” The Journal of Finance vol. 54, pgs. 2143-2184 (1999). https://doi.org/10.1111/0022-1082.00184
3Guido Baltussen, Sjoerd van Bekkum, and Zhi Da, “Indexing and Stock Market Serial Dependence around the World,” Journal of Financial Economics vol. 132, issue 1 (2019). https://doi.org/10.1016/j.jfineco.2018.07.016
To its advocates, the virtues of indexing are beyond reproach. With low fees and high transparency, index funds offer a cheap and straightforward way for an investor to earn average returns. This perspective is buttressed by mounds of academic research that have characterized passive investing as a stable equilibrium, meaning that even were everyone to index their investments, it would make no difference to either prices or the cost of capital.
Underlying this claim is an assumption that markets are populated by rational beings, whose collective behavior delivers market prices that always perfectly reflect all available information. But markets don’t work that way, and grubby reality is a world away from this frictionless ideal.
“We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
—John Maynard Keynes
The early 20th-century British economist John Maynard Keynes understood this only too well, famously comparing investors to participants in newspaper beauty contests. A popular feature in the London press of his time, these contests asked readers to choose the six prettiest faces out of a collection of a hundred photographs. The winner was the entry that came closest to the average selection. Although nominally about personal aesthetics, winning the contest meant successfully anticipating the anticipations of others. “It is not a case of choosing those which…are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes wrote. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
Investors tasked with choosing which stocks to own face the same quandary as players in the beauty contest. Should they expend time and energy to understand companies’ long-term business prospects and to project cashflows decades out? Or, given limited resources, is it wiser to try and figure out which stocks are likely to be popular six months hence? Writing seven years after the great crash of ’29 and attempting to make sense of the devastation left in its wake, it was clear to Keynes that only the former had any merit, but that most investors favored the latter, trying to “beat the gun, […] to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” A slight shift in mood is enough to set off cascading price changes as investors react en masse. The inherent instability spawned by this recursive guessing game is why prices are far more volatile than what is known of underlying fundamentals, and why life for investors struggling to get a purchase on cash flows and discount rates, in Keynes’s view, can be so forbidding.
But what happens when most investors opt out of selecting individual stocks? When beauty contestant judges pick the same pretty faces week after week?
The question is relevant because the answer would go some ways toward explaining today’s higher-than-average valuations. An end to the beauty contest would equate to a permanent decline in undiversifiable risk, which all else being equal, would justify paying a higher multiple for uncertain future cash flows. It might even make life a little less unpleasant for those relying on their projections of long-term fundamentals. After all, with fewer active traders whacking prices around, shouldn’t the signal be a little easier to unscramble from the noise?
The evidence on the ground, however, suggests a more complicated picture. The beauty contest hasn’t ended so much as shifted its locus of speculation from individual securities to trading vehicles that clump together groups of securities based on mechanical trading rules.
One indication that this is happening is the puzzling reversal in the positive serial dependence of short-term index returns. Serial dependence, or autocorrelation, refers to the degree of correlation between two observations of the same variable at different points in time. A random variable, the flip of a coin say, has an autocorrelation of zero, each flip independent of the one before. Historically, short-term index returns have had a small (but consistent) positive serial dependence, meaning that, on average, a positive return one day will be followed by a return in the same direction the next day and vice versa. One possible explanation for this phenomenon held that stocks reacted with a lag to non-fundamental shocks.2
But in 2000, this relationship turned negative, and it has remained so ever since. The chart below shows correlation between daily returns for the S&P 500 averaged over a ten-year window going back to 1949. Positive serial dependence increased steadily throughout the 1960s and ’70s, peaked shortly before the introduction of index futures in the ’80s, then declined steadily for two decades before falling consistently below zero at the start of this century.
According to a new study3 by researchers at Erasmus University and the University of Notre Dame, the explanation for this reversal can be laid squarely at the feet of indexing and the seismograph-like movements of mechanical trading rules amplifying the daily response to new information. The research considered 20 equity indices across 15 countries and found an identical change in the behavior of short-term returns. Moreover, they found a direct causal relationship between these patterns and the combined increase in index products including futures, ETFs, and mutual funds. According to the authors, “introducing indexing products seems to change the behavior of the underlying stock market across indexes and over time,” and more critically a higher level of indexing leads to “a more negative serial dependence.” It is unclear what the full consequences of the new pattern will be, but we may be seeing it on display at the far right of the graph above, in the sharply negative one-day autocorrelation in March 2020 at the onset of the pandemic. In plain language, it used to be that uncertainty about the future flowed from individual stock prices into indices; now, the tide has been reversed and uncertainty propagates from indices to individual stocks.
Another unsettling sign of change is the rise in the level of implied volatility of volatility (vol of vol), a measure of the market’s capacity for registering unexpected shocks. Roughly speaking, implied volatility—the volatility that is backed out from the price of options—reflects the market’s expectation for the range of potential outcomes for an asset over a specific period. When implied volatility is high, markets expect larger price moves (in either direction), or when it’s low, smaller moves. The most well-known measure of these signals is the VIX, which is calculated from the price of short-dated index options on the S&P 500 and is frequently referred to as the “investor fear gauge.”
Despite its notoriety, the VIX is a measure of disorder and quite distinct from a measure of potential disorder. For that we need to consider volatility of volatility, the true measure of market entropy. To measure that entropy, we use VVIX. Just as the VIX is calculated from the price of options on the S&P 500, the VVIX is based on the price of options on the VIX. Future returns are unknown, but the VIX tells us something about the range of returns we should expect. The VVIX, on the other hand, indicates how uncertain we are about the variability of that range.
Intuitively there are strong reasons to believe that while this vol of vol itself should vary day-to-day as the market digests unexpected shocks, like the VIX it should be stable around some long-term average. But, as can be seen in the chart below, since 2006, a period coinciding with the boom in passive investing, volatility of volatility has shown a consistent upward trend—a sign that the range of potential disorder is expanding.
Doubtless there is more than one culprit behind the increase in vol of vol. Low real interest rates driving down risk premiums probably figure in, as does the growth in systemwide leverage which magnifies fragility by accelerating the interdependence of financial flows. But we would be remiss to ignore the effects of ballooning index flows. Index replication relies on a well-behaved and liquid market for the underlying securities, a presupposition that is paradoxically undermined by the expanding share of index flows. Keynes’s insight was understanding the role of psychology in fueling the tussle between long-term investors and short-term speculators. But things are different at the asset class level. Strategic allocations are typically set in stone, which leaves precious little capital to take the other side of the trade and lean against speculative flows, and a tussle can turn into a rout.
“When you invent the ship, you invent the shipwreck.”
—Paul Virilio
The cultural theorist Paul Virilio asserted that every new technology embeds the potential for new unanticipated accidents. As he put it: “When you invent the ship, you also invent the shipwreck.” Indexing is an invaluable new vessel, which has ushered in a new era for many types of investors. And yet, as indexing has mushroomed over the past two decades, the switch in serial dependence to an amplification as opposed to dampening of short-term shocks and the increased probability of tail-risk events with the rise in vol of vol are ominous signs that we’ve yet to reckon with the consequences of a market swamped by passive flows. Shoals may await just over the horizon.
1James Seyffart, “Passive Likely Overtakes Active by 2026, Earlier If Bear Market,” Bloomberg Intelligence (March 11, 2021).
2H. Hong and J.C. Stein, “A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets,” The Journal of Finance vol. 54, pgs. 2143-2184 (1999). https://doi.org/10.1111/0022-1082.00184
3Guido Baltussen, Sjoerd van Bekkum, and Zhi Da, “Indexing and Stock Market Serial Dependence around the World,” Journal of Financial Economics vol. 132, issue 1 (2019). https://doi.org/10.1016/j.jfineco.2018.07.016
What did you think of this piece?
Fundamental Analysis
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.)
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.
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.
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.
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.)
What did you think of this piece?
Fundamental Analysis
One can only speculate on the reasons for this synchronous timing, but one possibility that stands out is the confluence of the five-year policy and leadership cycles in China. This is the first year of the 2021-25 Five-Year Plan, but more importantly, it is the final full year before the top 200 or so members of the Central Committee of the Communist Party of China are selected at its National Congress in October 2022. It bears remembering that those politicians are similar to counterparts elsewhere in facing challenges that have diverted them from other priorities. They spent the first two years of their terms coping with escalating US-China trade tensions, and just when “normal order” loomed after the signing of the Phase One trade agreement, COVID-19 hijacked everyone’s lives. Only recently have they gotten a chance to work on much-delayed goals.
As policymakers picked up where they had left off, they found themselves facing stakes heightened by the pandemic: stagnating incomes, weak consumer confidence, and a growing demographic crisis as birthrates continue to decline. These challenges may have accentuated their top priorities, ones that have been repeatedly highlighted in official policy statements over the last few years: innovation, rule of law, culture, the environment, and social harmony.
The fact is that ever since Deng Xiaoping initiated the initial series of capitalist overhauls in the 1980s, China has undergone multiple periods of reform. These changes cut a wide swath across economic activity and drastically curtailed certain targeted sectors. They were painful in their time, creating mass unemployment and fueling social discontent. Ultimately, they laid the groundwork and helped sustain several decades of nearly uninterrupted growth.
Previous reforms were far less visible to foreign observers because they barely touched the companies widely held by global investors at the time. For example, the coordinated supply-side reforms of 2015, undertaken in part to reduce chronic pollution, shuttered roughly one-fifth of China’s steel capacity (equivalent to Japan’s entire steel output) in under two years. Air quality improved dramatically, while bankruptcies almost tripled as many marginal producers were killed off. But not many foreign investors owned marginal steel producers, preferring to own faster growing companies such as Alibaba and New Oriental. Likewise, the anti-corruption campaigns that began in 2013 may have ushered in a more sustainable business environment, but they were terrible for liquor makers, whose products had become popular high-priced gifts to lubricate business deals and lobbying efforts. Kweichow Moutai, producer of its fiery namesake liquor, saw its sales growth plummet in 2014 and 2015, but the company was not nearly as widely owned externally as Tencent is today.
Much of the focus of late has been on one policy priority: common prosperity. Redolent of China’s collectivist past (the term was first used by Mao in 1950), the phrase frightens some foreign investors who are unsure which companies’ prosperity will be sacrificed at the altar of the commons. Yet policymakers have been clear: their focus is on growing middle-class disposable income, not “robbing the rich to help the poor,” according to Han Wenxiu, executive deputy director of the General Office of the Central Financial and Economic Affairs Commission. This overt aversion to a European-style welfare model may seem contradictory for a party that still pays lip service to its Marxist roots. But the reality is that China systematically underinvested in education, health care, and other social spending—especially in rural areas—as it sought to catch up economically with more developed economies. Until now, policymakers have done little in the way of redistribution; indirect taxes, which generally serve to widen income inequality, still represent two-thirds of fiscal revenue. With China coming into its own, we should expect its practices to converge with those in more advanced economies, including some form of income and wealth redistribution.
To my mind, these regulations are reminiscent of the US Progressive Era of the late 19th and early 20th centuries, epitomized by Theodore Roosevelt’s Square Deal.
In practice, the government’s targets for common prosperity—judging from recent policies and the detailed roadmap for its first pilot program in Zhejiang, the richest province in China and home to Alibaba—are education, health care, and housing. In these pivotal areas, structural impediments have exacerbated inequalities over time, producing a set of challenges that would be very familiar, for example, to residents of California. One of the more draconian national policy shifts, which recently consigned much of the private after-school tutoring business to the non-profit sector, does not go as far as South Korea’s complete ban of private tutoring in the 1980s.1 In each country, the reforms were designed to ease the burden on parents who spend up to thousands of dollars each month coaching their children on how to pass exams. (To put this cost in perspective, the Chinese city with the highest average annual per capita disposable income in 2020 was Shanghai at $11,000.) Likewise, China’s recent online regulations covering antitrust, data security, and the safety of minors are similar to the concerns of consumer advocates everywhere.
To my mind, these regulations are reminiscent of the US Progressive Era of the late 19th and early 20th centuries, epitomized by Theodore Roosevelt’s Square Deal. It was not an easy time to invest and was marked by muscular antitrust interventions, the inception of a progressive income tax, and the appearance of the first federal consumer and environmental protections. Certain industries faced a permanently higher level of regulation with which they had been unfamiliar. But many companies thrived, and the reforms arguably laid the foundation for a century of growth that shaped the American economy into the largest in the world today, home to the largest number of globally competitive companies.
Structural changes of this magnitude will inevitably shake up competitive forces, buffeting the outlook for growth and strength of free cash flow generation for many businesses—but not all of them in negative ways. If China’s reforms succeed in improving middle-class disposable income while opening more opportunities for more people and still ensuring that the country remains a meritocracy, the government will have set the stage for more sustainable end demand for many industries. It’s a tall order, but one notable advantage enjoyed by Chinese policymakers today is the benefit of a century of hindsight observing which policies worked—and which did not—in the countries that have tried them.

Endnotes

This commentary is excerpted from the Harding Loevner Third Quarter 2021 Global Report.
1The South Korean ban was ultimately overturned by the courts two decades later, though South Korea’s government has been adding new restrictions on tutoring ever since.
This commentary is excerpted from the Harding Loevner Third Quarter 2021 Global Report.
1The South Korean ban was ultimately overturned by the courts two decades later, though South Korea’s government has been adding new restrictions on tutoring ever since.
What did you think of this piece?
Behavioral Finance
There are many similarities between cultures at football clubs and investment organizations, despite the underlying processes required by their core activities—making decisions on the pitch about how to try and score and defend or making decisions about buying and selling securities—being very different.
In both industries, the goal is for the team to be greater than the sum of its parts. On the pitch, an individual must rely on teammates, but certainly not debate or challenge them. Rather, coaches teach decision making so that, like muscle memory, it is instantaneous and requires little active thought.
At Harding Loevner, rules and processes constrain decision making to prevent it from being dominated by cognitive biases. Colleagues think for themselves but must expose their ideas to challenge. This is the core of our investment culture—what we call “collaboration without consensus.” We believe that one of the most difficult biases to overcome in conducting research is the tendency to give precedence to evidence that confirms our beliefs and to ignore evidence that challenges them. So, it is important that our ideas be continuously exposed to challenge. However, this leads to other problems. Humans, as social beings, generally don’t like disagreement; they are literally fearful of it. That’s why an important part of a culture of collaboration without consensus is that it be enabled by both transparency and the value of tolerance. We strive to sustain an environment in which colleagues do not feel threatened by disagreement and recognize that challenges—while discomfiting—are essential for good decision making.
It would be nice to be able to say that our culture at Harding Loevner emerged from a successfully executed plan, but that wasn’t really the case. Thirty-plus years ago, the few of us at the firm just wanted to be good investors and to serve clients who shared our views about what made a successful investment program. The firm’s values simply reflected the personal values of the founding generation. We all believed strongly in acting with integrity and always putting clients’ interests first. Beyond that, I don’t think you could say we particularly held the values associated today with Harding Loevner. We didn’t set out consciously to make a culture based on transparency, personal accountability, tolerance, and the importance of process. Those values only developed as we learned more about decision making, often from our mistakes.
For example, we discovered early on that sharing information with our colleagues was valuable in sharpening our views. But we soon learned that without individual accountability and very clear rules of engagement, disagreements could very easily descend into finger-pointing and personal attacks. We also came to realize that no amount of experience is a substitute for exercising judgement within the constraints of process and structure. The alternative, too often, is a culture of blame and chaos.

Left to Themselves, Even Great Cultures Die

Part of a winning culture is the ability to adapt to changing circumstances, to have processes that change, and to take risks with new ways of behaving. Above all, perhaps, is the willingness to keep learning. Arie de Geus, former head of Royal Dutch Shell’s Strategic Planning group once said, “In the future, the ability to learn faster than competitors may be the only sustainable competitive advantage.” That ability must be embedded in culture no matter what other values the culture incorporates. A good example comes from the success and subsequent decline of Arsenal Football Club, which in the late 1990s broke with English football tradition by hiring a Frenchman to manage the team. Arsène Wenger’s on-the-pitch tactics and approach to nutrition and training overturned decades of English football culture and brought a level of domination rarely seen in professional sports. The Arsenal team of 2003-4 was unbeaten during an entire season, a feat that had not been accomplished since the late nineteenth century. Although the club went on to further success, other clubs gradually learned from, adopted, and refined its methods. Arsenal failed to innovate further and gradually slipped down the league table to a point where Wenger was eventually replaced.

The 2003-2004 Arsenal team earned the nickname the “Unvanquished” for becoming the first elite-level UK football club in more than 100 years to go an entire season undefeated—in large part thanks to its disruptive culture. Above, Kolo Toure, Robert Pires, and Ashley Cole celebrate the 2-2 tie with Tottenham that sealed the feat.

Source: ODD ANDERSEN / Staff via Getty Images

As we endeavor to strengthen Plymouth Argyle’s culture, my experience at Harding Loevner has been critical in giving me a clearer sense of what will work. At Harding Loevner, we were taking cautious steps in the dark, with nothing to give us confidence that we were on the right path. But we did learn, and that has been helpful as we try to make an Argyle culture that will enable us to achieve our vision. As such, we are approaching our task with an intentionality that would have felt presumptuous to my younger self. It starts with a more specific goal. English football is a multi-level pyramid in which especially good or poor performance brings promotion or relegation to the next level up or down in the hierarchy. At the end of 2019, a year after we had lost our spot in League One (the third level from the top), we said that in five years our goal was to be financially sustainable and playing two levels above where we were then.
To realize that vision, one of the key values we have espoused at Argyle, just as at Harding Loevner, is transparency. One difference is that our transparency extends to writing down our Vision & Values and posting them to our website. In this way, everyone at the club—as well as our supporters and sponsors—knows what the vision is and what the values are that we expect will underlie every decision. Another of our core organizational values is to be efficient and process oriented. Here, again, we are not exactly inventing the wheel. Increasingly the lessons those of us in finance and organizational science took to heart about the role of process in managing our cognitive biases have also found their way into successful sports cultures. The most famous example comes from baseball where the Oakland A’s, under general manager Billy Beane, incorporated objective data into their decision-making processes to come up with new ways to gain competitive advantage on a limited budget. Once it was widely revealed in Michael Lewis’s Moneyball, Beane’s approach influenced most of the rest of baseball, spread to basketball, and is now beginning to have an impact on English football. At Argyle, our most immediate source of inspiration has been the outrageous success of Brentford F.C., for years a lower-league club of modest means, which, under the ownership and guidance of Matthew Benham (who made his fortune successfully managing his own cognitive biases gambling on football matches) has risen to the English Premier League, the pinnacle of the football pyramid.
I could elaborate on how these and our other values trickle down via our areas of strategic focus to Argyle’s CEO’s goals and to the goals he sets for every individual. But for my purposes here, the point is just that these values and goals are written down, enabling the board to communicate to our fans how we will behave and to our staff what we ask of them. The result has been powerful. Two years into our five-year plan, we have regained our position in League One, halfway toward our goal of climbing to within a level of the overachievers at Brentford. More importantly, everyone at Argyle now knows what we are trying to achieve, what is expected of them, and the values that should underly their everyday decisions.

We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession.

I’ve learned from Harding Loevner the kind of culture that leads to sustained success. I’ve learned from Plymouth Argyle how impactful transparency and communication can be in cultivating that culture. Harding Loevner has reached the age where it can no longer rely on the people who made up the founding generation as its cultural torchbearers. Over a decade ago, we began laying groundwork for the transition of ownership and management of the firm from that generation to the next. We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession. As the people in whom the culture is most embodied prepare inevitably to move on, they have no choice but to write more of it down. We early settlers will need to be more transparent (at the risk of being annoying) about what our culture has meant to us personally and to the firm’s success under our leadership—not so that it may be set in stone to be accepted immutably, but that it may be evaluated critically. Our younger colleagues may have slightly different beliefs and values. We expect them to receive the vision, turn it over in their minds and revise it so that they may carry it on as their own. It will be their responsibility to make sure that the firm’s culture enables it to serve its clients as well in future as it has since 1989.
Part of a winning culture is the ability to adapt to changing circumstances, to have processes that change, and to take risks with new ways of behaving. Above all, perhaps, is the willingness to keep learning. Arie de Geus, former head of Royal Dutch Shell’s Strategic Planning group once said, “In the future, the ability to learn faster than competitors may be the only sustainable competitive advantage.” That ability must be embedded in culture no matter what other values the culture incorporates. A good example comes from the success and subsequent decline of Arsenal Football Club, which in the late 1990s broke with English football tradition by hiring a Frenchman to manage the team. Arsène Wenger’s on-the-pitch tactics and approach to nutrition and training overturned decades of English football culture and brought a level of domination rarely seen in professional sports. The Arsenal team of 2003-4 was unbeaten during an entire season, a feat that had not been accomplished since the late nineteenth century. Although the club went on to further success, other clubs gradually learned from, adopted, and refined its methods. Arsenal failed to innovate further and gradually slipped down the league table to a point where Wenger was eventually replaced.
As we endeavor to strengthen Plymouth Argyle’s culture, my experience at Harding Loevner has been critical in giving me a clearer sense of what will work. At Harding Loevner, we were taking cautious steps in the dark, with nothing to give us confidence that we were on the right path. But we did learn, and that has been helpful as we try to make an Argyle culture that will enable us to achieve our vision. As such, we are approaching our task with an intentionality that would have felt presumptuous to my younger self. It starts with a more specific goal. English football is a multi-level pyramid in which especially good or poor performance brings promotion or relegation to the next level up or down in the hierarchy. At the end of 2019, a year after we had lost our spot in League One (the third level from the top), we said that in five years our goal was to be financially sustainable and playing two levels above where we were then.
To realize that vision, one of the key values we have espoused at Argyle, just as at Harding Loevner, is transparency. One difference is that our transparency extends to writing down our Vision & Values and posting them to our website. In this way, everyone at the club—as well as our supporters and sponsors—knows what the vision is and what the values are that we expect will underlie every decision. Another of our core organizational values is to be efficient and process oriented. Here, again, we are not exactly inventing the wheel. Increasingly the lessons those of us in finance and organizational science took to heart about the role of process in managing our cognitive biases have also found their way into successful sports cultures. The most famous example comes from baseball where the Oakland A’s, under general manager Billy Beane, incorporated objective data into their decision-making processes to come up with new ways to gain competitive advantage on a limited budget. Once it was widely revealed in Michael Lewis’s Moneyball, Beane’s approach influenced most of the rest of baseball, spread to basketball, and is now beginning to have an impact on English football. At Argyle, our most immediate source of inspiration has been the outrageous success of Brentford F.C., for years a lower-league club of modest means, which, under the ownership and guidance of Matthew Benham (who made his fortune successfully managing his own cognitive biases gambling on football matches) has risen to the English Premier League, the pinnacle of the football pyramid.
I could elaborate on how these and our other values trickle down via our areas of strategic focus to Argyle’s CEO’s goals and to the goals he sets for every individual. But for my purposes here, the point is just that these values and goals are written down, enabling the board to communicate to our fans how we will behave and to our staff what we ask of them. The result has been powerful. Two years into our five-year plan, we have regained our position in League One, halfway toward our goal of climbing to within a level of the overachievers at Brentford. More importantly, everyone at Argyle now knows what we are trying to achieve, what is expected of them, and the values that should underly their everyday decisions.
We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession.
I’ve learned from Harding Loevner the kind of culture that leads to sustained success. I’ve learned from Plymouth Argyle how impactful transparency and communication can be in cultivating that culture. Harding Loevner has reached the age where it can no longer rely on the people who made up the founding generation as its cultural torchbearers. Over a decade ago, we began laying groundwork for the transition of ownership and management of the firm from that generation to the next. We are now at that critical juncture faced by any strong culture looking to endure and thrive through generational succession. As the people in whom the culture is most embodied prepare inevitably to move on, they have no choice but to write more of it down. We early settlers will need to be more transparent (at the risk of being annoying) about what our culture has meant to us personally and to the firm’s success under our leadership—not so that it may be set in stone to be accepted immutably, but that it may be evaluated critically. Our younger colleagues may have slightly different beliefs and values. We expect them to receive the vision, turn it over in their minds and revise it so that they may carry it on as their own. It will be their responsibility to make sure that the firm’s culture enables it to serve its clients as well in future as it has since 1989.
What did you think of this piece?
Behavioral Finance
Ferrill Roll, CIO: We’ve convened this discussion because after coping with four years of US-originated turbulence in Chinese equities—from tariffs and trade wars, to congressional action against Chinese companies listing in the US that hadn’t gone through the usual US auditing requirements, to executive orders prohibiting Americans from owning companies controlled by the Chinese military—we are now faced with turbulence in Chinese equities that has originated from Chinese regulatory actions. In that new, different environment, we thought it would be useful to discuss how we cope with this, what’s actually going on, and what our thinking is for the future.
First, I’d like to comment about our risk guidelines at Harding Loevner. We insist on diversification in all our strategies. And insofar as that pertains to Chinese equities, you will recall that it was just a year ago that we were in lively discussions about the limit that we had placed on Chinese equities—in our Emerging Market Equity strategy in particular but, in fact, in all of our strategies. We had set our limit—when times were calm, and we were being thoughtful about the future—at a maximum weight of 35% in China for a diversified emerging market portfolio.
When China managed to get the coronavirus under control faster than the rest of the world, Chinese shares surged relative to everywhere else. Our emerging market PMs were chafing under the inability to own as much as the index, let alone go overweight, in China. Clients were asking us questions about how we could be so ultra-conservative as to constrain our PMs from doing whatever they needed to achieve returns. And, frankly, we had rather tense discussions among our partners as some clients thought about leaving Harding Loevner as a manager because of our intransigence over these risk controls.
We think of our risk controls as constraints against our future selves—in the way that Ulysses tied himself to the mast before he passed by the sirens that would otherwise have lured him to destruction. We thought when we were setting our limits on China that they were sensible. A year on, we are now flooded with client calls about, “How much risk do you have in China? What are your exposures to the companies being buffeted by these regulatory shifts?” And we feel vindicated that we stuck to our pre-commitments. This is a well-established area of behavioral finance, that pre-commitments are the hardest things to keep when they are the most important things to keep. I think this is a lesson that we will take with us through the years going forward.
That said, Harding Loevner has a very clear long-term outlook that China is going to be a fruitful place to invest our clients’ money and to hopefully add value using our process of fundamental analysis and valuation. We launched our first single-country strategy, the Chinese Equity strategy, late last year. So, we’re optimistic that we will find lots of ways to add value in China.
Pradipta, you’re the Lead PM for the Chinese Equity strategy. Your entire portfolio is subject to these recent regulatory shifts. Why don’t you give us a quick summary of what’s happened recently and how it’s affected you?
Pradipta Chakrabortty, Lead PM Chinese Equity: So, there have been a slew of regulatory actions across different sectors and industries. I classify them under four buckets. First were the antitrust regulations that manifested through fines on Alibaba and moved on to fines on other companies in the internet space such as Tencent and Meituan. That has subsequently moved on to breaking down several barriers and walls that these gigantic platform companies had created around themselves.
The second bucket relates to the stability of the financial services sector and was manifested through regulations that resulted in the cancellation of the Ant Financial IPO. The third area, data security regulations, is much more recent. Immediately after the IPO of the ride-hailing service Didi Chuxing, you saw cybersecurity concerns emerging, leading to restrictions of Didi’s ability to onboard new users. And the fourth bucket, social issues-related regulations, is pretty broad across different sectors. One of those sectors affected was after-school tutoring, where you had severe restrictions, converting that industry into not-for-profit. This week, we saw news about concerns about how online gaming affects children. So that sector has been under a little bit of pressure. There’s also been noise around the gig economy and fair compensation for workers there.
So, it’s a whole gamut. The net result is that investors have been spooked. The MSCI China All Shares Index is down close to 8% in the first seven months of the year, underperforming the MSCI ACWI Index, which is up 13%.
FR: Jingyi, can you talk to us about the high-level goals the Chinese government is pursuing with all these changes?
Jingyi Li, Co-Lead PM Global Equity: The Chinese government’s long-term goal is to continue to develop the economy. It has done a good job leading China from a low-income country decades ago to where it is a mid-income country today. And it has showed the ambition to continue to grow the economy in the next decade or 15 years to become an entry-level developed country. That means the economy needs to grow around the mid-single digits for the coming one or two decades at least.
To continue to drive the economy to reach the next level, you need a lot of structural reforms, reforms that we have seen, but also at the same time, you need to address a lot of social issues. Some are social issues caused by new economies and new technologies. Some are common issues everywhere in the world, like inequality, like the competitiveness of the labor force. Without addressing these kinds of long-term profound social issues, the Chinese government—who rely on long-term growth as one of the key legitimacies of their government—is concerned that they may not be able to continue on this trajectory, just like many Latin American countries stuck in the so-called mid-income trap.
FR: Craig, would you agree that’s the main goal, or do you think there are some more jaundiced, pernicious goals that the government is pursuing?
Craig Shaw, Co-Lead PM Emerging Market Equity: China is run by the Communist party. It is not a democracy. You could call it a dictatorship, and the way they stay in power is by keeping people happy. There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history. They are doing their best to stay in power and keep their people happy, which is something we always have to be cognizant of.

There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history.

FR: So, you don’t think they’re going after companies that have skirted the domestic listings rules by raising money outside? You don’t think they’re targeting prominent individuals who made a lot of money and turned that into a personal soapbox for their own use?
CS: Well, those are issues. We’ve seen this over the decades in emerging markets. Remember how in Russia Mikhail Khodorkovsky at Yukos got involved in politics and lost everything and was in prison for quite a while. To a certain extent, if someone becomes influential and wealthy and powerful, they are perceived, whether they really are or not, as a threat to the government’s control over the population. It’s a risk. We certainly saw that with Jack Ma at Alibaba a little while ago, when he made some comments about the future of finance in China. And the powers that be didn’t seem to like it.
FR: Andrew, before you became Co-Lead PM of the International Equity strategy, you were the manager of research. In fact, you started at Harding Loevner as an emerging market analyst. So, you’re deeply familiar with how we think about regulation in the structure of our research process. Can you lay out for us how we assess regulation?
Andrew West, Co-Lead PM International Equity: Sure. We have three key features of our process that leads to us being aware of regulatory risk and reacting to it, and hopefully anticipating it. One is our constant analysis of Porter’s “Five Forces” that dictate industry structure. For each of the five—whether it’s bargaining power of buyers or suppliers, rivalry, threat of new entrants—we ask our analysts to both understand the existing regulatory issues that may influence those forces and to keep an eye out for incoming potential changes that could influence them. It’s all part of helping us understand the trajectory of profitability in the future, of growth opportunities, and helping us reflect that in our forecasts. The second key feature is our ongoing monitoring of environmental, social, and governance (i.e., ESG) risks. And third is our requirement of higher returns from riskier countries, where we tilt our valuations of stocks based on the riskiness of the countries in which they’re operating.
FR: I’m interested in the ESG analysis. At Harding Loevner, ESG analysis is really a risk analysis rather than a pursuit of return of goodness, if you will. We’ve had a lot of client inquiry over the last two years about the E part of ESG, and almost no inquiry about the S—the social part. Do you think that we have underemphasized the regulatory risks that have emanated from these social risks in ESG in the case of China?
AW: It is a topic that we have actively debated. And social risk is a risk. A lot of the concern has been around looking from the outside in, with international companies and other countries threatening China in some way over their internal political activities. But there are also internal social pressures inspiring new regulations. And that ties into what Jingyi spoke about before, when you asked him about the goals of the Communist party.
Have we under-recognized it? I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices. Awareness of that comes and goes. I think the actions in some industries were harsher than just about anybody would have forecast. Even if we’d been aware of the pressures for change, we may not have anticipated such sudden and violent regulatory reaction to those pressures.

I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices.

FR: Pradipta, in addition to your new role as a Lead PM of the Chinese Equity strategy, you have long been Co-Lead PM on the Frontier Emerging Markets Equity strategy. You’ve invested in a bunch of countries that have a lot of risk. How do you assess risk in China versus the regulatory risk in China versus the regulatory risk in, say, Turkey, which has an authoritarian president?
PC: I mean, Turkey is obviously a different case altogether. You can’t really put it in any bucket. But in several other frontier countries—Kenya, Nigeria, the Philippines—they all have a significant amount of regulatory risk, and we’ve seen regulatory actions in those markets. The difference is in terms of the communication and the transparency of the debates that go on in the public domain. In most of these other countries, you would see lawmakers and regulators going through a lot of public debate where you’re privy to their thoughts and their potential future actions, much more than you would in China.
But to be fair to the Chinese regulators, there have been hints about each of these regulations that have been enacted this year. The problem is that those clues have been rather cryptic and the end result quite shocking. For example, the after-school tutoring sector having been converted into a not-for-profit—there was really no clue about that coming. So, I would say communication is where there is definitely more work to be done by the Chinese regulators. If they do communicate their intentions or their thinking more clearly, there would be less disruption in the markets.
FR: Craig, you mentioned Russia and the case of Yukos and the expropriation of assets in that case. That was at least as shocking as the vaporization of billions of dollars of market value of these Chinese education companies. How do you think about risk in China versus regulatory risk or expropriation risk in Russia or any other of the emerging market countries that you’ve invested in over the last 20 years?
CS: China’s a little different. You can argue how effective democracy is in some of the emerging markets, but at least they are democracies, to some extent. Whereas China is not. And so, the government has total control over everything. They debate within themselves, but as far as dealing with representatives of the populace, it’s a little different. They have a lot more control and a lot of these moves that we’ve seen are all about enhancing that control.
If you look at Russia, it’s changed quite a bit over the years. There was a time that share prices would fall 20% if Putin was annoyed with something. Certainly, Putin has a great amount of control over what happens. But he has not been overly aggressive in terms of doing anything to industries. I mean, if you go back to the Yukos case, there was an arrangement made a long time ago when Putin first came to power, that he would let the oligarchs keep whatever they managed to gather during the chaos of the fall of the Soviet Union as long as they stayed out of politics. And to a large extent, he’s kept that promise. But he certainly can scare people.
FR: Presumably, you’ve come to rely on that, because you’ve been overweight Russia in your emerging market portfolio for five years.
CS: Yes. It’s not the easiest place to be, but we do what our process and philosophy guides us to, and have found some good quality-growth companies at reasonable prices.
FR: It’s one thing for emerging market or frontier emerging investors to parse these risks because they’re all risky neighborhoods, and each one is risky in its own way. But Jingyi, you’re now a global portfolio manager, having concentrated on China for a long time as analyst. How do you compare the regulatory risk in China versus the regulatory risk in the US?
JL: I think the regulatory system in the US is much more mature and proven to be better for entrepreneurs and innovators, very good and reliable for business, and, of course, very favorable for investors, especially long-term investors like us. Speaking of the regulatory risk, I would also like to point out the risk of not taking actions on some of these long-term issues. Because when we talk about cybersecurity, antitrust, all kinds of social issues—these are not specific to China. These are very common issues in every part of the world. The US is trying to address them. Europe is trying to address them.
If other countries are not able to take on these issues in sensible and timely ways, they will have challenges, and their long-term economic development eventually will affect the return of long-term investors like us. Also, there’s a question of how much regulatory risks have been discounted in the current stock crisis. In the past several months, obviously, the market has been more alert toward the regulatory risk in China. Maybe that’s sufficient, maybe that’s over-reaction. But in other parts of the world, in other markets, maybe the regulatory risks have not yet been fully discounted yet.
FR: How about it, Andrew? Are the price changes in Chinese equities causing you to be more interested in Chinese equities? Or does the scope of the regulatory risks cause you to be more cautious?
AW: It’s a tug of war. On one side, risks have risen, I think. Or the awareness of risks that were there have crystallized. And we don’t know exactly how much more is to come. My suspicion is that there might be a slowing down, but that’s not for sure. On the other hand, there’s definitely more risk discounted than before. So, on the one hand, you’ve got maybe some concerns about future margins, future growth for some companies. On the other, a lower price.
The International Equity strategy, which you and I are Co-Portfolio Managers of, has been underweight China for the past several years as China has risen in terms of the index weight. And that was modestly negative for us when Chinese stocks were going up. It’s been favorable for us as the market has declined recently. And so, we are looking at whether to add new securities or add to some existing securities that have become cheaper relative to fair values. My natural tendency is to be fearful when others are not, and to be less fearful when others are more. So, I would say, I would be looking to reduce that underweight on the assumption we find some securities that are over-discounting risk and under-appreciating long-term growth and profitability.
FR: Craig, you were chafing under the limit of 35% in China. I happened to check this morning. China is now less than 35% in the MSCI Emerging Markets Index. Are you more inclined to buy? And will you go overweight now than you can?
CS: We are doing the same thing we’ve always done—looking for quality-growth companies at reasonable prices. Andrew said it very well: It’s a tug of war. And it’s always been like that. Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities. We had five purchases in the second quarter. Four of them were in China in response to 1) new ideas from our analysts, and 2) lower share prices and valuations. This is what we do. It’s not always easy. Sometimes it’s not fun.

Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities.

FR: Pradipta, you have no choice but to invest in Chinese companies in the Chinese Equity strategy, but you do have choices between industries. Are there industries at this stage that you would avoid, other than the obvious one of the tutoring industry?
PC: Picking up on the ESG front, we’ve always considered ESG risk in these companies, and I think the social element has to be increased.
When I look at it through that lens, there are sectors like the property development sector, for example, where after the recent Politburo meeting there was talk about how housing is for living, not for speculation, right? Those kinds of comments give you hints that there are more regulatory strictures to come.
FR: Isn’t Harding Loevner generally biased against property development in the first place?
PC: Yes. So, that’s an industry thankfully we don’t own right now. We don’t want it because of quality and growth reasons, obviously. But then, there is another layer of risk that is coming.
FR: Confirming our bias against it.
PC: Yes. But I would also be very cautious about some of the other sectors where we do have stocks, like Health Care. Under the social equality principle and health care affordability for all, I would think—especially generic drugs, which have lower content in terms of technology and innovation—those probably are at risk of further price compression. Then the anti-trust regulations are breaking down barriers, which are changing industry structures from what we knew them to be a year back.
So, from the point of view that Andrew talked about earlier, the Porter structure is changing. We need to re-look at the growth cases. We need to re-look at the competitive advantage cases for some of our companies. And then act accordingly. Optically, the valuation might have become better. But in some cases, the valuation may not have become as much better as it seems.
FR: Jingyi, are there industries you have increased your aversion to in the last couple of months?
JL: The short answer is no. I don’t see any sort of a wholesale attitude change to any particular industry. That said, we need to look at our business from an ESG angle, especially the social angle, in a deeper and more profound way. We need to try to understand the social implications of their business models and to think about whether there’s any very profound social impact we should be aware of.
You asked about the sectors to avoid. I should point out that higher regulatory standards, or standards for social awareness, could also open investment opportunity in companies that are more aware of those issues to begin with, or with the management teams who can do a better job to adapt to these kinds of requirements, or even companies that provide solutions to address some of the social issues. So, all these regulatory changes may also provide us some interesting new investment opportunities, again using our fundamental Porter lenses and ESG frameworks.
FR: I’m going to sum up, and then, we can get to questions from outside. As Andrew pointed out, we explicitly try to assess regulatory risk in the framework of our research process, through the lens of Porter’s Five Forces. And I think importantly, we do have a culture of debate between analysts—between PMs and analysts, between people who know a lot about China and people who have questions about China—and that culture of debate is a very active part of getting to the underlying truth of what’s going on. The third thing I would point out is that the insistence on diversification in all our investment strategies is something that we are deeply wedded to, as I alluded to at the start when discussing the nature of pre-commitments.
I think ESG is getting a new take that is reinforcing our belief that ESG risks are exactly that, and that the way we’ve embedded ESG analysis into our research structure is the right way to approach the whole set of issues. And then, finally, the price declines in these Chinese equities are giving us a chance to reassess each of the companies within our coverage and ascertain whether future returns are higher because the prices are lower, or the prices are accurately reflecting the new risk. That is a company-by-company and stock-by-stock issue that we are actively engaged in right now.
 
Audience Question: Can you comment on your current views on VIEs and whether the VIE structure is at risk due to some of the regulations and regulatory changes that have come out of China?
 
FR: I’ll take that one. VIEs, for those who don’t know, are variable interest entities, which are special purpose vehicles that connect US-listed stocks to domestic Chinese businesses through holding companies and some third country and equity swaps to get the returns connecting the two.
We have long viewed VIEs as a precarious legal structure and, therefore, set limits on how much each strategy could invest in VIEs. Nothing in the current imbroglio of regulatory shifts affecting the share prices of companies utilizing VIEs has made us see VIEs as more risky or less risky. In our view, the precariousness lies in the legal structure itself and our limits on VIEs are not changing.
I would say that there is debate internally about whether Chinese authorities have, in some sense, blessed the VIE structure by allowing what are called CDRs—a Chinese equivalent of ADRs whose primary listing is a VIE—to be listed in domestic exchanges in China. While that gives some comfort, it’s a regulatory rather than a legal backing, in my view, and in the view of our legal experts.
I was also troubled by statements out of the recent Politburo meeting. I only get translations, but one of the statements was that “the Politburo is going to improve overseas listing supervision.” We’ve had the phrase “rectify” applied to several of these industries where regulatory changes have occurred. I’m uncomfortable with this word “improve” because it sounds a lot like rectified, which could be damaging. Jingyi, how would you characterize that phrase? What do you think it means?
JL: Yeah, I’m really reading the tea leaves here, but my understanding of this phrase, which is very interesting, if not important, is that the policymakers still understand the necessity of a VIE structure …
FR: In order for Chinese companies to raise capital abroad?
JL: To raise capital. They fully understand the historical background going back in the early 2000s. There are long debates inside China on what to do with the VIE structure, but, after all these years, I do not think they have taken a hostile view on this.
The reason that we have a change is they are always worried that some companies may abuse the structure. And that’s why they think they need to take a more active role to supervise Chinese companies that use it to get listed. It’s fine to use that structure, but it’s not fine in their eyes to use it to circumvent some of the regulatory frameworks that are in place to prevent some companies from doing certain things. That’s my understanding.
 
Audience Question: Why invest in China at all?
 
AW: We’ve invested in a lot of risky places and we’ve made money in a lot of risky places over the decades. As we said, we don’t get paid for being comfortable. China represents roughly 10% of the international index. Our analysts have found over 50 companies that meet our pretty high standards for quality and growth.
So, we think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades. We very rarely rule out any country’s securities. As I mentioned earlier, we may require higher returns to compensate us for the risks that we take, and we are intelligent about diversifying those risks as well.

We think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades.

PC: If I may add, as a market, China is massive with huge consumption opportunities that are transforming in a significant way. But, relatively speaking, there are pockets where the risk is lesser and much more aligned with what the government is trying to achieve in terms of its national and overall social objectives.
The massive production base in China is also transforming through the increasing penetration of automation. This entire area is one where we find very, very high-quality companies which are rapidly growing. Electric vehicles and their value chain are another area related to that and one which is very well-aligned with the government’s carbon neutrality goals. China has the largest value chain as well as some of the biggest consumer demand for these cars.
So, there are those pockets that continue to be very, very high-growth and have very high-quality companies that meet our requirements and are very attractive from a long-term point of view. Especially in a country which is right now going through a massive transformation.
Ferrill Roll, CIO: We’ve convened this discussion because after coping with four years of US-originated turbulence in Chinese equities—from tariffs and trade wars, to congressional action against Chinese companies listing in the US that hadn’t gone through the usual US auditing requirements, to executive orders prohibiting Americans from owning companies controlled by the Chinese military—we are now faced with turbulence in Chinese equities that has originated from Chinese regulatory actions. In that new, different environment, we thought it would be useful to discuss how we cope with this, what’s actually going on, and what our thinking is for the future.
First, I’d like to comment about our risk guidelines at Harding Loevner. We insist on diversification in all our strategies. And insofar as that pertains to Chinese equities, you will recall that it was just a year ago that we were in lively discussions about the limit that we had placed on Chinese equities—in our Emerging Market Equity strategy in particular but, in fact, in all of our strategies. We had set our limit—when times were calm, and we were being thoughtful about the future—at a maximum weight of 35% in China for a diversified emerging market portfolio.
When China managed to get the coronavirus under control faster than the rest of the world, Chinese shares surged relative to everywhere else. Our emerging market PMs were chafing under the inability to own as much as the index, let alone go overweight, in China. Clients were asking us questions about how we could be so ultra-conservative as to constrain our PMs from doing whatever they needed to achieve returns. And, frankly, we had rather tense discussions among our partners as some clients thought about leaving Harding Loevner as a manager because of our intransigence over these risk controls.
We think of our risk controls as constraints against our future selves—in the way that Ulysses tied himself to the mast before he passed by the sirens that would otherwise have lured him to destruction. We thought when we were setting our limits on China that they were sensible. A year on, we are now flooded with client calls about, “How much risk do you have in China? What are your exposures to the companies being buffeted by these regulatory shifts?” And we feel vindicated that we stuck to our pre-commitments. This is a well-established area of behavioral finance, that pre-commitments are the hardest things to keep when they are the most important things to keep. I think this is a lesson that we will take with us through the years going forward.
That said, Harding Loevner has a very clear long-term outlook that China is going to be a fruitful place to invest our clients’ money and to hopefully add value using our process of fundamental analysis and valuation. We launched our first single-country strategy, the Chinese Equity strategy, late last year. So, we’re optimistic that we will find lots of ways to add value in China.
Pradipta, you’re the Lead PM for the Chinese Equity strategy. Your entire portfolio is subject to these recent regulatory shifts. Why don’t you give us a quick summary of what’s happened recently and how it’s affected you?
Pradipta Chakrabortty, Lead PM Chinese Equity: So, there have been a slew of regulatory actions across different sectors and industries. I classify them under four buckets. First were the antitrust regulations that manifested through fines on Alibaba and moved on to fines on other companies in the internet space such as Tencent and Meituan. That has subsequently moved on to breaking down several barriers and walls that these gigantic platform companies had created around themselves.
The second bucket relates to the stability of the financial services sector and was manifested through regulations that resulted in the cancellation of the Ant Financial IPO. The third area, data security regulations, is much more recent. Immediately after the IPO of the ride-hailing service Didi Chuxing, you saw cybersecurity concerns emerging, leading to restrictions of Didi’s ability to onboard new users. And the fourth bucket, social issues-related regulations, is pretty broad across different sectors. One of those sectors affected was after-school tutoring, where you had severe restrictions, converting that industry into not-for-profit. This week, we saw news about concerns about how online gaming affects children. So that sector has been under a little bit of pressure. There’s also been noise around the gig economy and fair compensation for workers there.
So, it’s a whole gamut. The net result is that investors have been spooked. The MSCI China All Shares Index is down close to 8% in the first seven months of the year, underperforming the MSCI ACWI Index, which is up 13%.
FR: Jingyi, can you talk to us about the high-level goals the Chinese government is pursuing with all these changes?
Jingyi Li, Co-Lead PM Global Equity: The Chinese government’s long-term goal is to continue to develop the economy. It has done a good job leading China from a low-income country decades ago to where it is a mid-income country today. And it has showed the ambition to continue to grow the economy in the next decade or 15 years to become an entry-level developed country. That means the economy needs to grow around the mid-single digits for the coming one or two decades at least.
To continue to drive the economy to reach the next level, you need a lot of structural reforms, reforms that we have seen, but also at the same time, you need to address a lot of social issues. Some are social issues caused by new economies and new technologies. Some are common issues everywhere in the world, like inequality, like the competitiveness of the labor force. Without addressing these kinds of long-term profound social issues, the Chinese government—who rely on long-term growth as one of the key legitimacies of their government—is concerned that they may not be able to continue on this trajectory, just like many Latin American countries stuck in the so-called mid-income trap.
FR: Craig, would you agree that’s the main goal, or do you think there are some more jaundiced, pernicious goals that the government is pursuing?
Craig Shaw, Co-Lead PM Emerging Market Equity: China is run by the Communist party. It is not a democracy. You could call it a dictatorship, and the way they stay in power is by keeping people happy. There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history. They are doing their best to stay in power and keep their people happy, which is something we always have to be cognizant of.
There’s an old Chinese saying that the emperor will reign in heaven until the people throw him out. And that’s proven to be true over much of China’s history.
FR: So, you don’t think they’re going after companies that have skirted the domestic listings rules by raising money outside? You don’t think they’re targeting prominent individuals who made a lot of money and turned that into a personal soapbox for their own use?
CS: Well, those are issues. We’ve seen this over the decades in emerging markets. Remember how in Russia Mikhail Khodorkovsky at Yukos got involved in politics and lost everything and was in prison for quite a while. To a certain extent, if someone becomes influential and wealthy and powerful, they are perceived, whether they really are or not, as a threat to the government’s control over the population. It’s a risk. We certainly saw that with Jack Ma at Alibaba a little while ago, when he made some comments about the future of finance in China. And the powers that be didn’t seem to like it.
FR: Andrew, before you became Co-Lead PM of the International Equity strategy, you were the manager of research. In fact, you started at Harding Loevner as an emerging market analyst. So, you’re deeply familiar with how we think about regulation in the structure of our research process. Can you lay out for us how we assess regulation?
Andrew West, Co-Lead PM International Equity: Sure. We have three key features of our process that leads to us being aware of regulatory risk and reacting to it, and hopefully anticipating it. One is our constant analysis of Porter’s “Five Forces” that dictate industry structure. For each of the five—whether it’s bargaining power of buyers or suppliers, rivalry, threat of new entrants—we ask our analysts to both understand the existing regulatory issues that may influence those forces and to keep an eye out for incoming potential changes that could influence them. It’s all part of helping us understand the trajectory of profitability in the future, of growth opportunities, and helping us reflect that in our forecasts. The second key feature is our ongoing monitoring of environmental, social, and governance (i.e., ESG) risks. And third is our requirement of higher returns from riskier countries, where we tilt our valuations of stocks based on the riskiness of the countries in which they’re operating.
FR: I’m interested in the ESG analysis. At Harding Loevner, ESG analysis is really a risk analysis rather than a pursuit of return of goodness, if you will. We’ve had a lot of client inquiry over the last two years about the E part of ESG, and almost no inquiry about the S—the social part. Do you think that we have underemphasized the regulatory risks that have emanated from these social risks in ESG in the case of China?
AW: It is a topic that we have actively debated. And social risk is a risk. A lot of the concern has been around looking from the outside in, with international companies and other countries threatening China in some way over their internal political activities. But there are also internal social pressures inspiring new regulations. And that ties into what Jingyi spoke about before, when you asked him about the goals of the Communist party.
Have we under-recognized it? I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices. Awareness of that comes and goes. I think the actions in some industries were harsher than just about anybody would have forecast. Even if we’d been aware of the pressures for change, we may not have anticipated such sudden and violent regulatory reaction to those pressures.
I would say the market has revealed an under-recognition of regulatory risk. Just a year ago, there seemed to be no fear built into prices. And now there’s a lot of fear built into prices.
FR: Pradipta, in addition to your new role as a Lead PM of the Chinese Equity strategy, you have long been Co-Lead PM on the Frontier Emerging Markets Equity strategy. You’ve invested in a bunch of countries that have a lot of risk. How do you assess risk in China versus the regulatory risk in China versus the regulatory risk in, say, Turkey, which has an authoritarian president?
PC: I mean, Turkey is obviously a different case altogether. You can’t really put it in any bucket. But in several other frontier countries—Kenya, Nigeria, the Philippines—they all have a significant amount of regulatory risk, and we’ve seen regulatory actions in those markets. The difference is in terms of the communication and the transparency of the debates that go on in the public domain. In most of these other countries, you would see lawmakers and regulators going through a lot of public debate where you’re privy to their thoughts and their potential future actions, much more than you would in China.
But to be fair to the Chinese regulators, there have been hints about each of these regulations that have been enacted this year. The problem is that those clues have been rather cryptic and the end result quite shocking. For example, the after-school tutoring sector having been converted into a not-for-profit—there was really no clue about that coming. So, I would say communication is where there is definitely more work to be done by the Chinese regulators. If they do communicate their intentions or their thinking more clearly, there would be less disruption in the markets.
FR: Craig, you mentioned Russia and the case of Yukos and the expropriation of assets in that case. That was at least as shocking as the vaporization of billions of dollars of market value of these Chinese education companies. How do you think about risk in China versus regulatory risk or expropriation risk in Russia or any other of the emerging market countries that you’ve invested in over the last 20 years?
CS: China’s a little different. You can argue how effective democracy is in some of the emerging markets, but at least they are democracies, to some extent. Whereas China is not. And so, the government has total control over everything. They debate within themselves, but as far as dealing with representatives of the populace, it’s a little different. They have a lot more control and a lot of these moves that we’ve seen are all about enhancing that control.
If you look at Russia, it’s changed quite a bit over the years. There was a time that share prices would fall 20% if Putin was annoyed with something. Certainly, Putin has a great amount of control over what happens. But he has not been overly aggressive in terms of doing anything to industries. I mean, if you go back to the Yukos case, there was an arrangement made a long time ago when Putin first came to power, that he would let the oligarchs keep whatever they managed to gather during the chaos of the fall of the Soviet Union as long as they stayed out of politics. And to a large extent, he’s kept that promise. But he certainly can scare people.
FR: Presumably, you’ve come to rely on that, because you’ve been overweight Russia in your emerging market portfolio for five years.
CS: Yes. It’s not the easiest place to be, but we do what our process and philosophy guides us to, and have found some good quality-growth companies at reasonable prices.
FR: It’s one thing for emerging market or frontier emerging investors to parse these risks because they’re all risky neighborhoods, and each one is risky in its own way. But Jingyi, you’re now a global portfolio manager, having concentrated on China for a long time as analyst. How do you compare the regulatory risk in China versus the regulatory risk in the US?
JL: I think the regulatory system in the US is much more mature and proven to be better for entrepreneurs and innovators, very good and reliable for business, and, of course, very favorable for investors, especially long-term investors like us. Speaking of the regulatory risk, I would also like to point out the risk of not taking actions on some of these long-term issues. Because when we talk about cybersecurity, antitrust, all kinds of social issues—these are not specific to China. These are very common issues in every part of the world. The US is trying to address them. Europe is trying to address them.
If other countries are not able to take on these issues in sensible and timely ways, they will have challenges, and their long-term economic development eventually will affect the return of long-term investors like us. Also, there’s a question of how much regulatory risks have been discounted in the current stock crisis. In the past several months, obviously, the market has been more alert toward the regulatory risk in China. Maybe that’s sufficient, maybe that’s over-reaction. But in other parts of the world, in other markets, maybe the regulatory risks have not yet been fully discounted yet.
FR: How about it, Andrew? Are the price changes in Chinese equities causing you to be more interested in Chinese equities? Or does the scope of the regulatory risks cause you to be more cautious?
AW: It’s a tug of war. On one side, risks have risen, I think. Or the awareness of risks that were there have crystallized. And we don’t know exactly how much more is to come. My suspicion is that there might be a slowing down, but that’s not for sure. On the other hand, there’s definitely more risk discounted than before. So, on the one hand, you’ve got maybe some concerns about future margins, future growth for some companies. On the other, a lower price.
The International Equity strategy, which you and I are Co-Portfolio Managers of, has been underweight China for the past several years as China has risen in terms of the index weight. And that was modestly negative for us when Chinese stocks were going up. It’s been favorable for us as the market has declined recently. And so, we are looking at whether to add new securities or add to some existing securities that have become cheaper relative to fair values. My natural tendency is to be fearful when others are not, and to be less fearful when others are more. So, I would say, I would be looking to reduce that underweight on the assumption we find some securities that are over-discounting risk and under-appreciating long-term growth and profitability.
FR: Craig, you were chafing under the limit of 35% in China. I happened to check this morning. China is now less than 35% in the MSCI Emerging Markets Index. Are you more inclined to buy? And will you go overweight now than you can?
CS: We are doing the same thing we’ve always done—looking for quality-growth companies at reasonable prices. Andrew said it very well: It’s a tug of war. And it’s always been like that. Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities. We had five purchases in the second quarter. Four of them were in China in response to 1) new ideas from our analysts, and 2) lower share prices and valuations. This is what we do. It’s not always easy. Sometimes it’s not fun.
Some of the changes that have come around the last few months have made it a little more challenging, but our reaction has been to purchase more Chinese equities.
FR: Pradipta, you have no choice but to invest in Chinese companies in the Chinese Equity strategy, but you do have choices between industries. Are there industries at this stage that you would avoid, other than the obvious one of the tutoring industry?
PC: Picking up on the ESG front, we’ve always considered ESG risk in these companies, and I think the social element has to be increased.
When I look at it through that lens, there are sectors like the property development sector, for example, where after the recent Politburo meeting there was talk about how housing is for living, not for speculation, right? Those kinds of comments give you hints that there are more regulatory strictures to come.
FR: Isn’t Harding Loevner generally biased against property development in the first place?
PC: Yes. So, that’s an industry thankfully we don’t own right now. We don’t want it because of quality and growth reasons, obviously. But then, there is another layer of risk that is coming.
FR: Confirming our bias against it.
PC: Yes. But I would also be very cautious about some of the other sectors where we do have stocks, like Health Care. Under the social equality principle and health care affordability for all, I would think—especially generic drugs, which have lower content in terms of technology and innovation—those probably are at risk of further price compression. Then the anti-trust regulations are breaking down barriers, which are changing industry structures from what we knew them to be a year back.
So, from the point of view that Andrew talked about earlier, the Porter structure is changing. We need to re-look at the growth cases. We need to re-look at the competitive advantage cases for some of our companies. And then act accordingly. Optically, the valuation might have become better. But in some cases, the valuation may not have become as much better as it seems.
FR: Jingyi, are there industries you have increased your aversion to in the last couple of months?
JL: The short answer is no. I don’t see any sort of a wholesale attitude change to any particular industry. That said, we need to look at our business from an ESG angle, especially the social angle, in a deeper and more profound way. We need to try to understand the social implications of their business models and to think about whether there’s any very profound social impact we should be aware of.
You asked about the sectors to avoid. I should point out that higher regulatory standards, or standards for social awareness, could also open investment opportunity in companies that are more aware of those issues to begin with, or with the management teams who can do a better job to adapt to these kinds of requirements, or even companies that provide solutions to address some of the social issues. So, all these regulatory changes may also provide us some interesting new investment opportunities, again using our fundamental Porter lenses and ESG frameworks.
FR: I’m going to sum up, and then, we can get to questions from outside. As Andrew pointed out, we explicitly try to assess regulatory risk in the framework of our research process, through the lens of Porter’s Five Forces. And I think importantly, we do have a culture of debate between analysts—between PMs and analysts, between people who know a lot about China and people who have questions about China—and that culture of debate is a very active part of getting to the underlying truth of what’s going on. The third thing I would point out is that the insistence on diversification in all our investment strategies is something that we are deeply wedded to, as I alluded to at the start when discussing the nature of pre-commitments.
I think ESG is getting a new take that is reinforcing our belief that ESG risks are exactly that, and that the way we’ve embedded ESG analysis into our research structure is the right way to approach the whole set of issues. And then, finally, the price declines in these Chinese equities are giving us a chance to reassess each of the companies within our coverage and ascertain whether future returns are higher because the prices are lower, or the prices are accurately reflecting the new risk. That is a company-by-company and stock-by-stock issue that we are actively engaged in right now.
Audience Question: Can you comment on your current views on VIEs and whether the VIE structure is at risk due to some of the regulations and regulatory changes that have come out of China?
FR: I’ll take that one. VIEs, for those who don’t know, are variable interest entities, which are special purpose vehicles that connect US-listed stocks to domestic Chinese businesses through holding companies and some third country and equity swaps to get the returns connecting the two.
We have long viewed VIEs as a precarious legal structure and, therefore, set limits on how much each strategy could invest in VIEs. Nothing in the current imbroglio of regulatory shifts affecting the share prices of companies utilizing VIEs has made us see VIEs as more risky or less risky. In our view, the precariousness lies in the legal structure itself and our limits on VIEs are not changing.
I would say that there is debate internally about whether Chinese authorities have, in some sense, blessed the VIE structure by allowing what are called CDRs—a Chinese equivalent of ADRs whose primary listing is a VIE—to be listed in domestic exchanges in China. While that gives some comfort, it’s a regulatory rather than a legal backing, in my view, and in the view of our legal experts.
I was also troubled by statements out of the recent Politburo meeting. I only get translations, but one of the statements was that “the Politburo is going to improve overseas listing supervision.” We’ve had the phrase “rectify” applied to several of these industries where regulatory changes have occurred. I’m uncomfortable with this word “improve” because it sounds a lot like rectified, which could be damaging. Jingyi, how would you characterize that phrase? What do you think it means?
JL: Yeah, I’m really reading the tea leaves here, but my understanding of this phrase, which is very interesting, if not important, is that the policymakers still understand the necessity of a VIE structure …
FR: In order for Chinese companies to raise capital abroad?
JL: To raise capital. They fully understand the historical background going back in the early 2000s. There are long debates inside China on what to do with the VIE structure, but, after all these years, I do not think they have taken a hostile view on this.
The reason that we have a change is they are always worried that some companies may abuse the structure. And that’s why they think they need to take a more active role to supervise Chinese companies that use it to get listed. It’s fine to use that structure, but it’s not fine in their eyes to use it to circumvent some of the regulatory frameworks that are in place to prevent some companies from doing certain things. That’s my understanding.
Audience Question: Why invest in China at all?
AW: We’ve invested in a lot of risky places and we’ve made money in a lot of risky places over the decades. As we said, we don’t get paid for being comfortable. China represents roughly 10% of the international index. Our analysts have found over 50 companies that meet our pretty high standards for quality and growth.
So, we think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades. We very rarely rule out any country’s securities. As I mentioned earlier, we may require higher returns to compensate us for the risks that we take, and we are intelligent about diversifying those risks as well.
We think there are companies out there that are attractive, not just relative to other Chinese companies, but on a global basis. That is the opportunity. And then there’s dealing with the risks of it. That’s something that we’ve done for decades.
PC: If I may add, as a market, China is massive with huge consumption opportunities that are transforming in a significant way. But, relatively speaking, there are pockets where the risk is lesser and much more aligned with what the government is trying to achieve in terms of its national and overall social objectives.
The massive production base in China is also transforming through the increasing penetration of automation. This entire area is one where we find very, very high-quality companies which are rapidly growing. Electric vehicles and their value chain are another area related to that and one which is very well-aligned with the government’s carbon neutrality goals. China has the largest value chain as well as some of the biggest consumer demand for these cars.
So, there are those pockets that continue to be very, very high-growth and have very high-quality companies that meet our requirements and are very attractive from a long-term point of view. Especially in a country which is right now going through a massive transformation.
What did you think of this piece?
Behavioral Finance
In investing, there has been at least a little progress towards improving decision making by resisting the power of stories. Quantitative investors describe how they adhere to purely objective rules (rules and lines of code that, of course, they themselves have written) to govern their behavior and reduce bias. “Quantamentalists,” another breed of investor, allow some judgement to enter their decision making once they have established the framework. They do this in part in recognition that, as a rule, most humans don’t like rules. We suffer from what psychologists call “algorithm aversion,” i.e. preferring to go with our gut. That preference results from our need to remain in control, or at least to believe we are. Permitting human override of an algorithm may degrade the quality of its output, but in granting themselves the comfort of exercising some degree of control, decision makers likely improve their rate of adherence, for an overall improvement in outcomes. I fully expect self-driving cars to come with a steering wheel that will have no impact on direction of travel, but will allow the human passenger to feel more secure than if she were simply sitting back and giving herself over fully to the computer under the hood.
In his book The Success Equation, Michael Mauboussin writes extensively about the importance of a strong process and rules in activities where the immediate outcome is driven by luck and skill. He describes how it is possible to improve skill through what has become known as deliberate practice: repetitive, purposeful, and systematic repetition with immediate and specific feedback. Luck, however, can only be managed by having a strong process, with rules or standards constraining decision making and the urge to impute too much importance to our role in any one result. In activities such as investing or team sports—arenas where skill and luck both come into play—narrative is particularly seductive, making adherence to this recipe for success a constant battle.
The pandemic meant the stands were still empty at “Theater of Greens,” the home stadium for Plymouth Argyle this year, but the ideas were plentiful as to how to harness the theories of behavioral economics to put a more competitive squad on the field.

Richard Thaler, who won the Nobel Prize in Economics for his work in behavioral finance, has noted that 1980s basketball superstars like Larry Bird converted their three-point shot attempts at the same near-40% rate as 21st-century sharpshooters such as Steph Curry or James Harden. Yet, Bird took half as many three-point attempts as are normal today, favoring shots closer to the basket, which great players can hit roughly 50% of the time. It took 30 years for the three-point shot to become as popular as it is today or, in other words, for basketball to realize that 0.4 x 3 is greater than 0.5 x 2.
The Bill James Baseball Abstract, an annual compendium of baseball statistics that ultimately legitimized the science of baseball sabermetrics, was neglected for many years before a James disciple, Oakland Athletics General Manager Billy Beane, used the approach to identify underpriced skills for his small-market team, as popularized in Michael Lewis’s 2002 Moneyball. It was only then that James himself landed a job in the front office of the Boston Red Sox, helping the team finally overcome the “Curse of the Bambino,”1 and win its first World Series in 86 years.
Many baseball fans complain that the influence of Moneyball has been too great—players are chosen purely for their ability to walk or jack balls over the fence; defenders are all stacked on one side of the infield because that’s where the statistics say the vast majority of a given batter’s ground balls will be hit. “It’s no fun anymore!” Clearly, those fans prefer intuition and stories to success and efficiency. They also subscribe to the great man theory, that results are driven by individual managerial genius, the wizened skipper playing a hunch.2 And yet, organizations typically strive to create and adhere to processes that can improve their probability of success—to control luck.
I have been involved in two firms with many similarities, one being an investment manager and the other a football (soccer) club. An investment portfolio can, through careful construction, be more than the sum of its individual parts thanks to diversification. It may seem odd, but a football team is a portfolio. It, too, needs careful construction. You can’t simply rank order the most attractively priced available players and take the top 20 to form your squad. You would end up with a team made up only of defenders, and no goal scorers.
More than a decade after John Henry, the Red Sox owner who had hired Bill James, purchased Liverpool FC and brought Moneyball to the UK’s Premier League, systematic use of data analytics has finally worked its way throughout the ranks of English football. At my football club, Plymouth Argyle, which plays in the third tier of the leagues, we have set rules and standards to guide the decision-making of those who select the squad. Beginning with our philosophy, i.e., answering the question “What is the style of football we wish to play?,” we have defined the desired characteristics of each position. Our philosophy includes playing the ball forward from the back with quick passes along the ground to the opposition’s part of the field. Our goalkeeper must, therefore, be able to kick with both feet and play short passes while under pressure from the opposing forwards. We also prefer to play in a tactical lineup, known as a 3-5-2, with a pair of strikers at the front and a couple of fit defenders, one on each side, who dash up and down the wings depending on whether we or the opposition have the ball.
Defining the philosophy this way and defining how we will implement it enables us to search databases for players that match our criteria in each position, such as the defender we recently signed based on some impressive data around his defensive blocks, aerial duels won, and tackles per game. Then, in quantamental fashion, we can conduct research into aspects of players that can’t be quantified (yet!), such as their character, personality, or work ethic.
There are differences between assembling an optimal squad of football players and an investment portfolio. One is that securities prices are freely available, updated continuously, and can be compared with their hypothetical value generated by a model. That is not the case with football players. Transactions can only be made in two “transfer windows,” one midway through the season in January, the other during the summer before the next season starts. And no one has yet come up with a model that can assess players’ value in the way that we forecast cash flows and discount them to a present value to give an idea of what a share of stock is worth. I live in hope, though!

The market for football players is relatively efficient, but not completely so, and becomes less efficient the lower down the leagues you go. In this way, the relative inefficiencies of the market are parallel to those for, say, US large caps compared with those for emerging market small caps.

But surprisingly, perhaps, there are more similarities than differences. The market for football players is relatively efficient, but not completely so, and becomes less efficient the lower down the leagues you go. In the Premier League, the most watched football league in the world, there is a strong correlation between what you pay and the results you achieve. That is not the case lower down, so my club has a strong incentive to improve decision making, to exploit the behavioral biases and subsequent mispricing that is prevalent. In this way, the relative inefficiencies of the market are parallel to those for, say, US large caps compared with those for emerging market small caps. Similarly, though, as the potential gains to improved decision making increase, so does the resistance to replacing intuition with algorithms and process that reduces the degrees of freedom under which individuals operate. Those clubs which can overcome that resistance will generate a competitive advantage—an edge. I believe my football club has such an advantage, but I am on the alert for signs of backsliding—going along with “But that’s the way we’ve always done it!”
We have gone down this path at Plymouth Argyle because we want to spend the Club’s money wisely and compete by being smarter, not by spending more. At Harding Loevner we started down this path 25 years ago as decision making spread beyond the handful of founders to an expanded investment team. Each portfolio remained the product of two single decision makers but was now made with input from over 30 analysts. We had to learn how to structure a process that benefits from group wisdom but is not damaged by “groupthink.” The foundation of that was, and still is today, individual accountability and aggregation of individual decisions. Analysts drive the process and decide what stocks they will cover. They are free from direction by their colleagues, and free from direction by portfolio managers. They are not completely free, though. Just as Argyle’s team must recruit players who meet the objective standards we have established as being consistent with our playing philosophy, Harding Loevner analysts must confine their activities to securities of companies that they judge to conform with our investment philosophy, which focuses on growth, quality—which we have historically equated, in part, with a demonstrated track record of profitability—and price. When we look back at the last 25 years, we can see clearly that the arc of evolution of our investment process has been to define more clearly and rigorously the rules that restrict our analysts’ liberty to follow any company they chose. This has been highly effective at controlling biases and risk, and, overall has been good for returns.
Today, there are any number of voices, both internal and external, calling us away from the framework and structure that have served us well. The rise of the digital economy, and its steady proliferation of fast-growing but still-unprofitable businesses with compelling narratives, continually tests our reliance on an established track record as a guide to the future and the best indicator that a company has the culture and institutional strength to withstand cyclical downturns and shifting competitive landscape. Has the nature of growth changed? Have the kinds of characteristics that define quality shifted? Or are those merely the stories we tell ourselves to justify paying higher prices for the hot new fashion?
I don’t know the answers to those questions yet. I do know that, while it is necessary for portfolio managers to evolve along with markets, such evolution should take place deliberately and only after careful consideration. At Argyle we are at the early stages of translating our playing philosophy into a structured process for how we find players, and how they play on the field. Already, though, there have been occasions when we’ve had to adapt on the fly and adjust our typical tactical lineup. Football, like investing, is a game where the opposition can see what we do, and we must adapt to how they counter our plans. Players get injured, and replacement players may be less capable at implementing the approach. So, how we implement our philosophy must evolve, but we must be clear with ourselves that such adjustments are a change in process, not a change in philosophy. If we were to start changing our philosophy, we would surely be lost, tossed on a swirling sea of narrative.

Endnotes

1Purportedly begun in 1920 when, after he had led the club to three World Series titles in six years, the Sox traded George Herman “Babe” Ruth to the rival Yankees for $125,000 (about $1.7 million in today’s dollars, or roughly the salary of Boston’s current backup catcher, Kevin Plawecki).
2It could be said the great man theory is also a feature of investment marketing—how often do brand name investment managers attract large amounts of client assets and then collapse in ignominy?
Richard Thaler, who won the Nobel Prize in Economics for his work in behavioral finance, has noted that 1980s basketball superstars like Larry Bird converted their three-point shot attempts at the same near-40% rate as 21st-century sharpshooters such as Steph Curry or James Harden. Yet, Bird took half as many three-point attempts as are normal today, favoring shots closer to the basket, which great players can hit roughly 50% of the time. It took 30 years for the three-point shot to become as popular as it is today or, in other words, for basketball to realize that 0.4 x 3 is greater than 0.5 x 2.
The Bill James Baseball Abstract, an annual compendium of baseball statistics that ultimately legitimized the science of baseball sabermetrics, was neglected for many years before a James disciple, Oakland Athletics General Manager Billy Beane, used the approach to identify underpriced skills for his small-market team, as popularized in Michael Lewis’s 2002 Moneyball. It was only then that James himself landed a job in the front office of the Boston Red Sox, helping the team finally overcome the “Curse of the Bambino,”1 and win its first World Series in 86 years.
Many baseball fans complain that the influence of Moneyball has been too great—players are chosen purely for their ability to walk or jack balls over the fence; defenders are all stacked on one side of the infield because that’s where the statistics say the vast majority of a given batter’s ground balls will be hit. “It’s no fun anymore!” Clearly, those fans prefer intuition and stories to success and efficiency. They also subscribe to the great man theory, that results are driven by individual managerial genius, the wizened skipper playing a hunch.2 And yet, organizations typically strive to create and adhere to processes that can improve their probability of success—to control luck.
I have been involved in two firms with many similarities, one being an investment manager and the other a football (soccer) club. An investment portfolio can, through careful construction, be more than the sum of its individual parts thanks to diversification. It may seem odd, but a football team is a portfolio. It, too, needs careful construction. You can’t simply rank order the most attractively priced available players and take the top 20 to form your squad. You would end up with a team made up only of defenders, and no goal scorers.
More than a decade after John Henry, the Red Sox owner who had hired Bill James, purchased Liverpool FC and brought Moneyball to the UK’s Premier League, systematic use of data analytics has finally worked its way throughout the ranks of English football. At my football club, Plymouth Argyle, which plays in the third tier of the leagues, we have set rules and standards to guide the decision-making of those who select the squad. Beginning with our philosophy, i.e., answering the question “What is the style of football we wish to play?,” we have defined the desired characteristics of each position. Our philosophy includes playing the ball forward from the back with quick passes along the ground to the opposition’s part of the field. Our goalkeeper must, therefore, be able to kick with both feet and play short passes while under pressure from the opposing forwards. We also prefer to play in a tactical lineup, known as a 3-5-2, with a pair of strikers at the front and a couple of fit defenders, one on each side, who dash up and down the wings depending on whether we or the opposition have the ball.
Defining the philosophy this way and defining how we will implement it enables us to search databases for players that match our criteria in each position, such as the defender we recently signed based on some impressive data around his defensive blocks, aerial duels won, and tackles per game. Then, in quantamental fashion, we can conduct research into aspects of players that can’t be quantified (yet!), such as their character, personality, or work ethic.
There are differences between assembling an optimal squad of football players and an investment portfolio. One is that securities prices are freely available, updated continuously, and can be compared with their hypothetical value generated by a model. That is not the case with football players. Transactions can only be made in two “transfer windows,” one midway through the season in January, the other during the summer before the next season starts. And no one has yet come up with a model that can assess players’ value in the way that we forecast cash flows and discount them to a present value to give an idea of what a share of stock is worth. I live in hope, though!
The market for football players is relatively efficient, but not completely so, and becomes less efficient the lower down the leagues you go. In this way, the relative inefficiencies of the market are parallel to those for, say, US large caps compared with those for emerging market small caps.
But surprisingly, perhaps, there are more similarities than differences. The market for football players is relatively efficient, but not completely so, and becomes less efficient the lower down the leagues you go. In the Premier League, the most watched football league in the world, there is a strong correlation between what you pay and the results you achieve. That is not the case lower down, so my club has a strong incentive to improve decision making, to exploit the behavioral biases and subsequent mispricing that is prevalent. In this way, the relative inefficiencies of the market are parallel to those for, say, US large caps compared with those for emerging market small caps. Similarly, though, as the potential gains to improved decision making increase, so does the resistance to replacing intuition with algorithms and process that reduces the degrees of freedom under which individuals operate. Those clubs which can overcome that resistance will generate a competitive advantage—an edge. I believe my football club has such an advantage, but I am on the alert for signs of backsliding—going along with “But that’s the way we’ve always done it!”
We have gone down this path at Plymouth Argyle because we want to spend the Club’s money wisely and compete by being smarter, not by spending more. At Harding Loevner we started down this path 25 years ago as decision making spread beyond the handful of founders to an expanded investment team. Each portfolio remained the product of two single decision makers but was now made with input from over 30 analysts. We had to learn how to structure a process that benefits from group wisdom but is not damaged by “groupthink.” The foundation of that was, and still is today, individual accountability and aggregation of individual decisions. Analysts drive the process and decide what stocks they will cover. They are free from direction by their colleagues, and free from direction by portfolio managers. They are not completely free, though. Just as Argyle’s team must recruit players who meet the objective standards we have established as being consistent with our playing philosophy, Harding Loevner analysts must confine their activities to securities of companies that they judge to conform with our investment philosophy, which focuses on growth, quality—which we have historically equated, in part, with a demonstrated track record of profitability—and price. When we look back at the last 25 years, we can see clearly that the arc of evolution of our investment process has been to define more clearly and rigorously the rules that restrict our analysts’ liberty to follow any company they chose. This has been highly effective at controlling biases and risk, and, overall has been good for returns.
Today, there are any number of voices, both internal and external, calling us away from the framework and structure that have served us well. The rise of the digital economy, and its steady proliferation of fast-growing but still-unprofitable businesses with compelling narratives, continually tests our reliance on an established track record as a guide to the future and the best indicator that a company has the culture and institutional strength to withstand cyclical downturns and shifting competitive landscape. Has the nature of growth changed? Have the kinds of characteristics that define quality shifted? Or are those merely the stories we tell ourselves to justify paying higher prices for the hot new fashion?
I don’t know the answers to those questions yet. I do know that, while it is necessary for portfolio managers to evolve along with markets, such evolution should take place deliberately and only after careful consideration. At Argyle we are at the early stages of translating our playing philosophy into a structured process for how we find players, and how they play on the field. Already, though, there have been occasions when we’ve had to adapt on the fly and adjust our typical tactical lineup. Football, like investing, is a game where the opposition can see what we do, and we must adapt to how they counter our plans. Players get injured, and replacement players may be less capable at implementing the approach. So, how we implement our philosophy must evolve, but we must be clear with ourselves that such adjustments are a change in process, not a change in philosophy. If we were to start changing our philosophy, we would surely be lost, tossed on a swirling sea of narrative.
1Purportedly begun in 1920 when, after he had led the club to three World Series titles in six years, the Sox traded George Herman “Babe” Ruth to the rival Yankees for $125,000 (about $1.7 million in today’s dollars, or roughly the salary of Boston’s current backup catcher, Kevin Plawecki).
2It could be said the great man theory is also a feature of investment marketing—how often do brand name investment managers attract large amounts of client assets and then collapse in ignominy?
What did you think of this piece?
Fundamental Analysis
Source: Our World In Data

Igor Tishin, PhD, an Information Technology analyst at Harding Loevner, refers to US health care as a “rust heap.” Tishin frequently shares his view that some of the companies under his coverage are in a better position than traditional health care firms to deliver the sort of disruptive change the US health care system so obviously needs. This view puts him at odds with Patrick Todd, CFA, one of our Health Care analysts, who covers a number of high-quality durable-growth insurance, pharma, and diagnostics companies. In responding to Tishin, Todd acknowledges US health care’s need for reform yet is adamant that Tishin’s description of Big Tech’s bonafides is wildly overstated. Tishin paints this as the kind of apologist thinking that has tolerated US$60,000 C-sections.
Hostilities between our brown-bag combatants flared following the January announcement that Haven, a consortium formed to much fanfare several years ago between Amazon, JP Morgan, and Berkshire Hathaway—the most high-profile effort to date by powerful outsiders to develop a better model for delivering higher-quality, more cost-effective care—was disbanding. The following exchange was excerpted from Tishin’s and Todd’s recent internal research postings. We should note that the pair, avid skiers and hikers who regularly compare notes on their families’ outdoor adventures, are perfectly friendly. Often as not on topics not related to US health care, they find their views aligned.
Patrick Todd: Many in the media have concluded that the entrenched powers of private insurers, doctors, and major hospital systems caused Haven’s demise. It makes a good headline, but it’s inaccurate. I think Haven’s demise has more to do with Amazon’s ambition. Amazon has been developing similar offerings to those of Haven. For example, Amazon Care, the primary care and prescription plan for Amazon employees that is now being expanded to the public, is very similar to the former Haven platform for Amazon, JPM, and Berkshire employees. Amazon also just opened its own online pharmacy, building on the acquisition of Pill Pack several years ago. None of these are revolutionary ideas, but I just think Amazon realized they don’t need JPM and Berkshire in the mix.
While Haven has been in the news, I think the more important recent development is the more-or-less unnoticed expansion of the Affordable Care Act (i.e., Obamacare) tucked into the last COVID-19 relief bill. I see this as a sign the Biden administration will continue to expand government’s role in health care, including Medicaid but more importantly Medicare Advantage (MA), which very much benefits UnitedHealth, the market share leader. What’s also interesting is how UnitedHealth is moving more towards an integrated model like hospital network Kaiser Permanente. Through their Optum unit, UnitedHealth is buying up facilities and investing heavily in tech to create a more effective and efficient delivery model that lowers the cost of care. So, you’re seeing best-of-breed providers and insurers becoming more similar.

And so any attempts to fix the system are fruitless because the current setup is a decent compromise and the incumbents are generally doing a fine job. What a pathetic conclusion!

Igor Tishin: And so any attempts to fix the system are fruitless because the current setup is a decent compromise and the incumbents are generally doing a fine job. What a pathetic conclusion! The only thing that Haven’s failure proves to me is that they were not audacious enough and it will take a true outsider to bring simplicity, competition, and accountability to the health care industry’s parasitic relationship with vested interests in Washington and other parts of the economy. It’s going to take an entity with a “call option” mindset (i.e., little to lose, much to gain) and credible capabilities to expose the rot and hopefully fix the problem before the political will is hijacked. Fortunately, there is such a company with the ambition and a good deal of the ingredients in place to offer a data-driven health care system. I gather you’ve heard of Apple?
PT: I think we can both agree that there are inefficiencies in health care delivery, but “parasitic” is a bit extreme even for you, don’t you think? The US does spend more and fares worse on adult and infant mortality metrics. It also has higher rates of poverty and teen pregnancy, much higher levels of obesity, and higher car crash and gun deaths. A lot of the inefficiencies also have to do with how fragmented our payment systems are among Medicare, Medicaid, a fully nationalized program like the Veterans Administration, commercial insurance, insurance purchased on exchanges, etc. How is Apple supposed to fix the payments structure? Unless you’re suggesting we move to a cash system of some kind where the customer pays directly, which not a single other developed country has ever seriously considered doing, and in which case you’ve become even more disconnected from reality than when I last checked.
IT: Sunlight is a great disinfectant! Yes, fragmentation is a huge problem, and of course some policy changes would be required, but let’s look at some of the other parts of the system that are broken: the party receiving the service is not responsible for the payment; the party providing the service decides on the volume of consumption; the party that pays does not really care about the outcome as much as about the cost; and the outcomes and costs are extremely difficult to objectively compare across entities.
Introducing a comprehensive and coherent data platform to streamline treatment administration, track costs and outcomes, and fight balkanization can be a powerful step to expose each of the flaws in the current arrangement, clarify the vision for alternatives, and thus help unite political will for the policy change. Apple with its world-class personal data management platform, credibility with over one billion customers, and data privacy leadership (obviously critical in making such a system work) has a unique set of assets to tackle the issues.
PT: That is a list of blanket statements. Certain areas within health care do encourage volume, that’s true, but others do not. Medicare and some insurance pay hospitals a fixed fee for inpatient care regardless of how much it costs. If a hospital can deliver care more efficiently, they make more money. Conversely, if they do a poor job with the patient and costs are higher than expected, the hospital loses money. I also disagree that insurance companies aren’t incentivized to keep you healthy and keep their own costs low. As for the difficulty in tracking outcomes and costs, this is getting better, in my opinion—without the help of Apple. Doctors’ offices were still using fax machines not too long ago. But with the implementation of the 2009 HITECH Act, we now have electronic health records, and health systems and health care information technology companies are starting to make sense of all this data to improve outcomes and costs. You are starting to see some artificial intelligence applications as well.
IT: Every reform you mention would be enormously enhanced if deployed on a more robust and thorough data platform. The problem is hospitals and insurance companies have neither the expertise nor incentives to scale this up.
Take some of the cultural issues you mentioned contributing to the overall poor health of the US population. The US system is more “sick care” than health care; many more resources are devoted to fixing than preventing. Well, the only way to change that is to introduce personal accountability by rewarding the desired behavior. The Apple Watch can collect some basic but relevant personal data over long periods of time in a very efficient and economical manner. If the insurers really cared about the well-being of their customers, they would all cover putting a basic version of Apple Watch on people’s wrists and use this data to give them a break on their insurance premiums. Once the platform is out there and open to third-party developers, there would be no shortage of creative models for how to foster healthier living through such incentives. A portion of the insurers’ savings could also flow back to Apple and the app developers.
The biometrics on the Apple Watch are still pretty rudimentary, but the company has all sorts of other patents pending for blood pressure sensors, sweat analysis of blood sugar and blood alcohol content, and different types of motion detectors. The other major tech players clearly have a role to play as well. Apple stands out for its expertise in hardware solutions and the strength of its operating system, but Google probably has the strongest AI and data analytics capabilities to process all this data and help patients and their providers make smarter decisions. Amazon is still king of e-commerce and logistics, which will be key in closing the loop between those smart decisions and implementation in the real world through things like low-cost drug refills, mail-in tests and telemedicine, and more transparent pricing between vendors.

Not everyone is a biohacker trying to optimize their output. As a health care IT executive once told me, “Silicon Valley tends to overestimate the health curiosity of the individual.”

PT: It seems obvious that if the people in the US ate less and worked out more our health outcomes would be better. But not everyone is a biohacker trying to optimize their output. As a health care IT executive once told me, “Silicon Valley tends to overestimate the health curiosity of the individual.”
We are already seeing a big move towards value-based reimbursement models that encourage savings, and the health care system is investing heavily in developing the technology and contracts to make it work. In my view, a company like UnitedHealth is just way better positioned to drive these changes. In addition to their traditional insurance operation and growing portfolio of primary and urgent care facilities, they own OptumInsight, which is a leading data and analytics platform used by 9 out of 10 US hospitals. It spends almost US$4 billion a year on tech and innovation and has products designed to tackle waste in the system. In places where OptumHealth, UnitedHealth’s soup-to-nuts data-driven insurance and provider offering, has been in the market for a while, their cost of care is already 30% lower than comparable fee-for-service Medicare.
When you reference the transition away from sick care, what you are really getting at is population health management. Again, this is already happening, and the change is coming from inside the system. Optum, as an example, helps with biometric solutions and on-site services and wellness coaching. Just giving people data on an Apple Watch doesn’t really do anything. Measuring your steps and heart rate only helps at the margin. You need outreach to make it work.
IT: Who is better at outreach than Amazon? Amazon Prime has nearly 150 million US subscribers. Every time they check out of their cart is another opportunity to serve them a reminder about better choices they could be making about their health.
PT: I’m not saying the tech companies aren’t part of the solution, but I see them more as data suppliers and an alternative distribution source than the ones really instigating change. I thought it was interesting that Amazon’s own chief medical officer, TV medical pundit Vin Gupta, recently just about acknowledged as much. Speaking of which, the most direct way to lower costs and improve outcomes is detecting disease early. I’m personally very excited about all the innovation in “liquid biopsies” that scan the body for circulating cancer cells and other very early signs of disease. GRAIL, a company now in the process of being reacquired by Illumina, has shown some impressive data and I expect their Galleri test to become a routine part of the annual bloodwork ordered by physicians. The more and better tests of this kind that are administered, the better the insights will be that come from all your Big Tech big data analysis.
IT: Yes, and I would expect GRAIL to eventually develop a mail-in version of the test and sell it on Amazon.
Patrick, if I didn’t know better, I would say we are approaching a consensus over what needs to be done, and at this point mainly haggling over who does it and in what order. I think change will accelerate when the Big Tech companies can make wearables and other related technologies widely available enough to unlock the data flow in a more powerful way, creating new incentives and behaviors from many of the same actors—hospitals, pharma, and insurers. It’s like the same cast of characters playing a historical drama instead of a horror movie. The result will be savings to patients and their employers, savings to insurers and providers, and a cut of those savings flowing back to the tech companies. As you know, for years “health care TBD” has been part of my long-term valuation model for Apple. I should thank you for helping me understand now how that will play out.
PT: You’re welcome, I guess. Except I’m skeptical that Big Tech really wants to disrupt health care. They want the consumer data, and they want access to that gigantic profit pool. Saying they are “bending the cost curve” is just part of their sales pitch. Let’s be honest, what does real disruption in US health care look like? It’s called single-payer health insurance, aka Medicare For All, but I’m not holding my breath waiting for that to happen.
IT: And if you do (hold your breath) be sure to download Apple Watch’s new Blood Oxygen app first. It’s really cool!
Igor Tishin, PhD, an Information Technology analyst at Harding Loevner, refers to US health care as a “rust heap.” Tishin frequently shares his view that some of the companies under his coverage are in a better position than traditional health care firms to deliver the sort of disruptive change the US health care system so obviously needs. This view puts him at odds with Patrick Todd, CFA, one of our Health Care analysts, who covers a number of high-quality durable-growth insurance, pharma, and diagnostics companies. In responding to Tishin, Todd acknowledges US health care’s need for reform yet is adamant that Tishin’s description of Big Tech’s bonafides is wildly overstated. Tishin paints this as the kind of apologist thinking that has tolerated US$60,000 C-sections.
Hostilities between our brown-bag combatants flared following the January announcement that Haven, a consortium formed to much fanfare several years ago between Amazon, JP Morgan, and Berkshire Hathaway—the most high-profile effort to date by powerful outsiders to develop a better model for delivering higher-quality, more cost-effective care—was disbanding. The following exchange was excerpted from Tishin’s and Todd’s recent internal research postings. We should note that the pair, avid skiers and hikers who regularly compare notes on their families’ outdoor adventures, are perfectly friendly. Often as not on topics not related to US health care, they find their views aligned.
Patrick Todd: Many in the media have concluded that the entrenched powers of private insurers, doctors, and major hospital systems caused Haven’s demise. It makes a good headline, but it’s inaccurate. I think Haven’s demise has more to do with Amazon’s ambition. Amazon has been developing similar offerings to those of Haven. For example, Amazon Care, the primary care and prescription plan for Amazon employees that is now being expanded to the public, is very similar to the former Haven platform for Amazon, JPM, and Berkshire employees. Amazon also just opened its own online pharmacy, building on the acquisition of Pill Pack several years ago. None of these are revolutionary ideas, but I just think Amazon realized they don’t need JPM and Berkshire in the mix.
While Haven has been in the news, I think the more important recent development is the more-or-less unnoticed expansion of the Affordable Care Act (i.e., Obamacare) tucked into the last COVID-19 relief bill. I see this as a sign the Biden administration will continue to expand government’s role in health care, including Medicaid but more importantly Medicare Advantage (MA), which very much benefits UnitedHealth, the market share leader. What’s also interesting is how UnitedHealth is moving more towards an integrated model like hospital network Kaiser Permanente. Through their Optum unit, UnitedHealth is buying up facilities and investing heavily in tech to create a more effective and efficient delivery model that lowers the cost of care. So, you’re seeing best-of-breed providers and insurers becoming more similar.
And so any attempts to fix the system are fruitless because the current setup is a decent compromise and the incumbents are generally doing a fine job. What a pathetic conclusion!
Igor Tishin: And so any attempts to fix the system are fruitless because the current setup is a decent compromise and the incumbents are generally doing a fine job. What a pathetic conclusion! The only thing that Haven’s failure proves to me is that they were not audacious enough and it will take a true outsider to bring simplicity, competition, and accountability to the health care industry’s parasitic relationship with vested interests in Washington and other parts of the economy. It’s going to take an entity with a “call option” mindset (i.e., little to lose, much to gain) and credible capabilities to expose the rot and hopefully fix the problem before the political will is hijacked. Fortunately, there is such a company with the ambition and a good deal of the ingredients in place to offer a data-driven health care system. I gather you’ve heard of Apple?
PT: I think we can both agree that there are inefficiencies in health care delivery, but “parasitic” is a bit extreme even for you, don’t you think? The US does spend more and fares worse on adult and infant mortality metrics. It also has higher rates of poverty and teen pregnancy, much higher levels of obesity, and higher car crash and gun deaths. A lot of the inefficiencies also have to do with how fragmented our payment systems are among Medicare, Medicaid, a fully nationalized program like the Veterans Administration, commercial insurance, insurance purchased on exchanges, etc. How is Apple supposed to fix the payments structure? Unless you’re suggesting we move to a cash system of some kind where the customer pays directly, which not a single other developed country has ever seriously considered doing, and in which case you’ve become even more disconnected from reality than when I last checked.
IT: Sunlight is a great disinfectant! Yes, fragmentation is a huge problem, and of course some policy changes would be required, but let’s look at some of the other parts of the system that are broken: the party receiving the service is not responsible for the payment; the party providing the service decides on the volume of consumption; the party that pays does not really care about the outcome as much as about the cost; and the outcomes and costs are extremely difficult to objectively compare across entities.
Introducing a comprehensive and coherent data platform to streamline treatment administration, track costs and outcomes, and fight balkanization can be a powerful step to expose each of the flaws in the current arrangement, clarify the vision for alternatives, and thus help unite political will for the policy change. Apple with its world-class personal data management platform, credibility with over one billion customers, and data privacy leadership (obviously critical in making such a system work) has a unique set of assets to tackle the issues.
PT: That is a list of blanket statements. Certain areas within health care do encourage volume, that’s true, but others do not. Medicare and some insurance pay hospitals a fixed fee for inpatient care regardless of how much it costs. If a hospital can deliver care more efficiently, they make more money. Conversely, if they do a poor job with the patient and costs are higher than expected, the hospital loses money. I also disagree that insurance companies aren’t incentivized to keep you healthy and keep their own costs low. As for the difficulty in tracking outcomes and costs, this is getting better, in my opinion—without the help of Apple. Doctors’ offices were still using fax machines not too long ago. But with the implementation of the 2009 HITECH Act, we now have electronic health records, and health systems and health care information technology companies are starting to make sense of all this data to improve outcomes and costs. You are starting to see some artificial intelligence applications as well.
IT: Every reform you mention would be enormously enhanced if deployed on a more robust and thorough data platform. The problem is hospitals and insurance companies have neither the expertise nor incentives to scale this up.
Take some of the cultural issues you mentioned contributing to the overall poor health of the US population. The US system is more “sick care” than health care; many more resources are devoted to fixing than preventing. Well, the only way to change that is to introduce personal accountability by rewarding the desired behavior. The Apple Watch can collect some basic but relevant personal data over long periods of time in a very efficient and economical manner. If the insurers really cared about the well-being of their customers, they would all cover putting a basic version of Apple Watch on people’s wrists and use this data to give them a break on their insurance premiums. Once the platform is out there and open to third-party developers, there would be no shortage of creative models for how to foster healthier living through such incentives. A portion of the insurers’ savings could also flow back to Apple and the app developers.
The biometrics on the Apple Watch are still pretty rudimentary, but the company has all sorts of other patents pending for blood pressure sensors, sweat analysis of blood sugar and blood alcohol content, and different types of motion detectors. The other major tech players clearly have a role to play as well. Apple stands out for its expertise in hardware solutions and the strength of its operating system, but Google probably has the strongest AI and data analytics capabilities to process all this data and help patients and their providers make smarter decisions. Amazon is still king of e-commerce and logistics, which will be key in closing the loop between those smart decisions and implementation in the real world through things like low-cost drug refills, mail-in tests and telemedicine, and more transparent pricing between vendors.
Not everyone is a biohacker trying to optimize their output. As a health care IT executive once told me, “Silicon Valley tends to overestimate the health curiosity of the individual.”
PT: It seems obvious that if the people in the US ate less and worked out more our health outcomes would be better. But not everyone is a biohacker trying to optimize their output. As a health care IT executive once told me, “Silicon Valley tends to overestimate the health curiosity of the individual.”
We are already seeing a big move towards value-based reimbursement models that encourage savings, and the health care system is investing heavily in developing the technology and contracts to make it work. In my view, a company like UnitedHealth is just way better positioned to drive these changes. In addition to their traditional insurance operation and growing portfolio of primary and urgent care facilities, they own OptumInsight, which is a leading data and analytics platform used by 9 out of 10 US hospitals. It spends almost US$4 billion a year on tech and innovation and has products designed to tackle waste in the system. In places where OptumHealth, UnitedHealth’s soup-to-nuts data-driven insurance and provider offering, has been in the market for a while, their cost of care is already 30% lower than comparable fee-for-service Medicare.
When you reference the transition away from sick care, what you are really getting at is population health management. Again, this is already happening, and the change is coming from inside the system. Optum, as an example, helps with biometric solutions and on-site services and wellness coaching. Just giving people data on an Apple Watch doesn’t really do anything. Measuring your steps and heart rate only helps at the margin. You need outreach to make it work.
IT: Who is better at outreach than Amazon? Amazon Prime has nearly 150 million US subscribers. Every time they check out of their cart is another opportunity to serve them a reminder about better choices they could be making about their health.
PT: I’m not saying the tech companies aren’t part of the solution, but I see them more as data suppliers and an alternative distribution source than the ones really instigating change. I thought it was interesting that Amazon’s own chief medical officer, TV medical pundit Vin Gupta, recently just about acknowledged as much. Speaking of which, the most direct way to lower costs and improve outcomes is detecting disease early. I’m personally very excited about all the innovation in “liquid biopsies” that scan the body for circulating cancer cells and other very early signs of disease. GRAIL, a company now in the process of being reacquired by Illumina, has shown some impressive data and I expect their Galleri test to become a routine part of the annual bloodwork ordered by physicians. The more and better tests of this kind that are administered, the better the insights will be that come from all your Big Tech big data analysis.
IT: Yes, and I would expect GRAIL to eventually develop a mail-in version of the test and sell it on Amazon.
Patrick, if I didn’t know better, I would say we are approaching a consensus over what needs to be done, and at this point mainly haggling over who does it and in what order. I think change will accelerate when the Big Tech companies can make wearables and other related technologies widely available enough to unlock the data flow in a more powerful way, creating new incentives and behaviors from many of the same actors—hospitals, pharma, and insurers. It’s like the same cast of characters playing a historical drama instead of a horror movie. The result will be savings to patients and their employers, savings to insurers and providers, and a cut of those savings flowing back to the tech companies. As you know, for years “health care TBD” has been part of my long-term valuation model for Apple. I should thank you for helping me understand now how that will play out.
PT: You’re welcome, I guess. Except I’m skeptical that Big Tech really wants to disrupt health care. They want the consumer data, and they want access to that gigantic profit pool. Saying they are “bending the cost curve” is just part of their sales pitch. Let’s be honest, what does real disruption in US health care look like? It’s called single-payer health insurance, aka Medicare For All, but I’m not holding my breath waiting for that to happen.
IT: And if you do (hold your breath) be sure to download Apple Watch’s new Blood Oxygen app first. It’s really cool!
What did you think of this piece?
Multi-Asset
The GameStop debacle, and the meme stock phenomenon more broadly, certainly fit that category. The story bears all the hallmarks of a Hollywood script: how a ragtag group of mostly retail investors, armed with commission-free trading apps and loosely coordinated across online message boards, executed a colossal short squeeze on the hedge funds betting against a down-at-its-heels brick-and-mortar video game retailer while inflicting bloody noses on some of Wall Street’s supposedly most-sophisticated operators. Predictably, several films are already in the works. But beyond the thrill of extravagant market pyrotechnics served up with a generous side of schadenfreude at seeing the odd master of the universe brought low by the great unwashed, why should we care?
Market manipulation is hardly new, and short sellers have always been a vulnerable target. The algebra of short selling, where the size of a losing position balloons ever higher as losses accumulate, is such that short sellers are forever in danger of being squeezed. Wait too long to cover or, worse yet, fail to rebalance at all, and you risk being wiped out. No surprise then that short selling for profit (as opposed to for hedging) is the province of dedicated specialists.
Despite their somewhat louche reputation, attested to by the prevalence of short-selling bans that reflexively blossom every time the market wilts, short sellers are nonetheless a key part of a healthy market ecosystem. A healthy market, one that allocates capital to its most productive use at the lowest possible cost, is predicated on many financial species with different time horizons, preferences, and liquidity needs co-existing in symbiosis. Despite what the textbooks might say, liquidity and price discovery are not created in a vacuum; they spring from the unceasing dance between three types of market inhabitants: long-term investors, arbitrageurs, and liquidity providers. Long-term investors attempt to steer capital towards its most productive use, arbitrageurs improve price discovery by correcting the occasional mis-pricings that emerge between assets with similar payoffs, and liquidity providers lubricate transactions, which helps to shrink transaction costs. If any one of these groups grows too dominant, the dance can quickly turn into a scrum.
It may be too early to add dedicated short selling to the long list of business models disrupted by the internet just yet, but it’s safe to assume that the shorts’ cost of capital has gone up.
Dedicated short sellers are a rare breed of arbitrageur whose relatively small number and modest asset base belie their importance. Much like value investors, whose tendency to buy when others are selling has a stabilizing effect on falling markets, short selling has a similar calming effect in the opposite direction. By leaning against unwarranted price increases, short sellers are a counterweight to market excess, one that makes for a more hospitable environment for beta grazers and alpha hunters alike. In helping to expose flimsy business models, ferret out accounting malfeasance, and unearth cases of outright fraud, short sellers are natural predators that benefit the market’s ecology. Enron, Lehman Brothers, Valeant, and, more recently, Wirecard and Luckin Coffee all owe their comeuppance in large part due to the sleuthing of dedicated short sellers.
Although short sellers are at the center of the GameStop saga, most of the ink spilled has focused on the more conspicuous elements of the story: the evident power of massed retail investors, their copious use of derivatives to magnify leverage, and the populist tendencies that seemingly motivated many of the squeeze’s participants. What has received less coverage is the potential impact of meme stock manias on market structure.
On the face of it, the debacle mirrors many previous episodes of market manipulation, no different, say, than the Hunt brothers ill-fated attempt to corner the silver market in 1980. But there is a crucial difference. A conspiracy to manipulate markets pre-supposes a central origin, a mastermind to hatch the plot before putting it into action. But on this occasion the conspiracy, such as it was, emerged spontaneously. It began with local, seemingly random interactions online that began to feed on themselves in an accelerating feedback loop.
There was no syndicate head, no directives whispered into disposable cell phones, no encrypted texts, none of the subterfuges typically associated with a conspiracy. Quite the contrary, discussions were held in the open, within freely accessible (albeit anonymous) web forums, where anyone was able to proffer their views about the fundamental value of the business, comment on the high short interest, or add an opinion about the implications of the tight float of underlying shares outstanding.
Decentralized and self-organizing short squeezes that materialize spontaneously represent a new type of concern for regulators because it’s unclear which rules, if any, are being violated. Moreover, it’s far from clear what mechanisms can be put in place to prevent it from happening again. But while this may be a headache for regulators, it represents an existential threat to short sellers. It may be too early to add dedicated short selling to the long list of business models disrupted by the internet just yet, but it’s safe to assume that the shorts’ cost of capital has gone up.
The impact of this new regimen on short sellers is impossible to gauge with any precision. They are a secretive bunch, after all. But we can guess at their travails by looking at the performance of the most shorted stocks as represented by the Citibank US Short Interest Equity Index. The index is akin to a long/short portfolio constructed according to the level of short activity for each stock in the Russell 3000, measured as the ratio of the amount of stock on loan relative to its overall trading volume. After ranking stocks according to this ratio and removing stocks with the most extreme metrics such as high borrow cost, the index simply shorts the 10 percent of stocks with the highest short ratio and goes long the 10 percent of stocks with the lowest short ratio. Historically, simulating short sellers in this way has been a profitable strategy: from its inception in June 2015 through the end of 2019 the index generated a cumulative return of 35%, with a highly respectable return to risk (Sharpe ratio) of close to one. At the onset of the pandemic in early 2020, which coincided with a jump in retail trading reminiscent of the tech bubble, the index collapsed. Over the following months it gave up almost its entire accumulated historical performance before reaching its nadir in January of this year, just as the GameStop episode reached its crescendo. Given the index’s long exposure to the least-shorted stocks, it likely understates the actual damage inflicted on many actual short sellers.

Source: Bloomberg

It’s a truism that no one enjoys losing money, ever. And if the performance of the index is indicative of the damage inflicted on short sellers, we can expect an imminent thinning of their ranks and with it a weakening of their stabilizing influence.
There is a small town in Thailand whose large population of macaque monkeys draws a steady stream of tourists. The locals sell bananas to the tourists who feed them to the monkeys. When the flow of tourists dried up during the pandemic, this balance was thrown into turmoil. Within weeks, the town was overrun by gangs of starving monkeys. Whole neighborhoods were declared no-go areas by authorities after videos of rampaging monkeys went viral.
It’s probably a stretch to claim that having fewer short sellers would have quite such a dramatic impact on market structure as the loss of tourists had on this Thai town, or that the monkeys are now calling the shots, but markets are notoriously susceptible to unforeseen events. A seemingly inconsequential disturbance in one area can ripple out, propagating and growing until it ultimately leads to systemwide effects. While our attention is often drawn to conspicuous price movements, it’s easy to overlook the veiled institutional or structural changes that sometimes precede and may even precipitate them. Bananas, anyone?
It’s a truism that no one enjoys losing money, ever. And if the performance of the index is indicative of the damage inflicted on short sellers, we can expect an imminent thinning of their ranks and with it a weakening of their stabilizing influence.
There is a small town in Thailand whose large population of macaque monkeys draws a steady stream of tourists. The locals sell bananas to the tourists who feed them to the monkeys. When the flow of tourists dried up during the pandemic, this balance was thrown into turmoil. Within weeks, the town was overrun by gangs of starving monkeys. Whole neighborhoods were declared no-go areas by authorities after videos of rampaging monkeys went viral.
It’s probably a stretch to claim that having fewer short sellers would have quite such a dramatic impact on market structure as the loss of tourists had on this Thai town, or that the monkeys are now calling the shots, but markets are notoriously susceptible to unforeseen events. A seemingly inconsequential disturbance in one area can ripple out, propagating and growing until it ultimately leads to systemwide effects. While our attention is often drawn to conspicuous price movements, it’s easy to overlook the veiled institutional or structural changes that sometimes precede and may even precipitate them. Bananas, anyone?
What did you think of this piece?
Behavioral Finance
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.
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.
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.
What did you think of this piece?
Behavioral Finance
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.
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.
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.”
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.
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.
What did you think of this piece?
Fundamental Analysis
Indeed, when I started my career in investing in the late 1970s, obtaining even basic financial info about a German car company still required going to Germany and knocking on the company’s door.
Now gathering information no longer takes much effort. We are deluged by floods of data—not only the details of prices, volumes, margins, and capital investments of individual companies, but also highly granular data about credit card receipts, numbers of cars in parking lots, or words used in media reports. These new, “alternative” sources of information have briefly given some stock pickers a slight edge in predicting short-term stock price movements. The informational advantage provided by such data is but fleeting, however; once this data is commercially accessible to everyone, the advantage disappears. Thus, even for the short-term investor, information gathering itself no longer provides a lasting edge.
For long-term investors, the relationship to information has changed even more fundamentally. You no longer need to seek information; it finds you. Your job, rather, is to act as what Lou Gerstner, the former CEO of IBM, called an “intelligent filter”—determining the information that is important and ignoring data that (in the case of the investor) doesn’t help you forecast cash flows and estimate the value of a security.
The fact that filtering information is the long-term investor’s task, of course, doesn’t prevent most from feverishly pursuing every bit of information they can about the companies they follow. Egged on by the 24/7 news cycle, internet chat rooms, and by data providers to know their companies in as much depth as possible, investors often seek to become experts in every aspect of each company’s business. It’s dubious whether this helps them make better estimates of what a company’s shares are worth. Instead, the evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.
The evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.
In one unpublished study, described in Winning Decisions by J. Edward Russo and Paul J. H. Schoemaker, people who handicap horse races were asked to predict, based on increasing amounts of information, which horse would win a race. They found that, beyond a very limited amount of data, forecast accuracy did not improve with more data, but the handicappers’ confidence in their forecasts continued to grow with each extra bit of information.
Knowing more makes you feel better, in other words, but doesn’t help your decision-making. In investing, feelings and actual results arguably are even more disconnected. After all, feeling good about a decision is rarely a help in successful investing—to have a good outcome, an investment view must be different from that of most other investors, and standing apart from the herd almost always leads to discomfort.

Sitting on Our Asses

The job of an investment analyst, then, when forecasting a company’s business prospects and the price that should be paid for its stock is to distinguish between what is important—the signal—and what is useless noise. That’s what we do at Harding Loevner. Our “common language” is designed to guide investment collaboration by helping us focus on low-frequency signals that are important to a long-term investment thesis and avoid being distracted by torrents of high-frequency information that obscure the relevant underlying issues.
We recognize that our industry has an extensive tradition of emphasizing high-frequency signals to induce transacting. In the past, much of the revenue associated with financial services was transaction-based. Brokers were paid only when customers transacted (indeed, when I started my career, so were investment managers!). Unsurprisingly, brokers devoted great effort to stimulating customers to act. Customers responded as you’d expect them to—humans like action, not sitting still. Although the investment management industry has shifted in recent years to replace commissions with asset-based fees, there remains a popular expectation that a good investor will be active, including taking advantage of the most readily available and highest-frequency bits of information: stock price movements (both up and down).
Few investors, though, are able to capture any benefit from high-frequency signals. Our analysts don’t even look at stock prices until a company has been thoroughly researched and qualified as meeting our quality and growth criteria, its long-term cash flows have been forecast, and the fair value of its shares estimated.
Stock prices are much more volatile than the underlying qualities of the business they are supposed to reflect. Investors should remember the words of Charlie Munger, who said successful investing is a matter of “finding a few great companies, then you can sit on your ass.”1 Of course, while we spend a lot of time following Mr. Munger’s advice, that doesn’t mean we are sitting still. We are constantly questioning our assumptions, testing our hypotheses, updating our information and, occasionally, as a result, changing our minds. Usually, though, ignoring the calls of those whose business model, if not entire worldview, revolves around urging you to move is the key to success.

Compounding the Effect

An investment process structured around the long term, and asking questions about long-term strategy not short-term results, will focus on a few fundamental signals that show a company’s progress in creating value for its shareholders. It will focus on competitive structure of an industry, and durable competitive advantages, rather than on the outcomes of the recent past. It will take what you’ve learned and use that to forecast a company’s investments in its business and the cash flows those investments should generate over long periods of time. Only then can you make an informed guess as to what a company is worth and compare it to what the market is inviting you to pay.
A process focused on the long term also recognizes the importance of compounding—that over a long holding period, even if you did overpay, the rate at which a company continually reinvests its cash flows will be a much more important contributor to your return. In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

Humans invariably underestimate this phenomenon. Compound interest is one of the wonders of the world, yet few people understand how powerful it is. It appears our brains are designed to deal with linear, not exponential progressions.
If there was any doubt about our difficulty in intuiting the power of exponential growth rates, look at how unperturbed most people were a year or so ago when COVID-19 began spreading, first in tiny increments. People could not grasp what the impact of a very standard exponential growth curve could be until it was sloping nearly vertically upwards.
A long investment time-horizon also benefits from the long term being more predictable, despite being the sum of a series of short-terms. When some luck is involved, individual outcomes are unpredictable, but the rules of probability dominate as the number of independent trials and outcomes increase. The outcome of a single spin of a roulette wheel, a roll of dice, or draw of a card is unpredictable, but in the long run the house’s victory is as near a certainty as we can get in this world.
Our job is to turn the coins we toss into unevenly weighted ones, by being disciplined about the information we use, diligent in our research, and allowing the companies in which we invest our clients’ capital to do the heavy lifting for us.

Endnotes

1Charlie Munger, Berkshire Hathaway Annual Meeting, 2000.
The job of an investment analyst, then, when forecasting a company’s business prospects and the price that should be paid for its stock is to distinguish between what is important—the signal—and what is useless noise. That’s what we do at Harding Loevner. Our “common language” is designed to guide investment collaboration by helping us focus on low-frequency signals that are important to a long-term investment thesis and avoid being distracted by torrents of high-frequency information that obscure the relevant underlying issues.
We recognize that our industry has an extensive tradition of emphasizing high-frequency signals to induce transacting. In the past, much of the revenue associated with financial services was transaction-based. Brokers were paid only when customers transacted (indeed, when I started my career, so were investment managers!). Unsurprisingly, brokers devoted great effort to stimulating customers to act. Customers responded as you’d expect them to—humans like action, not sitting still. Although the investment management industry has shifted in recent years to replace commissions with asset-based fees, there remains a popular expectation that a good investor will be active, including taking advantage of the most readily available and highest-frequency bits of information: stock price movements (both up and down).
Few investors, though, are able to capture any benefit from high-frequency signals. Our analysts don’t even look at stock prices until a company has been thoroughly researched and qualified as meeting our quality and growth criteria, its long-term cash flows have been forecast, and the fair value of its shares estimated.
Stock prices are much more volatile than the underlying qualities of the business they are supposed to reflect. Investors should remember the words of Charlie Munger, who said successful investing is a matter of “finding a few great companies, then you can sit on your ass.”1 Of course, while we spend a lot of time following Mr. Munger’s advice, that doesn’t mean we are sitting still. We are constantly questioning our assumptions, testing our hypotheses, updating our information and, occasionally, as a result, changing our minds. Usually, though, ignoring the calls of those whose business model, if not entire worldview, revolves around urging you to move is the key to success.
An investment process structured around the long term, and asking questions about long-term strategy not short-term results, will focus on a few fundamental signals that show a company’s progress in creating value for its shareholders. It will focus on competitive structure of an industry, and durable competitive advantages, rather than on the outcomes of the recent past. It will take what you’ve learned and use that to forecast a company’s investments in its business and the cash flows those investments should generate over long periods of time. Only then can you make an informed guess as to what a company is worth and compare it to what the market is inviting you to pay.
A process focused on the long term also recognizes the importance of compounding—that over a long holding period, even if you did overpay, the rate at which a company continually reinvests its cash flows will be a much more important contributor to your return. In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.
In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.
Humans invariably underestimate this phenomenon. Compound interest is one of the wonders of the world, yet few people understand how powerful it is. It appears our brains are designed to deal with linear, not exponential progressions.
If there was any doubt about our difficulty in intuiting the power of exponential growth rates, look at how unperturbed most people were a year or so ago when COVID-19 began spreading, first in tiny increments. People could not grasp what the impact of a very standard exponential growth curve could be until it was sloping nearly vertically upwards.
A long investment time-horizon also benefits from the long term being more predictable, despite being the sum of a series of short-terms. When some luck is involved, individual outcomes are unpredictable, but the rules of probability dominate as the number of independent trials and outcomes increase. The outcome of a single spin of a roulette wheel, a roll of dice, or draw of a card is unpredictable, but in the long run the house’s victory is as near a certainty as we can get in this world.
Our job is to turn the coins we toss into unevenly weighted ones, by being disciplined about the information we use, diligent in our research, and allowing the companies in which we invest our clients’ capital to do the heavy lifting for us.
1Charlie Munger, Berkshire Hathaway Annual Meeting, 2000.
What did you think of this piece?
Fundamental Analysis
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?
[/vc_column][/vc_row]

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

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

Getting much better distribution and administration of vaccines suddenly becomes more urgent. As health officials have emphasized, the more the virus is contained, the less opportunity that variants will have to replicate and gain a larger foothold in a population. Mask-wearing, handwashing, and social distancing take on similarly elevated importance in this game of viral Whack-a-Mole. It seems overly optimistic, however, to think that the variants won’t soon become more prevalent regardless, including in the US, and that we won’t just as soon need new tools to combat them. One big plus about many of the new vaccines is that they can be modified quickly, increasing manufacturers’ ability to issue booster shots specifically aimed at the variants. But can vaccine updates be issued quickly enough to prevent added waves of infection and forestall still more variants from popping up? Let’s hope.
Based on conference calls I’ve been on with the vaccine manufacturers, and research I’ve read about the nature of the virus, it is surprising, and, frankly, a bit alarming, that so many viable variants are out there this soon. The rationale given now by scientific experts is that uncontrolled spread for too long gave the virus more chances to find better ways of eluding our immune systems. RNA viruses replicate for speed and aren’t good at “checking their work,” so the vast majority of mutations are just mistakes that typically function to weaken the virus and thus immediately go extinct. However, there has always been a small probability that some of these copying errors would confer a benefit on the virus. It is akin to rolling dice and having them come up ones 10 times in a row—if you roll 1 trillion times instead of 100 billion, there’s a decently higher chance of that happening. Still, in the lifecycle of a virus such a pace of snake-eye streaks typically isn’t seen until after we apply more Darwinian pressure and the organism is forced to mutate to survive. It’s disappointing that we’re getting so many variants at this juncture, but it wouldn’t be surprising if the pattern continues. It is also possible we could have another burst of variants to contend with once the virus has finally been brought under control and feels truly cornered.
As a healthy male in my early-40s, I’m less concerned about severe disease and hospitalization once I get vaccinated, but I am concerned about the risk of being a “long hauler,” one of the estimated 10% of COVID-19 patients who experience debilitating symptoms for months or potentially years (or longer—we just don’t know) after the initial infection has run its course. I’ve met two long haulers in the last month and they are both in the 45–55 age range. We have no idea yet, for any of these vaccines, what the reduction in risk of being a long hauler is.
So, as for life returning to “2019”? I don’t think that’s going to happen this year. If you get vaccinated by the summer, you’ll be better protected, but my expectation is that the new and future variants will become the dominant strains in the coming months, and so you won’t be 95% protected, more like somewhere in the 50–60% protection range, although with much higher protection against severe disease. To me, that’s still definitely not enough to return to greeting someone outside my family with a European faux kiss on the cheek.
As I wrote to this analyst and the rest of the group, my honest answer is: it’s very hard to say at this point. Beyond the manufacturing and distribution challenges he references, the most troubling recent news involves the increasing prevalence of COVID-19 mutations such as the B.1.1.7 variant that first emerged in the UK and the B.1.351 that originated in South Africa. Since mid-January, there has been mounting concern that some of these variants, in addition to being more contagious, might also be more resistant to the vaccines that have already been developed. The latest study results for a pair of vaccines still awaiting approval—one from Novavax and another from our portfolio holding Johnson & Johnson (JNJ)—confirm that at least for the South African variant this is indeed the case, as both vaccines showed reduced efficacy in preventing infection in South Africa, where B.1.351 is dominant. For the Novavax trial, the reduction in infection rates in the UK was 89%, compared to just 60% in South Africa. For JNJ’s vaccine, the reduction in infection rates was 72% in the US versus just 57% in South Africa. In other words, these vaccine candidates are still capable of dramatically reducing severe COVID-19, but aren’t capable of reducing the viral load enough to lower infection rates as dramatically as we had come to expect from Pfizer and Moderna’s vaccines, whose blockbuster phase 3 trial results in late 2020 were for populations not yet exposed to B.1.351. While the follow-up data are still preliminary, expectations for how those vaccines perform against the variant probably now need to be lowered as well.
If you get a vaccine by the summer, you’ll be better protected, but my expectation is that the new and future variants will become the dominant strains in the coming months, and so you won’t be 95% protected, more like somewhere in the 50-60% protection range.
Getting much better distribution and administration of vaccines suddenly becomes more urgent. As health officials have emphasized, the more the virus is contained, the less opportunity that variants will have to replicate and gain a larger foothold in a population. Mask-wearing, handwashing, and social distancing take on similarly elevated importance in this game of viral Whack-a-Mole. It seems overly optimistic, however, to think that the variants won’t soon become more prevalent regardless, including in the US, and that we won’t just as soon need new tools to combat them. One big plus about many of the new vaccines is that they can be modified quickly, increasing manufacturers’ ability to issue booster shots specifically aimed at the variants. But can vaccine updates be issued quickly enough to prevent added waves of infection and forestall still more variants from popping up? Let’s hope.
Based on conference calls I’ve been on with the vaccine manufacturers, and research I’ve read about the nature of the virus, it is surprising, and, frankly, a bit alarming, that so many viable variants are out there this soon. The rationale given now by scientific experts is that uncontrolled spread for too long gave the virus more chances to find better ways of eluding our immune systems. RNA viruses replicate for speed and aren’t good at “checking their work,” so the vast majority of mutations are just mistakes that typically function to weaken the virus and thus immediately go extinct. However, there has always been a small probability that some of these copying errors would confer a benefit on the virus. It is akin to rolling dice and having them come up ones 10 times in a row—if you roll 1 trillion times instead of 100 billion, there’s a decently higher chance of that happening. Still, in the lifecycle of a virus such a pace of snake-eye streaks typically isn’t seen until after we apply more Darwinian pressure and the organism is forced to mutate to survive. It’s disappointing that we’re getting so many variants at this juncture, but it wouldn’t be surprising if the pattern continues. It is also possible we could have another burst of variants to contend with once the virus has finally been brought under control and feels truly cornered.
As a healthy male in my early-40s, I’m less concerned about severe disease and hospitalization once I get vaccinated, but I am concerned about the risk of being a “long hauler,” one of the estimated 10% of COVID-19 patients who experience debilitating symptoms for months or potentially years (or longer—we just don’t know) after the initial infection has run its course. I’ve met two long haulers in the last month and they are both in the 45–55 age range. We have no idea yet, for any of these vaccines, what the reduction in risk of being a long hauler is.
So, as for life returning to “2019”? I don’t think that’s going to happen this year. If you get vaccinated by the summer, you’ll be better protected, but my expectation is that the new and future variants will become the dominant strains in the coming months, and so you won’t be 95% protected, more like somewhere in the 50–60% protection range, although with much higher protection against severe disease. To me, that’s still definitely not enough to return to greeting someone outside my family with a European faux kiss on the cheek.
What did you think of this piece?
Multi-Asset
For a vociferous minority, the only bankable hedge for inflation is gold. For them, every spike in the gold price is reproof of government perfidy and foreshadows an inflationary surge. The evidence linking gold’s price and inflation, however, is curiously threadbare. If gold is an unreliable hedge against rising prices, what role, if any, should it play in a portfolio?
Gold as Currency

Gold, having shed its function as a means of exchange and unit of account, is still used as a store of value. Its inflation-hedging bona fides spring from the notion that, unlike other stores of value, it cannot be debased. Central bankers have the power to conjure fiat money at the stroke of a keyboard, but they are powerless when it comes to the quantity of gold. The price of gold may vary from day to day, but with a fixed supply on the order of 250,000 tons, of which one fifth remains lodged in the earth’s crust waiting to be mined, scarcity ensures that over long time spans its purchasing power remains intact. In 1934 an ounce of gold would have set you back US$26; had you buried it in the ground only to dig it up today, 86 years later, it would be worth almost US$2,000. Not a bad return when you consider that a paper dollar lost approximately 99% of its purchasing power in the interim.
But, of course, this simple illustration is dreadfully misleading. It is true that, had you let slip a dollar bill down the back of the couch while resting after burying your gold some 86 years ago, that dollar bill would buy you far fewer goods at the cash register today. Most dollars, however, are not left lying around to gather dust; they are deposited for safekeeping and, until recently, they earned interest. Fairer would be to evaluate gold relative to what you would have earned holding cash on deposit. According to Barro and Misra1, the long-term compounded return on cash (T-Bills), after accounting for inflation, has been 1% per year, just shy of gold’s 1.1% real return. Gold may have won by a nose, but that extra 10 basis points came at the expense of frequent eye-watering price fluctuations and the occasional sleepless decade.

Echoes of the Gold Standard

It turns out that gold’s reputation as an inflation hedge is really founded on just two episodes: the end of the gold standard and the oil shock of 1979. Between 1971 and 1975 the price of gold quadrupled as the US severed the official link between the US dollar and gold. Again between 1977 and 1980 the price of gold tripled as the inflationary impact of the second oil shock rippled through the entire energy-dependent supply chain. Outside of these two peculiar instances, the relationship between gold and inflation largely falls apart. Remove just the years of 1974, 1979, and 1980, and as we can see the positive correlation between inflation and gold disappears entirely.

Figure 1: Correlation between change in Gold price vs. Inflation 1971-2020

If inflation isn’t driving the gold price, what is? The evidence suggests that a big part of what’s moving gold prices are real interest rates—or the difference between 10-year treasury yields and inflation—whose movements up or down are an important indicator of the underlying state of an economy and its expected growth. This inverse relationship between gold and real rates is born out in the next figure, which shows yearly changes in the price of gold and real interest rates from 1971 to 2020. The large increases in the gold price in 1974, 1979, and 1980, in addition to the price spikes of 2011 and 2020, all occurred against a backdrop of negative real rates. Correspondingly, the gold price declines of the early ’80s coincided with soaring real rates, a consequence of the tight monetary policy enacted during Paul Volker’s chairmanship of the US Federal Reserve.

This relationship between real rates and gold echoes the historical linkages between gold and the US dollar. Under a gold standard, because currency values in terms of gold were fixed, trade imbalances between countries were routinely resolved by a physical flow of gold. Gold would flow into countries that exported more than they imported and had high real exchange and interest rates, and out of countries where the opposite conditions held. But under a fiat system, where currency values in terms of gold are no longer fixed, real interest rates continue to exercise their pull, except now rebalancing occurs with a change in the price of gold instead of a flow. Perhaps because of its ongoing role as a central bank reserve asset and store of value, gold behaves like a shadow currency. A currency where, absent the prospect of a future cashflow, assessing how much to own comes down to what else you could be doing with that fraying dollar bill.

Hedging Inflation: It Depends

Just because gold has kept pace with the price of goods and services does not make it an effective inflation hedge in every scenario. And that’s because the alternate sources of expected inflation—diminished supply versus excess demand—have drastically different implications for real rates and hence for hedging strategies. If you think the world is in the thick of a deflationary or stagflationary bust that will depress real interest rates, then by all means buy gold. The current pandemic, like natural disasters more broadly, can certainly fit the pattern and to the extent it continues to depress consumption could still prove to be one of those kinds of periods. But if you are concerned about monetary excess, adding gold to a portfolio may turn out to be futile and may even magnify risks. If central bankers succeed in reviving inflation by stimulating demand growth, then we should also expect real rates to increase and the gold price to weaken. In that scenario, to hedge inflation you are better off buying TIPS and selling conventional bonds.
It’s only fair to point out that any notional horse race between gold and other assets assumes a functioning financial system nested in a stable society—not an unreasonable assumption for an optimist. But you don’t have to peer too far back in history to find examples of conflict, dispossession and collapse. Beyond keeping up with the price level, part of gold’s appeal lies in its tantalizing potential to ward off financial devastation. Although, if society deteriorates and its ability to function looks dicey, the risk of confiscation also shoots up and your chances of avoiding devastation by holding onto your lump of gold decline precipitously. This makes gold a bit like owning an out-of-the-money put option on social collapse underwritten by an ultimately insolvent counterparty. There is no chance of collecting, but at least its value should rise when people are fearful.

Endnotes

1Robert Basra and Sanjay Misra, National Bureau of Economic Research, “Gold Returns,” NBER Working Paper Series (February 2013).
Gold, having shed its function as a means of exchange and unit of account, is still used as a store of value. Its inflation-hedging bona fides spring from the notion that, unlike other stores of value, it cannot be debased. Central bankers have the power to conjure fiat money at the stroke of a keyboard, but they are powerless when it comes to the quantity of gold. The price of gold may vary from day to day, but with a fixed supply on the order of 250,000 tons, of which one fifth remains lodged in the earth’s crust waiting to be mined, scarcity ensures that over long time spans its purchasing power remains intact. In 1934 an ounce of gold would have set you back US$26; had you buried it in the ground only to dig it up today, 86 years later, it would be worth almost US$2,000. Not a bad return when you consider that a paper dollar lost approximately 99% of its purchasing power in the interim.
But, of course, this simple illustration is dreadfully misleading. It is true that, had you let slip a dollar bill down the back of the couch while resting after burying your gold some 86 years ago, that dollar bill would buy you far fewer goods at the cash register today. Most dollars, however, are not left lying around to gather dust; they are deposited for safekeeping and, until recently, they earned interest. Fairer would be to evaluate gold relative to what you would have earned holding cash on deposit. According to Barro and Misra1, the long-term compounded return on cash (T-Bills), after accounting for inflation, has been 1% per year, just shy of gold’s 1.1% real return. Gold may have won by a nose, but that extra 10 basis points came at the expense of frequent eye-watering price fluctuations and the occasional sleepless decade.
It turns out that gold’s reputation as an inflation hedge is really founded on just two episodes: the end of the gold standard and the oil shock of 1979. Between 1971 and 1975 the price of gold quadrupled as the US severed the official link between the US dollar and gold. Again between 1977 and 1980 the price of gold tripled as the inflationary impact of the second oil shock rippled through the entire energy-dependent supply chain. Outside of these two peculiar instances, the relationship between gold and inflation largely falls apart. Remove just the years of 1974, 1979, and 1980, and as we can see the positive correlation between inflation and gold disappears entirely.
If inflation isn’t driving the gold price, what is? The evidence suggests that a big part of what’s moving gold prices are real interest rates—or the difference between 10-year treasury yields and inflation—whose movements up or down are an important indicator of the underlying state of an economy and its expected growth. This inverse relationship between gold and real rates is born out in the next figure, which shows yearly changes in the price of gold and real interest rates from 1971 to 2020. The large increases in the gold price in 1974, 1979, and 1980, in addition to the price spikes of 2011 and 2020, all occurred against a backdrop of negative real rates. Correspondingly, the gold price declines of the early ’80s coincided with soaring real rates, a consequence of the tight monetary policy enacted during Paul Volker’s chairmanship of the US Federal Reserve.
This relationship between real rates and gold echoes the historical linkages between gold and the US dollar. Under a gold standard, because currency values in terms of gold were fixed, trade imbalances between countries were routinely resolved by a physical flow of gold. Gold would flow into countries that exported more than they imported and had high real exchange and interest rates, and out of countries where the opposite conditions held. But under a fiat system, where currency values in terms of gold are no longer fixed, real interest rates continue to exercise their pull, except now rebalancing occurs with a change in the price of gold instead of a flow. Perhaps because of its ongoing role as a central bank reserve asset and store of value, gold behaves like a shadow currency. A currency where, absent the prospect of a future cashflow, assessing how much to own comes down to what else you could be doing with that fraying dollar bill.
Just because gold has kept pace with the price of goods and services does not make it an effective inflation hedge in every scenario. And that’s because the alternate sources of expected inflation—diminished supply versus excess demand—have drastically different implications for real rates and hence for hedging strategies. If you think the world is in the thick of a deflationary or stagflationary bust that will depress real interest rates, then by all means buy gold. The current pandemic, like natural disasters more broadly, can certainly fit the pattern and to the extent it continues to depress consumption could still prove to be one of those kinds of periods. But if you are concerned about monetary excess, adding gold to a portfolio may turn out to be futile and may even magnify risks. If central bankers succeed in reviving inflation by stimulating demand growth, then we should also expect real rates to increase and the gold price to weaken. In that scenario, to hedge inflation you are better off buying TIPS and selling conventional bonds.
It’s only fair to point out that any notional horse race between gold and other assets assumes a functioning financial system nested in a stable society—not an unreasonable assumption for an optimist. But you don’t have to peer too far back in history to find examples of conflict, dispossession and collapse. Beyond keeping up with the price level, part of gold’s appeal lies in its tantalizing potential to ward off financial devastation. Although, if society deteriorates and its ability to function looks dicey, the risk of confiscation also shoots up and your chances of avoiding devastation by holding onto your lump of gold decline precipitously. This makes gold a bit like owning an out-of-the-money put option on social collapse underwritten by an ultimately insolvent counterparty. There is no chance of collecting, but at least its value should rise when people are fearful.
1Robert Basra and Sanjay Misra, National Bureau of Economic Research, “Gold Returns,” NBER Working Paper Series (February 2013).
What did you think of this piece?
Factor Investing
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.
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?
Fundamental Analysis
Value: Patience as a Virtue

Though we are frequently characterized today as “quality growth” investors, the truth is we started from a place of focusing on value. We have always believed that, as Warren Buffet put it, “price is what you pay; value is what you get.” We also recognize that, while the two converge over time, it is impossible to predict when that convergence may occur. Over the years other value-focused investors have come up with various ways of coping with this unpredictability. Some implement value strategies by timing their purchases so there is not only a share price that implies a discount to underlying value, but also a “catalyst” to accelerate that convergence. Another group, among them followers of the father of value investing, Ben Graham, effectively puts a cap on their patience. They buy stocks trading at a discount to value, but if price and value haven’t converged after some period, they move on to another investment. We were young, figured we had time to wait, and saw no need to identify catalysts or impose a time limit for estimated values to materialize in current market prices.

Growth: In Case We Were Wrong

Investment managers with our very fundamental, bottom-up approach to investing spend much effort determining what a share in a company is worth. That entails thinking about a company’s addressable market, market share, the relative power of its suppliers and customers, volumes, prices, and margins, and making forecasts of those variables, and others, many years into the future. Given that we don’t know what will happen tomorrow, let alone several thousand tomorrows from now, these forecasts are never going to be terribly accurate. Once we translate our forecasts into estimates of the company’s future cash flows, we discount those cash flows to a present value using a discount rate. What that discount rate should be is also highly uncertain. At the end of the day, we gain a rough idea of what a share in a company is worth, but one subject to a very large margin of error.

Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.

We liked prospective growth because it can bail us out of those forecasting errors. When we buy a stock, the return we achieve over time will be a function of changes in estimates of its value (i.e., its earnings multiple) and in the growth of its earnings. Changes in the multiple come about through changes in estimates of future cash flows and, if not more important, changes in the rate at which you discount those cash flows. Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.

Quality: The Element of Positive Surprise

Quality came into the process mainly as the way to control risk and boost our odds of success. Quality is related to growth in that a higher-quality company is more likely to make high levels of returns on its capital investments, and to have more growth opportunities in which to invest the cash it generates. But quality is also about financial strength and avoiding the risk of having to rely on a balance sheet that can’t withstand the vagaries of the economy, product cycles, or waves of competitive pressure. Finally, it’s about the ability of management to see opportunities and threats, and to deliver to shareholders the expected returns on growth opportunities.
Ideally, a company will exhibit a track record of such patterns and behaviors that extends across successive management teams—evidence of an enduring company culture that is hard to measure objectively but can lend some degree of confidence to our forecasts amid all the uncertainty. A high-quality company, in other words, is one which will tend to give us pleasant surprises. While we realized we would nearly always be wrong, outcomes can be better than forecast as well as worse. By focusing on high-quality companies, we believed we could skew the distribution of our surprises in the positive, not negative, direction.

Out of Our Minds

Thirty years later, our process has become more structured and systematic, and our methods more refined, but the essential relationship among the core aspects of our investment principles remains very much the same. So has our approach to tackling the intellectual challenges with which we wrestle to this day. Now, as then, we subscribe to a belief that it’s always better to get our thought processes, ideas, arguments, and however-partially baked notions out of our own heads and onto a page, where we are more accountable for them and others can help us make them better. We hope you’ll start looking to this space for more of what comes out of our minds.
Though we are frequently characterized today as “quality growth” investors, the truth is we started from a place of focusing on value. We have always believed that, as Warren Buffet put it, “price is what you pay; value is what you get.” We also recognize that, while the two converge over time, it is impossible to predict when that convergence may occur. Over the years other value-focused investors have come up with various ways of coping with this unpredictability. Some implement value strategies by timing their purchases so there is not only a share price that implies a discount to underlying value, but also a “catalyst” to accelerate that convergence. Another group, among them followers of the father of value investing, Ben Graham, effectively puts a cap on their patience. They buy stocks trading at a discount to value, but if price and value haven’t converged after some period, they move on to another investment. We were young, figured we had time to wait, and saw no need to identify catalysts or impose a time limit for estimated values to materialize in current market prices.
Investment managers with our very fundamental, bottom-up approach to investing spend much effort determining what a share in a company is worth. That entails thinking about a company’s addressable market, market share, the relative power of its suppliers and customers, volumes, prices, and margins, and making forecasts of those variables, and others, many years into the future. Given that we don’t know what will happen tomorrow, let alone several thousand tomorrows from now, these forecasts are never going to be terribly accurate. Once we translate our forecasts into estimates of the company’s future cash flows, we discount those cash flows to a present value using a discount rate. What that discount rate should be is also highly uncertain. At the end of the day, we gain a rough idea of what a share in a company is worth, but one subject to a very large margin of error.
Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.
We liked prospective growth because it can bail us out of those forecasting errors. When we buy a stock, the return we achieve over time will be a function of changes in estimates of its value (i.e., its earnings multiple) and in the growth of its earnings. Changes in the multiple come about through changes in estimates of future cash flows and, if not more important, changes in the rate at which you discount those cash flows. Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.
Quality came into the process mainly as the way to control risk and boost our odds of success. Quality is related to growth in that a higher-quality company is more likely to make high levels of returns on its capital investments, and to have more growth opportunities in which to invest the cash it generates. But quality is also about financial strength and avoiding the risk of having to rely on a balance sheet that can’t withstand the vagaries of the economy, product cycles, or waves of competitive pressure. Finally, it’s about the ability of management to see opportunities and threats, and to deliver to shareholders the expected returns on growth opportunities.
Ideally, a company will exhibit a track record of such patterns and behaviors that extends across successive management teams—evidence of an enduring company culture that is hard to measure objectively but can lend some degree of confidence to our forecasts amid all the uncertainty. A high-quality company, in other words, is one which will tend to give us pleasant surprises. While we realized we would nearly always be wrong, outcomes can be better than forecast as well as worse. By focusing on high-quality companies, we believed we could skew the distribution of our surprises in the positive, not negative, direction.
Thirty years later, our process has become more structured and systematic, and our methods more refined, but the essential relationship among the core aspects of our investment principles remains very much the same. So has our approach to tackling the intellectual challenges with which we wrestle to this day. Now, as then, we subscribe to a belief that it’s always better to get our thought processes, ideas, arguments, and however-partially baked notions out of our own heads and onto a page, where we are more accountable for them and others can help us make them better. We hope you’ll start looking to this space for more of what comes out of our minds.
What did you think of this piece?
*By checking “Opt-In Confirmation,” you consent to receive investment updates from Harding Loevner. You can withdraw your consent at any time. Contact us.
“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.
The information provided is as of the publication date and may be subject to change. Harding Loevner may currently hold or has previously held positions in the securities referenced, but there is no guarantee that Harding Loevner currently owns, or has ever owned, the securities mentioned herein. If Harding Loevner owns any of these securities, it may sell them at any time.
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.
© 2025 Harding Loevner
© 2025 Harding Loevner LP. All Rights Reserved.

Embedded Media

US EV sales by model for the last quarter. ???? https://t.co/qG0at8N6z2 pic.twitter.com/QHEAKBQUqy

— Roland Pircher (@piloly) April 11, 2025