geengraphy/iStock via Getty Images geengraphy/iStock via Getty Images 3 months 1 Year 3 Years 2 5 Years 2 10 Years 2 Since Inception 2,3 HL International Equity (Gross of Fees) -10.23 -2.79 10.53 9.29 8.46 8.48 HL International Equity (Net of Fees) -10.37 -3.39 9.84 8.59 7.80 7.68 MSCI All Country World ex-US Index 4,5 -5.33 -1.04 8.00 7.25 6.04 5.32 MSCI EAFE Index 5,6 -5.79 1.65 8.28 7.22 6.77 5.01 1 The Composite performance returns shown are preliminary 2 Annualized Returns 3 Inception Date: December 31, 1989 4 The Benchmark Index 5 Gross of withholding taxes 6 Supplemental Index.
Please read the above performance in conjunction with the footnotes on the last page of this report.
Past performance does not guarantee future results.
All performance and data shown are in US dollar terms, unless otherwise noted. 7 Includes companies classified in countries outside the Index. 8Includes countries with less-developed markets outside the Index.
Sector and geographic allocations are supplemental information only and complement the fully compliant International Equity Composite GIPS Presentation.
Source: Harding Loevner International Equity Model; MSCI Inc. and S&P.
MSCI Inc. and S&P do not make any express or implied warranties or representations and shall have no liability whatsoever with respect to any GICS data contained herein.
Stock markets fell in the quarter, as the world watched in horror Russia’s invasion of Ukraine.
The reaction by Western governments was swift and emphatic as they sought to tread a delicate balance between punishing Russian aggression and avoiding an escalating military conflict.
The US and its allies enacted crippling economic sanctions against Russia, including freezing a significant share of the Russian central bank reserve assets, cutting off many of the country’s banks from the SWIFT global financial messaging system, and outlawing the export of a variety of industrial and luxury goods.
The revulsion at Russian aggression also provoked an exodus of Western companies from Russian markets.
The sanctions initially led to a collapse in the ruble, forcing the central bank to raise overnight interest rates to 20% per annum to bolster the currency, while the Moscow stock exchange closed for almost a month before re-opening for domestic investors only.
With foreign investors effectively unable to trade, major market index providers expunged all Russian securities from their indices.
Prices for a wide range of commodities for which Russia is a major producer, including oil, gas, grains, and metals, surged on fears of disruption, prompting billions of US dollars in margin calls to cover futures positions.
Geography 1Q 2022 Trailing 12 Months Canada 4.8 21.0 Emerging Markets -6.9 -11.1 Europe EMU -11.1 -3.0 Europe ex-EMU -3.3 11.9 Japan -6.4 -6.1 Middle East -6.8 8.1 Pacific ex-Japan 3.8 3.9 MSCI ACWI ex-US Index -5.3 -1.0 Sector 1Q 2022 Trailing 12 Months Communication Services -6.0 -16.1 Consumer Discretionary -14.3 -21.3 Consumer Staples -7.1 0.5 Energy 7.0 24.0 Financials 1.7 9.8 Health Care -4.8 3.3 Industrials -8.5 -1.3 Information Technology -15.0 -5.1 Materials 5.3 9.9 Real Estate -2.7 -8.5 Utilities -2.3 2.5 Source: FactSet (as of March 31, 2022).
MSCI Inc. and S&P.
Companies held in the portfolio at the end of the quarter appear in bold type; only the first reference to a particular holding appears in bold.
The portfolio is actively managed therefore holdings shown may not be current.
Portfolio holdings should not be considered recommendations to buy or sell any security.
It should not be assumed that investment in the security identified has been or will be profitable.
To request a complete list of holdings for the past year, please contact Harding Loevner.
A complete list of holdings at March 31, 2022 is available towards the end of this report.
Headline inflation, which had already been rising rapidly around the world prior to the invasion, received a fillip from the shock to energy and food supplies stemming from the war, increasing the pressure on central banks to tighten monetary policy.
The Bank of England, along with the South Korean, South African, and Brazilian central banks, continued raising short-term policy rates to beat back rising prices.
In the US, the Federal Reserve lifted rates for the first time since December 2018 and signaled a willingness to do whatever it takes to bring inflation under control, announcing an aggressive rate hike path for the months ahead.
The yield curve flattened dramatically; in March, the US two-year yield briefly exceeded the ten-year yield for the first time since 2019, flashing a recession warning as bond investors bet that higher yields would crimp growth.
The prospect of tighter monetary conditions further undermined the case for highly priced growth stocks, whose expected cash flows, in lying further out into the future, are more sensitive to interest rates.
Through mid-February, just prior to the outbreak of hostilities, the MSCI ACWI ex-US Growth Index had declined nearly 9%, while its value counterpart had actually risen, by nearly 4%.
That large underperformance for growth stocks persisted through the end of the quarter, echoed in an even larger disparity between highly priced stocks and less expensive ones; for non-US markets as a whole the most expensive quintile of stocks fell more than 15%, while the least expensive eked out a small gain.
High-quality companies were no refuge from the sell-off of growth stocks unless they were also in expensive, such as the highly profitable but slower-growing pharmaceutical companies, which outpaced the rest of Health Care by a wide margin.
The poor showing for high-quality companies marked the first time since 2001 that they underperformed in a quarter when the Index declined more than 5%.
Sector performance reflected the meteoric rise in commodity prices caused by supply shocks from war and sanctions, with both Energy and Materials finishing in positive territory.
Demand for commodities could be set to fall, though, given that consumer confidence (critical to the slumping Consumer Discretionary sector) and business confidence (a big influence on swooning Information Technology, or IT, stocks) seem to be flagging.
Financials managed modest gains on the prospect of higher interest rates and wider margins.
Canada was the best performing region, helped by its heavy weight in energy and financial stocks.
In Emerging Markets (EMS), exceptional returns in Brazil were offset by weakness in China, which faces an economic slowdown aggravated by difficulties in maintaining its zero-COVID policy and the government’s attempts to slowly deflate its colossal real estate bubble.
China’s “no limits” friendship with Russia also threatened to expose the country to retaliatory Western economic sanctions.
Worsening the sentiment toward China, the US Securities and Exchange Commission began the procedural implementation of the Holding Foreign Companies Accountable Act, identifying several US-listed Chinese companies whose latest financial reports fail to adhere to US audit standards and could be subject to delisting.
Shortly after, Chinese officials signaled room for compromise on a mutually agreeable auditing framework, suggesting this is at least one area where the sentiment is likely worse than reality.
The International Equity Composite fell 10.2% in the quarter gross of fees, well beyond the 5.3% decline of the MSCI All Country World ex-US Index.
In a quarter during which investors fled from richly priced, high-quality growth companies, it should come as no surprise that, whether viewed through the lens of sector or geographic attribution, our portfolio underperformed within most sectors and regions.
A laundry list of the contributors to underperformance would not improve much on the explanation.
An exception, of course, is the value destruction from our two Russian holdings, Lukoil ( OTCPK:LUKOY ) and Yandex ( YNDX ) , nearly 230 basis points of value wiped off the portfolio, roughly nearly half the total underperformance in the quarter, which dominates whichever category they fall under in any breakdown of returns.
A more informative parsing of returns comes from viewing them according to how they relate to rankings of growth, quality, and valuation.
Viewed through the lens of growth, our efforts to resist a skew towards the most expensive members of the faster-growing quintiles of the market meant that only a modest amount of our underperformance, about 50 basis points, is attributable to our preference for growth businesses.
The rest, like sector or regional attribution, comes across as poor stocks within the different quintiles of growth.
In contrast, our choice to emphasize the highest-quality companies (three-quarters of the portfolio come from the top two quintiles of our quality rankings) has detracted about 180 basis points from relative performance.
The headwind to this leaning is mirrored in a parsing of portfolio returns to valuation, given that high quality and fast growth have both increasingly come only at a high price.
However, much we’ve steadily reduced holdings of highly priced stocks, the portfolio remains skewed toward the expensive end of the market, and that skew has cost about 190 basis points of relative performance. ¹ Includes companies classified in countries outside the Index.
Source: FactSet; Harding Loevner International Equity Composite; MSCI Inc. and S&P.
The total effect shown here may differ from the variance of the Composite performance and benchmark performance shown on the first page of this report due to the way in which FactSet calculates performance attribution.
This information is supplemental to the Composite GIPS Presentation.
Within the highest quality and valuation cohorts, we had some holdings that performed worse than their suddenly out-of- style peers.
In Health Care, shares of Japanese hematology diagnostics equipment maker Sysmex ( OTCPK:SSMXY ) tumbled after it reported issues with its largest distributor in China.
Capital goods holdings underperformed, including Swedish compressor manufacturer Atlas Copco ( OTCPK:ATLKY ) , fluid handling specialist Alfa Laval ( OTCPK:ALFVF ) , French energy solutions provider Schneider Electric ( OTCPK:SBGSF ) , Japanese robot maker Fanuc ( OTCPK:FANUY ) , and Sanhua Intelligent Controls , one of our newer Chinese holdings.
The common threads for these underperformers are their valuation, their diverse multinational footprint, and their dependence on their customers’ confidence in maintaining capital investment.
Within IT, payments specialist Adyen ( OTCPK:ADYYF ) , one of our fastest-growing businesses (and thus one of our priciest), fell heavily even as it surprised with faster-than-expected revenue growth for the latest half-year.
Infineon Technologies ( OTCQX:IFNNY ) , a German manufacturer of power-management chips, also underperformed the IT sector, reflecting European automaker shutdowns due to component supply issues in Ukraine.
Taken together, these drags on relative performance account for more than the 70-basis-point remainder of our shortfall not accounted for by style allocation or the Russian holdings.
That’s because there were some offsets on the positive side, most notably Israeli cybersecurity specialist Check Point ( CHKP ) , Anglo-Australian mining giants Rio Tinto ( RIO ) and BHP ( BHP ) , and Swiss hearing aid maker Sonova Holding ( OTCPK:SONVF ) .
As previously shared in interim communications, we own shares in two Russian companies: Lukoil, a major producer of Russian oil and gas; and Yandex, an internet search engine with diversified communications assets.
As the Russian invasion unfolded in its full horror, we marked down the value of the positions, ultimately to zero when the US-listed shares became untradeable.
Even though the Moscow Stock Exchange resumed trading some of these shares in late March, trading of ADR shares in New York remains closed, and recovering value from these holdings is at best a distant and uncertain prospect, so we continue to hold the securities at a zero value.
We’ve owned shares in Lukoil and Yandex for several years with the view that while a grasping and ruthless government posed political risks, companies able to navigate those risks and build sound growing businesses that deliver highly valued products and services to their customers could nevertheless generate strong business results.
Due to fears of the Russian state’s confiscatory tendencies and corporate governance risks more generally, shares in these companies traded at a discount relative to their global peers, which could lead to strong returns for intrepid investors.
Additionally, these political risks bore almost no correlation to other risks embedded in our portfolio.
In an investment climate where most fast-growing, resilient businesses commanded historically high valuations, Russian shares offered a tempting mix of diversification and inexpensive growth.
In the end, it wasn’t the corporate governance or expropriation risks that proved our undoing, nor even the brutal and unexpected invasion itself.
Instead, it was the resulting broad social revulsion in most developed democracies, which united previously divided or reluctant actors, calling down a ferocious firestorm of nearly inconceivable official and private actions targeting the Russian economy, and in the process also rendering Russian investments held by private Western bystanders effectively worthless.
If anything, the episode will have alerted skeptics to the potency of seemingly remote investment risks, including social ones.
But we must stress that the Russian invasion and the West’s financially fierce response, as dramatic as they are, have merely accelerated the style headwinds we’ve been facing in recent months, as investors retreat from high-priced stocks.
Well before the Ukraine crisis, headline inflation had been rising almost everywhere and intruding on the discount rates used to value shares.
The energy and food shocks emanating from the conflict and consequent sanctions have supercharged the existing trends for expected inflation, bond yields, and equity discount rates, and the prospects for tighter monetary policies to combat the rise in prices.
These trends have the largest effects on the present value (and therefore the current price) of distant future earnings, and thus pointedly on the price of growth stocks whose expected cash flows lie far in the future.
The damage from these style headwinds was almost as great in the first quarter of 2022 as in the prior 14 months, since the first COVID-19 vaccine was approved and the retreat began from higher growth and quality towards less-expensive, lower-growth companies that will earn more of their cash flows in the near and medium term.
The monetary policy tightening now underway by central banks is intended to dampen speculative or less productive demand for goods, services, and assets by raising borrowing costs.
But those policies, when combined with the demand destruction likely to emanate from soaring food and energy prices, may contain the seeds of their own reversal.
If consumer and producer confidence take more than a temporary hit from the war in Ukraine and its ramifications, a recession, either in Europe or more globally, could conspire to reduce the inflationary impulse from COVID-19 re-openings and offset some of the need for monetary tightening.
We’re not in the business of making such forecasts but, were that scenario to unfold, it’s possible that the headwinds for our quality/growth investment style would abate.
Much has been written recently about “the end of globalization” being another result of the war in Ukraine, and about the reluctance of some large countries, notably China and India, to sign onto the sanctions imposed by Western and Asian-Pacific governments.
We, like many observers, worry that China, ostensibly aiming to be neutral, might risk some consequences by facilitating sanctions workarounds for Russia, and misjudge the West’s resolve.
The economic disincentives would appear to work against the possibility.
China’s total trade with Russia in 2020 was around a tenth of its US.4 trillion trade with the US and Europe.
Given China’s flagging growth as it manages its deflating property market, a multi-year prospect, if previous property bubbles are anything to go by, and its stated priority to improve “common prosperity” for its people, the last thing it’s likely to want is to impair its access to the global trading system and court rejection by its largest customers.
Indeed, the statement by economic policy czar and Vice Premier Liu He on March 16th affirming the importance of economic growth and markets, offered insight into the government’s leanings and helped reverse a dramatic swoon in Chinese stocks that had coincided with reports that China might be contemplating military aid to Russia.
The separate salutary comments from the Chinese securities regulator regarding its ongoing negotiations with the US over audit inspections added to the more reassuring narrative (although, we’ll note, the US legislation that sparked the whole audit and delistings issue has a long fuse that could allow negotiations and decisions to be tortuously slow).
While risks of unforeseen consequences arising from the Ukraine conflict are high, on this front we are cautiously optimistic that China will work hard to maintain its neutrality in a credible way, as it is a huge beneficiary of trade with the rest of the world, especially the rich developed nations.
We think it likely that China, along with India, will continue to buy oil and gas from Russia (just as Europe, at least for now, plans to keep its gas pipelines open), and do not expect that fact to alter China’s trade relations with the West much.
Nevertheless, we must contemplate that our optimism is misplaced on the importance of membership in the global network of exchange.
If our central and optimistic case, admittedly an educated guess, is wrong, then we’d need to greatly modify our views of which companies in our opportunity set will face new barriers to profitable growth, and which might stand to benefit, relatively, from a further receding of globalization. (Global trade, after all, has never matched the peak share of GDP it reached in 2008, before the Global Financial Crisis.) We’d expect such a world to be less efficient, as the cold logic of comparative advantage is demoted as a determinant of which goods or services are produced and where.
That would lead to a less prosperous world, since exploiting comparative advantage is a cornerstone of wealth creation.
If regional blocs began to raise limits on the movement of capital as well as goods, we’d need to parse which of our multi-national companies were at risk of declining sales from increasingly hostile, siloed countries.
Royal Dutch Shell ( SHEL ) has found its Siberian oil and gas joint venture assets stranded by the combination of sanctions and the public opprobrium of Russia’s actions.
Could Fanuc’s robots, L’Oréal ’s cosmetics, or Apple’s ( AAPL ) iPhone businesses in China or elsewhere face something similar?
On the other hand, there would be substantial opportunities for companies that enable others to make investments in more resilient supply chains.
Strangely, such a “near-shoring” wave would bring sustained new orders to many of the capital goods companies that have hurt our relative performance this quarter, such as Fanuc, Atlas Copco, and Schneider.
In addition, the desire or need to make do without energy from Russia, along with the high energy prices currently seen, will spur greater efforts to build substitutes for oil and gas.
Our fundamental investment process guides our search for durably growing companies with strong finances.
Ideally, we’d like to pay no more than our estimate of fair value for such a company’s shares, but as a practical matter we’ve been willing to pay some premium to own superior companies.
We rarely own deep value stocks since shares of companies that meet our quality and growth criteria generally don’t plumb the depths of value except fleetingly.
Why, then, not own more of those at the other end of the spectrum, the fastest-growing companies, whose shares are typically very highly priced relative to their current fundamentals?
The short answer is that rapid growth is not reason enough when share prices are too high to support acceptable future returns, or when confidence in the business model or financial strength is lacking.
For several years such “disruptive innovators” have been at the forefront of growth stock investing.
Most of them we regard as speculative businesses.
We will entertain them as candidates for investment only when there’s an already-profitable business behind the hype and a market valuation suggesting its growth potential has yet to be fully discounted.
We think investors should proceed with humility when forecasting leaps in corporate sales and profits decades into the future.
We looked at stocks scoring in the bottom quintile of our global quality rankings and in the most expensive quintile of our valuation rankings each month.
While not all of the stocks in this speculative and expensive group can be considered “disruptive innovators,” many that meet that description would be found in this group.
From the end of December 2018 through December 2020, these stocks soared, delivering a 145% return (compared to a 36% return for the benchmark Index) and roughly doubling their respective weight in the Index at their peak to over 3%.
During that period, we owned none of those stocks (and frequently had to explain why while they were outperforming).
Their returns were not sustained, however: from January 2021 through March 2022, expensive, lower-quality stocks lost 42.2% (dropping 22.6% in the last quarter alone) while the Index gained 2.5%.
As many investors have chased speculative and expensive stocks higher, and, recently, lower (see chart at end of report), our approach has been consistent throughout; our portfolio’s relative valuation has been steady over the past ten years, staying close to a 50% premium to the benchmark.
While the price drop in speculative stocks doesn’t tempt us to purchase them, the underperformance of quality growth stocks has created some interesting opportunities.
We have begun to act, proceeding deliberately.
A number of Japanese quality growth stocks which have declined sharply in recent months, have our eye.
Of course, to buy we must also sell; our recent sales have been of companies that for the most part are achieving our mileposts for business growth but whose share prices still otter no margin for error.
We continue to root out the potential knock-on effects of the Ukraine crisis on our portfolio companies.
Harrowing as it was to mark our two Russian positions down to zero, the erasure of Russia and Ukraine from the global economy was but a small shock to the system of global trade since their combined contribution to global GDP is less than 2%.
The effect on individual companies’ sales can nevertheless be substantial.
Mining equipment manufacturer Epiroc ( OTCPK:EPOKY ) generated roughly 6% of its sales in Russia in its recent fiscal year, as did Japanese construction and mining equipment manufacturer Komatsu ( OTCPK:KMTUY ) ; we expect their Russian sales to decline markedly this year.
European carmakers that had been sourcing parts from Ukraine were forced to close some assembly lines for weeks until they could procure alternative inputs, which may indirectly depress demand for Infineon’s automotive power chips and sensors.
Shell announced it would sell or otherwise exit its stake in its joint venture with Gazprom ( OTC:GZPMF ) of oil and gas producing assets, which represented about 3.5% of 2021 group earnings.
Beyond that, our companies have limited exposure, with Russian sales typically making up less than 2% of each company’s total revenues.
The crippling sanctions leveled on the Russian economy raise the specter of what could happen if tensions with a larger and more integrated global trading partner, e.g., China, rose to a level that invited a similar response.
As discussed, we consider such a scenario very unlikely.
Even the specter, though, is enough to prompt global companies to reassess their supply chains with an eye toward increasing redundancy and flexibility.
This trend was already underway following the Trump administration’s imposition of higher tariffs and the experience of supply and logistical bottlenecks during the pandemic.
We’re now seeing some of our businesses draw on their balance sheets to mitigate these threats.
Consider Kubota ( OTCPK:KUBTY ) , the Japanese farm tractor maker, which has been facing supply chain challenges in the form of component shortages and higher shipping costs.
Kubota generates 70% of its sales overseas but manufactures 70% of its products in Japan.
It plans to invest in manufacturing capacity outside Japan to cut the domestic share to 50% in a bid to lower transport costs and improve resiliency.
Other examples include Samsung Electronics ’ ( OTC:SSNLF ) plan to invest US billion in an advanced chip-making plant in Texas, and TSMC ’s ( TSM ) plan for a competing US billion plant in Arizona, both of which are aiming to begin production as soon as 2024.
It’s possible that more resilient supply chains may become a competitive advantage, but we don’t think global companies, regardless of where they are based, will seek to insulate themselves fully from the risk of closed markets or severed trade and financial links that have developed over decades.
Companies with competitive products will continue to take advantage of opportunities to sell them wherever they can, and the relentless competition to lower costs will continue to push companies toward the cheapest suppliers.
In a world where black swans seem to be multiplying, our focus on companies with sound business models, strong balance sheets, and positive cash flow should at least provide some additional defense against the unexpected.
Source: FactSet, MSCI Inc. * Since March 7 we have valued our Russian holdings at effectively zero due to an inability to trade their shares and no observable indicative market prices to use as proxies.
Model Portfolio holdings are supplemental information only and complement the fully compliant International Equity Composite GIPS Presentation.
The portfolio is actively managed therefore holdings shown may not be current.
Portfolio holdings should not be considered recommendations to buy or sell any security.
It should not be assumed that investment in the security identified has been or will be profitable.
To request a complete list of portfolio holdings for the past year contact Harding Loevner. 1 JD.com was received as a spin-off from Tencent and sold.
The portfolio is actively managed therefore holdings identified above do not represent all of the securities held in the portfolio and holdings may not be current.
It should not be assumed that investment in the securities identified has been or will be profitable.
The following information is available upon request: (1) information describing the methodology of the contribution data in the tables above; and (2) a list showing the weight and relative contribution of all holdings during the quarter and the last 12 months.
Past performance does not guarantee future results.
In the tables above, “weight” is the average percentage weight of the holding during the period, and “contribution” is the contribution to overall relative performance over the period.
Contributors and detractors exclude cash and securities in the Composite not held in the Model Portfolio.
Quarterly data is not annualized.
Portfolio attribution and characteristics are supplemental information only and complement the fully compliant International Equity Composite GIPS Presentation.
Portfolio holdings should not be considered recommendations to buy or sell any security. 1 Benchmark Index 2 Supplemental Index 3 Variability of the Composite, gross of fees and the Index returns over the preceding 36-month period, annualized 4 Asset-weighted standard deviation (gross of fees) 5 The 2022 YTD performance returns and assets shown are preliminary 6 N.A., Internal dispersion less than a 12-month period.
Original Post Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
This article was written by Additional disclosure: The International Equity Composite contains fully discretionary, fee-paying accounts investing in non-US equity and equity-equivalent securities and cash reserves and is measured against the MSCI All Country World ex-US Total Return Index (Gross) for comparison purposes.
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