QUALIPORT
Fighting The Last War

By Maynard Paton (TMFMayn)
April 14, 2003

Investors too often 'fight the last war'. Rather than consider what's about to happen, they're too busy looking back through the past to prepare for what's been and gone. Revisiting French military history gives a flavour of the condition.

At the start of the First World War, the French army still remained committed to their 19th century campaign strategies. Unfortunately, the country's heroic and dashing cavalry and infantry charges proved to be pure folly in the face of entrenched German machine gunners.

Come the Second World War, the French were not going to make the same mistake twice. This time, they were ready to play the defensive game and so dug in behind the Maginot Line. However, Hitler's Panzers raced through (unprotected) Belgium and into northern France and out-witted the static French in a fast-paced and chaotic battlefield.

In both world wars, past battlefield strategies counted for nothing; the development of the machine gun and the tank meant fresh military thinking was continually required. Times had changed, the technology had moved on and, to succeed, military tactics had to adapt too.

Fighting yesterday's market

Nowhere is 'fighting the last war' more prevalent in investment than looking back at past stock market valuations and data. Pundits are always talking about the market's P/E being this or that sometime in the past, and comparing it to today's level. Yet such comparisons are akin to a French general drawing up his battle plan.

Here are some points:

* Can you trust past earnings? Accounting standards have changed over time. Their transparency and (believe it or not) conservatism have increased, which could put some historical earnings figures in doubt. Profits from certain big name firms may have been temporarily depressed in the past, which could also distort the stats.

* New valuation paradigms: It's worth remembering that tried and tested stock market axioms can disappear. For example, up until the late 1950s, dividend yields always used to exceed the income from long-term gilts because everybody thought shares were too risky. However, investors have since gone along with George Ross Goobey and his belief that dividends are much better bets against inflation, and priced shares accordingly 

* Globalisation: Markets now consist of different companies with different prospects. For instance, profits from FTSE 100 companies are now more reliant on overseas operations than ever before, leading to domestic market valuations of the past becoming less and less relevant to today. The prospect of greater prosperity in China and India, home to about one third of the world's population, could well herald global overseas earnings growth beyond all expectations. Who knows?

* Old problems solved: Investors of the past had to contend with world wars, oil spikes, international political upheavals, foreign exchange turmoil, powerful industrial unions and so on, which never did much for corporate profits and valuations. But the advent of the atomic bomb, the Euro, Thatcherism and the fall of Berlin Wall look to have solved some of the old problems for good. (That said, unforeseen problems will undoubtedly emerge.)

Summary

Times change. People change. Companies change. Successful investment comes from basing your decisions on the facts as they stand today, not how they stood years or decades before. There's no harm in assessing the stock market's current level, but those who do must remain firmly in the present day.

Legendary investor Peter Lynch described the syndrome as 'penultimate preparedness'. He explained that, having been surprised by one event, investors want to make up for it and so prepare for a repeat, rather than look forward and anticipate the future. The condition is amply shown by the emergence of growing pack of bearish stock market commentators following three years of falling share prices.

Suffice to say, one thing that never changes over time is the effect of human nature on the financial markets. As well as 'fighting the last war', fear, greed, overconfidence, denial, anger, regret and complacency regularly helps to produce great investment buying and selling opportunities.