The Viewpoint: Living forwards, investing backwards

There is a saying that life can only be understood backwards; but it must be lived forwards. This resonates with investing too. The value of an investment is determined by the future, but all we know about it is in the past. Investing has always, to some, been akin to fortune telling, weather forecasting, prediction markets and other iterations of future gazing.

The value of an investment is determined by the future, but all we know about it is in the past.

I say to some, as there are notable investors who believe the future is unknowable and investments should be made on this basis. Warren Buffett has been the greatest example of success using this approach. His portfolio consists mainly of companies offering goods and services that have remained largely unchanged over the many decades of his investment career. Businesses such as Coca-Cola, American Express, and US railroad company BNSF are big parts of his investment portfolio not just because he thinks they will benefit from the future, but also because they should be resilient to it.

The emotional cycle of greed and fear

Over the course of my career, I’ve seen times when the stock market was future looking, and times when it was not. Times when investors thought they could forecast a long way forward and as a result pay a high price for what they bought, and times when they could not. Although technological cycles, such as the internet and AI, play a role in this oscillation in investment horizons, they have been more aligned to the traditional emotional cycle of fear and greed.

In March 2009, the peak of the financial crisis, the US stock market traded at a mere 10x PE (price to earnings) multiple of the next 12 months forecast earnings. The greatest stock market in the world was essentially a value stock. This was because of the fear of what tomorrow would bring as the global financial system was on the verge of collapse.

By comparison, during the technology boom of the late 1990s and early 2000s, the peak PE of the US stock market was in March 2000, when it hit 24.4x. This was a time when the internet seemed like an invention of infinite promise. For investors, it became more important that they owned the beneficiaries of this invention, and less important what price they paid.

Nine years isn’t that long in investing, yet the PE of the US stock market fell by 59%! Such is the cycle of greed and fear. Of course, the internet did change the world, just not as fast or as profitably as expected in March 2000. And the US economy and stock market prospered in the decade after the financial crisis. Investors who acted counter to the prevailing emotions would have been rewarded handsomely. As Warren Buffet himself said, be fearful when others are greedy, and greedy when others are fearful.

This brings us to today. On a forward 12-month basis the PE of the US stock market is around 20x. Not back to the levels of the internet bubble but certainly elevated compared to its low of 2009. This is a market where investors are feeling confident about the future and are paying a relatively high price to be part of it. For context, over the last 25 years the average PE has been around 16.4x.

It’s perhaps not a coincidence that we are towards the upper end of valuation metric ranges as we are once again in the middle of technology-led optimism.

It’s perhaps not a coincidence that we are towards the upper end of valuation metric ranges as we are once again in the middle of technology-led optimism with respect to AI. There is no doubt AI is one of the most consequential inventions of our lifetime. What we are living through today is like what those who saw the invention of electricity, lived through the build-out of railroads, witnessed the first flight of a plane, or drove in a car for the first time must have felt. Suddenly anything seems possible.

These technological changes all heralded a time of upheaval and societal change which had major consequences for investors and business owners at the time. As the world changed, businesses were destroyed and new ones created. This process of creative destruction is quite natural, and each time has, in the end, led to a better world.

An era of creative destruction

We are now living through another period of creative destruction. Investors have placed their bets. The old world has gone and not everyone will make it through to the future. The builders of the new world have been rewarded with huge share price moves to the upside, and those who are perceived to be victims have seen their share prices collapse. This is its own fear (AI losers) and greed (AI winners) cycle.

Will investors once again be rewarded for acting contrary to the prevailing emotion? History would say yes, but of course no one really knows, and it could be different this time. There are some lessons however that are useful in helping investors understand what may happen next.

It is notable in history that the builders of the next great invention are rarely the ones who benefit financially from it. This was the case with railroads, fibre for the internet, cars, planes etc. This is usually because new technologies are met with such excitement and promise that they are ultimately overbuilt. This leads to lower returns for the company’s investors than they were initially excited about. Is Nvidia today’s Ford? Is Anthropic today’s AOL? Only time will answer that.

It is also notable that in the end the profits were made by those companies who learnt how to use new technologies rather than invent them. Amazon would be an example of this. It didn’t invent the internet, but it did use it to reinvent retail.

This debate is alive and well in today’s markets. Will it be the companies who build out the infrastructure that will be the ultimate AI winners? Or the companies who build the applications on top of it? And will the applications companies be current incumbents, or new companies we have not yet heard of?

Looking to the past tells us that markets are at their most dangerous when the future feels infinitely bright, and at their most rewarding when the future looks irretrievably bleak.

It shows us that new technologies do change the world, but rarely in a straight line, and not always to the benefit of the companies first celebrated by investors. It is important not to dismiss AI’s potential, but it is also important to recognise that traditional investment skills such as valuation, competitive advantages, and returns on capital still matter.

Looking to the future, AI may hold extraordinary productivity gains, new business models and powerful long-term winners, but it may also redistribute value in ways that are hard to predict. For investors, the past teaches humility and how little we know about how this technology cycle will end.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. Reference to any security is for information purposes only and should not be considered a recommendation to buy or sell.

The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change. Forward looking statements are subject to certain risks and uncertainties. Actual outcomes may be materially different from those expressed or implied.