Secrets of Success: Long-term bears can be short-term bulls

As with generalship, one of the most important things in investment is to be able to distinguish strategy and tactics - or to put it another way, to differentiate between the long game and the short game.

As with generalship, one of the most important things in investment is to be able to distinguish strategy and tactics - or to put it another way, to differentiate between the long game and the short game. It is perfectly possible, if a little confusing, to be both bullish and bearish at the same time: just as a good general can be both in tactical retreat and yet still advancing from a strategic point of view. (Wellington in the early stages of his Iberian campaign comes to mind.)

The only sensible approach for most investors is to adopt the stance of a far-seeing general: aim to get the long-term strategy right and then spend a little time, if you can, playing around with tactical overlays, recognising that most of the time you will be operating in the "fog of war", when nothing seems as clear-cut as you would wish when making decisions.

Thus, it seems perfectly possible to be relatively bearish about equities as a class from a strategic point of view, but to be quite bullish on a shorter-term perspective. There is nothing inconsistent about saying that you expect the returns from shares to be modest over the next few years, while also believing that this year might turn out to be another good one in which to have increased one's tactical exposure to the stock market.

Of course, there is always risk in any such position-taking. The arguments that the American fund manager Bill Miller put forward for being bullish about the market in 2005, which I mentioned here a couple of weeks ago, strike me now as being very persuasive (which is not to say that some unforeseen event may not yet throw his calculations out of kilter).

His argument essentially is that investor sentiment has not yet shaken itself clear of the bearishness induced by a deep bear market: most investors look at their portfolios and see that they have made no money over five years. At a time when interest rates are rising (making cash look more attractive) and other assets (such as property and commodities) have been booming, the last thing investors are going to do in practice is to look to increase their exposure to the stock market.

You only have to examine sales of equity unit trusts, which fell precipitously last year, to see that most advisers - who drive the majority of unit trust sales - must be taking a similarly cautious view in their advice to clients. As Miller himself pointed out, most professionals he knows are pretty bearish, making them indifferent even to good news and oversensitive to bad tidings.

Yet it is precisely these conditions that hindsight shows produce the most positive returns from markets. Of the big issues that seem to dominate the headlines today - the situation in Iraq, rising oil prices and the American deficits - it is hard to claim that these are not known to investors. Serious problems though they are, all three of them should by now be fully factored into the price of financial assets.

What investors may be overlooking is the fact that while consumers are overloaded with debt, companies in general are not. In fact, the financial health of corporate America - and to a lesser extent UK industry - has rarely been as good as it is now. Ever since the investment bubble in telecoms, media and technology burst, most companies have been drawing in their horns, reducing their debt, building up their reserves of cash, and paying out more in dividends (a trend that seems certain to continue).

According to one of the slides that Miller used in his presentation, the profitability of US industry, as measured by the return on equity, is around its highest levels in 130 years of recorded corporate history. As a result, the earnings numbers that US companies will report this year are likely to be rather better than most investors are expecting, probably at least 10-11 per cent better than a year ago.

Miller's case for being bullish about 2005 is that these numbers will prove difficult for the markets to go on ignoring indefinitely. In fact, there seems to be quite a bit of momentum building in the stock market since the US presidential election, so the process of readjustment may already be happening.

Being a professional, Miller knows as well as anyone that a good year in 2005, if it happens, won't change the longer-term prospects for equity markets as a whole; those who only start buying shares again next year because they have done well this year and last year could well turn out to be disappointed.

(It is worth remembering Warren Buffett's aphorism that in investment "you pay a high price for a cheery consensus": if you wait for everyone else to feel the same way, you will miss the boat.)

Miller's success as a fund manager has in fact been built on taking a longer-term approach than many of his counterparts in the fund management business; rather like Buffett, his ideal share is one with a strong franchise that he can buy and hold for many years. He is a big holder of both Amazon and eBay for that reason, and has owned both shares all the way through the bull and bear markets. His view is that e Bay could become the next Microsoft.

More recently, he has been buying shares in Google (where he is now the second largest shareholder) and Electronic Arts - the latter because talking to all the major companies in the video games field showed their verdict to be that "the war in video games is over - and Electronic Arts has won". In the long run, a good general in investment knows that it is great companies, bought at a reasonable price, that produce the best returns. Tactical manoeuvres can help in the shorter term, but will always be of secondary importance.

jd@intelligent-investor.co.uk