Scenario planning can help refine your investing strategy.
Back in the summer of 1998, at the height of the Russian financial crisis, I bought a copy of Daniel Yergin and Thane Gustafson's book Russia 2010: And What It Means for the World which gave me an introduction to the management technique known as scenario planning.
When the book was written in the early 1990s, Yergin and Gustafson had proposed four possible scenarios for Russia's future with names like "Muddling Down" and "Time of Troubles." Whilst I was reading it, Russia hit the financial headlines for all the wrong reasons when it defaulted on its debts, and it looked as if their worst-case scenario might be coming true.
On reflection I felt that Russia's prospects were not as bad as most people were saying, so a few months later I took a plunge into the bombed-out Russian stock market. This turned out extremely well, and as a result scenario planning is now a major part of my investment toolkit.
One of many possible futures
Scenario planning takes known facts about the future, such as geography, demographics and the availability of raw materials, and combines them with plausible social, technological and economic conditions to create a variety of scenarios. It is a "big picture" modelling technique which aims to guide your strategy (asset allocation) rather than your tactics (share selection).
It was developed by the oil supermajor Royal Dutch Shell (LSE: RDSB) in the 1970s and Shell continues to use it today. You can see this from their corporate website which details two scenarios which help Shell's senior managers prepare to adapt to changing conditions.
In "Scramble", Shell envisages a future where countries prioritise national energy security above all other considerations, including reducing carbon emissions. But in "Blueprint" coalitions of countries and companies emerge to deal with climate change and make huge investments in alternative energies, such as wind and solar power, which create serious alternatives to oil.
Scenario planning is routinely used by the world's militaries, because they need to have some idea as to how to deal with potential enemies. NATO's ongoing military action in Libya almost certainly follows some of its contingency plans which were drawn up years ago.
Back to Russia
When the Russian financial crisis hit one thing that sprang to mind was Nathan Rothschild's advice that you "buy on the sound of cannons, sell on the sound of trumpets."
So I had a good look at the Russian stock market, guided by Russia 2010's scenarios, and eventually put several months' salary into the First Russian Frontier Investment Trust, which as its name suggests had substantial interests in Russia.
After a few years the trust changed its name to the Eastern European Trust (LSE: EST) and diversified away from Russia, but I held on and it eventually became one of Peter Lynch's ten-baggers.
Today's Russia is very much like Yergin and Gustafson envisaged in their scenario "Two-Headed Eagle", where an increasingly corrupt Russian state, an arbitrary legal system and weak property rights makes the country a much riskier proposition for investors than it was in 1998. So I've recently sold up and moved on to other things.
Some of the future can be predicted
Niels Bohr said that "prediction is very difficult, especially if it's about the future." But some things are easy to predict. An example is the profile of a country's population which is highly dependent upon the characteristics of its present population, such as the current number of people of each age and sex together with the fertility rate, migration rate and life expectancies.
The science of demographics allows us to use this information to predict the population by age and sex in several decades' time with a high degree of accuracy. Whilst countries have been known to deliberately change their demographics through total war, extermination programs and things like China's "one child" policy, this isn't going to happen in modern-day Europe.
Europe's future is growing old
Western Europe's demographics mean that the average age of its population will continue to rise for the next few decades. So there will be less demand for schools (fewer children) and more will be spent on pensions and medical care (more older people) which is why my portfolio is very overweight in healthcare shares such as Smith & Nephew (LSE: SN).
The resulting shortage of workers will encourage more immigration from countries with younger populations and the use of new forms of labour-saving machinery, such as robots and artificially intelligent (AI) computer programs, which will create opportunities for investors in the emerging robotics and AI industries.
Chindia is the future
Short of global war or a natural disaster of Old Testament proportions, I can't see anything stopping China and India from continuing to industrialise and becoming two of the biggest economies in the world during the next two or three decades. So I've been investing in India for some time via the JPMorgan Indian Investment Trust (LSE: JII) and the New India Investment Trust (LSE: NII).
But I'm very wary of China because of its political system so I avoid Chinese companies. Instead I indirectly invest in China, primarily through Yum! Brands (NYSE: YUM.US), the owner of Colonel Sanders' KFC, which is the biggest fast-food restaurant operator in China. Every day Yum! opens at least one new restaurant in China and it's on course to more than triple its number of outlets by 2020.
Yum! is just getting started in India, which looks as if it could become another big market.
A hedge
However, there's always the possibility that things don't work out as forecast so I've hedged my bets through UK-based multinationals which have a big presence in these and other emerging markets such as Diageo (LSE: DGE) and Unilever (LSE: ULVR).
I also use global emerging markets investment trusts like Templeton Emerging Markets (LSE: TEM) as well as the Australian multinational miner BHP Billiton (LSE: BLT) which sells a lot of raw materials to China and India.
In this follow-up article, I look at two other scenarios which underpin my investment strategy; "I, Robot" and "Is The Oil Running Out?"
More from Tony Luckett:
> Tony owns shares in BHP Billiton, Diageo, JPMorgan Indian Investment Trust, New India Investment Trust, Smith & Nephew, Templeton Emerging Markets, Unilever and Yum! Brands. The Motley Fool owns shares in Unilever.
