Shanghai Evans Investment Management Limited

Article 2: Demographics, economics and investing

Introduction

This is our second Article and looks to some key concepts that have a major impact on investment and investment markets. Investing, like so much in life, is about trying to predict the future; will what I invest in meet my financial goals? In finance, we don’t talk about ‘predicting’ the future (which implies some sort of mysterious crystal ball) but, rather ‘forecasting’ the future. Forecasting is about understanding what are the causal relationships that help us predict future outcomes in an unbiased and systematic way. Much of financial research is about trying to establish causal relationships that help us predict financial markets and investment returns.

Here are some typical questions researchers ask:

  • how does the GDP growth rate affect stock prices?
  • how does inflation affect interest rates and bond prices?
  • how does a decline in the population affect real estate prices?

Data: a framework for analysis

We often assume that the direction of causality is ‘top – down’ meaning that large factors (i.e. the economy) influence small factors (the profits of a company) more than the other way around.

Macroeconomics and demographics are the ‘big forces’ that influence what happens in all industries, all companies in an industry and the securities issued by all companies. They are the starting point for our analysis.

There is one other factor – regulation – we must consider at every level. Changes in regulation can impact the whole economy, industries or companies and so must be assessed at each level.

Managing the data

In today’s world of technology, there is a lot of potential data that we can study when looking at financial markets. Below is a screenshot of economic data on China as at 13 February 2019.

Equally, there is a very large amount of demographic data as well.

The professional analyst

A professional analyst will work with a huge amount of data, perhaps thousands of variables. They will use technology to create a model that looks at complex first, second and third order interactions between the variables. It will connect real-time to the data to always be updated. It will be very complex, time consuming and still not always forecast correctly! Predicting the future is very difficult.

Most people who are not financial professionals would be well-advised to take on professional advice to assist with their decision making; have an expert do your work for you, at a competitive price. But, at least, for most people, they will want to understand the market to a certain extent so they can ‘follow it’ themselves and, also, talk knowledgeably with their financial advisor. If you are investing your own money, it makes sense to have some basic knowledge and understanding of financial markets. Thus, the important question here is: how does the individual create a simple model out of this complex subject so that they understand what is happening from day-to-day?

Heuristic

Definition – is any approach to problem solving or self-discovery that employs a practical method, not guaranteed to be optimal, perfect, logical, or rational, but instead sufficient for reaching an immediate goal. We will revisit the concept a heuristic in our Column on behavioral finance. There, we will see that heuristic can have a negative connotation; oversimplifying. But there is also a positive side to heuristic, when it is used in context.

As a person with another job, we need to be able to monitor a small amount of information to be sure we have the ‘big picture’ of how our investments are doing, but in a very general way. We can look upon this as an ‘early warning system’ that something is changing and we need to consult our Financial Advisor about our investments in more depth. The most efficient overview is to monitor the large and important factors, like economic and demographic trends (and regulation). Then there may be some other factors that are unique to your portfolio for you to watch as well.

Case illustration

Let us assume you are a Qualified Investor in private equity and have invested in ten start-up companies in the healthcare sector, each in the amount of CNY 5 million. You have hired a group of analysts to monitor your companies, but you still want to be able to understand the large economic and other effects that might influence the value of your investments. You are a long-term investor and don’t care about daily changes in the stock exchange. You want to follow the longer-term trends that will decide if your companies will become successful one day. So, you have decided to monitor five variables on a monthly basis as following:

  1. GDP growth – the more the economy is growing the more success any firm in that economy will have and this is particularly true of new companies with high potential growth a sudden increase in the GDP growth rate would be a positive
  2. FX rate – growth in China is dependent on a steady FX value to maximise international trade that supports China’s growth – any volatility (up or down) could disrupt trade and would be a negative
  3. Consumer income – as people earn more money they have more to spend on healthcare – any drop in the trend for consumer income would be a negative
  4. Population age – as people get older, they spend more on healthcare – an increase in the age of the population would be a positive
  5. Government expenditure – if the government decreases sending in some areas but increases healthcare spending for the population, that would be a positive

Most people will not be able to spend all their time monitoring their investments, they will have to rely on other qualified people to do that. However, it is very rewarding to know that you have the ability to monitor general (big) trends and understand the impact they have on your investments. Setting up a simple program as above can both help you understand changes in your investments’ values and help you make better investment decisions, with your Financial Advisor, in the future.

“Demographic and economic trends drive investment returns.”

John D. Evans, CFA (author) has over 24 years’ experience in the international capital markets working with issuers of securities and investors around the world. He has designed and taught Master’s programmes in investment management at universities in the UK and China. He was most recently Professor of Investment Management at XJTLU in Suzhou. He now manages SEIML, a consultancy to early-stage companies in China.

Jina Zhu (translator) did her Master’s in Economics in France and is fluent in Mandarin, English and French. She also works at SEIML supporting early-stage companies grow and raise capital in China.

13 February 2019