Top-Down vs. Bottom-Up: Which Approach in Stock Investing is Right for You?
When we evaluate stocks to invest, there is an important debate on the approach. What is more important: the stock or the context? Let us understand this question in the form of your approach to looking at a stock. Let us say you are evaluating a mid-cap stock for investment but are not sure whether to invest in the stock or not. Should you give more importance to the intrinsic strengths of the stock or should you give more importance to the fact that GDP is slowing down in India and therefore equities may not be a good choice. Effectively, what we are doing here is to compare two approaches to investing viz. top-down and bottom-up.
What exactly is top-down approach to investing?
A top down approach is also known as an EIC (Economy, Industry, Company) approach. The process flow of top-down investing goes like this.
Is the macroeconomic situation strong in terms of high growth, low inflation, low interest rates, robust economic reforms, among others?
Is the industry situation conducive to help the stock outperform? What is the demand situation, scope for innovation, pricing, creating brand value etc?
Is the company having intrinsic strengths in terms of profits and solvency? What are the operating margins, efficiency ratios and the valuation of the stock?
What exactly is the bottom-up approach?
The bottom-up approach believes that good companies are good investments irrespective of whether the overall economy is good, bad or ugly. For example, companies like TTK Prestige and Eicher have done extremely well even through the toughest of markets. Here the principal focus is only on the company you are investing in and the industry factors and macroeconomic factors are just used to ratify your findings. The process flow of bottom-up approach is something like this.
Does the company have unique strengths and is it disruptive enough to create wealth for shareholders?
What are the valuations of the stock and what is the moat created by the company? Above all, what is the margin of safety in the stock?
Do the industry level factors and economy level parameters like inflation and interest rates support value creation?
When does top-down work and when does bottom-up work?
Normally, we find that large institutions and investors have their own unique preferences. But broadly, one can draw some demarcation lines.
Top down approach works when the basic approach to investing is focused on large cap. In any market, the large cap stocks tend to be more vulnerable to macro factors than the smaller companies. For example, when the interest rates move up, the large rate sensitive stocks get impacted more. Similarly, when the pharma scene in the US got tight, it was the large pharma companies that got hit more than the smaller niche players. Bottom-up works better for small cap and mid cap stocks.
There is also a sectoral dependence for whether you should adopt a top down or bottom up approach. In case of sectors like banking, commodities and autos, the macro factors play a bigger role so top-down works better. On the other hand, for sectors like pharma, auto ancillaries, software etc, the micro factors play a much bigger role. In these cases, it is possible to differentiate at a company level, irrespective of the macro environment.
A top down approach is preferred by global institutional investors as it provides a context to invest. For example, an India-specific fund is driven by macro and industry factors since they benchmark to the MSCI EM index. For an individual investor or for a PMS or even a domestic mutual fund, there is a lot more value in bottom-up investing since you are there for the long haul and willing to live through cycles in the economy.
More often, they are complementary than competitive
In practice, investors use a bit of both approaches. A top-down works better in case of economic boom conditions or when the economy is too shaky. The bottom-up approach is best when the market conditions and the macro conditions are normal. That is when a bottom approach can create the most value. Also, an investor who uses the bottom up approach to identify the right stocks to invest in, can also apply the top down approach to time his entry and exit. So, investing is not just about top-down or bottom-up. The truth, perhaps, lies somewhere in between.
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