The Merits of Bottom-Up Investing

Top-down approach

Many professional investors employ a top-down approach.  This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them.

• This approach is difficult and risky, being vulnerable to error at every step.  
• Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy, on particular industries, and finally on specific companies. 
• It is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers.

By way of example, a top-down investor must be

• correct on the big picture, 
• correct in drawing conclusions from that, 
• correct in applying those conclusions to attractive areas of investment, 
• correct in the specific securities purchased and 
• finally, be early in buying these securities.

The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing.

• It is not clear whether top-down investing is a greater-fool game, in which you win only when someone else overpays, or a greater-genius game, winnable at best only by those few who regularly possess superior insight.  
• In either case, it is not an attractive game for risk-averse investors.

There is no margin of safety in top-down investing. 

• Top-down investors are not buying based on value; they are buying based on a concept, theme, or trend.  
• There is no definable limit to the price they should pay, since value is not part of their purchase decision.  
• It is not even clear whether top-down-oriented buyers are investors or speculators.  If they buy shares in businesses that they truly believe will do well in the future, they are investing.  If they buy what they believe others will soon be buying, they may actually be speculating.

Another difficulty with a top-down approach is gauging the level of expectations already reflected in a company's current share price. 

• If you expect a business to grow 10% a year based on your top-down forecast and buy its stock betting on that growth, you could lose money if the market price reflects investor expectations of 15% growth but a lower rate is achieved.  
• The expectations of others must therefore be considered as part of any top-down investment decision.

Bottom-up strategy

By contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. 

Value investors search for bargains security by security, analysing each situation on its own merits.

An investor's top-down views are considered only in so far as they affect the valuation of securities.




A bottom-up strategy is in many ways simpler to implement than a top-down one.

• While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all.  
• The entire strategy can be concisely described as "buy a bargain and wait."   
• Investors must learn to assess value in order to know a bargain when they see one.  
• Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

Differences between Bottom-up and Top-down investors


One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintaining cash balances at times. 

• Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear.  
• A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available.
• Top-down investors, by contrast, may attempt to time the market, something bottom-up investors do not do.  
• Market timing involves making a judgment about the overall market direction; when top-down investors believe the the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion.

Another difference between the two approaches is that bottom-up investors are able to identify simply and precisely what they are betting on.  The uncertainties they face are limited:

• what is the underlying business worth; 
• will that underlying value endure until shareholders can benefit from its realization; 
• what is the likelihood that the gap between price and value will narrow; and, 
• given the current market price, what is the potential risk and reward?

Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. 

A disciplined investor can reevaluate the situation and, if appropriate, sell the investment: 

• when the underlying value changes, 
• when management reveals itself to be incompetent or corrupt or 
• when the price appreciates to more fully reflect underlying business value.   

Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid.  

In investing it is never wrong to change your mind.  It is only wrong to change your mind and do nothing about it.

Top-down investors, by contrast, may find it difficult to know when their bet is no longer valid. 

• If you invest based on a judgement that interest rates will decline but they rise instead, how and when do you decide that you were wrong?  
• Your bet may eventually prove correct, but then again it may not.  
• Unlike judgements  about value that can easily be reaffirmed, the possible grounds for reversing an investment decision that was  made based upon a top-down prediction of the future are simply not clear.  

The Most Dangerous Way to Invest Today

The Most Dangerous Way to Invest Today
By Todd Wenning December 19, 2008 Comments (7)

This market panic has taught or reminded investors of many important lessons, including the importance of diversification, investing only in companies whose business you can understand, and that "cash ain't trash" after all.
Another lesson that must be heeded is that "bottom up" research is a downright dangerous way to invest. To review, "bottom up" research looks at businesses first and de-emphasizes macroeconomic factors. If this market has taught us anything, however, it's that ignoring the economy can have dire consequences.

No Fa-Fa-Fa-Foolin

Picking a stock without considering the economic environment is like picking out your clothes in the morning without considering the weather that day. Sure, that Def Leppard 1987 Hysteria Tour T-shirt may be comfortable and give you tons of street cred, but it's just not practical in a foot of snow.
All joking aside, no matter what sector you're looking at, there are macroeconomic factors that will make a big difference to your investing thesis -- durable-goods orders if you're looking at manufacturers, housing starts for homebuilders.
Right now, for example, companies dependent on consumer spending are facing some serious headwinds:

The American labor force is weakening.
In the last three months, the economy has shed 1.25 million jobs. Unemployment currently sits at 6.7%. Add that figure to the 12.5% underemployment rate (part-time workers who want to work full-time), and you have nearly 20% of the American workforce not contributing its full potential to the economy. These figures could get higher, since they haven't even taken into account the massive layoffs recently announced by Bank of America (NYSE: BAC), 3M (NYSE: MMM), and Dow Chemical (NYSE: DOW).

Consumer credit is drying up.
To compound the problem of unemployment, credit card companies like American Express (NYSE: AXP) and Capital One Financial (NYSE: COF) have become much more conservative with their lending standards, raising rates, reducing credit limits, or denying credit altogether. With 60-plus-day delinquencies up some 24% since August, it's hard to blame them for these moves. But the combination of less available credit and less income from employment will inevitably lead to less spending.

Baby boomers are being walloped by this economy.
This economy couldn't have come at a worse time for the 78 million or so baby boomers approaching or already in retirement. According to Fidelity, at the end of 2007, its 401(k) participants aged 60 to 64 held a median 66% of their portfolios in equities. Given that the S&P 500 is down 38% year-to-date, it's reasonable to assume that the median boomer 401(k) lost about 25%-30% of its value this year. Besides the stock market losses, an estimated $4.5 trillion of wealth has been wiped out as a result of the real estate market crash of the past two years.
This new reality is significant on many levels, but the biggest consequence of a poorer boomer generation may be found in the retail sector. The boomer demographic accounts for about 40% of total consumer spending (about $3.8 trillion annually). Since consumer spending makes up 70% of our GDP, you can see how much a suddenly stingy boomer generation can hurt our economy.
If boomers cut just 10% of their $3.8 trillion in annual spending this year, it could set GDP back some 3%. Less boomer spending would negatively affect retailers across the board, from women's clothiers like Ann Taylor (NYSE: ANN) to casual-dining restaurants like Darden Restaurants' Red Lobster and Olive Garden.

Where we're left
Despite these mounting economic woes, there are still stocks worth buying in this market. But the research process must begin with a macroeconomic analysis, followed by a thorough vetting of businesses.
Since we launched our Motley Fool Pro service in October, we've taken the plight of the U.S. consumer very seriously, focusing our research on companies that produce goods and services that people need, versus what they want. For example, we'd be much more inclined to research a stock like Johnson & Johnson (NYSE: JNJ) versus a beaten-down retailer like Abercrombie & Fitch. Consumers can do without $100 blue jeans, but they are much less likely to do without things like Band-Aids, Sudafed, and Tylenol.
Even though Abercrombie may look like a value at the moment from a bottom-up approach, it could be an even better value six months or a year from now. After all, even value is vulnerable without a catalyst to unlock it, and there appears to be no economic catalyst in sight for consumer-goods companies like Abercrombie. Ignoring that fact could cost you money and sleep while you wait -- potentially for years -- for retail to rebound.
At Pro, we're only interested in buying undervalued stocks with both strong fundamentals and positive economic support. Our top priority is accuracy, and we have a goal of generating positive returns with at least 75% of our investments. This means we must not only be selective with the investments we make, but also fully consider the economic environments in which they operate.

Pro analyst Todd Wenning pours some sugar in his afternoon coffee, in the name of love. He does not own shares of any company mentioned. Johnson & Johnson, Dow Chemical, and Bank of America are Motley Fool Income Investor recommendations. 3M and American Express are Motley Fool Inside Value picks. The Fool owns shares of American Express. The Fool is investors writing for investors.