Top-down or bottom-up?

Are you going to take a top-down approach to identify an investment or the bottom-up way? How about trying a blend of the two?

Adarsh Gopalakrishnan

For investors looking to take a plunge into the stock markets, making the choices is the most tricky part. The Mumbai Stock Exchange features 6000-odd listed companies and the National Stock Exchange nearly 2000. Then, there are also the host of new debutants who are trying to lure you to bet on their initial public offerings.

How then do you actually pick out a stock from such a bewildering line-up of choices? Well, seasoned fund managers use one of two approaches to home in on the businesses they bet on- Top-down investing or Bottom-up investing.

Quite a few managers also adopt a mix-and-match of the two approaches. But how do the two approaches actually work? Here's an example that should clarify the picture:

Consider an imaginary country Wunderland, whose economy is soaring following the advent of free market capitalism.

This economy is chugging along at 10 percent with demand for things such as steel, cars and so forth, growing at multiples of the general economy.

You identify the automobile sector as an attractive bet based on its growth rate and underlying dynamics such as the number of market participants, potential client base, etc.

You then identify two attractive candidates in the industry based on financial and operational prudence. Then you decide to split the cash and buy both. As an investor, you sit back and wait to ride the growth wave.

Another investor holidaying on the beaches of Wunderland sees a rather attractive looking car at an equally attractive price. He then decides to investigate further and begins to dig into the company making the car.

This company, in addition to being immensely profitable, is run by talented individuals who design attractive, quality cars while keeping costs in check. They do all this without incurring any serious borrowing.

This investor also chances on a report that chronicles the wonderful opportunities of Wunderland and the potential of the nascent automobile industry. He then clears out savings and bets on this car maker on the Wunderland Stock Exchange.

Both of the above scenarios, when successful, result in an identical outcome: A pot load of money for betting on Wunderland's car companies. However, both investment decisions came from different rationale — one based on a bet of a surging economy whose inhabitants will consume more automobiles; identifying how general prosperity and growth trickle down to the bottom line of a car company.

The second is based on the confidence placed in a car company whose exemplary products and operational prudence will allow its bottom line to thrive in a prosperous economy. The first rationale is referred to as the top-down approach and the second as the bottom-up approach to investing.

Top-down

The top-down approach traditionally involves identifying investment opportunities or themes based on macroeconomic indicators.

For example, GDP growth or industrial growth are metrics to identify the rate at which an economy is growing. A theme or sector is identified among the various sub-sectors which are powering growth.

In a fast growing developing economy such as China or India, infrastructure, steel, automobiles, industrial equipment are among the sectors that exhibit high growth as the governments spends to develop the economy.

Following this, companies that are beneficiaries of participation in this growth are identified and analysed.

The investors may then choose a company, index or fund to invest in which will enable them to participate in the growth of the identified asset.

Other metrics that could be considered for top-down analysis include strength of the currency, perception of policy making, etc. The downside of a top-down approach is the speed with which information moves in the modern day markets.

This may ensure that a company that benefits from growth may already have priced in the growth information much before it is reflected in soon-to-be-released GDP or industrial data.

Bottom-up

The bottom-up approach first involves identifying an ‘intrinsically' superior asset or company. Bottom-up analysis places emphasis on understanding the factors that lend to ‘intrinsic' superiority.

The factors may be financial, operational or managerial but it is an advantage that stems from and is unique to the company.

However, bottom-up bets have their downside as well. In adverse economic conditions, regardless of how competent a company is, it will suffer when the economy suffers. When consumption suffers, no amount of conviction-driven bottom-up analysis can help.

Holistic Viewpoint

Interestingly, most modern investors use a method that incorporates the best of both worlds.

Top-down analysis is employed to gauge the operating environment in terms of government policy, social and economic stability, national economic health, public spending, and reforms, among other tangible and intangible metrics.

Bottom-up analysis provides a perspective on individual participants in the economy, such as how well does a company operate relative to its domestic and international peers?

How efficient is a company with its capital? How sustainable are its profit margins? These kinds of questions provide a micro picture.

Both the perspectives, when viewed together, provide a more coherent context and holistic viewpoint on the price paid for an asset.