What is bottom-up investing?
Bottom-up investing is an approach to investing that focuses on analyzing individual stocks and minimizes the importance of macroeconomic cycles and market cycles. In bottom-up investing, the investor focuses his attention on a specific business and its fundamentals, rather than on the industry in which that business operates or the economy as a whole. This approach assumes that individual businesses can be successful even in an industry that is underperforming, at least on a relative basis.
Bottom-up investing forces investors to consider microeconomic factors first and foremost. These factors include the overall financial health of a business, analysis of financial statements, products and services offered, supply and demand, and other individual indicators of business performance over time. For example, a company’s unique marketing strategy or organizational structure can be a leading indicator that prompts a bottom-up investor to invest. Alternatively, accounting irregularities on the financial statements of a particular business can indicate problems for a business in an otherwise booming industrial sector.
Key points to remember
- Bottom-up investing is an approach to investing that focuses on analyzing individual stocks and minimizes the importance of macroeconomic cycles and market cycles.
- In bottom-up investing, the investor focuses his attention on a specific company and its fundamentals, rather than on a top-down investment that is primarily concerned with industry groups or the economy in general.
- The bottom-up approach assumes that individual businesses can be successful even in an industry that is underperforming, at least on a relative basis.
How bottom-up investing works
The bottom-up approach is the opposite of top-down investing, which is a strategy that first takes macroeconomic factors into account when making an investment decision. Rather, top-down investors look at the overall performance of the economy and then look for sectors that are performing well, investing in the best opportunities within that sector. Conversely, making good decisions based on a bottom-up investment strategy involves choosing a company and giving it a thorough review before investing. This includes becoming familiar with the company’s public research reports.
Most of the time, bottom-up investment does not stop at the individual firm level, although this is the dimension where the analysis begins and where the weight is greatest. The industrial group, the economic sector, the market and the macroeconomic factors are successively integrated into the overall analysis, but starting from the bottom and gradually moving up.
Bottom-up investors are typically those who use long-term buy and hold strategies that rely heavily on fundamental analysis. This is because a bottom-up investment approach gives an investor a deep understanding of a single company and its stocks, giving insight into the long-term growth potential of an investment. Top-down investors, on the other hand, may be more opportunistic in their investment strategy and may seek to enter and exit positions quickly to take advantage of short-term market movements.
Bottom-up investors may be more successful when they invest in a business that they actively use and know in the field. Companies like Facebook, Google, and Tesla are all good examples of this idea, as each has a well-known consumer product that can be used every day. When an investor views a business from a bottom-up perspective, they first understand its intrinsic value from the perspective of its relevance to consumers in the real world.
Example of a bottom-up approach
Facebook (NYSE: FB) is a good potential candidate for a bottom-up approach because investors intuitively understand its products and services well. Once a candidate like Facebook is identified as a “good” company, an investor takes a deep look at their management and organizational structure, financial statements, marketing efforts, and price per share. This would include calculating financial ratios for the business, analyzing how those numbers change over time, and projecting future growth.
Next, the analyst gets a head start on the sole proprietorship and will compare Facebook’s financial data with that of its competitors and peers in the social media and internet industry. This can show whether Facebook stands out from its peers or shows anomalies that others don’t. The next step is to compare Facebook with the greatest number of tech companies on a relative basis. After that, general market conditions are taken into consideration, for example if Facebook’s P / E ratio is in line with the S&P 500, or if the stock market is in a general bull market. Finally, macroeconomic data is included in decision making, examining trends in unemployment, inflation, interest rates, GDP growth, etc.
Once all of these factors are incorporated into an investor’s decision, starting from the bottom, a decision can then be made to complete a trade.
Who benefits from bottom-up investing?
Ascending or descending investment
As we’ve seen, bottom-up investing begins with the financial data of a sole proprietorship and then adds more and more layers of macro analysis. In contrast, a top-down investor will first look at various macroeconomic factors to see how these factors can affect the overall market, and therefore the stocks in which they wish to invest. It will analyze gross domestic product (GDP), falling or increasing interest rates, inflation, and commodity prices to see where the stock market may be heading. They will also look at the overall performance of the sector or industry in which a stock is located. These investors believe that if the industry is doing well, there is a good chance that the stocks they are looking at are doing well and generating returns. These investors can consider how external factors such as rising oil or commodity prices or changes in interest rates will affect some sectors relative to others, and therefore companies in those sectors.
For example, if the price of a commodity such as petroleum increases and the company in which he plans to invest uses large amounts of petroleum to manufacture his product, the investor will assess the effect that the rise in prices. oil prices will have on the company’s profits. Their approach therefore begins very broadly, by looking at the macroeconomics, then the sector and finally the stocks themselves. Top-down investors can also choose to invest in a country or region, if its economy is doing well. So, for example, if European stocks falter, the investor will stay out of Europe and can instead invest money in Asian stocks if that region is growing rapidly.
Bottom-up investors will research the fundamentals of a business to decide whether or not to invest in it. On the other hand, top-down investors take the broader market and economic conditions into account when choosing stocks for their portfolio.