One of the keys to successfully managing your investment portfolio is using a number of investment analysis strategies. Investment analysis is a way to assess different types of assets and securities, industries, trends and sectors to help you determine the future performance of an asset. This will help you determine how well it will fit with your investment goals. Two of these strategies are called top-down and bottom-up investing.
Top-down investing involves looking at economic factors as a whole to make investment decisions, while bottom-up investing examines company-specific fundamentals such as financials, supply and demand, and types of goods and services offered by a business. While both methodologies have advantages, both approaches have the same goal: to identify the right stocks. Here is a review of the characteristics of the two methods.
Key points to remember
- The top-down approach is easier for less experienced investors and for those who don’t have the time to analyze a company’s financial statements.
- Bottom-up investing can help investors choose quality stocks that outperform the market even during downturns.
- There is no right or wrong method of investment analysis, which one you choose depends on your individual goals, risk, and comfort level.
From top to bottom
The top-down approach to investing focuses on the big picture, or how the overall economy and macroeconomic factors determine markets and, ultimately, stock prices. They will also look at the performance of sectors or industries. These investors believe that if the sector is doing well, there is a good chance that stocks in these industries are doing well as well.
Top-down investment analysis includes:
Bank stocks and interest rates
Take a look at the table below. It shows a top-down approach with a correlation between the yield of the 10-year Treasury and the ETF Financial Select Sector SPDR (XLF) between 2017 and 2018.
A descending investor may view rising interest rates and bond yields as an opportunity to invest in bank stocks. Usually, not always, when long-term yields rise and the economy is doing well, banks tend to earn more income because they can charge higher rates on their loans. However, the correlation of rates to bank stocks is not always positive. It is important that the overall economy is doing well while yields increase.
Home builders and interest rates
Conversely, suppose you think there will be a drop in interest rates. Using the top-down approach, you could determine that the home construction industry would benefit the most from lower rates, as lower rates could lead to increased purchases of new homes. As a result, you could buy shares of companies in the residential construction industry.
Commodities and equities
If the price of a commodity such as oil increases, the top-down analysis might focus on buying shares of oil companies like Exxon Mobil (XOM). Conversely, for companies that use large amounts of oil to manufacture their product, a top-down investor might consider how rising oil prices could hurt company profits. At first, the top-down approach begins by looking at macroeconomics, and then explores a particular sector and the stocks within that sector.
Countries and regions
Top-down investors can also choose to invest in a country or region if its economy is doing well. For example, if the European economy is doing well, an investor may invest in exchange traded funds (ETFs), mutual funds or European stocks.
The top-down approach looks at various economic factors to see how these factors can affect the overall market, certain industries and, ultimately, individual stocks within those industries.
From bottom to top
A portfolio manager will look at a stock’s fundamentals regardless of market trends when using the bottom-up investing approach. They will focus less on market conditions, macroeconomic indicators and industry fundamentals. Instead, the bottom-up approach focuses on the performance of an individual business in an industry versus specific businesses in the industry.
The objective of bottom-up analysis includes:
- Financial ratios including price / earnings (P / E), current ratio, return on equity and net profit margin
- Earnings growth, including expected future earnings
- Revenue and sales growth
- Financial analysis of a company’s financial statements, including balance sheet, income statement and cash flow statement
- Cash flow and free cash flow show how a business generates cash and is able to finance its operations without taking on more debt.
- The leadership and performance of the company’s management team
- The products of a company, its dominant position in the market and market share
The bottom-up approach invests in stocks where the above factors are positive for the company, regardless of how the market as a whole moves.
Bottom-up investors also believe that if one company in one industry is doing well, it doesn’t mean that all companies in that industry will follow suit. These investors are trying to find particular companies in an industry that will outperform others. This is why bottom-up investors spend so much time analyzing a business.
Bottom-up investors typically review research reports that analysts publish on a company, as analysts often have intimate knowledge of the companies they cover. The idea behind this approach is that individual stocks in a sector can perform well, regardless of poor industry performance or macroeconomic factors.
What constitutes a good prospect, however, is a matter of opinion. A bottom-up investor will compare companies and invest in them based on their fundamentals. The economic cycle or general industry conditions are of little concern.
Which one is right for you?
As with any other type of investment analysis strategy, there is no right answer to this question. Choosing the right one for you depends primarily on your investment goals, your tolerance for risk, and your preferred method of analysis. You can choose to use one, or you can consider going for a hybrid – that is, incorporating elements of both to build and maintain your portfolio. You can start with a top-down approach and then move to a bottom-up investing style if you are looking to realign your portfolio. There really is no right or wrong way to do it. As mentioned above, it all depends on what is right for you.
The bottom line
A top-down approach starts with the economy at large, analyzes macroeconomic factors, and targets specific industries that perform well in the economic context. From there, the top-down investor selects the companies in the sector. In contrast, a bottom-up approach examines the fundamental and qualitative parameters of several companies and selects the company with the best future prospects, the most microeconomic factors. Both approaches are valid and should be taken into account when designing a balanced investment portfolio.