When approaching the stock market, there are two main ways to look at investing. You can look at it from a macro point of view or from a micro point of view. Do you care more about big trends and market behavior? Or are you more concerned with the performance and prospects of individual companies? If you’re attracted to the latter, you have a micro approach, also known as bottom-up investing.
Bottom-up investing is an approach that focuses on specific companies and their performance outside the confines of broader market factors. Bottom-up investors find the companies they like. Moreover, they assess your fundamentals determine whether the business itself has the means to succeed. For example, this includes finance, management, market share, etc. Additionally, bottom-up investors believe that well-equipped companies will succeed regardless of market factors.
Bottom-up investing takes a lot of work. However, it’s a proven philosophy that investors can use to build high-performing portfolios. Here’s how to approach investing from the bottom up.
The bottom-up investment philosophy
Investing in individual companies is a time-consuming practice. First, investors need patience to assess the company and its stock market performance. Second, they need the knowledge to pull it all together in an investment thesis. Here is just a sample of some of the the basics of bottom-up investing:
- Products and services. What is the market demand for this company’s products? How do they differ from the competition? What are their prices and margins? Who are the first consumers? Investors learn all they can about the company’s main revenue mechanisms.
- Financial health of the company. What types of assets and liabilities does the company have on its balance sheet? How are its revenues and cash flow changing? What kind of debts does he have? What is his credit rating? Does it pay a dividend? Investors need a clear and accurate picture of the company’s ability to manage its finances, so that it can continue to grow profitably.
- Direction and management. Who are the key figures in the c-suite? Also, what is their mandate or area of expertise? What is their leadership style? How do they present the company in the media in general? Having confidence in the company’s leadership is an important part of forming an investment thesis about the company’s ability to succeed.
- Recent stock market performance. How has the stock traded over the past few years? What made him dive or jump in the past? Has it stagnated for long periods? Are there any worrying or promising trends? The stock’s recent performance provides context for how it stands at its current valuation and how it might perform in the future.
Therefore, bottom-up investing uses a healthy mix of quantitative and qualitative analysis.
Bottom-up or top-down investing
Bottom-up investing involves in-depth investigation into the fundamentals of specific companies. However, top-down takes an opposite approach. These investors first look at the macroeconomic factors that determine major market trends. For example, interest rates, economic signals, inflation and more. A top-down investor might hypothesize:
The Federal Reserve has announced two interest rate hikes over the next six months. On a macro scale, this will make it more expensive for companies to borrow money. As a result, top-down investors may turn away from asset-heavy companies that rely more on borrowing to finance new asset purchases that expand their businesses.
They believe that macroeconomic factors affect business performance, both positively and negatively. They will look to sectors, regions and other large market segments where they believe the tailwinds will improve business performance. The goal is broad, as opposed to specific.
It is important to understand that bottom-up investors will not ignore market trends! They will look to market trends as the context for a specific company’s performance within it.
The pros and cons
Like any investment strategy, bottom-up investing has significant advantages and disadvantages. For example, here’s what investors can expect and what to be wary of if they start at the bottom.
Benefits of bottom-up investing
- Potential for long-term value and significant return on investment by prospecting solid companies.
- Improved portfolio stability through stocks equipped to withstand general market trends.
- More conducive to value investing, since there is a better understanding of the business.
- Investor confidence is higher in companies that they have taken the time to properly evaluate.
Disadvantages of bottom-up investing
- Identifying and evaluating companies takes a long time.
- Individual businesses are more prone to volatility if unexpected turbulence occurs.
- Investors might prospect companies that are actually lagging behind market or industry growth averages.
- Bottom-up investing requires a solid understanding of microeconomic variables.
Should you be a bottom-up investor?
Bottom-up investing is a powerful strategy with proven results. For example, see famous stock pickers like Warren Buffett and Peter Lynch. They are praised for their ability to extract rough diamonds. In fact, these super investors and others like them have simply taken the bottom-up approach. They prospected individual companies, instead of following market trends.
There are significant benefits to being a bottom-up investor. Specifically, one of the biggest benefits is the overall knowledge you have of the stocks in your portfolio. You have a deep understanding of the companies in which you have invested. And it will give you the confidence to face their performance, good and bad.
Top-down investing follows trends. And bottom-up investing is when investors follow what they’ve taken the time to learn, regardless of the behavior of the market as a whole.