How do top-down and bottom-up investing differ?
One of the keys to successfully managing your investment portfolio is to use a number of investment analysis strategies. Investment analysis is a means of evaluating 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 match 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 looks at company-specific fundamentals such as financials, supply and demand, and the types of goods and services offered by a business. Although there are advantages to both methodologies, both approaches have the same goal: to identify large stocks. Here is an overview 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 time to analyze a company’s finances.
- Bottom-up investing can help investors select quality stocks that outperform the market even during periods of decline.
- There is no right or wrong way to analyze investments – which one you choose depends on your individual goals, risk and comfort level.
From top to bottom
the from top to bottom approach to investing focuses on the big picture, or how the overall economy and macroeconomic factors drive the markets and, ultimately, stock prices. They will also examine 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 will also do 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 10-year Treasury yield and the SPDR Financial Select Sector ETF (XLF) between 2017 and 2018.
A bottom-up investor may consider rising interest rate and bond yields as an opportunity to invest in bank stocks. Usually, but not always, when long-term yields rise and the economy does well, banks tend to earn more revenue because they can charge higher rates on their loans. However, the correlation of rates with bank stocks is not always positive. It is important that the overall economy does 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 homebuilding industry would benefit the most from lower rates, as lower rates could lead to increased new home purchases. As a result, you could buy actions companies in the residential construction sector.
Commodities and stocks
If the price of a commodity such as the rise in oil, the top-down analysis could focus on buying stocks of oil companies like Exxon Mobil (XOM). Conversely, for companies that use large amounts of oil to make their product, a top-down investor might consider how rising oil prices could hurt the company’s earnings. Initially, the top-down approach begins to look at macroeconomics then explores a particular sector and the stocks in 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 can invest in exchange traded funds (AND F), mutual fundor shares.
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 fund manager will look at a stock’s fundamentals regardless of market trends when using the from bottom to top investment 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 company within a sector relative to specific companies within the sector.
The emphasis on bottom-up analysis includes:
- Financial ratios including price/earnings ratio (P/E), Current ratioreturn 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 the balance sheet, income statement and cash flow statement
- Cash flow and free movement of capital show how well a company generates cash and is able to finance its operations without taking on more debt.
- The leadership and performance of the company’s management team
- A company’s products, market dominance 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 does well, it doesn’t mean that all companies in that industry will also follow suit. These investors are trying to find the particular companies in an industry that surpass others. This is why bottom-up investors spend so much time analyzing a company.
Bottom-up investors typically look research reports that analysts issue about a company since 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.
However, what constitutes a good prospect is a matter of opinion. A bottom-up investor will compare companies and invest in them based on their fundamentals. The business cycle or general industry conditions are of little concern.
Which is good for you?
As with any other type of investment analysis strategy, there is no right answer to this question. Which one is right for you depends primarily on your investment goals, your risk tolerance, along with the analysis method you prefer to use. You can choose to use one, or you can consider going hybrid, i.e. bringing elements of both to build and maintain your portfolio. You can use a top-down approach to start, but then switch to a bottom-up investing style if you are looking to realign your wallet. There really is no right or wrong way to do this. As mentioned above, it all depends on what suits you.
A top-down approach starts with the broader economy, analyzes macroeconomic and targets specific industries that are performing well in the economic context. From there, the down-level investor selects companies in the industry. A bottom-up approach, on the other hand, looks at the fundamental and qualitative metrics of multiple companies and selects the company with the best future prospects, the most microeconomic factors. Both approaches are valid and should be considered when designing a balanced investment portfolio.