The wider economy exerts significant effects on the businesses that operate within it. This is a fact that should be pretty obvious to anyone with even a passing interest in investing.
Thus, it might be tempting to approach investing as an exercise in macroeconomic forecasting - after all, if you can just predict the direction of the overall economy, then you don't have to spend much time figuring out which businesses present the best value plays.
On the other hand, you may prefer to invest solely on the basis of an individual company's fundamentals. These two approaches are known as "top-down" and "bottom-up" investing, respectively. Here's how they're different.
Top-down
Even the best companies can struggle if macroeconomic conditions turn against them. Poorly-run companies that may look cheap will run into even bigger problems if the economy enters a recession. So it's important for value investors to keep their eyes open and to be cognizant of the wider risks that they face.
How does top-down analysis work? First, an analyst will look at broad economic indicators like GDP, national debt or interest rates, and may even compare and contrast different countries. They will also attempt to make some assessment of market sentiment and the stage of the business cycle that the economy is in.
Next, they will analyze the various sectors in the economy to try to figure out which ones are performing best. If you read research put out by investment banks or hedge funds, you will often come across whole-sector recommendations: cyclical, defensive, telecommunications, industrials and so on. Finally, they will look at the companies within a given sector that are most attractively valued.
Bottom-up
By contrast, bottom-up analysis starts by identifying well-priced companies on a case-by-case basis. This is the method generally preferred by value investors, who will look at ratios and metrics like price-earnings, return on capital employed, return on equity, debt ratio, free cash flow and others.
Growth investors can also adopt a bottom-up approach by looking for businesses with rapidly increasing revenues or earnings, although it should be noted that growth investing (if it is indeed investing, rather than speculation) is functionally the same as value investing - in both cases, you are trying to buy assets for less than their intrinsic value.
There is a widely-held belief among successful value investors that the bottom-up approach is the only sound one. Warren Buffett (Trades, Portfolio), Charlie Munger (Trades, Portfolio), Howard Marks (Trades, Portfolio), Seth Klarman (Trades, Portfolio) and many others have all expressed their doubts that anyone is able to reliably predict macroeconomic trends. However, all of them believe that it is certainly possible to arrive at an accurate assessment of an individual business's valuation, and have advised other investors to follow suit.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Leon Cooperman: The Effect of Recent Monetary Policy Has Not Been Good
- Peter Lynch: The Value of a Long-Term View
- Understanding the Midstream Energy Sector Today
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