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Stepan Lavrouk
Stepan Lavrouk
Articles (634) 

Seth Klarman: Value Investors Should Work from the Bottom Up

It's better to not have to time the market

April 29, 2020

In investing, there are essentially two ways to go about making a decision on how to deploy capital. You can be "top-down" or "bottom-up." Some people call this "macro" vs. "micro" investing, although I’m not sure this captures the full distinction.

In his book, "Margin of Safety," value investor Seth Klarman (Trades, Portfolio) explains the difference between these two approaches

Bottom-up

A bottom-up approach to investing involves looking at the nuts and bolts of each individual company and determining whether it is a good investment based on fundamentals. A value investor will try to gauge the strength of a company’s balance sheet, its cash position, its competitive advantages and so on, and will try to decide whether or not it is trading below intrinsic value.

By contrast, a top-down approach bases investment decisions on predictions of macroeconomic factors. For someone to be successful as a top-down investor, that person needs to take in a lot of information about all parts of the economy, synthesise that into a thesis about how particular sectors will react to what is happening and then extrapolate how individual companies will perform in this projected environment. This task is made still more difficult by the fact that geopolitical and social events can interact with the global economy in unforeseen ways.

If all of this seems confusing, then you are beginning to understand why Klarman prefers the bottom-up approach. He illustrates the problems with a top-down approach as follows:

“By way of example, a top-down investor must be correct on the big picture (e.g., are we entering an unprecedented era of world peace and stability?), correct in drawing conclusions from that (e.g., is German reunification bullish or bearish for German interest rates and the value of the deutsche mark), correct in applying those conclusions to attractive areas of invest- ment (e.g., buy German bonds, buy the stocks of U.S. companies with multinational presence), correct in the specific securities purchased (e.g., buy the ten-year German government bond, buy Coca-Cola), and, finally, be early in buying these securities.”

Klarman believes that there can be no margin of safety in top-down investing. If you base your investment decisions on what you think the broader market is about to do, then you are not focusing on what the true value of your purchases is. The decision to invest is based on the extrapolation of a trend, eg. "the market will continue to go higher," or on the idea that a trend will stop and will revert to a historical mean, eg "the market has gone to a historical low, let’s buy here."

Moreover, Klarman believes that a bottom-up approach is not only more effective, it is actually simpler than the top-down approach. For one thing, a bottom-up investor does not try to time the market; they invest only when there are enough opportunities available trading at below their intrinsic value. If such opportunities are not available, as is often the case at the top of a bull market, they simply hold cash. Top-down investors must always be guessing and trying to pinpoint when the market will turn, and that is not something that many seem to be able to do on a consistent enough basis.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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