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Value Investing: Bottom-up vs. Top-down

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Jan 31, 2011
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Most value investors I know take a bottom-up approach by looking at stocks one at a time and do their research by reading annual reports and 10-K filings. After determining an appropriate price to pay, they then check the price of the stock. If the stock price is less than their estimation of intrinsic value … they begin buying the stock.

Bottom-up investors don't focus on any other factor that doesn't have a direct effect on the company and its future prospects. The latest economic report, the price of gold, or the annual rainfall in Brazil is not taken into account.

Top-down investors start at the opposite end. They first access the economic backdrop or the macro view, then select an industry that would benefit, and finally make a few stock selections. Die-hard value investors would never peek nor give a moment's care to the macro view. Their only concern: Is the stock price greater than or less than the value of the business?

One of the many lessons that the financial crisis of 2008 taught value investors is that one can't be agnostic about the economy or the macro view. Seth Klarman , president of The Baupost Group, founded in 1983, has an outstanding track record of an annual compounded return of 20%. He commented during a conference in October 2008 that value investors would've thought about buying stocks in 2008 if they had kept an eye on the credit markets. Credit spreads during 2007 and 2008 were telling investors that something serious was taking place and that liquidity was drying up. In other words, an attractively priced stock was going to get even more attractive. If you loved XYZ stock at $50, you were going to love it at $20 because that's where equity prices were going. During such times there is no telling how low things will go. It's no coincidence that Klarman wrote a book titled Margin of Safety that sells for over $1,000 if you can find it. By looking at the credit market, Klarman had a leg up on most value investors and was able to outperform the S&P 500 in a very difficult year. Historically, value managers lost less in down markets and made less in up markets. A majority of their outperformance was attributed to losing less in down markets. During the recent crisis, value managers with excellent long-term track records underperformed the S&P 500. Here's some insight on how this time was different.

Select Value Managers' Performance in 2008

Fund Return in 2008
Weitz Value -40.70%
Third Avenue Value Fund -45.60%
Longleaf Partners -50.60%
Legg Mason Cap. Mgmt. Value -54.60%
S&P 500 -37%

A bird's-eye view

Learning from the mistakes of others, I'd like to give you my view from 10,000 feet high on how I'm seeing the big picture and what it means to our stock selections.

The first indicator I look at is rail carloads. I started to follow rail carloads when Warren Buffett was asked to identify one indicator that would be most relevant in getting a handle on the overall economy.

The Association of Railroads reports weekly on carloadings for 19 different major commodity categories. Freight railroading is a "derived demand" industry — demand for rail services occurs as a result of demand elsewhere in the economy for the products railroads haul. Thus, rail traffic is a useful gauge of broader economic activity, especially of the "tangible" economy.

The end of November marked the ninth straight month with higher year-over-year weekly rail carloads. This string of gains hasn't happened since 2004. While we're still not out of the woods, the economy seems to be gaining strength.

Personal consumption accounts for close to 70% of U.S. GDP. If consumers aren't buying, then the health of the economy can't be that good. I've found that luxury retailers are a very good lead indicator, since they usually are the first to begin spending after a recession.

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