If we want to make good investing decisions, we must be well informed, not only about the company we’re evaluating but also about the environment in which it operates. Specifically, we should understand the state of its industry and the broader economy.
That idea came from the authors of the 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors," Stephen Horan, Robert R. Johnson and Thomas Robinson. As they wrote, “Companies do not operate in isolation, and sound investment decisions are not made in isolation.”
So how do we go about analyzing these three pillars of an investment asset? By taking one of two approaches to an integrated analysis: top-down or bottom-up. The authors provided this graphic to illustrate:
They summarized the information this way:
“A top-down investor first analyzes the economy as a whole, then industries, and finally tries to identify firms within the selected industry expected to outperform rivals relative to expectations. From a value investor’s perspective you must also determine whether these companies are a good value relative to other potential investments. A bottom-up investor first identifies companies and then considers industry and economy-wide dynamics when deciding whether or not to invest. Central to each methodology is a consideration of the broader economy and industry, as well as an analysis of the individual firm.”
Top-down analysis
One of the first analyses done in the top-down approach is to figure out how to allocate all resources in a portfolio context; this much for cash, this amount for fixed income, this much for equities and so on. Interest rates are the main driver of this analysis and, as we know, at least one guru—Warren Buffett (Trades, Portfolio)—takes interest rates very seriously.
He was quoted in a 2017 CNBC article:Â “The most important item over time in valuation is obviously interest rates," Buffett said last year. "If interest rates are destined to be at low levels... It makes any stream of earnings from investments worth more money. The bogey is always what government bonds yield.”
Also at the top level, investors decide how much they will also allocate to international and to domestic equities.
Having determined those allocations, the search begins for strong (or forecasted to be strong) sectors, which is to say the most promising for investment. With a sector identified, the analysis next turns to industries (the authors define industries as subsets of sectors). Finally, investors search for companies within specific industries.
They do this by looking for attractive companies based on the relationship between valuation and expected performance. For value investors, it means finding promising companies that are selling for less than their intrinsic value.
Top-down investing is quite popular among hedge fund managers, according to an article in The Balance. The article’s shortlist names Ray Dalio (Trades, Portfolio) of Bridgewater Associates, Caxton Associates (Trades, Portfolio) and George Soros (Trades, Portfolio) of Soros Fund Management (at least until it became a “family office” and stopped reporting on its activities).
Bottom-up analysis
This approach begins by identifying individual companies of interest. That identification process will screen for one or more fundamental characteristics such as return on equity, price-earnings ratio or total debt (such screening capacities are available here at GuruFocus).
Bottom-up is used by the majority of individual investors, and by growth and value investors alike. However, growth and value investors take different paths within the bottom-up approach. Growth-oriented investors will screen for high revenue or earnings growth since they are looking for stocks that will provide capital gains in the short term. Value investors screen for companies that may be out of favor now (making them bargain-priced) but will deliver capital gains in the future, when they get back into favor.
Think of the value and growth approaches as points on a spectrum rather than two mutually exclusive categories. For example, many investors take the middle of the road, searching for high-growth companies available at reasonable price multiples, what’s known as “growth at a reasonable price” (GARP).
Even Buffett is in the middle of this road; where he once followed Benjamin Graham in focusing almost completely on really cheap stocks, he now searches for what he calls wonderful companies at fair prices.
Screening is an essential ingredient in decision-making, but not the only one or the last one. Instead, we should think of it as the first step toward a decision, a process for developing a shortlist. Each stock on this list is then analyzed against industry and economic criteria.
Conclusion
Top-down and bottom-up are the two basic approaches to doing investment analysis. Each has its pros and cons and there are also combinations like GARP. Both are equally valid, so choices usually revolve around personal preferences.
Authors Horan, Johnson and Robinson concluded with this summary:
“The strategic value investor needs a disciplined approach to narrow down the myriad investment opportunities to a subset for further analysis and valuation. The two approaches described here, top-down analysis and bottom-up analysis, are both useful and disciplined. Whichever directional approach is chosen, it is important that analysis includes the overall economy, industry, and company factors.”
Read more here:
- Ă‚ Strategic Value Investing: Barriers to Success
- Strategic Value Investing: Value Investing for Higher ReturnsÂ
- Ă‚ Strategic Value Investing: A Thoughtful Approach
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