Ever wonder how to choose an investment? Fundamental investment analysts and many investors typically choose one of two competing methods: Top Down or Bottom Up.
The Top Down approach is done by studying the economy first. Then you review and modify your expectations of the economy based on that research. The next step is to choose an appropriate industry to invest in based on your assessment of the economy. Finally, you would choose companies to invest in from that industry that also fit your view of the economy.
The Bottom Up approach is pretty much the opposite. In this method, you review or search for companies that meet certain criteria, i.e., growth vs. value or large vs. small, etc. Then, you review these companies in light of their industry prospects. Finally, you choose those companies that met your screening process, were either leaders in their industry or in an industry that had strong prospects, and that will or could prosper given the economic conditions you expect.
Under normal (whatever that is) circumstances, either approach can work. However, during abnormal (the new normal?) times, usually one works better than the other. For example, during slower economic times, the bottom up approach may work better. This is because you look for companies that are prospering in the slower economic environment despite the poor conditions and, therefore, have more potential to add value during the economic downturn.
Now, though, the two methods seem to be competing against each other.
There is a great deal of concern right now about the direction of the economy including talk of a double dip recession. From a Top Down point of view, this would argue that one should look for industries to invest in that are more defensive in nature in order to provide some protection against the faltering economy. Consumer staples is an industry that generally does “better” during times of weak economic growth. Then, the analyst or investor would look for companies in the selected industry that seem to be top performers and financially able to withstand the effects of the slowing economy.
The Bottom Up approach seems to argue that it should be the method used now more than ever. This is because it is very important to know the company you are investing in and because many companies are reporting very strong earnings and profit growth. Just a quick look at the Wall Street Journal and one can find lots of companies reporting earnings and profits that meet or exceed expectations. In fact, earnings are coming in so strong that many companies are hoarding cash and/or making stock buybacks. Ultimately, this may be a defensive play in the short run but set these same companies up for more growth in the future.
So, on one hand, you have an approach arguing to be more defensive and careful in your investing choices and, on the other hand, you have a method that seems to make it easy to find strong investment opportunities based on their reported earnings. This leads to the question of which way do we go?
Our approach is to come at it from both perspectives. We continually monitor both the economy and individual investments and try to work them through each other. In other words, if we are looking at a certain segment of the investment universe or a certain specific investment, we do a Bottom Up analysis to make sure it fits with our view of the economy. We also, at times, start with the economy and adjust our investment mix based upon what we feel might be coming down the road from an economic standpoint. Thus, we also do some Top Down investment analysis.
What do you think?