Top-down or bottom-up approach to investing ?

Top-down or bottom-up approach to investing ?

What do you think is the most sought after ride in any amusement park ? Merry-go-round ? Bumper cars ? Ferris Wheel ? Nope. Like they say investing is like riding a roller coaster, it’s the roller coaster that is the most popular ride in amusement parks. While you ride the investment roller coaster, you also need to follow certain strategies that can guide you through profitable stock discovery.

Top-down & bottom up are 2 strategies that investors can use to analyse stocks.

Top-down approach

Beginners who are not so equipped to do a technical analysis on stocks often can use this strategy to pick good companies to invest. The basis of this strategy is to look at macroeconomic data & events. More like the view that you get when you are 36000 feet above the ground on a plane. This also is a way to understand a particular sector, industry and take decision on movement of stock prices.

Some of the key macroeconomic data / events that is used by top-down investors :

  1. Government policies that might give subsidies to a particular sector , PLI ( performance linked incentives ) or any other measure that is in line with the prevalent govt policy to boost a particular industry / sector.
  2. GDP & inflation data
  3. Interest rates – govt bonds, loans, deposits
  4. Price of commodities

For Example GOI has introduced PLI scheme in recent years sectors including automobile and auto components, electronics and IT hardware, telecom, pharmaceuticals, solar modules, metals and mining, textiles and apparel, white goods, drones, and advanced chemistry cell batteries. This not only helps boost local manufacturing but also help cut import bills. In turn companies operating in these sectors will have better financial metrics and hence will affect their stock prices. However, one has to be cautious about the fact that not every company benefitting from PLI scheme is a good one.

Bottom-up approach

The second type of strategy is called bottom-up approach where investors do a fundamental analysis of stocks basis certain indicators – Financial ratios, cash flows, reserves & surplus, sales etc. This clearly shows that investors using this approach look at company specific data in detail to make their investment decisions. This is typically done by experienced investors who are looking at finding the next undervalued stock so that they can get in early.

Bottom-up approach investors use various tools to figure out the performance of a company :

  1. Research reports
  2. Con calls with management to understand the future plans, competition, investment outlook etc.,
  3. Analyst views on guidance for both business & stock prices
  4. Visit to companies that they want to invest

Bottom-up investors do a lot of ground work before taking a decision on investing in a particular company.

So the question arises which investment strategy is good for you ? There isn’t really a right or wrong answer. It completely depends on whether you are an active or passive investor and your own goals. A lot of people also use a mix of both the strategies during the timeline of their investments. At the end of the day the goal for both type of investors is to find undervalued stocks that have the potential to make money in.