What is top down and bottom-up Investing?
In investing whether knowingly or not I am sure many of us do not have a professional approach. A lot of us have been through the ‘wild catting’ stage whereby the term is derived from the oil industry. In search of oil geologists will have to drill holes all over a prospective area because they do not know exactly where the oil lies. In stock market investing we all have done the same when we first started i.e throwing darts aimlessly at the dart board hoping to hit the bulls eye. We buy stocks on rumors, tips, recommendations from brokers and gurus or on whatever information we can get hold on. Of course we ended up getting our fingers burnt. We can’t blame ourselves because investing is not a game that can be mastered in a short period of time.
As we progress we learn a few tricks here and there and of course we became wiser. We do not chase stocks anymore, listen to rumors, bet the farm on a certain tips and we do not do things that had earlier get us into trouble. And yet we still cannot manage to make enough profits to maintain our lifestyles. In other words we cannot leave our full time job to become full time stock market investors. We still have to depend on our full time job to put food on the table.
To be frank in order to be a successful investor you have to go through a lot of challenges and obstacles. There are many aspects of trading we need to master like psychology, money management, stock picking, investing style whether be a passive or active investor and so on. But from my experience before we even start to dabble in the market the first thing we need to do is to understand what sort of personality we have. Basically there are four types of human personalities and they are sanguine, phlegmatic, choleric and melancholy. Understanding your own personality helps you understand your temperament and also of others.
Know your personality
Basically, I am a choleric and people like us are money-minded people. We are always looking for money making opportunities and we are very aggressive in our behavior. We are not the type of investors that will buy and hold for long period of time. Hence passive trading is not for me so I know that I am more incline towards active investing. So I reckoned that before you start investing again it is better for you to find out what personality you inherit. Then select the investing style that suits your personality.
Passive or Active Investing
After knowing our personality then our next move is to determine whether we are suited for either passive or active investing. Passive investors are those who will select some stocks based on some strong fundamentals and then hold on to it till for a long period of time. These types of people are suitable for the top down approach to investing. Active investors on the other hand tend to rebalance their portfolio every now and then. In short they are short term investors and stock picking and timing the market is their strategy. In actuality most of us are bottom-up investor because we tend to spend most of our time stock pick our portfolio.
Top down and bottom up approach
Whatever approach we apply in our investment strategy it falls back to either the top down or bottom up investing. In the top down approach we are basically looking at the macro side of investing. To build a top down portfolio you must first look into the country specific if you are not a global investor. By this I mean you pick your own country as your investment destination. The next thing you need to do is to identify the Sector/Group rotation. This is important because the benchmark index for any country in particular say in Malaysia the FBMKLCI is the total combination of different benchmark group indexes. FBMKLCI is the total of all the individual indexes from Trading and Services, Hotel, Plantation and so on.
After we have identified a particular Group that is moving in line with the Composite Index then we will look into the different Sectors within the Group. Although the movement of the Group correlates with the Composite Index it does not mean that all Sectors within the Group are also moving in the same direction. If you look closely into the different Sectors within a Group, you are bound to find out that there are some that move in different directions. This can be summarize by the following diagram
Thus our objective is to locate those Sectors that are moving in tandem with the Group. Having identified those Sectors then our next objective is to identify those individual stocks that are moving in line with the Sectors. After that you apply your fundamental screens to your stock picking process. This may include the following.
Liquidity. This refers to the volume of the stock trades every day. The bigger the volume the more liquid the stock. This is an important consideration when you intend to make a big investment that will have a ready market when you want to exit one day.
Market Capitalization. Again this also corresponds to the strategy above where we need to screen the size of the company we invest in.
Strategic or special attribute such as brand name, strong management, cost effective producer or maybe innovative that differentiates this company from others.
Good valuation. The performance metrics of a company need to be taken into consideration such as price to earnings, price to book ratios, debt equity ratios cash flows and etc.
Management assessment. Assess whether the management is focused and committed to their goals. If the management is known to be cost effective and innovative but it is not reflected in their profit and loss accounts and also if there is no product launch for the past year then this is a warning sign that the management is not doing its job. Also, watch out for any insider disposal of stocks. If the directors are selling their shares then this is a red flag.
Peer to Peer analysis. This is to compare the profitability and cost effectiveness of the company as compared to its peer within the same sector. Compare their profit and cost ratios. Some companies may be low priced but some of their hidden value is not reflected in their share price like a newly acquired contract or subsidiary.
As you can see when we practice bottom-up investing we tend not to see the forest but only the tree. In bottom-up investing we are always trying to time and stock pick without giving much consideration into the Sector/Group rotation. When a Sector moves up the individual stocks within the Group that you bought might not move up. So to be a better investor we need to look into the forest instead of individual trees.