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Top Down vs Bottom Up Approach
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How It Works And How Experts Manage Them
When it comes to selecting good companies to invest in, there has been much debate on the top down and bottom up approaches.
Most fund management companies use the top down approach and recommend that investors examine the economic and industry outlooks first before deciding on which stock to purchase.
However, investing gurus like Benjamin Graham, Phillip Fisher, Warren Buffet and Peter Lynch favour the bottom up approach.
They say that macroeconomics forecast is actually major distractions for investors as the projections might turn out to be wrong. Instead, investor’s efforts should be placed more on detecting the quality of earnings and asset value of the company.
Both approaches have their strengths and weaknesses, but they share a common goal; of identifying good fundamental companies to invest in. Let’s take a look at the difference between the two.
Top Down Approach
With the top down approach, investors study the economic trends, and the determine the industries and companies that are likely to benefit most of them.Take, for example, if the US dollar appreciate against UK Pound Sterling. The resulting reduction in prices of imported paper will contribute to lower operating costs for media companies and enhance their earnings. Investors will then search the more efficient and cheaply-priced media company.
Top-down investors will first look at the entire forest instead of specific trees and try to identify the main market theme ahead of the market in general. They believe that picking individual companies comes second because if the economic conditions are not right for the industry that that a company operates in, it will be difficult for the company to generates profits, regardless of how efficient it is. Nevertheless, such investors may sometimes miss good companies that are still performing well, even in depressed sector.
Bottom Up Approach
Bottom up investors conduct extensive research on individual companies. As long as the company’s prospect look strong, the economic, market or industry cycles are of no concern. In fact, the downturn in the stock market may provide investors with a good margin of safety to buy stocks at depressed levels and ride them up to big gains.Thus, bottom up managers will buy stocks even though the macroeconomic and industry outlooks look uncertain. When the industry may be out of favour and most investors are ignoring the true earning of companies, bottom-up managers ca detect good and well-managed ones selling at prices that are far lower than their intrinsic worth.
However, to top down managers, bottom up managers may be attempting to catch a “falling knife” (a stock whose price has fallen significantly in a short period of time) in a down market. Unless bottom up managers have plenty of bullets to average down on their purchase prices, they may run out of cash if the stock prices continue to go lower. In addition, they may sometimes fail to see the wood for the trees – they may identify certain companies but miss the overall industry trend.
Combination Approach
The top down and bottom up approaches are two distinct and fundamentally very different approaches to investing. Investors can combine the two approaches by applying top-down analysis on asset allocation decisions while using a bottom-up approach to select the individual securities in the portfolio.You should wait for a clearer economic picture before investing. You may miss fishing stocks at the market bottom but at least you know where the bottom is.
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