Top-down and bottom-up investment are vastly different ways to analyze and invest in stocks. There are advantages to both methods. However, both approaches have the same goal; to reveal large reserves. In this article we consider the features of both methods.
From The Top Down
“Top-down” approach to investing focuses on the “big picture” or the overall economy and macroeconomic factors drive markets and ultimately the stock prices. They will also look at the performance of sectors or industries. These investors believe that if the sector is good, the chances of stocks in those sectors will also do well.
Top-down investment analysis includes:
- Economic growth and gross domestic product (GDP) in the United States and around the world
- The monetary policy of the fed, including lowering or raising interest rates,
- Inflation and commodity prices,
- Bond price and yield, including U.S. Treasury bonds.
Bank Stocks And Interest Rates
Below is a Chart showing the top-down approach, correlating with the 10-year Treasury bonds yield DWCPS financial select sector etf (xlf) for the last couple of years.
Top-down investor may look at rising interest rates and bond yields as an opportunity to invest in banking stocks. Usually, not always, when long-term interest rates will rise, and the economy is good, banks tend to earn more revenue since they can charge higher interest rates on their loans. However, the ratio of the prices of the banking shares are not always positive. It is important that the economy as a whole works well, and the yield will rise.
Home Builders & Interest Rates
Conversely, suppose that I believe that there will be a decline in interest rates using a top-down approach, it is possible to determine that the construction industry will benefit from lower rates, since lower rates can lead to a spike in the purchase of new homes. As a result, you can buy shares of companies in the sector of the economy.
Products And Promotions
If the price of a commodity such as oil increases, top-down analysis can focus on the purchase of shares in oil companies Exxon Mobil Corporation (KGS). Conversely, for companies that use large amounts of oil to make their product a top-down investor can consider how rising oil prices can hurt the Company’s profit. In the beginning, the top-down approach begins to look at the macroeconomy, and then drills down to specific sectors and stocks in this sector.
Countries And Regions
Top-down investors can also choose to invest in one country or region, if its economy is doing well. For example, if the European economy is doing well, the investor may invest in European ETFs, mutual funds or shares.
In short, the top-down approach considers various economic factors to see how these factors may affect the market as a whole, and therefore individual sectors, and ultimately individual stocks in these sectors.
Additional top-down investing, please read the top-down approach to investing.
From The Bottom Up
Bottom-up investment approach, the cash Manager will learn the basics of the stock regardless of market trends. They will be less attention to market conditions, macroeconomic indicators and principles of the industry. Instead, the bottom-up approach focuses on how companies in the industry about specific companies in this sector.
Bottom-up focus of the analysis includes:
- Financial ratios , including price to earnings (p/E) current ratio, return on equity and net profit margin,
- Earnings growth, including expected future revenues,
- Revenue and sales growth,
- Financial analysis of enterprise financial statements, including balance sheet, income statement and statement of cash flows,
- Cash flow and free cash flow show how well the company generates cash and can Finance their operations without adding more debt.
- Management leadership and performance
- The company’s products, dominating the market and the stock market.
The bottom-up approach invests in the stock market, where these factors are positive for the company, regardless of how the overall market can do.
Bottom-up investors also believe that companies in the industry all right, that does not mean that all companies in this sector will also be good. These investors are trying to find specific companies in a sector that will outpace the rest. That’s why bottom-up investors spend a lot of time analyzing the company. Bottom-up investors typically consider research reports, analysts, because analysts often have in-depth knowledge of the companies they cover. The idea of this approach is that individual stocks in the sector can perform well, regardless of low performance in the industry and macroeconomic factors.
However, what constitutes a good prospect, it is a matter of opinion. From the bottom up, the investor can compare companies and invest in them based on their fundamentals. The business cycle or broader industry conditions are of little concern.
The top-down approach starts with the broader economy, analyzes the macroeconomic factors and challenges of specific industries that work against economic conditions. From there, the “top-down” is selected by the investor company in the industry. The top-down approach is easier for investors who are less experienced and for those who don’t have the time to analyze the financial performance of the company.
The bottom-up approach looks at fundamental and qualitative indicators of several companies and selects the company with the best prospects for the future. Bottom-up investing can help investors to choose quality stocks that outperform the market even in times of recession.
Both approaches are valid and should be considered when designing a balanced investment portfolio.
More about the different methods of stock selection, we encourage You to check out Our promotions choosing a Textbook, and “top-down” approach to investing.