The difference between bottom-up and top-down investing
All investors want to make money from equity markets but you can go about it in many different ways.
Styles like growth, value and income are widely understood, as are buying shares directly or using funds or investment trusts.
And within the wider funds space there is the age-old debate about active versus passive, where you elect to put your cash to work with a trusted expert who picks stocks on your behalf, or go with trackers or ETFs, which will follow an index, sector or investment theme.
While more experienced investors will have already established what kind of investor they are, what sort of assets are attractive, and where to begin looking, those newer to investing may be confused with how to start a screening process.
One way is to decide if you are a top-down investor or a bottom-up one. These are two broad ways investors can work out a starting point to begin searching for investments that are right for them.
WHAT’S THE DIFFERENCE BETWEEN THE TWO?
• Top-down investing means you first look at the overall economic picture and then start drilling down in to areas that appear most fruitful. It is also known as macro investing.
• Bottom-up investing is stock picking, where the investor pays much more attention to a company at the start of the research process and less attention to its sector or the economy.
AN EXAMPLE OF TOP-DOWN INVESTING
Let’s look at a couple of hypothetical examples. The referenced investment products are for illustration only and not a recommendation for readers to buy.
John is a 50-year-old from Liverpool with two grown-up children and a third doing their A Levels. He works in the shipping insurance industry and already has a firm grasp of international markets and economies, and is comfortable investing overseas.
He believes that GDP growth of 6%-plus in China makes it an attractive investment market as the population in that region becomes increasingly wealthy and educated. He also thinks US consumers can continue to prop up the US economy for the foreseeable future, so likes North America as an investment space too.
In China John believes that smartphones and internet access will continue to drive digital entertainment, and believes that makes the technology and social media industries in China potentially exciting.
As part of his study of the markets, John puts online retail giant Alibaba on his research list as it has the potential to benefit from more Chinese people buying stuff on their smartphones.
John also wants access to wider trends in the US and China, so he looks for ETFs and funds to bolster his portfolio. One product he intends to research is iShares MSCI USA SRI UCITS ETF (SUAS), which blends large cap growth with income and owns names like Microsoft, Walt Disney and Pepsi.
He is also interested in learning about Fidelity Asia Pacific Opportunities Fund (BQ1SWL9), which has around three quarters of its assets in young and mature Asian companies.
That’s top-down investing, albeit a little simplified. It is a useful approach for choosing a specific country (if you are open to foreign stock investing), and it works well for asset classes like stocks, commodities and currencies.
Currencies don’t really have a bottom-up counterpart, anyway, because their value against other currencies is entirely based on macroeconomic factors.
The late 1990s was a great example of top-down investing, for instance, when many investors saw huge profits for companies that were taking advantage of the internet. While some of those stocks have done extraordinarily well since then, many more did not, crashing, burning and generating miserable returns for those that invested in them.
AN EXAMPLE OF BOTTOM-UP INVESTING
Now let’s look at an example of a bottom-up investor. Meet Sarah, a 36-year-old mother of two young children from Watford. She returned to work three years ago by taking a part-time job managing the women’s fashion floor in a local Marks & Spencer (MKS) store.
She’s nervous about directly owning shares in foreign businesses, preferring familiar brand names from the UK. She knows the fashion industry well, but is also aware that she can access global economies and companies either by buying shares in UK companies that sell a lot overseas, or by investing in funds that invest in overseas firms.
Sarah has learned a lot about Marks & Spencer in her time with the company, and while she understands that clothing sales performance has been propped up by far better food sales, she believes fashion sales can be turned round over the coming years through better buying and using the powerful Marks & Spencer brand.
On a next 12 months price-to-earnings multiple of 10.7 (based on Refinitiv data) the shares are on a rough 50% discount to the wider retail sector, and Sarah wonders if there is substantial share price recovery potential if management get the business back on track.
Should she proceed and buy the shares, her decision will have been influenced by her in-depth knowledge of the business – something that falls under the banner of ‘bottom-up investing’.
Choosing an investment because of the robust fundamentals or recovery potential, not the bigger industry, country or macroeconomic picture, is most widely used for equities, but it can also be easily applied to corporate bonds, since they have a similar source of value (the company).
Such an investor does not ignore macro trends, but they would put much more weight on company fundamentals than wider industry dynamics.