Two extremely important approaches to investing in equities are the top down and the bottom up approach in investments. The difference between the top down and bottom up approach is that the former starts with the macros and then drills down to the micros while in the latter case, the focus is more on the stock and the macros are used purely to ratify the view. If you were to purely look at a top down versus bottom up approach argument, then there are no clear answers. Obviously, top-down works very well in certain circumstances while bottom-up works well in certain circumstances. The skill of the stock picker also lies in understanding which method to apply and when to apply.
Understanding top-down and bottom-up approach..
In a top-down approach, you essentially adopt an EIC approach to investing. E refers to the Economy and you first take a call on whether the domestic and global economic scenario is conducive for investment. Once the Economy condition is satisfied then you assess the” I”, which represents the Industry in which the company operates. You look at factors like how the industry is growing, what are the input costs, what are the output price trends, entry barriers in the industry etc. Once the investor is convinced that the strengths and opportunities outweigh the threats and weaknesses of the industry, then you move to the last step. C refers to the specific company where you propose to invest and that which has passed the Economy and Industry test. Then you drill down to financials like profitability, solvency, liquidity, efficiency, valuations etc. It is based on this EIC approach that the top-down approach is implemented.
The bottom-up approach looks at stock triggers straight away. The company is the starting point. Bottom-up approach is based on the premise that good companies can successfully create wealth even in tepid markets and when the economy is not performing great. This is true if you look at specific instances like TTK Prestige, Eicher and Indo Count which actually gave phenomenal returns at a time when the markets did not show any great outperformance overall. The difference between the top-down and bottom-up approach is that the latter believes that stocks can be economy and sector agnostic.
When can top-down approach work well for investors..
The top-down approach works very well in case the market is being largely driven by macro factors. Let us take some practical examples. Back in 2008, at the peak of the Lehman crisis, all the asset classes across the board and across the world were crashing. Similarly, in December 2015 when the US Fed hiked Fed rates for the first time, equities across the world lost nearly $13 trillion in terms of market capitalization. In such circumstances a top-down approach can work very well. Another case is where the markets are quoting at salivating valuations. Take the case of mid-2002 and March 2009 when the Nifty was quoting at around 11 P/E. In such circumstances, a top-down valuation argument is good enough to buy stocks. Top-down can work well here. Another case is where the key trigger for markets is a global event. It could be the Greek crisis, the oil price crash or even the bet on Euro zone. All these are macro stories where the top-down approach can work pretty well. Instead of focusing on top down versus bottom up investing, it is more important to understand which method works better in what circumstances.
When does bottom-up approach work well for investors..
The basic difference between top down and bottom up approach is that the latter is more stock specific. The argument that stocks can be economy agnostic and sector agnostic is true most of the time if not all the times. There are some basic rules that one needs to follow. In times of high volatility (say, VIX above 25), your bottom-up approach may not really work as the focus shifts towards predominant macro risks. On the other hand, mid-cap stocks are more amenable to a bottom-up approach than to a top-down approach. That is because, most mid-caps operate on a unique set of economic drivers which are not exactly connected to the broad macro-economy. We have seen stocks like Britannia and Lupin give phenomenal multi-bagger returns between 2010 and 2013 despite the markets being tepid overall. These had nothing to do with the macro-economy or the industry. These are unique company-specific stories.
Top down and bottom up approach to investing do work quite effectively in certain unique set of circumstances. However, the real alpha for fund managers is when they are able to identify a company before it becomes a star in the market. That is what alpha is all about and that is only possible through a bottom-up approach to investing.