May 5, 2008|
Investing framework: Top down vs bottom up
In the previous article, we examined the importance of independence in building an investing framework. In this article, we shall discuss the merits of a top down vs. a bottom up approach for investing.Earlier articles in the series
Defining top down vs. bottom up
The top down approach of stock picking involves first choosing high growth/brilliant industries and only then choosing the most promising companies in these industries i.e. choosing a hot company in a hot industry. On the other hand, the bottom up approach to stock picking puts its emphasis solely on the companies, with very little emphasis on industry or economy level information.
The advantage of bottom up investing
Top down investing can be tricky because apparent likelihood for physical growth in an economy/industry and the businesses therein do not turn into obvious profits for equity investors. Why? Because unforeseen events at the economy level, competition at the industry/business level and valuations at the equity level introduce a great deal of uncertainty.
To quote Warren Buffett, Fortune Magazine, 1999, "...glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the manufacture of radios and televisions, for example...a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
The problem with taking one's concentration away from the company level information is that one spreads one's limited mental energy too thin. With bottom up investing, one pays close and undivided attention to the actual point of investment- the equity value of the business/company. As Warren Buffett says, "If Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn't change one thing I do." He has recently reiterated the importance of thinking small.Read Warren Buffett's comment in Berkshire's 2008 AGM
How to inculcate the bottom up approach
One should focus most of one's time and attention on the valuations of individual companies, with only a very limited glance at the arcane accounting mathematics, valuation of the overall market, industry prospects or macro economic projections. It is a good idea to spend most of one's time reading and thinking on information that directly relates to the company and its competitors: annual reports, results, and announcements.
Interestingly, just like the "independence", "focus on information close to the companies" should come easier to retail investors than their professional counterparts. In the quest of complex answers to easy problems, they often go into esoteric territories that absorb precious time and energy.
This is not to say that macro economic variables and industry prospects are unimportant. It also doesn't mean that significant money hasn't been made by a few from sophisticated plays on macro-variables. George Soros comes to mind. Even Warren Buffett, the consummate bottom up investor, talks about interest rates and corporate profits as a % of GDP. But that has to do with things like setting his expectations of a return correctly- and not for deciding which stocks to choose. Top down crystal ball gazing is much too complex and it is very difficult to derive value oriented investment ideas from it.
We shall continue with our discussion on building an investing framework in the next article.
Reading is an excellent way to develop one's investment framework. We urge you to refer to investment classics (books, articles and speeches) in the original.
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