Bottom-up vs. Top-down – How to choose the right stock-picking approach
If you’ve been investing in the stock market for a while, or if you’re doing research about the best ways to choose what companies to invest in, you’ve probably heard of the bottom-up and top-down approaches.
How can you use these two approaches to filter the stocks that you want to focus on? Let’s have a look at both strategies to help you understand how to best use them in your trading.
Understanding the bottom-up approach
When using the bottom-up approach, investors believe that individual companies can perform well even if their industry, or the overall economy, isn’t doing that well. Because in the end, so the theory goes, it all comes down to the company’s fundamentals and its competitive advantages that will help them thrive.
According to this technique, market cycles and conditions, as well as the global macroeconomic environment, do not have a big impact on company performance. Of course, these factors are taken into account eventually, but the process begins at the bottom, finding a promising company and working your way up to consider macroeconomic perspectives.
With the bottom-up method, companies are assessed according to their relevance to users in the real world. It mostly considers microeconomic factors to make an investment decision, like the company’s overall financial health (P/E ratio, cash flow, earnings per share, sales, profits, operating profit margin, debt ratio, working capital ratio, price-to-sales ratio…), which kind of products/services it offers and the management and leadership team, as well as the evolution of supply and demand.
- The bottom-up approach gives investors a deep understanding of a company, giving them clues about potential growth prospects
- This process helps investors select companies that are outperforming the market or companies that are able to grow during unfavorable conditions
- It is an ideal method for investors following a “buy-and-hold” strategy
- This method requires time, as you need to do a thorough review of a company before investing
- You also need to know how to read a company’s research reports and financial statements
- With this technique, you can overlook important and relevant macroeconomic factors that could impact a company’s growth prospect
- Bottom-up investing is more relevant for long-term investments, as it bets on longer-term growth
If a company has a strong and unique marketing strategy in a niche market that might currently be underperforming, but its sales are increasing, investors following the bottom-up method could decide to invest in this company.
Bottom-up investors also like to invest in companies they use and know about, like Meta (formerly known as Facebook), Amazon, and Google for instance.
Understanding the top-down approach
When using the top-down approach, investors believe that they should first take into account the general health of an economy to spot countries with the best economic conditions. Then, they look at promising sectors before considering companies that will outperform within these industries.
With this stock-picking method, investors first take into account market cycles and conditions, as well as the global macroeconomic environment and outlook, because they consider that they are important elements of a company’s performance. At the end of their analysis process, they take into account the company fundamentals to find out the most promising firms to invest in.
For an idea of the big picture conditions with top-down investing, investors first have a look at macroeconomic factors like growth (GDP), trade (trade balance), inflation (CPI, PP, etc), employment (employment report, unemployment rate), exchange rate, commodity prices, monetary policy (interest rates, QE program…), changes int the political climate, etc.
- Often used to make strategic trades or investments over the short to medium-term to focus on what works now
- Great way to know which industries are currently performing well in a given country
- Perfect approach to take into consideration the big picture and know which sectors drive the markets
- With this type of market analysis, investors might consider opportunities that they wouldn’t have considered otherwise, as the top-down approach broadens their scope
- It might also be a great way to better diversify their investments
- Top-down investing is often considered a more efficient method when it comes to investor time spent on selecting investments, as they first look at large-scale economic aggregates before selecting high-performing regions, sectors, then companies
- It is an easier approach for less-experienced traders and investors
- By mostly looking at macroeconomic factors, top-down investors might miss out on great opportunities – when certain industries prosper, not every business flourishes
- It might be difficult to do research properly if investors don’t understand the market, business, and economic cycles, as well as which macroeconomic factors impact the most countries/sectors they want to focus on
- Sudden changes in the geopolitical environment can make a trading approach obsolete quickly
British investors might find out that economic growth in the US is better than the local market and decide to focus on investment opportunities in the United States.
From this point, they can decide which sectors will perform better in this macroeconomic environment and find outperforming companies within these sectors. As the United States is starting to normalize its monetary policy, top-down investing could suggest that financial firms are a good choice.
What’s the best approach?
The first thing to understand is that there is no single approach for all types of investors and traders. In the end, it all comes down to your preferences!
Think about your preferred style of investing, your goals, as well as your knowledge and your anticipated time in a trade to be sure you’re making the right choice and you’re able to take advantage of the best opportunities.
You should also know that both techniques aren’t mutually exclusive, as you can use both methods in your trading to build a stronger and more diversified portfolio.
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