Top-down research and bottom-up research are vastly different ways to look at stocks. There are great advantages to both methodologies, but too much reliance on only one will keep your portfolio from reaching its maximum potential. In this article we'll show you the characteristics of both, and how to meet in the middle between the two so you'll be on your way to finding the ultimate "sweet spot" of investing.
Top-down research begins by thinking about the big picture. Top-down investing looks at macroeconomic variables, as the state of the overall economy plays a big role in the investment decision. Certain sectors are always performing better than others, and top-down research will look for opportunities in these sectors first. (For more on this topic, see A Top-Down Approach To Investing and Sector Rotation: The Essentials.)
Typical topics that are researched at this level include:
- Intellectual Property: Patents and other intellectual property that a company owns can be extremely valuable, as licensing fees essentially become free cash flow for the company. Intellectual property also creates an expensive barrier to entry for any competitors that wish to enter the company's markets. (For related reading, see The Hidden Value Of Intangibles and Advertising, Crocodiles And Moats.)
- Novel Products: A company that is first to market in a new product category or that comes out with a novel product for an existing market can pick up market share quite rapidly. Larger-than-anticipated sales growth reports are usually a boon to stock prices, as the market can justify a higher valuation multiple on the company's future earnings. (For more insight, see Forecasting Sales Growth.)
- Demographics: Money is constantly flowing in and out of different demographic groups. Because demographics are used to describe the whole of a society, there are literally millions of customers at stake. Companies benefiting from large demographic shifts into their markets are essentially increasing their potential audience for free, and this can pave the way for strong revenue growth for many years.
A good example of a top-down thinking process would go something like this: "I know that there is a huge population of baby boomers that will begin to enter retirement in the next 10 to 15 years. This could lead to a larger-than-average demand for certain goods as people of that generation retire and begin spending their savings. I think many of them will want to do a lot of traveling - maybe I should look into travel-related companies with some of my research time."
Many of the greatest investment ideas from the past 15 years could be summed up with just a few sentences that might have been overheard at a cocktail party or informal investment meeting. Consider the following:
Cisco Systems (CSCO) - "Internet growth is really exploding. This thing looks like it's going to be big, and worldwide. There is going to be a huge need for equipment to get the Internet up and running. These folks at Cisco make those things - it's just like the guy selling picks and shovels outside the gold mine."
Intel Corporation (INTC) - "The personal computer is so helpful and productivity-enhancing that just about every office worker in the country will have one soon. Probably every household as well. Processors need to be in every single one, and nobody seems to have a competitive product to match Intel. It will take a long time for anyone to catch up to them technologically."
Bottom-up research, by contrast, is all about the numbers. An easy way to begin doing this type of stock research is by using a stock screener. In this method, certain variable constraints are entered into a program that filters out any companies not meeting the specified criteria. Also at this level of research, the state of the economy is not considered, the idea being that a great company can make money in any market environment. Bottom-up research is a great way to discover companies that we would ordinarily not be drawn to. This could be because the company is small (as measured by market cap), or that it operates in a "non-sexy" industry. If the numbers look good, a bottom-up investors will happily buy stock in his or her local garbage collector! Some of the other items that are studied at this level include:
- Potential Market Size: While difficult to calculate precisely, gauging the potential market for a product or service gives us an idea of how much earnings potential the company can achieve. Some products and services that have low net margins require high sales volume in order to achieve maximum profitability. (For related reading, see The Bottom Line On Margins.)
- Sales and Earnings Figures: Strong earnings and sales in the present is essential here, as the company is evaluated on its current merits. Future earnings potential is also important, but a bottom-up research play should look good for purchase today, not some date in the future.
- Balance Sheet: A clean balance sheet is a key factor in bottom-up investing because it shows management's effectiveness and prudent allocation of capital. Companies with high debt loads or poor current accounts management are to be avoided here. (To learn more, see Reading The Balance Sheet, Breaking Down The Balance Sheet and Testing Balance Sheet Strength.)
- Cash Flow: Strong free cash flow shows that a company is able to fund its operations without adding more debt, and leaves room for potential dividend increases in the future.
- Market Share: The best companies will be making consistent market share gains as well as expand into new markets with solid growth prospects.
An important thing to keep in mind when doing bottom-up research is that each industry has its own ranges of valuation, profitability and earnings growth. A technology company growing earnings at 10% a year may be a very poor investment, but an auto company growing earnings at 10% is more likely to be a great pick. Be sure to look at the industry averages when changing industries so that the figures you research for any company in that industry can be viewed in the proper perspective.
Wait for the Great Pitch to Hit
"The Stock Market is a no-called-strike game. You don't have to swing at everything…you can wait for your pitch." - Warren Buffet
There are literally tens of thousands of stocks out there to choose from. This means that if you are diligent enough, you should be able to find companies that fit the requirements of both kinds of research. The above example of Cisco is a good one because the company would have satisfied any bottom-up researcher's requirements, beginning in the early 1990s. Cisco had a reasonable valuation, consistent management and strong fundamentals for nearly a decade before the internet boom of the late '90s caused the stock to really take off.
As an investor, you can start at either end of the research spectrum, but in many cases, it is easier to start with the top-down approach, and using this, produce a list of companies and industries that look exciting to you. From this list, you can then begin to conduct your due diligence by doing extensive bottom-up research. You may find that many of the companies on your list don't look so good anymore, and that's OK. Only a handful of companies should make it through the gauntlet; the goal is to find just a few companies that you feel very confident in. These companies could make great candidates for long-term holdings.
If we look at the careers and philosophies of the greatest investors of our time, we can see a common theme. They were mostly highly educated people who developed a profound understanding of the fundamental numbers and details of the companies they owned. But they also had a long-term thesis - a non-quantifiable belief in the future of a business based on a vision of the future. Hold true to the same goals and soon you'll be swinging for the fences.