Top-down and bottom-up investing are vastly different ways to analyze and invest in stocks. There are advantages to both methodologies. However, both approaches have the same goal; to identify great stocks. In this article, we'll review the characteristics of both methods.
The top-down approach to investing focuses on the "big picture" or how the overall economy and macroeconomic factors drive the markets and ultimately stock prices. They will also look at the performance of sectors or industries. These investors believe that if the sector is doing well, chances are, the stocks in those industries will also do well.
Top-down investment analysis includes:
Bank Stocks & Interest Rates
Below is a chart showing a top-down approach with correlating the 10-year Treasury yield to the Financial Select Sector SPDR ETF (XLF) over the last couple of years.
A top-down investor might look at rising interest rates and bond yields as an opportunity to invest in bank stocks. Typically, not always, when long-term yields rise, and the economy is performing well, banks tend to earn more revenue since they can charge higher rates on their loans. However, the correlation of rates to bank stocks is not always positive. It's important that the overall economy is performing well while yields rise.
Home Builders & Interest Rates
Conversely, suppose you believe there will be a drop in interest rates, using the top-down approach, you might determine that the homebuilding industry would benefit the most from lower rates since lower rates might lead to a spike in new homes purchases. As a result, you might buy stocks of companies in the homebuilding sector.
Commodities & Stocks
If the price of a commodity such as oil rises, the top-down analysis might focus on buying stocks of oil companies like Exxon Mobil Corporation (XOM). Conversely, for companies that use large quantities of oil to make their product, a top-down investor might consider how rising oil prices might hurt the company’s profits. At the onset, the top-down approach starts looking at the macroeconomy and then drills down to a particular sector and the stocks within that sector.
Countries & Regions
Top-down investors might also choose to invest in one country or region if its economy is doing well. For example, if the European economy is doing well, an investor might invest in European ETFs, mutual funds, or stocks.
In short, the top-down approach examines various economic factors to see how those factors may affect the overall market, and therefore certain industries, and ultimately individual stocks within those industries.
For more on the top-down investing, please read A Top-Down Approach To Investing.
The bottom-up investing approach, a money manager will examine the fundamentals of a stock regardless of market trends. They will focus less on market conditions, macroeconomic indicators, and industry fundamentals. Instead, the bottom-up approach focuses on how an individual company in a sector is performing compared to specific companies within the sector.
Bottom-up analysis focus includes:
- Financial ratios including the price to earnings (P/E), current ratio, return on equity, and net profit margin,
- Earnings growth including future expected earnings,
- Revenue and sales growth,
- Financial analysis of a company's financial statements including the balance sheet, income statement, and the cash flow statement,
- Cash flow and free cash flow show how well a company generates cash and is able to fund its operations without adding more debt.
- Management's leadership and performance,
- A company's products, market dominance, and market share.
The bottom-up approach invests in stocks where the above factors are positive for the company, regardless of how the overall market may be doing.
Bottom-up investors also believe that just because one company in a sector is doing well, that does not mean that all companies in the sector will also perform well. These investors try to find the particular companies in a sector that will outperform the others. That’s why bottom-up investors spend so much time analyzing a company. Bottom-up investors typically review research reports that analysts put out on a company since analysts often have an intimate knowledge of the companies they cover. The idea behind this approach is that individual stocks in a sector may perform well, regardless of poor performance by the industry or macroeconomic factors.
However, what constitutes a good prospect, is a matter of opinion. A bottom-up investor will compare companies and invest in them based on their fundamentals. The business cycle or broader industry conditions are of little concern.
A top-down approach starts with the broader economy, analyzes the macroeconomic factors, and targets specific industries that perform well against the economic backdrop. From there, the top-down investor selects companies within the industry. The top-down approach is easier for investors who are less experienced and for those who don't have the time to analyze a company's financials.
A bottom-up approach looks at the fundamental and qualitative metrics of multiple companies and picks the company with the best prospects for the future. Bottom-up investing can help investors pick quality stocks that outperform the market even during periods of decline.
Both approaches are valid and should be considered when designing a balanced investment portfolio.