Top-down investing starts by looking for big themes in the economy or the investment universe. It builds a portfolio with these in mind.
Bottom-up investing starts with an assessment of individual companies to build a portfolio.
The small picture
Howard Marks offers some very wise advice: “The more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage. With hard work and skill, we can consistently know more than the next person about individual companies and securities, but that’s much less likely with regard to markets and economies. Thus, I suggest people try to ‘know the knowable.’” (Marks, The most important thing illuminated: uncommon sense for the thoughtful investor, 2013) p143
This makes a lot of sense to me. But, how can we avoid the impact of major trends or themes on our portfolios. Surely we have to be aware of them.
Big picture and small picture
John Neff managed the Windsor Fund for more than 30 years. Over the period when he was at the helm, the average annual total return of the Windsor Fund beat the S&P 500 by 3.15% per annum. Neff writes: “As advocates of Measured Participation, we attacked stock picking from both directions. Broad economic themes, at times, highlighted oil stocks or bank stocks; then we would burrow down to determine the fundamentals of each investment candidate. On other occasions, a particularly pummeled stock wandered onto our radar scope when its Price/Earnings ratio came into range.” (Neff, John Neff on Investing, 1999) p110.
Neff tells us: “Windsor chalked up its most eye-catching gains after anticipating correctly major inflections points. The ability to see these shifts coming and gear up for their aftermath requires both top-down and bottom-up analysis. A wise investor studies the industry, its products, and its economic structure.” (Neff, 1999) p111.
Major inflection points
This emphasis on anticipating ‘major inflection points’ smacks of market timing. It is a very enticing but a dangerous game. In practice, inflection points in business and the economy do not happen at the same time as inflection points in the stock market. Those in the stock market usually happen when you are least expecting them. It is often when an economic or stock market trend seems firmly in place that a bit of straw comes along and breaks the camel’s back.
All investors struggle with the big themes, the big picture. It’s not just how the big picture affects asset allocation or fundamental strategies. The big picture also affects the prospects of individual companies. It’s not just ‘whither the economy?’ It’s also ‘wither interest rates?’ And ‘wither commodity prices?’ Or ‘wither exchange rates?’ It is also any number of other big picture issues. The investor then has to gauge their impact on individual companies.
The more one approaches investing from the top down the more one’s investing is subject to the vicissitudes of forecasts and predictions. The Motherlode leans strongly against any approach to investing that depends on forecasts.
Monitoring top down issues
Here’s how I deal with the problem. I start bottom-up and monitor for the impact of big picture themes on my individual stocks.
This past week I received and read the Management Information Circular and Annual Report of a copper mining company we hold shares in. It represents 7.89% of our portfolio currently. We have owned the shares for years. This company makes money from successfully developing and operating mines. The small picture is its specialist technical, engineering, construction and operational skill which allows the company to develop and successfully run complex mines and processing plants and its money making ability. Since our family only holds shares in 12 companies it is relatively easy to study the annual and quarterly reports of the companies we hold shares in and stay abreast of their operations and economic performance.
The big picture as it affects this company is the world economy, demand for industrial commodities, China’s economy which consumes an outsized portion of world copper production, oil prices (a mine operating cost), geopolitical risks, copper prices and so on. I pick up information about all these issues from a variety of sources. In effect, I am monitoring top-down issues constantly to make sure I stay reasonably educated about them.
I suppose I can say I favor the bottom-up approach combined with lots of reading about big picture issues that might affect individual stocks. With this approach, one never starts with a top-down theme and then looks for stocks to play that theme. One looks for superb stocks priced as bargains wherever you happen to find them. Part of that analysis includes reflecting on how big picture themes might affect the company.
I should add that whenever I am thinking about making a change in the portfolio, I look carefully to see how the stock might affect the business (hence risk) diversification and balance of the portfolio.
This post recaps the first part of Chapter 34. Bottom Up and Various Qualities of the Motherlode and the chapter continues with these Sections:
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