Which is better: top down or bottom up investing?

Choosing common stocks

Small picture things

There is a debate amongst investors about where to start when choosing common stocks. The debate is between the top down and bottom up approaches. I have always favoured the bottom up approach.

In this post I will discuss both and offer a few thoughts.

Top down vs Bottom up

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.

What are big themes? Examples would include aging demographics and its impact on the health and retail sectors; slower economic growth as developed economies mature and birth rates decline; the rise of Asia and emerging markets; clean energy and the green economy; reversal of globalization; food supply; national security including digital security; shifts in housing preferences; home office; robotics; e-commerce; and so on.

Top down investors identify the big themes and then look for investments to play those themes. It’s a two-step process, in that order.

Bottom up investors look for what Warren Buffett calls ‘seven footers’, companies that exhibit all the hallmarks of truly outstanding businesses, wherever they can find them. They will have outstanding economic performance, a great business franchise, financial strength, highly competent and coinvested management and quality business operations. If they have all those attributes, there is a good chance they are on the right side of some significant secular trend in the economy.

You look for the business first and afterwards, as a kind of reflection, think about how it fits with the big themes. It’s a two-step process, in that order.

There is always a danger. Let’s say you find a company that almost checks the boxes to be a seven footer. You think, on reflection, this company is a perfect play on demographics. On that basis you decide to invest. You have just made a big mistake. You have lowered your standards because you were persuaded by an attractive narrative.

To be a good bottom up investor you need to read widely about trends in society, the economy and the stock market. It’s just that they provided background. They don’t drive the investment process and shouldn’t modify your principles of operation.

What some experts say

Let’s look at some comments around this debate from a couple of well-known investors.

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. John Neff on Investing is a book he wrote describing how he came to investing, how he achieved those results and his experiences as a fund manager. (Neff, John Neff on Investing, 1999)

John 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, 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.

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.

Howard Marks offers some very wise advice that explains the benefit of bottom up investing: “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

Discussion

There are secular trends of varying lengths in business, the economy and society. Since serious investors are in for the long haul, they would do well to learn as much as they can about certain long term trends and try to understand them. There is a caution for investors in trying to take advantage of long term trends. Such trends can be woven into an enticing story about a stock and its underlying company. Many investors have lost money trying to tie their fortunes to a trend such as demographics and an aging population. They become victims of the halo effect or the affect heuristic. Their Kahneman system 1 makes the decision for them. They never do the homework necessary to examine the true investment merits of the company. For more on the halo effect see my post here.

I suspect that a lot of investors will lose a lot of money by investing in themed ETFs. They carry with them all the shortcomings and dangers of investing in a story or narrative and have none of the discipline of ensuring the companies in the ETF actually have superb businesses. This is halo investing at its worst.

When I look at the companies in my own portfolio, many are quite prosaic. One makes labels. One brokers real estate deals. One makes and sells toys. One brokers truck transport. And so on. I suppose I could describe them in terms of some of the themes I listed at the beginning of this post. That would make them sound sexy.

Conclusion

But, I don’t need sexy. I just want them to make lots of money.

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To dig further into the whole subject of identifying common stocks take a look at Chapter 31. General approach to choosing common stocks

To learn more about major trends in the economy and how they impact our investing you can check out

Chapter 8. The Economy and the Stock Market – Cycles and Trends

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You can reach me by email at rodney@investingmotherlode.com

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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.

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