A Top-Down Approach To Investing

An area that most investors struggle with is the art of picking stocks. Should they base their decisions solely on what the company does and how well it does it? Or should investors be more concerned about larger macroeconomic trends, such as the strength of the economy, and then determine which stocks to buy? There is no right or wrong answer to these two questions. However, investors should develop systems that help them to achieve their investment goals. The second option mentioned is referred to as the top-down investing approach to the market. This method allows investors to analyze the market from the big picture all the way down to individual stocks. This differs from the bottom-up approach, which begins with individual stocks' fundamentals and eventually expands to include the global economy. This article will concentrate on the process used when investors implement the macro-to-micro style referred to as the top-down approach.


Start at the Top: The Global View
Because the top-down approach begins at the top, the first step is to determine the health of the world economy. This is done by analyzing not only the developed countries of North America and Western Europe, but also emerging countries in Latin America and Asia. A quick way to determine the health of an economy is to look at the amount of gross domestic product (GDP) growth of the past few years and the estimates going forward. Oftentimes, it is the emerging market countries that will have the best growth numbers when compared with their mature counterparts.

Unfortunately, because we live at a time in which war and geopolitical tensions are heightened, we must not forget to be mindful of what is currently affecting each region of the world. There will be a few regions and countries throughout the world that will fall off the radar immediately and will no longer be included in the remainder of the analysis simply due to the amount of financial instability that could wreak havoc on any investments.


Analyze the Trends


After determining which regions present a high reward-to-risk ratio, the next step is to use charts and technical analysis. By looking at a long-term chart of the specific countries' stock index, we can determine whether the corresponding stock market is in an uptrend and is worth taking further time to do some analysis on or is in a downtrend, which would not be an appropriate place to put our money at this time. These first two steps can help you discover the countries that would match your wants and needs for diversification.  

Look to the Economy
The third step is to do a more in-depth analysis of the U.S. economy along with the health of the stock market in particular. By examining the economic numbers such as interest rates, inflation and employment, we are able to determine the current strength of the market and have a better idea of what the future holds. There is often a divergence between the story the economic numbers tell and the trend of the stock market indexes.

The final step in macroanalysis would be to analyze the major U.S. stock indexes such as the S&P 500 and Nasdaq. Both fundamental and technical analysis can be used as barometers to determine the health of the indexes. The fundamentals of the market can be determined by such ratios as price-to-earnings,price-to-sales and dividend yields. By comparing the numbers to past readings, it can help determine whether the market is at a level that is historically overbought or oversold. Technical analysis will help ascertain where the market is in relation to the long-term cycle. Use charts that show the past several decades and zone down the time horizon to a daily view. For example, indicators such as the 50-day and 200-day moving averages are used to help us find the current trend of the market and whether it is appropriate for investors to be invested heavily in equities.

So far, our process has taken a macro approach to the market and has helped us determine our asset allocation If, after the first few steps, we find that the results are bullish, there is a good chance a majority of the investment-worthy assets will be from the equities market. On the other hand, if the outlook is bleak, the allocation will shift its focus from equities to more conservative investments such as fixed income and money markets.

Microanalysis: Is This Investment Right for You?

Deciding on an asset allocation is only half the battle. The next integral step will help investors determine which sectors to focus on when searching for specific investments such as stocks and exchange traded funds (ETFs). Analyzing the pros and cons of specific sectors (ex. health care, technology and mining) will narrow the search even further. The process of analyzing the sectors involves tactics used in the prior approach such as fundamental and technical analysis. In addition to the mentioned tools, investors also must consider the long-term prospects of the specific sectors. For example, the emergence of an aging baby boom generation over the next decade could serve as a major catalyst for sectors such as healthcare and leisure. Conversely, the increasing demand for energy coupled with higher prices is another long-term theme that could benefit the alternative energy and oil and gas sectors. After the entire amount of information is processed, a number of sectors should rise to the top and offer investors the best opportunities.

The emergence of ETFs and sector-specific mutual funds has allowed the top-down approach to end at this level in certain situations. If an investor decides the biotech sector is an area that must be represented in the portfolio, he or she has the option of buying an ETF or mutual fund that is composed of a basket of biotech stocks. Instead of moving to the next step in the process and taking on the risk of an individual stock, the investor may choose to invest in the entire sector with an ETF or mutual fund.

However, if an investor feels the added risk of selecting and buying an individual stock is worth the extra reward, there is an additional step in the process. This final phase of the top-down approach can often be the most intensive because it involves analysis of individual stocks from a number of perspectives.

Fundamental analysis includes a variety of measurements such as price/earnings to growth ratio,return on equity, and dividend yield, to name a few. An important aspect of individual stock analysis will be the growth potential of the company over the next few years. Ideally, investors want to own a stock with a high growth potential because it will be more likely to lead to a high stock price.

Technical analysis will concentrate on the long-term weekly charts, as well as daily charts, for an entry price. At this point in time, the individual stocks are chosen and the buying process begins.

The Positives of Top-Down
The proponents of the top-down approach argue the system can help investors determine an ideal asset allocation for a portfolio in any type of market environment. Oftentimes a top-down approach will uncover a situation that may not be appropriate for large investments into equities. The ability to keep investors from over-investing in equities during a bear market is the biggest pro for the system. When a market is in a downtrend, the probability of picking winning investments drops dramatically even if the stock meets all the required conditions. When using the bottom-up system, an investor will determine which stocks to buy before taking into consideration the state of the market. This type of approach can lead to investors being overly exposed to equities and the portfolio will likely suffer. Other benefits to the top-down approach include the diversification among not only top sectors, but also the leading foreign markets. This results in a portfolio that is diversified within the top investment worthy sectors and regions. This type of investing is referred to in some small circles as "conversification", a mixture between concentration and diversification.

The Not-So-Positives of Top-Down Investing
So far, the top-down approach may sound foolproof; however, there are a few factors investors must consider. First and foremost, there is the possibility that your research will be incorrect, causing you to miss out on an opportunity. For example, if the top-down approach indicates that the market is set to continue lower in the near future, it may result in a lesser exposure to equities. However, if your analysis is wrong and the market rallies, the portfolio will be underexposed to the market and will miss out on the rally gains. Then there's the problem of being under-invested in a bull market, which can prove to be costly over the long term. Another downfall to the system occurs when sectors are eliminated from the analysis. As a result, all stocks in the sector are not included as possible investments. Oftentimes there will be a leader in the sector that is overlooked due to this process and will never make its way into the portfolio. Finally, investors could miss out on "bargain" stocks when the market is near lows.

Find What You've Been Looking For
In the end, investors must remember there is no single approach to investing and that every approach has its own pros and cons. One of the keys to becoming a successful long-term investor is finding a system that best fits your goals and objectives. Maybe the top-down approach is just what you've been looking for!

 

"Top-down" and "Bottom-up" investing?

Before we look at the differences between top-down and bottom-up investing, we should make it clear that both of these approaches have the same goal - to ferret out great stocks. Now, let's look at the different strategies used by top-down vs. bottom-up investors to select companies in which to invest. 
 

Top-down investing involves analyzing the "big picture". Investors using this approach look at the economy  and try to forecast which industry will generate the best returns. These investors then look for individual companies within the chosen industry and add the stock to their portfolios. For example, suppose you believe there will be a drop in interest rates. Using the top-down approach, you might determine that the home-building industry would benefit the most from the macroeconomic changes and then limit your search to the top companies in that industry.

Conversely, a bottom-up investor overlooks broad sector and economic conditions and instead focuses on selecting a stock based on the individual attributes of a company. Advocates of the bottom-up approach simply seek strong companies with good prospects, regardless of industry or macroeconomic factors. What constitutes "good prospects", however, is a matter of opinion. Some investors look for earnings growth while others find companies with low P/E ratios attractive. A bottom-up investor will compare companies based on these fundamentals; as long as the companies are strong, the business cycle or broader industry conditions are of no concern.

Companies Seeking Growth Abroad Could Have Found It At Home.

We are seeing a pattern in Q2 among S&P 500 companies where companies with the majority of their revenues coming from the United States are experiencing higher EPS growth and revenue growth than those companies with a more international focus.

As the United States economy struggles with elevated unemployment and slow GDP growth, companies in the S&P 500 index continue to invest in international operations in search of new growth opportunities. With many emerging markets undergoing rapid economic development, it makes sense for companies to want exposure there for the long term. In the nearer term, however, international markets do not appear to be the reliable source of growth that has been anticipated.

The Chinese economy, which as recently as 2010 was growing in excess of 10% per year, is now growing at a much slower 7.5% rate. While 7.5% is still an impressive growth rate, especially for an economy that large, it is significantly lower than what had been expected when many companies began investing in China. In Europe, many countries continue to struggle with recession or slow growth and very high unemployment, depressing consumer spending.

Difficulties in foreign markets have made the United States begin to look more attractive, and domestic business is now driving earnings results. To quantify this, we compiled geographic revenue data to determine the percentage of revenue each company earns from the United States. Then the companies were placed into three groups: those with more than 50% of revenue coming from the United States, those with less than 50% of revenue coming from the United States, and those that do not disclose revenue on a geographic basis.

As seen above in Exhibit 1, companies with half or more of their revenues coming from the United States are seeing earnings grow by 7.6% this quarter, while the more internationally focused companies are seeing an earnings decline of 4.9%. Companies that do not disclose the geographic origin of their sales are growing revenues by 17.7%. The undisclosed group contains many companies that are strictly domestic, like regional utilities and retail chains. Many of these companies do not break out revenues by country because 100% of their revenues are derived from the United States. Similar to the earnings pattern, the revenue growth data exhibits the pattern of higher growth for the U.S.-focused companies than for the internationally focused companies.

On a sector basis, the pattern holds true for the most part, with the exception of the consumer discretionary and utilities sectors, as shown above in Exhibit 2. The consumer discretionary sector is primarily U.S.-focused, with 42 of the companies earning >50% of revenues in the United States and only 12 companies receiving most of their growth from abroad. Of the internationally focused companies in the sector, earnings growth is boosted by Expedia Incorporated (EXPE.O) and Priceline.com Incorporated (PCLN.O), which have had success penetrating the European travel market. In utilities, there is only one company with an international focus, and most of the remaining companies are expected to show weak earnings growth.

Looking ahead, analysts expect U.S.-focused companies to continue to outperform on the earnings front. As shown above in Exhibit 3, estimated growth rates for these companies are consistently higher than those for the internationally focused companies throughout the rest of the year.