The Hindu Business Line : Investing, top-down or bottom-up?

A blend of top-down and bottom-up approach may work to your advantage. Further, while every style has its advantages, one must understand the limitations associated with each.

Different investors adopt different styles of investing. But their approach is governed principally by such factors as risk appetite, preference for the asset class and return expectations.

Some of the popular investing styles are top-down, bottom-up, value-versus-growth, contrarian and momentum investing. A look at the top-down and bottom-up approaches to investing.

Top-down approach

Any investment decision involves understanding the economy and tracking economic trends to forecast the future.

The top-down approach begins with the `big picture' — of studying the macro-economic environment. At this stage investors/fund managers look at such factors as the rate at which the economy (global as well as domestic) is likely to grow, the political conditions and the regulatory environment, among others. For example, if an investor wants to invest in India, he needs to project not just India's GDP growth but also of the US, China and West Asia with which it trades. An eye on geo-political developments also holds significance today as terrorism and war do impact an economy.

Based on the first level of analysis, one may decide to invest in a particular region/country. The next step would be to decide on sectors/industries that hold promise from a long-term perspective.

For example, if an investor expects the per capita disposable income to rise sharply and, accordingly, the spending pattern to switch in favour of lifestyle products, he may decide to take an exposure to sectors such as organised retail, travel, multiplexes and branded apparel.

Fund managers generally expect certain sectors to perform better than the whole economy and, hence, bet on them. In some cases, they identify select themes (known as thematic investing) that are likely to play out over the three/five-year period.

Today, the much-talked about themes in India are outsourcing, domestic consumption and infrastructure on which fund managers and institutional investors pin their hope.

The third and the final level involves selecting individual stocks based on their fundamentals. Applying ratios such as price-to-earnings and market cap-to-sales and comparing the same with those of the peers helps in finding out if a stock is undervalued or overvalued.

Top-down investors are largely growth investors who buy companies with high growth and, as such, they do not necessarily look for cheap stocks.

Bottom-up approach

Bottom-up investing begins with a micro-analysis, at the company level. This school of thought sets store by the inherent strengths/weaknesses of the company, discounting external factors at large. As long as the company's fundamentals are strong, movements in business cycles and changes in economic trends will not matter much. The stock-selection process uses various filters such as management quality, promoters' track record, business outlook, market competitiveness and relative valuation. Stock selection is followed by a forecast of industry prospects and general economic conditions.

Bottom-up investors typically look at under-researched companies that have the potential to unlock value in the long-term. This style largely finds favour with value investors (read the article on `Value vs Growth investing' next week) who hunt for good bargains.

However, it must be noted that there is no single style that works for every one or at all times. In practice, a blend of top-down and bottom-up approach may work to your advantage.

Further, while every style has its advantages, there are limitations to each. In the top-down approach, as the emphasis is on economic conditions and market movement, changes contrary to expectations may have a larger impact on your portfolio.

Likewise, sticking only to the bottom-up approach has certain drawbacks. In the process of focussing on individual companies, industries and sectors with promising outlook may be left out. Hence, investors must avoid such pitfalls by taking a balanced view of the micro and macro variables that influence their investing process.

Please send suggestions and queries to younginvestor@thehindu.co.in, or

The Research Bureau,

The Hindu Business Line,

859-860, Anna Salai, Chennai-600002.

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