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Stock Picking
Top down versus bottom up analysis
May 12, 2008
Brendon Lau, ShareAnalysis
The article on our top-down analysis two weeks ago prompted some readers to ask how that approach differs from our "regular" bottom-up stock analysis and whether one approach has an edge on another, particularly in this volatile climate.
Top-down analysis starts with the "big picture" (e.g. macro-economic factors) and breaks it down into finer components to forecast expected returns. Some of the variables that might be used in this approach are expected GDP growth, wages, and population/demographic trends. Sometimes, under unusual market conditions, even investor sentiment is factored in.
From here, analysts would formulate a view on which sectors (and sub-sectors) are likely to outperform the broader market. Only after these two steps do the analysts look at individual stocks in specific industries to try to pick those in the best position to deliver superior returns.
In contrast, analysts using the bottom-up approach would focus on quantitative and qualitative stock- and sector-specific factors that impact on a particular stock. Although they do not totally ignore broader economic conditions and market cycles, these variables often play second fiddle to other factors like competitive pressure and debt levels of a company. Analysts and investors using this approach have an underlying belief that specific companies can still perform well if the industry or wider economy is suffering a downturn.
Which approach is superior? It depends on whom you ask. The top-down approach is great for identifying sectors that are more likely to attract buying interest and sectors that are most at risk as global economies struggle with the ongoing credit crisis.
However, the bottom-up approach is great at identifying stocks that have been oversold or overbought on sentiment. Renowned investors such as Warren Buffett are big believers in the latter. Buffett generally ignores macro-economic forces when researching companies, as his attention is focused on the intrinsic value of these companies.
Regardless of your investment style, it is useful to remember that both approaches are two sides of the same coin and are not mutually exclusive - if anything, they are quite complementary. The obvious example is for investors to use our top-down analysis to pick sectors to invest in and then use our bottom-up valuation to pick stocks with the best upside potential within those sectors.
On the other hand, one could also adopt a contrarian investing strategy by using our bottom-up analysis to pick superior stocks in out-of-favour sectors.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
More articles from this edition of CompareShares:
Stock Tips: Broker Recommendations May 12th 6 to BUY, 6 to SELL and 6 to HOLD
Stock Picking: Top down versus bottom up analysis
Investor profile: A veteran trader warns against complex systems
Market reports: Top Ten CFD stocks for the week
Stock pick: Stock of the week Cue Energy Resources
Finance: Profits show big banks weathering storm
Companies: Westpac approaches St George over merger
Companies: China forms company to make jumbo jets
Economy: Ripper plays down WA minerals boom
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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