Top Down or Bottom Up?

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At the outset, I would like to mention that I had been away from writing to prep for my CFA exams, but turns out they are postponed (for the Nth time) so we’re hopefully back with regular articles now – He said like he had millions of avid readers, who couldn’t do without these wannabe blogs.

Anywho!

Let us talk about investing styles and what is a potentially better style for you.

A brief about Top Down and Bottom Up:

As the name suggests, top down and bottom up are investing approaches based on which you determine potential investment opportunities.

Top down approach suggests that you first look at the bigger picture first, and eventually boil down to specifics. Start with, say, the overall macroeconomic situation, then shift focus on a certain outperforming/ high growth sector and then an effort to pick stocks within this sector can be made.

Bottom up on the other hand, is the exact opposite (duh) with most of the focus being primarily on an individual company, and then moving up to the bigger picture such as sector and overall macroeconomics.

Contrary to what people think, both the investing approaches do involve focus on all aspects. It is just the amount of time and effort allocated to each aspect, that varies across top down and bottom up approach.

Now let’s see what type of approach would suit you better.

If you are someone who does not have major experience in the investing world or are from an academically non finance world, it would make sense to not go and pick individual stocks, based on random pieces of news and tips that may seep into your mind as the next potential multi-bagger.

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However, if you are someone working in, say, the agriculture sector and have a good hang on the rural space and you see a lot of growth in the coming few years here, you may like to be overweight on such a theme. This is the Top Down approach, of course.

But, how to play this without enough investing experience?

Since we cannot focus on individual companies, it is better to rely on a larger number of companies within the same theme.

Here’s a few options:

1) Thematic Mutual Funds:

Thematic mutual funds are the funds which invest funds based on a certain theme. For our example with the rural demand, here’s a few mutual funds from the Value Research website (which in my opinion is one of the best websites to research mutual funds):

Just typing rural, returns a couple of mutual funds which invest based on this theme.

2) Smallcase:

Smallcase is a relatively new concept which may seem very similar to mutual funds, but has better transparency, lower cost and you are in control for the entire process. Smallcases are baskets of securities with set allocations picked by seasoned investors.

In buying a smallcase, you actually hold the shares in your own demat account and pay just brokerage on the same. You also have the option to sell any share from the respective portfolio, which you do not like, an option not available with buying mutual funds.

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Now, let us look at the fairly seasoned or qualified investors, who are willing to spend time in research and find their way from the bottom up.

Since bottom up investors, focus on select stocks itself, knowing the fundamentals of the business is of extreme importance. This would mean knowing the business model, the profit margins, the balance sheet risk, etc.

Say within the theme of rural demand itself, an investor decides to pick Escorts (not a recommendation) which manufactures tractors used in the agriculture process, there’s a lot to know about the business. What the monthly sale volumes are, when is demand high, how monsoons affect agriculture, quarterly financials, annual reports, management plans, etc.

Here’s a few sources that are very useful in individual stock research.

1) Trendlyne:

Trendlyne gives you access to a lot of aspects of a company, with regard to its margins, valuation and some technical aspects as well, but I think the biggest advantage is the broker reports that they provide. While it is true that brokers do not necessarily get the price targets right, broker reports are instrumental in understanding the overall business model of a company, which is easily one of the most important aspect for bottom up investing.

2) Screener.in:

Now that after going through the business model of the company, it is necessary to know about the numbers and if they correlate with the business model of the company. So, if Escorts has seen monthly increase in tractor volumes, but revenues do not seem to increase much, it could hint at discounting of the product. This would again have a potential negative impact on margins, if cost structure is more or less the same.

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Rather than browsing through the entire annual report of the company and opting for the boring process of plotting the numbers in an Excel sheet, you could opt for screener, which presents the annual numbers as well as quarterly numbers, along with a lot of other information.

And that isn’t even the best part.

All of the financial information can be easily downloaded as an Excel file from the website, making it easier to do your own analysis.

I know! I’m just as psyched as you are!

Of course, both the approaches aren’t mutually exclusive and can be used together. If someone understands banking sector, they can do an in depth analysis of the sector which involves studying the balance sheet strength, the credit/ loan growth, NPA provisioning, impact of moratorium and then go and buy Yes Bank (Yes, this was sarcasm. Please do not buy Yes Bank)

But for someone who doesn’t understand banking, they can stick to a Nifty Bank fund or the likes to remain long on the sector, without the risk of overallocation.

But in either case, do not invest anywhere just because someone else tells you to! Thank you for coming to my Ted Talk (aka my fortnightly rant).



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Tej Lahoti
Chartered Accountant || CFA (L1) & FRM (P2) Aspirant || Loves Markets, Music, Movies and Memes.
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