Posted here is the article on moneycontrol.com, written by Mr. Nirmal Jain of IIFL, on the two approaches to investing.
Nirmal Jain, IIFL
An investor can take 2 different approaches when looking to buy a share, a) top down and b) bottom up. While Top-down research and bottom-up research are vastly different ways to look at stocks, they both try and achieve exactly the same � to pick out the stocks which can deliver the best returns.
Top-down research begins by thinking about the big picture. Top-down investor looks at macroeconomic variables e.g. GDP growth rate, interest rates, inflation, flows, market valuations etc, as the state of the overall economy & valuations play a big role in the investment decision. The investor then tries to identify sectors that will perform better than others, and looks for opportunities in these sectors first. For example, if an investor believes that interest rates are going to come down in the coming months, he would like to identify sectors which will be positively impacted by the rise in interest rates, e.g. real estate, auto. He would then pick out the best performing stocks in that sector and add them to his portfolio.
By contrast, bottom up investing is all about the detail, or the smaller picture. The stocks are chosen based on their valuations and the growth potential of the company, instead of looking whether the company is in the right sector or not. A bottom up investors looks at company specific factors: market size, competitive position of the company, sales, earnings, expected future earnings and balance sheet of the company before deciding whether or not to invest. A bottom investor would study variables like price to earnings ratio, any debt or net cash the company has and its dividend yield. A bottom up investor would be unlikely to be swayed by economic conditions, instead focusing on whether a particular company offers good value and can potentially generate good returns over a period of time.
Bottom up investing is likely to provide better returns over a longer period (5 -7 years) but at the same time it might show extreme variations from the market returns. E.g. currently we are seeing that the markets are being driven by the top down approach. Indian markets are moving on factors like emerging markets vs developed markets growth vs. valuations. As a result FII money is coming in and going out resulting in wild variations in the market. Further since most of the FII money is index money large caps are doing much better than small and mid caps even though mid caps are trading at a substantial discount to large caps and large caps seem to be fully priced. As a result most of the bottom-up investors are underperforming the indexes like Nifty.
Markets take their own time to recognize the value of the companies e.g. during 1998 - 2000 PSU banks traded at 0.1 x � 0.5x P/B and < ~ 5x earning when the markets was willing to give a much higher multiple to companies in the IT space (P/E 30x � 50x). They continued to trade at these levels for 2 years and hence an investor invested in the sector would have hugely underperformed the markets for these 2 years. SBI e.g. generated a return of -30% for the period 1st April 1998 � 31st March 2000, while at the same time Nifty generated a return of 32.87%. However if you see the returns since 1st April 1998 to now SBI has generated a return of 10x as against 5x generated by the Nifty in the same time frame.
For investors with a long term view, value investing is the methodology to follow. However for investors with a slightly shorter term view a mix of top down and bottom-up approach is likely to yield best results. Such investors should use the top down approach to identify the current sectors, market capitalization etc to have exposure to and should use the bottoms up approach to identify the companies within those sectors.
An investor can take 2 different approaches when looking to buy a share, a) top down and b) bottom up. While Top-down research and bottom-up research are vastly different ways to look at stocks, they both try and achieve exactly the same � to pick out the stocks which can deliver the best returns.
Top-down research begins by thinking about the big picture. Top-down investor looks at macroeconomic variables e.g. GDP growth rate, interest rates, inflation, flows, market valuations etc, as the state of the overall economy & valuations play a big role in the investment decision. The investor then tries to identify sectors that will perform better than others, and looks for opportunities in these sectors first. For example, if an investor believes that interest rates are going to come down in the coming months, he would like to identify sectors which will be positively impacted by the rise in interest rates, e.g. real estate, auto. He would then pick out the best performing stocks in that sector and add them to his portfolio.
By contrast, bottom up investing is all about the detail, or the smaller picture. The stocks are chosen based on their valuations and the growth potential of the company, instead of looking whether the company is in the right sector or not. A bottom up investors looks at company specific factors: market size, competitive position of the company, sales, earnings, expected future earnings and balance sheet of the company before deciding whether or not to invest. A bottom investor would study variables like price to earnings ratio, any debt or net cash the company has and its dividend yield. A bottom up investor would be unlikely to be swayed by economic conditions, instead focusing on whether a particular company offers good value and can potentially generate good returns over a period of time.
Bottom up investing is likely to provide better returns over a longer period (5 -7 years) but at the same time it might show extreme variations from the market returns. E.g. currently we are seeing that the markets are being driven by the top down approach. Indian markets are moving on factors like emerging markets vs developed markets growth vs. valuations. As a result FII money is coming in and going out resulting in wild variations in the market. Further since most of the FII money is index money large caps are doing much better than small and mid caps even though mid caps are trading at a substantial discount to large caps and large caps seem to be fully priced. As a result most of the bottom-up investors are underperforming the indexes like Nifty.
Markets take their own time to recognize the value of the companies e.g. during 1998 - 2000 PSU banks traded at 0.1 x � 0.5x P/B and < ~ 5x earning when the markets was willing to give a much higher multiple to companies in the IT space (P/E 30x � 50x). They continued to trade at these levels for 2 years and hence an investor invested in the sector would have hugely underperformed the markets for these 2 years. SBI e.g. generated a return of -30% for the period 1st April 1998 � 31st March 2000, while at the same time Nifty generated a return of 32.87%. However if you see the returns since 1st April 1998 to now SBI has generated a return of 10x as against 5x generated by the Nifty in the same time frame.
For investors with a long term view, value investing is the methodology to follow. However for investors with a slightly shorter term view a mix of top down and bottom-up approach is likely to yield best results. Such investors should use the top down approach to identify the current sectors, market capitalization etc to have exposure to and should use the bottoms up approach to identify the companies within those sectors.
