Sunday, August 28, 2011

Top down vs. bottom up stock picking strategy

You must have heard about top down or bottom up strategies of stock selection many times from equity analysts on TV or business magazines, but might have been wondering for what it is and how to use it effectively while picking your set of stocks.

Top down investing actually starts from macro, which means the investors who follow this strategy takes the call on economy first, then decide on the industry and then decide on the company they want to invest in, while on the other hand bottom up investing starts from micro, i.e the investors following this strategy first look at the company and then look at the industry it operates in and then asses the macro economic factors to decide whether they would want to invest in that company or not.

Top down investing is usually followed when you want to invest in a country which has bright prospects in immediate future or has been growing much faster than average world growth. For example India and China is a classic case for top down investors where the growth is more than 2 times than the world average GDP growth and will continue to grow at this pace for next decade or so. Hence anybody investing in these economies would surely make money in next 5 years or so. After zeroing in on the economy the investor then look for the industries which are directly proportional to the economic growth. For example, with India growing at 8% plus for next decade or so, the direct beneficiary of this growth would be sectors like Banking, Health care, cement, power and many others. Once the industry is decided the investor then look for companies which will participate in that growth and will deliver higher revenue, profits and hence higher stock prices in future.
Bottom up investing is usually followed in a severe bear market when the stock prices of companies across industries fall dramatically and trade below their intrinsic value. The investors who are bottom up stock pickers select stocks which are butchered without fundamental reasons and are trading at prices which is significantly below its true worth.After selecting the stock the investor analyzes the industry it operates in and try to assess the prospect of the industry in future. If the industry has good prospect and the economy is expected to do well the investors invest in the company.

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