Top Down Vs Bottom Up – Which Investor Has the Edge?
By David Nelson, CFA
There’s no shortage of articles from the financial community calling for a significant market downturn. The best point out excess and froth or data that has slipped under the radar. Pointing out red flags is healthy and part of the investment process.
The worst make tired arguments of impending doom because the market is at all-time highs. Their authors have been left at the starting gate waiting for conditions to be perfect before pulling the trigger. The opportunity cost of missing the last 5 years dwarfs losses from the financial crisis.
Macro Investors Hate the Market
For a majority of Top Down Macro managers stop signs are everywhere. Below is a list of the 5 most popular reasons to avoid the market.
- The Biggest Bull Market in a Generation – Stocks have come too far too fast. The current Bull Market started in March of 2009 and at 69 months is getting g long in the tooth.
- Economic Data Doesn’t Support a Market Move Higher – Macro investors continue pointing to a disconnect between market fundamentals and stock prices. I would agree that traditional valuation measures point to a market that is fairly valued and certainly not cheap but by no means a bubble.
- Margins at All-Time Highs – Bears point out that margins are unsustainably high and will soon revert to the mean crushing U.S. Profits (I’ve been hearing this one since 2011)
- China – China is often mentioned as a negative catalyst. The world’s second largest economy has seen its growth rate slow and supports a financial system that is at best opaque. While China is having trouble meeting goals for its export based economy, in some ways that’s actually good news for the U.S. We’ve been exporting jobs for decades as China offered cheap labor and pricing. As the Chinese economy matures their workers are demanding higher wages and better living conditions. Moving manufacturing capability off-shore is no longer a no-brainer.
- Geo Political – There’s no question that the geo-political backdrop is concerning. I’ve mentioned often that rising tensions in the Middle East, South China Seas and the Ukraine are the biggest risks investors face.
Look, all of the above are valid red flags and the conversation is healthy as long as it doesn’t leave you paralyzed unable to take action. I think most would agree that some of these arguments aren’t much different than the rhetoric we heard in early 2013.
Top Down vs Bottoms Up
I mention the above because as a professional investor for over 25 years I’ve wrestled with the Top Down vs Bottom Up approach throughout my career.
- Top Down – Investor starts off looking at the world from the top down focused on broad economic themes drilling down to sectors and then individual stocks that meet their criteria. If the economic backdrop isn’t attractive they stay out of the market or at the very least, under invested holding large amounts of cash.
- Bottom Up – The bottom up investor might have a view of the same economic themes but starts off scanning at the company level looking for value, positive estimate revisions, product cycles, pricing power etc.
Macro Investors are Market Timers
Trading the market avoiding pull backs or corrections can certainly add to performance. The key of course is doing it consistently and profitably. For many this approach creates excess churn adding little and often subtracting from long term performance. While most market timers are technicians looking at support levels, breadth, moving averages, shooting stars and the inevitable Fibonacci retracement; Macro investors ultimately are market timers as well.
They are focused on economic data, broad market valuations, sentiment, job formation and frankly a list too long for this forum.
Focus More on Stocks & Less on the Market
Here’s why I prefer the Bottom Up Approach. First it tends to keep me in the game longer. In addition even bear markets have stocks and sectors that can do relatively well.
Quantitative investing with a fundamental focus gives investors like me the ability to scan thousands of stocks ultimately ranking them based on factors I believe are important in the investment process.
All of us have our favorite metrics to measure the health and potential growth of a company. I focus on estimate revisions and valuation vs a given growth rate. I think most investors seek companies that are growing. The debate usually centers on just how much you are willing to pay for it.
The beauty of this approach is that in its own way it does some of the timing for you. While it’s rare I won’t be able to find enough stocks to populate a model or portfolio often some sectors or industries are left underweight simply because too few stocks meet the criteria.
Here’s an Example
Financials are a sector I’m finding difficult to buy right now. The positive estimate revisions and deep value that existed in year’s past is gone. Over the last half decade Washington has waged a war on the financial sector and won. Banks are increasingly being pushed to utility like status with most of their traditional profit centers being taken away. With revenue growth at a standstill banks are turning to increased fees to fill in the gaps.
Where Are the Perp Walks?
Trading volumes have fallen dramatically and investment banking margins are not what they were in year’s past. While government has been quick to punish bank shareholders with massive fines for past sins, current and former CEO’s who pulled the puppet strings have been largely left untouched.
For those looking to employ the bottoms up approach there is no shortage of styles. The key is that you have to be good. The investor wheel or stock clock has been with us for some time and I frankly can’t remember who first came up with it. I first saw it when I started in the business in the early 90’s and is still valid today.
The good value investor gets in close to the bottom having successfully identified an undervalued security and more importantly the catalyst to drive it higher. Having made his profit he in turn sells to the Growth At the Right Price investor who needs some confirmation that fundamentals are improving but is unwilling to over pay. The successful GARP manager sells to the good Momentum investor who doesn’t care about valuation but will stay with it as long as the fundamentals are improving.
Here’s where it gets interesting and what makes a market. The good Momentum investor sells to the bad Momentum player who is late. After suffering steep losses the bad Momentum investor capitulates and sells to the bad Value investor who is way too early. Unwilling to take any more pain they end up selling to the good Value investor and the cycle starts all over again.
The key is to stay on the left side of the clock. In at 6 and out at 12 is perfect. Anything in-between will do just fine. After Midnight, you turn into a pumpkin.
Waiting for the Correction
A bull market that runs for long periods invites those seeking their Elaine Garzarelli moment. Many hedge funds and retail investors haven’t participated in the returns of the last couple of years and sit patiently on the sidelines waiting to get long.
Bulls are nervous too. When I pick up the paper each morning there’s always a headline that kicks me in the gut forcing me to second guess my research. Each tick higher in the Bull Market by definition brings us closer to the top so the temptation to succumb to those fears and pull the rip cord is always with us. Listening to my gut has predicted 8 out of the last 2 bear markets. I’ll stick with stock fundamentals looking at the world from the bottom up.