Top-Down vs. Bottom-Up: Which Approach in Stock Investing is Right for You ?

Let's understand this friends. 

What exactly is top-down approach to investing?

A top-down approach is also known as an EIC (Economy, Industry, Company) approach. The process flow of top-down investing goes like this.

Is the macroeconomic situation strong in terms of high growth, low inflation, low interest rates, robust economic reforms, among others?

Is the industry situation conducive to help the stock outperform? What is the demand situation, scope for innovation, pricing, creating brand value etc?

Is the company having intrinsic strengths in terms of profits and solvency? What are the operating margins, efficiency ratios and the valuation of the stock?

When does top-down work and when does bottom-up work?

Normally, we find that large institutions and investors have their own unique preferences. But broadly, one can draw some demarcation lines.

Top-down approach works when the basic approach to investing is focused on large cap. In any market, the large cap stocks tend to be more vulnerable to macro factors than the smaller companies. For example, when the interest rates move up, the large rate sensitive stocks get impacted more. Similarly, when the pharma scene in the US got tight, it was the large pharma companies that got hit more than the smaller niche players. Bottom-up works better for small cap and mid cap stocks.

There is also a sectoral dependence for whether you should adopt a top down or bottom-up approach. In case of sectors like banking, commodities and autos, the macro factors play a bigger role so top-down works better. On the other hand, for sectors like pharma, auto ancillaries, software etc, the micro factors play a much bigger role. In these cases, it is possible to differentiate at a company level, irrespective of the macro environment.

A top-down approach is preferred by global institutional investors as it provides a context to invest. For example, an India-specific fund is driven by macro and industry factors since they benchmark to the MSCI EM index. For an individual investor or for a PMS or even a domestic mutual fund, there is a lot more value in bottom-up investing since you are there for the long haul and willing to live through cycles in the economy.

Wise investing 

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