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Top down approach
An investor who embarks on top down approach places a lot of emphasis on the macro environment while casting his equity portfolio. Firstly, the investor studies the global and domestic macro economic scenario and draws his conclusions on how the economy is likely to perform in the future and how the key economic variables are likely to move in the future. Then he moves on to study different sectors within the economy and analyze which sectors are to benefit from the economic conditions. For example, if his view is that interest rates will come down in the economy over the next 1 year, he will look for sectors that can benefit most from such an economic event. He might zero in on automobiles sector, for example, as lower interest rates do spur demand for two and four wheelers. Based on such considerations, the investor will allocate his portfolio amongst sectors - based on his macro top down call. If he is very optimistic on interest rate reductions, he may decide to allocate say 20% to automobiles and another 20% to construction/real estate sectors. Once he decides his sectoral allocations based on this top down approach, he will then start looking for specific companies that he would like to own within this sectoral allocation. For example, once he has decided to allocate 20% of his portfolio to the auto sector based on his top down call, he will then start examining all the companies within this sector to decide the 3 - 4 companies that he would like to own in his portfolio from this sector. This analysis will be done on the basis of merits and fundamentals of each company and their relative valuations.
In other words, in a top down approach, the investor firstly analyzes the economy, then the industry and finally the company. The followers of top down approach believe that a company will perform well only if the economic conditions are favourable to the sector in which it operates.
A top down approach will be useful for industries which are cyclical in nature as macroeconomic factors would have a bearing on the companies within these industries. It is sensible to study the economic conditions while analyzing such sectors.
Bottom up approach
Bottom up investors have an opposing approach when compared with top down investors. Followers of bottom up approach start their analysis from the company, then move on to the industry prospects and finally the economic forecasts. These investors place emphasis on the company's credentials and the company's ability to chart out its growth path - under diverse economic conditions. A bottom up stock picker does not ignore macro factors - but what he does is when he finds a company that appears attractive based on its fundamentals and valuation, he would typically do a scenario analysis to project how this company might get impacted if one of the macro variables - like interest rates, oil prices etc were to change.
A bottom up stock picker looks for companies that appear attractive, irrespective of the sector they operate in. He does not typically start out with a notion that he needs to find stocks from a particular sector to populate say 20% of his portfolio based on a macro call. He looks at the merits of individual stocks, and starts adding them to his portfolio, based on his conviction in each of those stories. From a risk management perspective, his fund house may place a sectoral cap which stipulates the maximum exposure that he can take in any one sector. This factor will influence his portfolio construction, from a risk management perspective rather than from a stock selection perspective.
Bottom up approach can be used for companies which are less sensitive to macro economic variables. Defensives like pharma and FMCG are good examples of businesses that are relatively less impacted by economic variables.
One point of caution for analyzing stocks with bottom up approach is to compare the numbers of the company with similar companies and the industry averages so as to find out how attractive the company's stock actually is. For instance, if we compare growth rates of two companies which belong to very different sectors, the analysis will be misleading. This is where the importance of industry averages comes in as it serves as a reference point to gauge the profitability of a company as a stock investment.
Which one is better : top down or bottom up?
Both top down as well as bottom up investors can profit from their investments; one by making the right sectoral calls and the other by picking stocks of well performing companies. The challenge is more herculean for the bottom up managers as they have to perform an extensive analysis of individual companies to pick up stocks which they believe are strong even in the face of poor economic conditions. Bottom up stock picking calls for a lot more research resources and lot more effort in constantly meeting company managements and keeping abreast of their businesses. The flip side of this is that a fund manager's conviction is typically higher when he has subjected the stock to a rigourous bottom up analysis. Bottom up strategies are usually adopted by fund managers who have access to sufficient on-ground research resources to do justice to this intensive effort.
Many FIIs who invest globally rely more on top down strategies to get their country allocations in place and then their sector allocations within the countries they choose to invest in. For such fund managers, a top down strategy gives them a useful framework within which they can cast and maintain portfolios. From a local perspective, fund managers who look to capitalise on momentum will typically rely more on top down calls to get their sector allocations right, and then hope to generate alpha based on correct sector calls. One can argue that a pure top down approach is a higher risk - higher return approach as compared to a pure bottom up approach.
In reality, most fund managers opt for a blend of top down and bottom up approaches. The extent to which they rely on bottom up stock picking is significantly influenced by the extent of research resources available with them to do full justice to this more labour-intensive exercise.
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