It really does not matter where you start your hunt for good companies to invest in as long as you find good value.
The goal of both top down and bottom up investing strategies is to find companies that go on to perform well. However, the approaches are different.
Top Down
Exponents of this investing methodology attempt to time their investments to coincide with the various phases of the economic cycle. By moving from investments in one industry to another according to the current point in the cycle, they hope to gain advantage by being well placed for the prevailing economic conditions. Companies are still evaluated according to their fundamentals but firstly the desired industry or sector is identified. This is known as sector rotation.
One four-stage economic cycle model for this approach suggests that various industries may provide better returns going forward as follows:
Stage of
Economic Cycle | Favoured
Industries |
|---|
| Full Recession | Cyclical and Transport, Technology, Industrials |
| Early Recovery | Industrials, Basic materials industry, Energy |
| Late Recovery | Energy, Staples, Services |
| Early Recession | Services, Utilities, Cyclical and Transport |
Investors use various indicators to try to ascertain the current point in the economic cycle. So they might look at whether each of the following indicators is rising, falling or flat:
- Gross domestic product.
- The yield curve.
- Consumer expectations.
- Industrial production.
- Interest rates.
However, an added complication is that professional investors in financial markets try to predict the economy, which means that the market cycle is usually months ahead of the economic cycle.
Sector rotation fell out of favour in the 1990's because it did not work very well. Some believe that it is useful now and going forward.
Bottom Up
Rather than concerning themselves with macroeconomics, bottom up investors start with fundamental analysis of the companies themselves. What matters here is that an individual company has good prospects. General economic conditions are downplayed or even of no concern.
Different investors interpret good prospects in a company in different ways but most use value indicators such as these:
- Price to earnings ratio.
- Price to cash flow ratio.
- Price to book value.
- Debt or net cash.
- Dividend yield
Which Is Best?
Sector rotation is difficult to get right. Economic indicators can be misleading and history rarely repeats itself exactly. The bottom line is that we cannot be sure of where we are in the economic cycle. The predictive nature of the markets adds yet another layer of complexity.
On the other hand, identifying good value in individual companies is relatively straightforward. We need to know if they are cheap or expensive and whether the business is sustainable through difficult times.
David Dreman and others demonstrate in their books that value investing often produces superior returns. When the downside is protected by buying shares when they are cheap relative to the indicators described above, there can be more potential on the upside than there is risk on the downside. It often then takes only modest improvements in trading or finances to produce relatively large upward movements in share prices.
My approach is to use bottom up value investing. However, if that value is found in the 'right' sectors -- all the better. I just want to have my cake and eat it too!
