We live in a complicated world that is only getting more complex by the day. There are a million moving parts and players that influence each and every individual, country, and economy. Keeping track of these various ‘market moving’ news items can be just as difficult as trying to filter out the important information from what is not important. In reality, it is an impossible task and this is why we far prefer a bottom-up investment strategy. 

Bottom–up investing involves starting the investment process at the company level and working your way up to the macro-economic level. It consists of looking for good companies with strong financials, attractive financial metrics and a level of growth that meets the investors’ needs.  A bottom-up investor would typically set up some sort of stock screen as a means to find a list of companies that meet certain requirements. The screen could filter companies by size, leverage, dividends, revenue growth, etc. Once a list of ideal companies is compiled, the investor then looks at the various industries the companies operate in. Are they growing more or less relative to the industry? How competitive is the industry? Do they have some sort of edge in the business compared to competitors? This process allows the list to be thinned down even further. The investor gradually moves toward a more high level point of reference such as overall GDP growth of the country or a specific trend expected for one of the company’s primary drivers of profitability.  While the higher-level factors are kept in consideration, a bottom-up investment approach would typically give a higher weighting to the lower levels (fundamentals) of the analysis. After all, a company may be operating in a slow-growth industry but if they have found a way to grow faster than everyone else, it may not even matter!

Given that over 90% of returns are often due to simply being exposed to the appropriate asset class or industry, why would anyone bother with a bottom-up approach? Shouldn’t you be more focused on the larger economic trends occurring? Quite simply, no. If an investor holds an appropriately diversified portfolio, they will already have exposure to the next big trend and do not need to worry about trying to time a market appropriately or paying attention to every random (and useless) data point that comes out on a daily basis. Grasping this concept can lead to a lot of extra time and a lot less stress.  Since a diversified portfolio should already have an exposure to the next ‘hot’ asset or investment, an investor can now focus on choosing the best company within both the good and bad sectors.

This leads to the second reason why we prefer a bottom-up investment approach and was hinted at earlier.  Even if a company operates in a bad industry, if it functions more profitably or efficiently than its competitors, it may not only outperform peers but also outperform the market as it surprises to the upside while having lower initial expectations. On the flipside, even if an industry downturn is affecting the share price of a good company, as long as the fundamentals remain strong and the company can ride out the downturn, they will be able to see another day and hopefully learn some sort of lesson that makes the company even stronger. This is one of the reasons why we love looking at the earnings of companies during recessionary periods. Sure the share price probably took a hit but if the core business remained intact and they were even able to grow earnings, there should not be much to worry about as long as your investment time frame is longer-term.  A final reason why we far prefer a bottom-up approach is less based on the merits of investing on fundamentals and more based on the futility of other approaches.

Trying to predict what an entire economy or industry is going to do is next to impossible. Investors simply do not have the ability to predict when and where the next innovation will occur or guess which political leader in a far off country will make some unexpected foreign policy decision. To even have a basic grasp of all of these factors, an individual would have to devote a lot of time to keeping up with uncountable developments as well as being well versed in essentially every academic subject from economics and politics to specific geographic histories and psychology. Individual companies have far fewer moving parts and are much easier to gain a strong understanding of as well as to keep track of over time.

We aren’t saying ignore the macro-economic trends, because they are important. However, an investor that is appropriately diversified can benefit from all of the trends without losing sleep over whether that next GDP report will miss estimates by a half percent or if a jobs report not only adds jobs, but the right kind of jobs. It might just be us, but we would far prefer a good nights sleep.

You heard from us, now we want to hear from you. What is your investment strategy and why?