Skip to main content

Investment Approach : Top down and Bottom up Methods



Traditionally, there exist two strategies for investing in stock markets. One is the 'top-down approach', where the investor analyses the overall macroeconomic scenario, picks sectors that will do well in the given macro scenario and then selects stocks from those sectors that are cheap. This approach presumes that macro factors influence the sector and stock performances more.


The second approach is the 'bottom-up approach, where the investor directly considers a universe of stocks based on independent analysis and parameters. Within the universe, he or she identifies stocks with good potential irrespective of the sector to which the stock belongs, without giving much weightage to the overall macroeconomic scenario. This approach presumes that stock specific factors carry more weight than the macro ones. The top-down approach usually requires knowledge and understanding of the economy in general and also about the specific sectors and stocks within it. In the bottom-up approach, the emphasis is on in-depth analysis of the specific stock that is to be purchased or sold. The sectors where the price performance is linked positively to the economic cycles are known as cyclical sectors (high beta). Metals, automobiles, and real estate, etc, fall under this category. Sectors that are little less influenced by economic cycles are known as defensive sectors (low beta). Pharma, utilities, and consumer staples, for example. Such defensive sectors and stocks have steadier earnings and more predictable cash flows.


The top-down approach assumes that by allocating money across different sectors (cyclical and defensive), the investor will be able to diversify his portfolio risk. Even if a sector is extremely attractive, the investor won't be able to invest all his money in it. Many professional money managers using top down approach usually have sector limits, too. Similarly, in the bottom-up approach, too, there will usually be a limit on the exposure to a single stock. But which strategy works all the time? The key to the top down approach is that sector returns should be negatively co-related to each other. A 100% co-relation is perfect comovement with each other and -100% is perfect co-movement with each other but in the opposite direction. The cyclical ones should usually offset some of the weakness in the defensive ones and vice-versa. But as of now, many of the cyclical sectors and the defensive ones have higher and positive co-relations of more than 90% with each other. This breaks down the theory of price movements of cyclical and defensive sectors being self-balancing at least to a reasonable extent. For instance, the traditional defensive sector such as pharma, has a co-relation of more than 80% positive with major sectors, including cyclical ones such as automobiles (98%) or metals (94%).


In fact, the major sector co-relations now are reasonably higher and positive with each other, with many of them above 90%. This does increase the systemic risk in the markets, especially in the event of a steep fall, as all the sectors are vulnerable to the same source of risk or to the same set of factors or to the same type of trades being unwound. The power/utilities sector, a defensive one, has relatively lower positive correlation with other sectors. Surprisingly, only the real estate sector, which typically falls in the cyclical category, has maximum negative co-relation with other sectors such as auto, pharma, and FMCG.


This high positive co-relation between sectors may sometimes defeat the objective of the top-down approach, as defensives act more like cyclical ones. Typically, in the early stages of an economic recovery, especially after a crisis, most of the sectors and stocks exhibit higher positive co-relations with each other as macro-factors dominate more than stock-specific ones. This is in tandem with the margins recovery in general driven by operational leverage, though revenues remain sluggish. As the market recovery matures, sector co-relations should move lower as stock-specific factors start exerting higher influence on prices. The incremental margins typically peak in the later stages of an economic recovery as revenue growth drives earnings.


In other words, when sectors' or stocks' co-relations are higher and are expected to move down, it's appropriate to adopt a bottom-up or a stock picking strategy. And when the co-relations are lower and are expected to move higher, it's time to adopt a top-down or macro strategy. Thus, an appropriate mix of top-down and bottom-up strategies is advisable, depending on the prevailing scenario.

 

Popular posts from this blog

Tata Mutual Fund

Being a part of the Tata group, the fund has the backing of a very trusted brand name with strong retail connect. While the current CEO has done an excellent job in leveraging the Tata brand name to AMC's advantage, it is ironic that this was just not capitalised on at the start. Incorporated in 1995, Tata Mutual Fund remained an 'also-ran' fund house for around eight years. Till March 2003, it had a little over Rs 1,000 crore in assets and 19 AMCs were ahead of it. But soon after that the equation changed. It was the fastest growing fund house in 2004 and 2005. During these two years, it aggressively launched six equity funds, two debt funds and one MIP. The fund house as of now stands at No. 8 in terms of asset size. This fund house has a lot to offer by way of choice. And, it also has a number of well performing schemes. Tata Pure Equity, Tata Equity PE and Tata Infrastructure are all good funds. It also has quite a few good debt funds. The funds of Tata AMC are known to...

UTI Mutual Fund

Even though only a few of UTI’s funds are great performers, this public sector fund house has many advantages that its rivals do not. It has a huge base of retail equity investors and a vast distribution network. As a business, it looks stronger than ever, especially in the aftermath of credit crunch. UTI is, by a large margin, the most profitable fund company in the country. This is not surprising, since managing equity funds is more profitable than debt. Its conservative approach and stable parentage is likely to make it look more attractive to investors in times to come. UTI’s big problem is the dragging performance that many of its equity funds suffer from. In recent times, the management has made a concerted effort to improve performance. However, these moves have coincided with a disastrous phase in the stock markets and that has made it impossible to judge whether the overhaul will eventually be a success. UTI’s top performers are a few index funds, some hybrid funds and its inf...

Salary planning Article

1. The salary (basic + DA) should be low. The rest should come by way of such allowances on which the employer pays FBT and you don't pay any tax thereon. 2. Interest paid on housing loan is deductible u/s 24 up to Rs 1.5 lakh (Rs 150,000) on self-occupied property and without any limit on a commercial or rented house. 3. The repayment of housing loan from specified sources is also deductible irrespective of whether the house is self-occupied or given on rent within the overall ceiling of Rs 1 lakh of Sec. 80C. 4. Where the accommodation provided to the employee is taken on lease by the employer, the perk value is the actual amount of lease rental or 20 per cent of the salary, whichever is lower. Understandably, if the house belongs to a family member who is at a low or nil tax zone the family benefits. Yes, the maximum benefit accrues when the rent is over 20 per cent of the salary. 5. A chauffeur driven motor car provided by the employer has no perk value. True, the company would...

8 Investing Strategy

The stock market ‘meltdown’ witnessed since the start of 2005 (notwithstanding the recent marginal recovery) has once again brought to the forefront an inherent weakness existent in our markets. This is the fact that FIIs, indisputably and almost entirely, dominate the Indian stock market sentiments and consequently the market movements. In this article, we make an attempt to list down a few points that would aid an investor in mitigating the risks and curtailing the losses during times of volatility as large investors (read FIIs) enter and exit stocks. Read on Manage greed/fear: This is an important point, which every investor must keep in mind owing to its great influencing ability in equity investment decisions. This point simply means that in a bull run - control the greed factor, which could entice you, the investor, to compromise with your investment principles. By this we mean that while an investor could get lured into investing in penny and small-cap stocks owing to their eye-...

Debt Funds - Check The Expiry Date

This time we give you an insight into something that most debt fund investors would be unaware of, the Average Portfolio Maturity. As we all know, debt funds invest in bonds and securities. These instruments mature over a certain period of time, which is called maturity. The maturity is the length of time till the principal amount is returned to the security-holder or bond-holder. A debt fund invests in a number of such instruments and each of these instruments would be having different maturity times. Hence, the fund calculates a weighted average maturity, which would give a fair idea of the fund's maturity period. For example, if a fund owns three bonds of 2-year (Rs 30,000), 3-year (Rs 10,000) and 5-year (Rs 20,000) maturities, its weighted average maturity would be 3.17 years. What is the big deal about average maturity then, you may ask. Well, knowing a fund's average maturity is important because it tells you how sensitive a fund is to the change in interest rates. It is ...
Related Posts Plugin for WordPress, Blogger...
Invest in Tax Saving Mutual Funds Download Any Applications
Transact Mutual Funds Online Invest Online
Buy Gold Mutual Funds Invest Now