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

Understanding Your Cibil Credit Information Report

   WE ARE all familiar with the anxiety and uncertainty that we feel when applying for a loan. After all, it's the lender who decides whether we can own our dream home, our first car, or whether our children can pursue higher education. In a nutshell, a better life depends on the lender's decisions.    While other factors do play a part in the lender's decision, the Cibil Credit Information Report ( CIR ) plays a crucial role in a lender's decision to approve a loan application.    Previously, lenders would treat all loan seekers equally. Each applicant, if approved by the lender's internal credit policy, would be charged at the same interest rate for a particular loan size and purpose. The lenders would charge a higher interest rate to all the borrowers, in order to compensate for the possible default of a small portion of the loan disbursed. In other words, it's like a professor (the lender) punishing an entire class (borrowers) for the mischief played b...

What are the factors affect the changes in Interest Rate of Fixed Deposits?

  What are the factors affect the changes in rate of Fixed Deposits? Fixed Deposits are now considered to be a very old fashioned method of saving, but still attract many investors since they have guaranteed returns at the end of the tenure of the investment at a decent interest rate. There are various factors that affect the rates of interest for a Fixed Deposit. Policies of the Reserve Bank of India   - The several norms and restrictions posed by the Reserve Bank of India , in order to gain optimum control over credit and inflow and outflow of fund throughout the country. The repo rate changes, cash reserve ration tends to change and these changes affect the banking products like Fixed Deposits, loans etc. Recession   - When unemployment in a country crosses the benchmark set Recession hits, and slowly the country faces an economic slow movement, affecting the purchasing power of the people in the country, forcing the Reserve Bank of India to release more funds in the financial marke...

Capital Protection Oriented Funds

Download Tax Saving Mutual Fund Application Forms Invest In Tax Saving Mutual Funds Online Buy Gold Mutual Funds Leave a missed Call on 94 8300 8300   Capital Protection Oriented Funds   Erosion of capital is one of the key concerns for investors wanting to invest in equity mutual funds. To address this concern, asset management companies have launched Capital Protection Oriented Funds (CPOFs). What are CPOFs? CPOFs are generally three to five-year, closed-ended funds where 70-80% of the portfolio is invested in fixed income securities, which mature on or before the scheme's tenure. The investment in fixed income securities grows to 100% at the end of the tenure, providing the investor with capital protection. The remaining portion (20-30%) is used to take exposure to equity, which provides the upside. Exposure to equities is either by directly buying equity stocks (plain vanilla CPOFs) or by b...

Mutual Fund Review: ING Dividend Yield

  ING Dividend Yield's small assets enable the fund manager to churn in impressive returns… Strategy The aim of the fund is to invest in stocks which offer a high dividend yield. This fund deploys a value based strategy which aims to gain from investing in fundamentally strong and free cash flow generating businesses. The scheme focuses not only on growth but also on the cash generated by the business, which mostly leads to stable returns even in volatile markets. This fund has a low volatility because of its investment in high yielding stocks. The scheme tries to include stocks that yield dividend above the dividend yield of the Nifty and stocks with liquidity, which throws up a universe of 150 stocks.   Our View Launched in October 2005, this fund invests at least 65 per cent of its assets in high dividend yield stocks. The fund has consistently maintained a mix of stocks across varying market capitalisation, with a higher tilt to mid caps compared to small caps. Howev...

SBI Small Cap Fund

SBI Small Cap Fund scheme seeks to provide investors with opportunities for long-term growth in capital along with the liquidity of an open-ended scheme by investing predominantly in a well diversified basket of equity stocks of small cap companies. SBI Small Cap Fund has widened its margin of outperformance relative to its category and benchmark in the last one year, earning itself a five-star rating. The fund shows a hefty 18 percentage-point outperformance relative to its peers in the last one year, 5 percentage points over three years and 4 percentage points over five years. Needless to say, it has also outpaced its benchmark to deliver convincing five-year annualised returns of 37 per cent. A believer in the credo that a small market cap does not reflect business quality, the fund looks for five attributes in the stocks it buys: competitive advantage, return on capital, growth, management and valuation. SBI Small Cap Fund is among the few in this space to remain at quite a man...
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