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

Group Health Insurance

Buy Group Health Insurance Online   For Human Resources, the biggest challenge today is to decide whether medical benefits should be offered to employees or not, what type of plans should be offered, what will be the cost and how will the cost be split between employees and employer. Well, most of these are subjective and would depend on a lot of factors including company size, average employee salary, etc. However, this article will give you a fair idea on how you should go about deciding these factors: 1. Why offer group health insurance benefit to employees : Studies have proved that retention rates among employers offering GHI are much higher than the ones who are not offering. Moreover, the cost of providing this benefit as a percentage of salary is very low as compared to the perceived value. As an example, say if average salary of an employee in your organization is 4 LPA. If you decide to offer a health insurance benefit to him for a Sum insured of ...

Choose gold ETF over Physical Gold

Investing in gold is overall a good portfolio hedging strategy as long as gold does not account for more than 5-10 per cent of your investment portfolio. Between physical gold and gold ETF, investing in gold ETF is a better proposition because these funds invest in physical gold making them the closest to investing in physical gold at no risk of holding physical gold.   You will need to have a demat account to invest in gold ETFs and there is little to choose between any of the gold ETFs, you can pick any fund that you wish to as long as you pick the fund with the lowest expense ratio.   -----------------------------------------------------------------   Also, know how to buy mutual funds online:   1) DSP BlackRock Mutual Funds: http://prajnacapital.blogspot.com/2011/05/buying-dsp-blackrock-mutual-funds.html   2) Reliance Mutual Funds: http://prajnacapital.blogspot.com/2011/06/buying-reliance-mutual-funds-online.html   3) Reliance Mutual Funds: http://prajnacapital....

Why credit history is critical?

Will you need a loan to buy a car or a house? Do you know why some people get their loans sanctioned quickly without any hassle, whereas others find that their approval is delayed or their application is rejected? If you want a loan, you will need to work to build a solid credit history because this can have a bearing on the ease with which you get loans. Read on to learn more about what is a credit history and how to build a good credit score. What is a credit history? Your credit history is a way of tracking your credit behaviour and habits — basically it shows how disciplined and regular you are when it comes to repaying your dues on loans that you have taken. It will show a complete record of your past borrowing and repayment record including details about any late payments or if you have defaulted on a loan. This track record is readily accessible to lenders and is used by them to when reviewing your loan application. Borrowers who have historically had a bad record of managing...

Commercial Paper (CP)

Invest Mutual Funds Online Download Mutual Fund Application Forms Commercial Paper (CP): These are issued by corporate entities in denominations of Rs.2.5mn and usually have a maturity of 90 days. CPs can also be issued for maturity periods of 180 and one year but the most active market is for 90 day CPs.   Two key regulations govern the issuance of CPs-firstly, CPs have to be compulsorily rated by a recognized credit rating agency and only those companies can issue CPs which have a short term rating of at least P1. Secondly, funds raised through CPs do not represent fresh borrowings for the corporate issuer but merely substitute a part of the banking limits available to it. Hence, a company issues CPs almost always to save on interest costs ie it will issue CPs only when the environment is such that CP issuance will be at rates lower than the rate at which it borrows money from its banking consortium. ----------------------...

JM Financial Mutual Fund - Its Schemes

  JM Financial Mutual Fund is a part of JM Financial Group which is one of the first mutual fund companies in India which started its operation in 1993-1994. JM Financial Asset Management Limited is sponsored by JM Financial group. The mission of the group company is to generate good returns in all the product categories. JM Financial Mutual Fund has launched a variety of schemes in the following categories. ·                            Equity ·                            Debt ·                            Arbitrage ·                            Liquid Equity Schemes: The schemes that are launched in the equity category are: ·                            JM Midcap Fund ·                            JM Balanced Fund ·                            JM Agri and Infra Fund ·                            JM Basic Fund ·                            JM Contra Fund ·                            JM Contra Fund ·                            JM Emerging Leaders Fund ·             ...
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