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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.

 

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