Top-Down vs Bottom-Up Investing: Which Is Better?
Just like the saying “All roads lead to Rome”….
When it comes to investing, there are many approaches to take.
One is the top-down approach.
And the other is the bottom-up approach.
What do those investing methods mean?
More importantly, is one superior than the other?
Come, let’s take a look.
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What Is Top-Down Investing?
As the name might suggest, top-down investing involves looking at the sectors or countries that would do well and then diving into the individual stocks.
Right now, the tech sector is all the rage.
People heading online for their daily needs to more businesses going digital amid the COVID-19 pandemic has fuelled demand for tech stocks.
This is evident from the US’ Nasdaq Composite Index, which is mostly made up of tech companies, hitting a record-high level on 6 August, surging 62% from its most recent bottom seen in March 2020.
Talk about a market rally!
Those who still believe that COVID-19 has accelerated the adoption of technology for individuals and companies over the long-term can then drill down into the individual stocks.
For a local example, we can consider the Singapore real estate investment trust (REITs) sector.
A REIT pools money from investors to invest in a portfolio of income-generating real estate assets. These assets can be shopping malls, offices, industrial buildings, hotels, or even data centres.
There are more than 40 REITs and property trusts listed in Singapore that investors can pick from.
While the COVID-19 pandemic has impacted a number of REITs, including those belonging to the Straits Times Index, there are also more-resilient ones.
For instance, those with data centre assets have benefitted from the accelerated adoption of digital technology.
How Can Top-Down Investors Research for Stocks?
While we have given examples about top-down investing with the technology and REITs sector, let’s take a look in general on how you can research for stocks as a top-down investor.
Top-down investors can start by having a world-view of the countries that can prosper over the long run.
They can study macroeconomic factors such as GDP growth, population growth, geopolitical risks, and megatrends such as e-commerce growth.
From there, they can shortlist sectors that might do well due to these macroeconomic factors.
With a particular industry, they can further break it down into smaller segments.
The segments that are faster growing than others in the industry may hold more potential.
From those segments, we can identify companies with the highest propensity for growth.
Here’s a quick guide on picking stocks as a top-down investor.
If picking individual stocks is not your thing…
You can choose to invest in industry-specific exchange-traded funds (ETFs) to capture the particular sector’s growth.
Exchange-traded funds (ETFs) are open-ended investment funds that commonly track the performance of an underlying index.
Since they are traded on a stock exchange, they are aptly named as such.
Investing in ETFs allows you to diversify your portfolio instantly without much effort.
For example, if you think REITs as a sector would do well, you can choose to invest in REIT ETFs listed on SGX such as:
- Phillip SGX APAC Dividend Leaders REIT ETF (SGX: BYJ) (SGX: BYI)
- NikkoAM-StraitsTrading Asia Ex Japan REIT ETF (SGX: CFA) (SGX: COI)
- Lion-Phillip S-REIT ETF (SGX: CLR)
The ETFs each hold around 30 companies, providing nice diversification for investors with minimal work.
What Is Bottom-Up Investing?
On the other hand, bottom-up investors don’t focus too much on the macro-economy or market cycles.
Rather, they focus on individual companies and look out for stocks that have performed well or have the potential to grow, regardless of the industry they’re in.
For instance, bottom-up investors might select stocks based on specific financial metrics, such as growing revenue, high return on equity, and low debt-to-equity ratio.
However, each bottom-up stock picker would have a different set of criteria for picking the best stocks to invest in.
How Can Bottom-Up Investors Shortlist Stocks?
One way for bottom-up investors to find stocks would be to use stock screeners.
For instance, I was able to filter a total of 725 SGX-listed stocks down to just 17 using these three criteria (you can choose to customise the selection criteria according to your requirements):
- Debt-to-equity (between 0% and 20%) — ensures a strong balance sheet
- Return on equity (between 10% and 29%) — reveals companies with efficient management
- P/E ratio (between 10x and 20x) — shows undervalued to fairly-valued companies
Some stocks that showed up were:
- Cortina Holdings Limited (SGX: C41)
- Kimly Ltd (SGX: 1D0)
- Micro-Mechanics (Holdings) Ltd (SGX: 5DD)
- SATS Ltd (SGX: S58)
- SBS Transit Ltd (SGX: S61)
- SIA Engineering Company Ltd (SGX: S59)
- Straco Corporation Ltd (SGX: S85)
- UMS Holdings Limited (SGX: 558)
- Venture Corporation Ltd (SGX: V03)
(Note: As with all investments, you have to do your due diligence to further sieve out stocks that meet your investing objectives.)
Which Is Better: Top-Down or Bottom-Up Investing?
There’s no right or wrong way.
Nor is one approach superior to the other.
Both approaches work well for investors if they know what they are doing.
Some investors may also combine both approaches. I’m one of such investors.
Most of the time, I look for stocks from the bottom-up approach and also ensure that the company is in a sector that can grow for the foreseeable future.
At other times, I look for countries or industries that can do well and dive into individual stocks from there.
So, at the end of the day, it all depends on your personal preference.
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock. The writer may have a vested interest in the companies mentioned.