What is Bottom-Up Investing?
When approaching the stock market, there are two broad ways to look at investing. You can look at it from a macro standpoint or a micro standpoint. Do you care more about broad market trends and behavior? Or are you more concerned with the performance and prospects of individual companies? If you gravitate to the latter, you have a micro approach, also known as bottom-up investing.
Bottom-up investing is an approach that focuses on specific companies and their performance outside the bounds of broader market factors. Bottom-up investors find companies they like. In addition, they evaluate their fundamentals to determine whether the company itself has the means to succeed. For example, this includes financials, management, market share, etc. Moreover, bottom-up investors believe that well-equipped companies will succeed regardless of market factors.
Bottom-up investing takes a lot of work. However, it’s a proven philosophy that investors can use to build high-performing portfolios. Here’s how to approach investments from the bottom up.
The Bottom-Up Investing Philosophy
Investing in individual companies is a time-intensive practice. Firstly, investors need the patience to evaluate the company and its stock performance. Secondly, they need the knowledge to piece everything together in an investment thesis. Here’s just a sampling of some of the fundamentals for bottom-up investing:
- Products and services. What is the market demand for this company’s products? How are they different from the competition? What are their price points and margins? Who are the primary consumers? Investors get to know everything they can about the company’s core revenue mechanisms.
- Company financial health. What types of assets and liabilities does the company have on its balance sheet? How are its revenues and cash flows? What type of debts does it have? What is its credit rating? Does it pay a dividend? Investors need a clear and accurate picture of the company’s ability to manage its finances, so it can continue to grow profitably.
- Leadership and management. Who are the key figures in the c-suite? Moreover, what’s their tenure or area of expertise? What’s their leadership style? How do they present the company in the media overall? Having confidence in the company’s leadership is an important part of forming an investment thesis about the company’s ability to succeed.
- Recent stock performance. How has the stock traded over the past several years? What caused it to dip or jump in the past? Has it been stagnant for extended periods? Are there any worrying or promising trends forming? How the stock performed recently provides context for how it stands at its current valuation and how it might perform in the future.
Therefore, bottom-up investing employs a healthy mix of quantitative and qualitative analysis.
Bottom-Up vs. Top-Down Investing
Bottom-up investing involves significant probing into the fundamentals of specific companies. However, top-down takes an opposite approach. These investors look first at macroeconomic factors that drive broad market trends. For example, interest rates, economic signals, inflation and more. A top-down investor might hypothesize the following:
The Federal Reserve has announced two interest rate hikes in the coming six months. On a macroeconomic scale, this will make it more expensive for companies to borrow money. As a result, top-down investors may shy away from asset-heavy companies that rely more heavily on borrowing to fund new asset purchases that grow operations.
They believe that macroeconomic factors trickle down to affect company performance, both positively and negatively. They’ll gravitate to sectors, regions and other broad segments of the market where they believe tailwinds will uplift company performance. The focus is broad, as opposed to specific.
It’s important to understand that bottom-up investors won’t ignore market trends! They will look to market trends as context for how a specific company performed within it.
The Pros and Cons
Like any investment strategy, there are significant pros and cons to bottom-up investing. For example, here’s what investors can look forward to and what they need to beware of if they start at the bottom.
Pros of Bottom-Up Investing
- Potential for long-term value and significant ROI by prospecting strong companies.
- Better portfolio stability from stocks equipped to weather broad-market trends.
- More conducive to value investing, since there’s a deeper understanding of the company.
- Investor confidence is higher in companies they’ve taken the time to properly evaluate.
Cons of Bottom-Up Investing
- Identifying and evaluating companies takes a significant amount of time to complete.
- Individual companies are more prone to volatility if unexpected turbulence arises.
- Investors might prospect companies that actually lag market or sector growth averages.
- Bottom-up investing takes a strong understanding of microeconomic variables.
Should You be a Bottom-Up Investor?
Bottom-up investing is a powerful strategy with proven results. For example, see famous stock pickers like Warren Buffett and Peter Lynch. They’re lauded for their ability to pick diamonds out of the rough. In fact, these super investors and others like them merely took the bottom-up approach. They prospected individual companies, instead of riding market trends.
There’s important benefits that come with being a bottom-up investor. Specifically, one of the most important benefits is the encompassing knowledge you have about the stocks in your portfolio. You have a deep understanding of the companies you’ve invested in. And this will give you the confidence to weather their performance, good and bad.
Top-down investing follows the trends. And bottom-up investing is when investors follow what they’ve taken the time to learn, regardless of how the broader market behaves.