Bottom-up investing focuses on the fundamental value of an individual company. This investment style is considered a deep dive into the value of an individual stock on a case-by-case basis. Investors who employ a bottom-up style will consider the industry or macro environment only secondarily to the fundamental performance of the company itself.
The bottom-up style assumes that individual companies can outperform despite the performance of an industry or the current economic climate. When using a bottom-up approach, investors should understand how a specific company generates its returns by understanding how the company’s revenue is produced and how expenses are generated by operations. Investors need to become familiar with products and services offered by a specific company along with an understanding of the company’s assets, liabilities, and income.
In contract to bottom-up investing, a top-down approach would examine the fundamental of an industry or the overall economy and make bets on the assumption that a rising tide would lift all boats. This could include sector analysis which involves understanding the demand for a product or service for a particular industry. Or it could involve studying whether a sector is attracting greater attention from consumers or businesses that buy that sector’s products. The growth of the tablet market in 2010 would be a good example of this kind of top-down sector approach.
Investors that use a top-down approach might examine economic data points like Gross Domestic Product or Non-Farm Payroll reports. They might also look at how a specific commodity such as oil would affect a driller, or how the change in a currency rate would affect an industry. Another type of top-down analysis is the study of monetary policy, which would analyze how the likelihood of a central bank’s move to increase or decrease interest rates would have an impact on different sectors and add (or limit) the amount of cash available to buy securities in a market.
The Methods
Understanding management structure, a company’s finances, and their products and/or services is tantamount to bottom-up investment success. Understanding the critical financials of a company is also crucial to the bottom-up investing approach. There are a number of key statistics and ratios which include revenues, EBITDA, and earnings per share that allow an investor to compare performance amongst a number of different companies.
Investors who focus on bottom-up investing need to understand a company’s products and services and determine if they are efficiently allocating capital to the most profitable revenue producer.
If a company is focusing to increase business lines and investing into profitable businesses, they could be candidates for further research and a possible future purchase. Investors need to examine each company with a different set of criteria to understand whether to invest in the company or not. For example, a manufacturing company would require a different evaluation matrix than a financial institution, and even two manufacturers would usually require slightly different criteria when assessing their value.
Cash flow is one of the most important indicators of the health of a company. Free cash flow is cash on hand after maintaining the asset base of the company. When companies have free cash flow, they have the capital to expand or invest in other businesses. Investment into other lines of business or increasing a specific line by purchasing a direct competitor is an important factor when evaluating a company’s profile and developing a bottom-up model of the company’s future growth.
Company insider trading is another good metric, since it most likely tracks management’s sentiment of a company’s health. Insider selling on a large scale is a clear red flag that there are issues with a company’s profitability.
The historical stock multiple is part of stock analysis that makes investing difficult for a number of reasons. This is the number that you get when dividing the stock price by its earnings per share. Investors disagree on what a healthy stock multiple is and will usually compare this to historical ranges for the company and its sector. Very aggressive growth stocks, usually carry high multiples, while well-established corporations that have steady earnings generally carry low multiples.
Pros and Cons to Bottom-Up Investing
Bottom-up investing allows an individual to become very familiar with a business in which he plans to invest capital, which means nasty surprises about a company are less likely to show up down the road that will impact the stock’s value. This approach is similar to running your own business in that it involves a close analysis of the business’s performance and the relative value of its everyday operations.
The downside to bottom-up investing is the amount of time it takes to research and analyze the workings of an individual company. One can literally spend 40 hours per week just analyzing one company, so each investor needs to decide when the point of diminishing returns is for a bottom-up approach to a certain company.