Bottom-up investing

Bottom-up investing is a strategy that overlooks the significance of industry or economic factors and instead focuses on the analyses of individual stocks and companies.

Analysts will focus on the idiosyncratic, microeconomic circumstances surrounding the company or security. Broader macroeconomic themes will be secondary to the analysis or not used at all.

For example, a hedge fund that specializes in technology investments or a venture capital firm generally engages in bottom-up investing. Macroeconomic themes, such as the trajectory of interest rates, inflation, or the price of oil may be viewed as tertiary or wholly irrelevant to the analysis.

This approach to investing assumes that individual securities can move independently of their industries or the broader economy. It can be applied to companies of all sectors but is somewhat more commonly associated with “growth” industries rather than “value” industries. For growth companies, more of their future cash flow (cash flow is fundamentally the basis on which companies are valued) is expected to come far out in the future and revenues are less dependent on the economic cycle, which might make them more amenable to a bottom-up approach.

Bottom-up investing will focus on a company’s individual economic health, revenue generation strategies, cost structure, capital structure, competitive positioning, and quality of the management team.

Activist investing is an example of a strategy that employs a heavy emphasis on a bottom-up approach by attempting to influence the operations of the company, usually by obtaining seats on a company’s board of directors. Activism could still nonetheless use a top-down approach by first targeting companies within industries that are expected to perform well within the intended investment timeframe.

Example of Bottom-Up Investing

One might approach an investment in McDonald’s (MCD) by looking through the company’s financial statements and model out its future projected revenues and expenses as part of a discounted cash flow approach to determine a fair value price per share.

An investor might believe that if it performs a deep-dive analysis of the company, talk to management, suppliers, individual franchise managers, understand future initiatives or trends that might not be priced into the value of the company, it can obtain a competitive advantage over the market in terms of understanding the company’s value and/or future direction.

For example, if an analyst can obtain knowledge of a new product that is likely to attract or retain customers or management’s plan to cut labor costs through automatization initiatives – before the rest of the market catches on – this can provide an information advantage.

It can then proceed to perform industry analysis. For example:

  • Will the fast-casual dining industry perform well relative to other industries over the next X months/years?

And then on to the broader economy, such as:

  • How will higher oil prices impact McDonalds’ cost structure relative to a competitor?
  • How would higher interest rates impact the stock relative to another portfolio investment and how will that impact its weighting in the portfolio if we invest?
  • If 3% of their revenue comes from country X, which may be entering recession, how sensitive are customers to the projected growth deceleration and how might that impact the valuation if the market is underappreciating that?

Or an analyst or individual, due to intentions of holding the stock over the course of decades, for example, could simply ignore the macroeconomic backdrop under the idea that the stock will go through multiple business cycles over the course of the expected holding period. Or believe that the fast-casual dining industry isn’t sensitive enough to macroeconomic factors relative to the broader market to invest the additional time researching.

Contrast With Top-Down Investing

Bottom-up investing contrasts with the top-down approach. Top-down investors will identify main trends regarding debt and business cycles, inflation, projected interest rate movements, capital flows, and country-specific factors to map out an investing plan. They may then look at certain industries expected to outperform others over the next 6+ months and identify the best opportunities to invest in within those sectors.

Bottom-Up Investing for Day Traders

Bottom-up trading is, of course, a fundamental trading strategy. And whether one identifies as a “bottom-up” or “top-down” trader is a matter of preference or personality. Bottom-up investing is most common among long/short equity and credit funds, while top-down investing is most common among macro funds.

Of course, if one trades wholly on the basis of momentum or technical factors, then that’s an entirely different manner of trading. But chart patterns can still nonetheless inform fundamental trading strategies, such as entry and exit points.