Top-Down vs. Bottom-Up by Joe Rooney, Burgandy Asset Management
There are two common categories of investors: “top-down” and “bottom–up.” These terms refer to an investor’s starting point when approaching a potential investment. Top-down investors begin by evaluating the macroeconomic environment, while bottom-up investors start by researching individual companies.
The debate between top-down versus bottom-up investing is not new and there is strong conviction on both sides. Burgundy has been a bottom-up investor since the day we opened our doors and this will not change. It is part of our philosophy and has contributed to an investment process that is both consistent and repeatable, which are key factors in adding value for our clients over time.
The common misconception is that Burgundy, as a bottom-up investor, completely disregards the risks of the macroeconomic environment. Rather, we recognize there are cycles in the economy and accept there will always be a recession in our future. We seek to minimize the effects of the ebbs and flows of the macro environment by owning high-quality companies. We must understand the long-term viability of an industry and do this by looking at the economy through the eyes of the business. Innovation is occurring at a rapid pace in today’s world, and we want to make sure no rogue waves are going to wipe us out. Ultimately, it is about understanding the extremes.
David Einhorn's Greenlight Capital returned -2.9% in the second quarter of 2021 compared to 8.5% for the S&P 500. According to a copy of the fund's letter, which ValueWalk has reviewed, longs contributed 5.2% in the quarter while short positions detracted 4.6%. Q2 2021 hedge fund letters, conferences and more Macro positions detracted 3.3% from Read More
We focus our time on finding as many quality businesses as possible, considering how scarce they are. A combination of patience and short-term volatility in the market, quite often driven by top-down emotions, provides us with buying opportunities for these companies.
So, what is a quality business? In short, a company that has a sustainable competitive advantage, with traits such as:
- Industry-leading profit margins
- Pricing power
- Barriers to entry
- Growth in free cash flow
- An excellent record of capital allocation (yes, Warren Buffett has shown this can be a competitive advantage)
Quality businesses combine these characteristics with a strong balance sheet to create economic resilience. And, in fact, a strong economy is not a prerequisite for these companies to make money. As our CIO Richard Rooney says, the companies in which Burgundy chooses to invest tend to sail well in a light wind.
This search for resilience often leads us to consumer-oriented companies because they possess the most consistent customers. Consistency provides durability to businesses that sell billions of items to hundreds of millions of people. We also commonly find this type of company in the industrial or technology space. While not all are created equal, we do see similar themes in the higher-quality businesses. These companies have products or services that are mission-critical to their customers and the cost is relatively small compared to the total operating costs of the customers’ businesses. For example, consider the cost of elevator maintenance – a small but essential service for property managers – compared to the overall cost of running a commercial or condo property.
One final note when considering top-down and bottom-up investing: remember that most successful entrepreneurs would never consider selling a privately owned high-quality business because of a potential slowdown in the industry or the broader economy. This attitude is effective in building wealth and highlights why we seek good businesses in the public markets. Once we have identified these quality businesses, the next step is to invest at bargain prices, which often present themselves in difficult economic times.