There’s a lot of discussion on which is the better investing strategy, bottom-up investing or top-down investing. The definitive guide can be found in Chapter 7 of Seth Klarman’s book, Margin of Safety.
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Here’s an excerpt from that book:
There is no margin of safety in top-down investing. Topdown investors are not buying based on value; they are buying based on a concept, theme, or trend. There is no definable limit to the price they should pay, since value is not part of their purchase decision. It is not even clear whether top-down-oriented buyers are investors or speculators. If they buy shares in businesses that they truly believe will do well in the future, they are investing. If they buy what they believe others will soon be buying, they may actually be speculating. Another difficulty with a top-down approach is gauging the level of expectations already reflected in a company’s current share price.
If you expect a business to grow 10 percent a year based on your top-down forecast and buy its stock betting on that growth, you could lose money if the market price reflects investor expectations of 15 percent growth but a lower rate is achieved. The expectations of others must therefore be considered as part of any top-down investment decision. (See the discussion of torpedo stocks in chapter 6.)
By contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. An investor’s top-down views are considered only insofar as they affect the valuation of securities. Paradoxically a bottom-up strategy is in many ways simpler to implement than a top down one. While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all. The entire strategy can be concisely described as “buy a bargain and wait.”
Investors must learn to assess value in order to know a bargain when they see one. Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large. One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintaining cash balances at times. Bottom up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear.
A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available. Topdown investors, by contrast, may attempt to time the market, something bottom-up investors do not do. Market timing involves making a judgment about the overall market direction; when top-down investors believe the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion. Another difference between the two approaches is that bottom-up investors are able to identify simply and precisely what they are betting on.
The uncertainties they face are limited: what is the underlying business worth; will that underlying value endure until shareholders can benefit from its realization; what is the likelihood that the gap between price and value will narrow; and, given the current market price, what is the potential risk and reward?
Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. When the underlying value changes, when management reveals itself to be incompetent or corrupt, or when the price appreciates to more fully reflect underlying business value, a disciplined investor can reevaluate the situation and, if appropriate, sell the investment. Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid. In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.
Top-down investors, by contrast, may find it difficult to know when their bet is no longer valid. If you invest based on a judgment that interest rates will decline but they rise instead, how and when do you decide that you were wrong? Your bet may eventually prove correct, but then again it may not. Unlike judgments about value that can easily be reaffirmed, the possible grounds for reversing an investment decision that was made based upon a top-down prediction of the future are simply not clear.
This article originally appeared on The Acquirer's Multiple - Stock Screener.