Top-down and bottom-up equity research are two completely strategies for stock-picking. There are advantages to both, but if you only focus on one, you may miss out on important information that could impact the performance of your portfolio. The saying “You can’t see the forest for the trees,” means that when you are too close to a situation you need to step back and get a greater perspective. Top-down equity research gives you that wider perspective.
The first step in the top-down equity research process is to analyze the macroeconomic, political and social variables within a particular country or region. For example, you can look for opportunities in North America and Western Europe, but more than likely there are greater growth opportunities in emerging regions like Latin America and Asia. A crucial stage throughout the process is to identify risks in the market (economic, political or social). Generally, higher returns are often linked to greater risk, especially in emerging markets. Reviewing gross domestic product (GDP) for each country and reading estimates for the next year is also good indicator of future potential. You need to conduct a broad analysis of the economic, political, and sentiment drivers within each country or region to formulate forecasts and develop your portfolio strategy.
Certain sectors do better than others, so a top-down approach would be to examine the stocks within a high performing sector. You can uncover general trends in the sector as well as compare a potential security to others in the same sector. However, sophisticated investors know after the dot.com bust in 2000 that sometimes a huge success in one sector can be too much of a good thing.
In 2000, there were just too many companies focused on the same type of technology, so the success of some companies meant failure for others. You should also look at the period in the economic cycle which is favorable for your industry. For example, toy stores will have their greatest financial rewards in December.
Company analysis is researching a company’s financial information to determine whether the company would make a good investment or not. Is the company making money consistently? You can look at a company’s cash flow to see whether there is a steady stream of income that more than covers the steady stream of expenses. Another measure that is Earnings Growth or Sales Growth to see if the company is performing better year over year, as well or better than, his competitors.
In summary, first start at the top with the big picture of macro-economic and industry analysis before moving onto company analysis. You’ll get see both the forest and the individual trees.