Investors practicing bottom-up investing focus on a company’s fundamentals, and not predictions of what may happen in an industry or the economy

We think that most investors are far better off with “bottom-up investing” as opposed to “top-down investing.” Bottom-up is where you look closely at individual stocks and single out those with a history of sales and earnings, not to mention dividends. Then you buy a diversified, balanced selection of stocks that represent prosperous businesses with a strong hold on their markets.

We advise you to invest this way within the framework of our three-part Successful Investor portfolio strategy.

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Over periods of five years and beyond, top investment honours mostly go to a member of the bottom-up investing crowd. That’s partly because bottom-uppers tend to make fewer big mistakes. This lets their gains accumulate. This also leads to longer holding periods, which provide greater tax deferrals and lower brokerage costs.

Bottom-up investing versus top-down investing

Using the top-down approach—you might call it predictive finance—you downplay what’s currently going on. Instead, you focus on trying to figure out what happens next. You may disregard lots of details about stocks you buy. Instead, you’re likely to zero in on external factors such as stock-market trends, the economy, interest rates, gold and so on. Or, you may focus on a single key trend, event or detail.

Top-down advisors can draw negative or positive conclusions from these trends. In the late 1990s, for instance, many investors took a highly positive top-down view of the profits that businesses could make by taking advantage of the Internet. Some of these investors routinely bought any new issue that claimed to have an Internet-based business plan. A handful of Internet stocks have done extraordinarily well since then, of course. However, the majority “crashed and burned”—generating miserable results if not total losses.

By the time beginning investors have built up enough of a stake to begin serious investing, most have settled on a mix of top-down and bottom-up. As years pass, successful investors tend to put more weight on bottom-up investing. They like the way it cuts risk.

“Top-down” ideas and events get lots of attention in the media and in brokers’ research, so they tend to get “priced into” the market, as traders say. In other words, investors react to this kind of potential calamity or windfall by paying a little less or more for investments than they otherwise would.

Of course, investors may underestimate or fail to recognize good or bad fundamental information for lengthy periods. They may fail to take hidden assets into account for years. Ultimately, good investments go up and bad investments go down, but both can seem to ignore the fundamentals for months if not years.

So, all in all, it pays to focus on the fundamental bottom-up Successful Investor approach—although you need patience to profit from it.

What hidden assets are and why they are important to bottom-up investors

Hidden assets are valuable assets that some investors overlook, discount or disregard altogether. They have special appeal for companies that are using takeovers of other firms to grow. They can be found in real estate and in research spending and elsewhere.

If you buy a stock for its hidden assets, and those assets stay hidden or ignored by investors— or turn out to be less valuable than you thought—it can’t hurt you much. By definition, a stock’s hidden assets have not had much impact on its price so far. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profits, grab investor attention, and push up its stock price.

You should always look for hidden assets while evaluating a stock. If you find them, it will add to the appeal of any stock you find with sound bottom-up fundamentals. 

Patience and the bottom-up investing approach 

Losing patience can cause you to sell your best bottom-up choices right before a big rise.

All too often, investors buy a promising stock just as it enters a period of price stagnation. Even the best-performing stocks run into these unpredictable phases from time to time. They move mainly sideways in a wide range for months or years before their next big rise begins. (Stock brokers often refer to these stocks as “dead money.”)

If you lack patience, you run a big risk of selling your best choices in the midst of one of these phases, prior to the next big move upward. If you lose patience and sell, you are particularly likely to do so in the low end of the trading range, when stock prices have weakened and confidence in the stock has waned.

To achieve the best long-term results, we think you should stick with our three-part Successful Investor philosophy:

• Invest mainly in well-established, dividend-paying companies, with a history of rising sales if not earnings and dividends.
• Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities.
• Downplay or avoid stocks in the broker/media limelight. When stocks spend time in the limelight, they tend to become overpriced, and this leaves them vulnerable to a sharp downturn on any hint of bad news. Instead, look for stocks with hidden value that are less widely recognized—at least so far—as attractive investments.

What are the reasons you would take a top-down strategy over a bottom-up investing approach?

How has your investing approach changed over time? Do you have a preferred strategy that’s different from when you began investing?

This post was originally published in August 2018 and is regularly updated.