Wednesday, 2 October 2013

Quote for the day

“Markets have a distinct game theory component in that, the fewer the total number of survivors after a "wash and rinse" period, the greater the future opportunity that comes available (with comparatively few left to exploit it). To put it another way: If the money always came flying in through the window, too many profit seekers would crowd the window. Pain facilitates gain by blocking the pathways of the insufficiently persistent, motivated and seasoned.” - Jack Sparrow

02-Oct-2013 CSE Trade Summary

Crossings - 02/10/2013 - Top 10 Contributors to Change ASPI

Following Stocks Reached New High / Low on 02/10/2013

Investing: Top-down Or Bottom-up

When it comes to investing in good companies, there has been much debate on the top-down and bottom-up approaches. Most fund management companies use the top-down approach and recommend that investors examine the economic and industry outlooks first before deciding on which stocks to purchase.

On the other hand, investment experts like Warren Buffet and Peter Lynch favor the bottom-up approach. They say that macroeconomic forecasts are actually major distractions for investors as the projections might turn out to be wrong. Instead, investors' efforts should be placed more on detecting the quality of earnings and asset value of the company.

Both approaches have their strengths and weaknesses, but they share a common goal, which is identifying good fundamental companies to invest in.

With the top-down approach, investors study the economic trends and then determine the industries and companies that are likely to benefit the most from them. Say, for instance, the reduction in prices of imported paper will contribute to lower operating costs for media companies and increase their earnings. Investors will then search for more efficient and cheaply priced media companies. On the other hand, negative events like high interest and inflation rates or currency depreciation, can affect a country's economy and definitely cause stock prices to tumble.

Top-down investors will first look at the entire forest instead of specific trees and try to identify the main market theme ahead of the market in general. They believe that picking individual companies comes second because if the economic conditions are not right for the industry that a company operates in, it will be difficult for the company to generate profits, regardless of how efficient it is. However, such investors may sometimes miss good companies that are still performing well, even in a depressed sector.

Conversely, bottom-up investors conduct extensive research on individual companies. As long as the company's future prospects look strong, the economic, market or industry cycles are of no concern. In fact, the downturn in the stock market may provide investors with a good margin of safety to buy stocks at depressed levels and ride them up to big gains.

So, bottom-up managers will buy stocks even though the macroeconomic and industry outlooks look uncertain. When the industry may be out of favor and most investors are ignoring the true earnings of companies, bottom-up managers can detect good and well-managed ones selling at prices that are far lower than the intrinsic value.

However, to top-down managers, bottom-up managers may be attempting to catch a 'falling knife' (a stock whose price has fallen tremendously in a short period of time) in a down market. Unless bottom-up managers have plenty of bullets to average down on their purchase prices, they may run out of cash if the stock prices continue to lower. Moreover, they may sometimes fail to see the wood for the trees; they may identify certain companies but miss the overall industry trend.

The top-down and bottom-up approaches are two distinct and fundamentally very different approaches to investing. Investors can combine the top-down and bottom-up approaches by applying top-down analysis on asset allocation decisions while using a bottom-up approach to select the individual securities in the portfolio.
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