Top-down analysis

As the name implies, top-down analysis starts by analyzing the big picture and working your way down. Think about taking a world view — something members know we believe every investor must do — that incorporates everything from geopolitical events to monetary and fiscal policy and macroeconomic data points.

From there one might ask what this world view means for various sectors of the economy: Is it boom times with rising rates that require you to own more economically sensitive sectors like energy, financials and industrials? Or are we slowing, possibly heading into a recession that requires a more defensive posture with a focus on sectors like consumer staples and healthcare? By the same token, an understanding about the macroeconomic picture will allow you to think about monetary policy, therefore dictating whether you can own high valuation stocks (when money is free and liquidity is high), or if a much stricter adherence to valuation is warranted (when money is expensive, future earnings get discounted more, and liquidity is scarce).

One step deeper and we can focus on which industries inside of those favorable sectors may deserve the most focus. For example, within the energy sector we have the exploration& production companies which really follow how cruide oil moves (Chevron, Diamondback), the equipment and services energy (Kinder Morgan, Schlumberger, Halliburton). Within the financial sector we have the fintech companies which have high valuation which gets hit when interest rates go up (Paypal), the money-center banks which move with interest rates, or the asset management companies that are less rate-sensitive (Morgan Stanley).

The industrial sector offers another great example of how a top-down analysis may work. This sector has many industries to choose from including the airlines, aerospace & defense, railroads, construction, machinery and more. With the crisis in Ukraine intensifying, the airline industry has taken a beating. Take a look at the U.S. Global Jets ETF, down 10% over the past month. Who wants to travel to Europe when Russia is attacking a nuclear facility? Meanwhile, iShares U.S. Aerospace & Defense ETF, which represents aerospace & defense, rose 7% over the same period.

Bottom-up analysis

Bottom-up analysis works in the opposite direction. The focus is placed on the individual companies and the valuations placed on their stocks. From this angle, we attempt to incorporates a focus on business fundamentals, quality of management and competitive moats. We do this a number of ways, including tracking corporate filings, investor events, research reports and of course, studying quarterly earnings releases.

By combining the top-down view with the bottom-up view, the hope is to identify the best-run companies in the industries and sectors that benefit the most from the broader macroeconomic operating environment.

Combining the two

Of course, sometimes you find yourself loving the individual company due to the bottom-up analysis, but the stock belongs to a hard-hit sector due to macroeconomic headwinds. You can’t just rush in to the stock and pay whatever the market is asking for at the time. If you think about bottom-up analysis as picking a house, and a top-down analysis as choosing a neighborhood, your purpose is to choose a good house in a good neighborhood; both has to be good for the value of your house to go up. After all, a great house in a bad neighborhood rarely offers a promising risk-reward profile.

This is the case we found ourselves in virtually all of our portfolio holdings, but especially the names such as Advanced Micro Devices (AMD), Microsoft (MSFT) or Salesforce (CRM) which reported stellar quarters yet because of high valuations into a tightening monetary policy environment, the stocks have plummeted much lower than levels before they reported good earnings. Their earnings release left us with even more conviction that we are sitting on a long-term winner. However, none of that mattered at the moment, not in this market where the world view, characterized by inflation, energy shortages and fears that a wrong move could spark World War III, has investors demanding energy, utilities and defense stocks along with the safety offered by healthcare and to some extent the staples.

So, what do we do when posed with this dynamic? When the bottoms-up view says to buy but the top-down says to avoid? Well, patience is a virtue and that’s exactly what we do, we remain patient and wait for the broader macroeconomic and geopolitical environment to become more favorable and for the selling pressure to dry up.

You also want to patiently build your position in those stocks, not catching a falling knife, but strategically buy at incrementally lower prices over a long period of time. We discussed this concept here. You need to space out the buys, each one more than 5% below your previous purchase. You also want to make sure that you aren’t repeatedly buying at the same level (a trap easy to get sucked into in a choppy market such as this) and that each buy is helping you reduce your overall cost basis.

Sure, you may not catch the bottom – nobody ever does without a good deal of luck – but in this environment, protecting your downside is exceedingly more important than trying to capture every single tick to the upside.