A bottom-up investing methodology focuses on analyzing individual companies initially before evaluating a stock-sector and the economic outlook.
This differs from a top-down approach where an analyst would evaluate the macroeconomic environment first, and then focus on a sector before analyzing an individual stock.
Bottom-up investors will first evaluate specific financial metrics, as well as the company management to search for companies that are undervalued. Because bottom-up analysts hone in on company specifics, their portfolios can be less diversified compared to portfolios created by top-down analysts.
A bottom-up approach prioritizes company-specific information.
The steps you might take could be:
- Understand management
- Evaluate a company’s finances
- Understand cash flow
- Analyze the products and services
- Focus on capital allocation to profitable sectors
The Role of Management
Management is at the core of every successful business. Great management can enhance a companies reputation and drive successful profitability. Alternatively, poor management can waste resources and deteriorate a company’s reputation.
A bottom-up approach to investing, carefully analyzes the company management.
You want to make sure that the Chief Executive Officer (CEO) is a consensus builder and allocates resources to profitable businesses.
To generate robust profits, a CEO needs to take risks. You want to make sure that the business that drives revenue and profitability are a core focus of the company.
Lastly, you want to make sure when you are performing bottom-up investing that the management has a deep bench, that has several key players in pivotal roles. This includes the President of the company, the Chief Operating Officer, and the Chief Financial Officer.
Management is very important in the process of efficiency. They are responsible for productivity and expenses, and the best ways to utilize resources.
The bottom-up process lays the return on investment at management’s feet. They are responsible for all the investment of funds, the allocation of resources the generation of profitability, as well as, the reduction of costs within the company.
These responsibilities allow a company to remain in a good market position and ahead of the competition.
The bottom-up investor also wants to make sure that the company can handle external factors such as political uncertainty, as well as economic changes. You want management to be flexible and be able to change its short-term goals to ever-changing market environments.
Companies that cannot do this will likely perish during extended periods of market uncertainty.
Understanding the company’s finances, and several key statistics and ratios are imperative to bottom-up investing. This includes company revenues, net income, earnings before interest, taxes, and amortization.
One of the most important concepts to a bottom-up investor is free cash flow.
This is cash that is available after funds are used to support operations and maintain assets. Free cash flow is unlike earnings or net income in that it excludes the non-cash expenses.
So when an analyst looks at free cash flow he/she does not remove expenses that are on the income statement that reflect spending on equipment and assets as well as working capital from the balance sheet.
Additionally, interest payments are usually excluded from the calculation of free cash flow. Many believe this is one of the purest ways to determine the actual profitability of a company.
Products and Services
The products and services that received allocated investment funds are important to the bottom-up investing process.
This is where a company has made a conscious decision to allocate capital and you want to make sure that this business is a candidate for scalable gains. A bottom-up investor wants to also determine if a company is making an appropriate investment.
While it’s not unusual for a company to broaden its horizons, it would make more sense for an integrated oil company to invest in oil services rather than a technology company.
Bottom-Up Investing Compared to Top-Down Investing
While the bottom-up investing approach evaluates a company first, other approaches take a different tact. Top-down investing is a forecasting approach that evaluates the broader macro picture before drilling down.
This methodology first evaluates the economic outlook looking at growth, and interest rates before evaluating a sector that is likely to outperform.
A top-down investing approach looks at the broader global macro environment to determine the current economic cycle to see what sectors are likely to outperform soon.
Once this is determined, individual companies are then evaluated to see if they can outperform. While top-down investing initially looks at the macro environment, a bottom-up approach initially focuses on individual companies as its priority.
The fundamental analysis that is used to evaluate a company can be the same in a top-down or bottoms-up investing methodology. You might use the same metrics such as evaluate management and looking at key financial metrics.
The key difference is that the top-down investor looks at the broader picture first. The bottom-up investors look at the company first. The top-down investor and the bottom-up might never evaluate a specific company at the same time.
This is because the trends in economic cycles, used by the top-down investor, might never line up with the financial metrics, analyzed by the bottom-up investor.
Example of Bottom-up Investing
A bottom-up investor could analyze a company like Chipotle by initially evaluating the companies financial statement and generating a model of future revenues and expenses.
This would allow you to use a discounted cash flow methodology to determine the fair value of the stock price. The next step would be to speak with the management, as well as evaluate the supply chain to determine future trends in expenses and the return on investment.
You would then try to see if the company has a competitive market advantage in the fast-casual food sector.
The upshot is that a bottom-up investor evaluates company-specific metrics first using several criteria. If the company has the correct financial metrics and company management, you might determine that the return on investment is appropriate.
There are several techniques such as discounted cash flow analysis that can be used to determine if the share price is undervalued.
Once this is determined, a bottom-up investor might then look at the specific sector to determine if it will outperform or underperform in the current economic environment.
This differs from top-down investing that looks at the macro environment initially.