Top-down investing looks at the overall economy first, determines which part of the economic cycle we are in, selects sectors which should outperform during that time period, then buys the best stocks within those sectors.
Investors who follow a to-down approach might say “the market is weak, I’m going to sell my restaurant stock because things are tight and people are going to eat in”.
Buying stocks based on profits is termed bottom-up investing. In bottom-up investing, the company’s fundamentals are primary factor that determines the direction of the stock.
Investors who believe in bottom-up investing might think “I don’t care where the market is going, this company is too strong — the stock’s gonna to go higher”.
Two Weaknesses in Bottom-up Investing
DavidSharek.com primarily looks to purchase stock in companies with above-average profit growth (20% or more) — this is a bottom-up investing. Although the bottom-up approach has lead to success, it has two weaknesses.
- When the market goes down, top stocks typically go down more than the market does.
Although its hard to believe, the top stocks fall more during harsh market declines. For example, in 2008 Apple (AAPL) stock declined 57% (from $198 to $85) as the S&P 500 fell 38%. AAPL was a top-stock at the time, as the iPhone helped crank out profit growth of 36% in 2008.
- Stocks can start to rise before the profits so.
When you look at a chart of a stock that has made a dramatic run higher — say the stock usually starts to rise before the numbers do. For instance in 2010 mining equipment manufacturer Joy Global’s (JOYG) stock turned the corner well before company profits did. Investors saw the economy rising, knew more energy would be needed, and bought stock in JOYG because its machines dig for coal.
The Cheat Sheet is valuable for bottom-up investing because it’s like a simple top-down flash card that tells where-to-invest-when.
The Winner is…
Both work well, but a combination of bottom-up and The Cheat Sheet packs a powerful punch.
Disclosure: At the time of this publication, clients of DavidSharek.com and family of David Sharek owned shares of AAPL.