Top-down research starts by thinking about the big image of the economy. Top-down investor invest time in analyzing at macroeconomic variables e.g. GDP growth rate, interest rates, inflation, flows, market valuations etc, as the state of the overall economy & valuations play a big role in the investment decision. The investor then tries to identify sectors that will perform better than others, and looks for opportunities in these sectors first. For example, if an investor believes that interest rates are going to come down in the coming months, he would like to identify sectors which will be positively impacted by the rise in interest rates, e.g. real estate, auto. He would then pick out the best performing stocks in that sector and add them to his portfolio.
Bottom up investing is all about the detail, or the small image of the economy. The stocks are chosen based on their valuations and the growth potential, profitability, growth and image of the company, instead of looking whether the company is in the right sector or not. A bottom up investors looks at company specific factors: market size, competitive position of the company, sales, earnings, expected future earnings and balance sheet of the company before deciding whether or not to invest. A bottom investor would study variables like price to earnings ratio, any debt or net cash the company has and its dividend yield. A bottom up investor would be unlikely to be swayed by economic conditions, instead focusing on whether a particular company offers good value and can potentially generate good returns over a period of time.
Like with all investing, it’s important to diversify. You can use whichever approach appeals to you the most, or a combination of the two. For instance you could use the top down approach to focus on a particular industry which interests you and which you believe is likely to outperform. Once you’ve decided on a sector, you can use the bottom up approach to decide which company is likely to give you the best value for your money. This is a great way to seek out a company which may not be well known, but which is performing well in its industry.