Stock Selection Part 3 1 comments

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I have mentioned in Part 1 many months back that I practise both top-down and bottom-up investing, but it may be useful to examine the contexts in which each of these may be more efficable.

Those who read earlier articles would remember my classification of a stock's price rise as triggered by three main factors: market-sector-company, in approximate 40-30-30 proportions. Generally I believe there is no point to trying to time the market and the many macroeconomic factors driving it: why not just view the world with rose-tinted lenses like Peter Lynch and assume that the world is generally going to get better as we go along, rather than dart in and out of the market at every piece of breaking news on consumer demand, housing starts, purchasers' index, GDP growth etc? And indeed, the higher 40% attributed to this (random-driven) segment reflects my belief that investing, even of a long-term nature, constitutes a substantial proportion of "leap-of faith" (a euphemism to substitute "gambling" which some investors might bristle at).

So the investor's/trader's focus should be on the other 60% which I think might yield systematic gains if the individual works hard at self-improvement. Top-down investing as I define it has nothing to do with the market, but rather to do with the sector: it's about choosing the sector to invest in, and then picking a good stock inside the sector to buy. Bottom-up investing goes the other way. In other words, it's about the chronological order of the stock screening process: A then B, or B then A?

There is no right answer and it might boil down to investment philosophy, actually (was thinking about titling this Investment Philosophy Part 4). Many unit trust managers practise top-down investing but you will also have heard of highly successful investors professing their preference for bottom-up: Peter Lynch, Warren Buffett.

The success of bottom-up investing, to a large part, depends on what Phillip Fisher calls "scuttlebutt". Peter Lynch had perfected this to an art form, in his "walk around the shopping mall" approach. This technique of course is mainly suited for consumer plays, and is ideally suited to the US market which is the world's largest consumer market and hence offers plenty of room for topline and bottomline growth for consumer product companies. Ditto Warren Buffett and his key plays of Coca-Cola, Disney, Gillette, American Express which at heart are all consumer demand-plays. Transpose this to the Singapore market and it might be less effective for two reasons: (1) the small size of domestic demand hence less expansion space for consumer plays; (2) scuttlebutt is less easy (less access to products) for industrial plays, and the initial company research in a bottom-up investing process in these companies often boils down to financial statement analysis.

A good bottom-up stock selection process often churns out a list of undervalued companies, or what are known as "value plays" or "asset plays". In developed capital markets such as the US there are specialised buyout firms that capitalise on such market pricing inefficiencies: one would have heard of the LBO (leveraged-buyout) boom in the 1980s. Unfortunately in Singapore the buyout market is hardly advanced, and it might take a long time for asset plays to unlock their value (as Raffles Holdings eventually did through its sale last year). On the other hand, theme plays tend to capture the imagination of the market, from shipping to steel to oil&gas to properties to China stories (in chronological order of themes since 2003). And when the market's imagination is captured, the typical stock in the hot sector tends to go from slightly undervalued to greatly overvalued. Those who adopted the correct sectoral picks consecutively and exited appropriately would probably have doubled or tripled their money.

Top-down investing tends to pick out growth sectors and growth stocks, and that is what the Singapore market has rewarded with enormous capital gains in the last few years. In a bull market, investors focus on growth, hence the comparative success of the top-down approach. But in a bear market, it would be the bottom-up approach that might yield the better gains, for the investor would have familiarised himself with the company's operations (through scuttlebutt or otherwise) and convinced himself of its ability to ride the cycles before committing his money.

So, the long and short of it is that there is a time for both investing approaches. But no matter what one adopts, so long as he corroborates each approach with its counterpart (ie. company analysis then sector analysis for bottom-up, vice versa for top-down), he can't go far wrong. Yet the chronological order of the screening procedure is certainly not trivial.