Bottom-up Investing – How You Can Invest Like Klarman

This article on bottom-up investing was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by freephotocc, edited by The Broken Leg.

Should we strive to be top-down or bottom-up investors?

Bottom-up investing involves quantitative methods of evaluating stocks, making it a largely scientific endeavour. On the other hand, top-down investing, due to its stronger focus on qualitative factors, can be described as more artistic.

Both approaches have been used successfully in the world of finance. However, when it comes to long-term value investing, there is a clear winner.

Seth Klarman thinks so, too.

“There are three central elements to a value-investment philosophy. First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities. Second, value investing is absolute-performance, not relative–performance-oriented. Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).”

How Does Bottom-Up Investing Apply To Value Investing?

One must commit to a bottom-up investing approach in order to produce positive returns with a value-oriented portfolio. The reason for this, as Klarman alludes to above, is that the bottom-up investing style is what guides us to our best investment opportunities.

The aim of any value investing strategy is to identify undervalued securities. One reason why bottom-up investing promotes such a strategy is that it does not rule out any opportunities based on geography or industry – a key difference between top-down and bottom-up investing.

While bottom-up investing focuses on the merits of each individual investment opportunity – working its way up through the company, industry, and broader economy – top-down investing begins by reviewing the broader state of the economy and industry, then filtering down through the results in the opposite direction.

From his book Margin of Safety, Klarman explains:

“Top-down investors are not buying based on value; they are buying based on a concept, theme, or trend. There is no definable limit to the price they should pay, since value is not part of their purchase decision. It is not even clear whether top–down-oriented buyers are investors or speculators. If they buy shares in businesses that they truly believe will do well in the future, they are investing. If they buy what they believe others will soon be buying, they may actually be speculating.

By contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. An investor's top-down views are considered only insofar as they affect the valuation of securities.”

So, bottom-up investors use solid fundamental analysis to make their investment picks, while top-down investors leave it a largely down to chance. It must therefore be an appropriate assumption that everyone who invests is engaged in bottom-up investing...

So Everyone Adopts A Bottom-Up Investing Approach, Right?

When it comes to worldwide usage, top-down investing is the much more popular strategy. The reason for this is actually incredibly simple – top-down investing is cooler.

Think about it. Given the choice between the following options, would you:

  1. a) Trawl through hundreds of companies’ financial statements and select opportunities based on specific measures or ratios, or
  2. b) Use your expertise and innate talent to showcase your ability to filter out the boring industries and risky countries, then select the hottest new tech company coming out of Silicon Valley, which is sure to put your name in lights?

Which option do you think provides the greatest opportunity to make a quick impression on Wall Street?

The speed and ease with which one can execute top-down investment approaches is likely one of the main reasons that their popularity exceeds that of bottom-up investing strategies. Overcome with short-termist thinking and driven by peer pressure to perform, Wall Street analysts and traders are, above all, afraid of standing out. Therefore, when it comes to choosing between the growing company in the popular industry in the developed country versus the obscure company in the depressed industry in the developing country, there is always a clear winner.

Is There A Clear Winner When It Comes To Investment Style?

However, only one of these two strategies will lead you to superior investments.

Again, Klarman explains:

“In the discussion of institutional investing in chapter 3, it was noted that a great many professional investors employ a top-down approach. This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them. This approach is difficult and risky, being vulnerable to error at every step. Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy, on particular industries, and finally on specific companies. As if that were not complicated enough, it is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers.”

It may surprise you to learn what the true problem is when it comes to investing. It’s the infinite subjective conclusions one can reach on any investment opportunity. If we can limit the degree by which our investments are decided by our own personal opinions on the security, our investment performance will rise.

Comparatively objective strategies such as Tobias Carlisle’s Acquirer’s Multiple, Joel Greenblatt’s Magic Formula, and Benjamin Graham’s Net Net provide evidence that such a statement is true. Greenblatt even found that after providing a list of potential stocks to his subscribers, they actually performed worse than if they had chosen a random sample. Furthermore, those who bought their stocks and subsequently forgot about their portfolio performed better than those who actively managed their portfolio.

The key message here is that top-down investing provides investors with more opportunities to do themselves in. By furnishing investors with subjective choices between countries, industries, business types, and business structures, they inevitably miss out on countless great investing opportunities.

Why Do Investors Feel The Need To Make Their Own Lives Difficult?

Bottom-up investing strategies reduce the opportunity for investors to adopt a subjective mindset. After all, it is a lot more difficult to mess things up when making decisions that tend to be largely driven by quantitative factors and ratios. Bottom-up investing also tends not to exclude specific countries and industries, making the pool of available investments far larger than that afforded by top-down investing.

“Paradoxically a bottom-up strategy is in many ways simpler to implement than a top-down one. While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all. The entire strategy can be concisely described as ‘buy a bargain and wait.’ Investors must learn to assess value in order to know a bargain when they see one. Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.”

One of the most perverse aspects of bottom-up investing is the fact that most people don’t use the approach more. We actually grasp the idea quite well in other aspects of life. For example, many people these days shop at discount stores. They would rather pay a lower price for products that are similar in quality. However, this same idea of buying what is cheap and makes mathematical sense always fails to make its way to their investing strategy.

So, Is Bottom-Up Investing Science Or Art?

When it comes to investing, we need not give our own tendency for flamboyant behaviour a chance to appear. By sticking to an objective and scientific approach, we can prevent our own poor judgement from damaging our portfolios. Klarman agrees.

“There is no margin of safety in top-down investing.”

Ultimately, what the equation comes down to for Klarman is whether or not any given investment prospect provides the investor with a margin of safety. When it comes to the scientific and quantitatively-driven bottom-up investing approach versus the artistic and qualitatively-driven top-down approach, Klarman sees only one clear winner. So should you.

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