The types of strategies or philosophies investors use to grow their portfolios might be as varied as the types of investments they have to pick from—growth vs. value stocks, conscience-based investing or industry trends, to name a few.
More or less, however, stocks are commonly analyzed two different ways: top-down vs. bottom-up investing.
The top-down strategy starts with researching the big investing picture, including world economic news, market trends and other macroeconomic indicators.
Stocks are chosen based on how investors believe the market as a whole will perform. Individual stocks might play a role, but they aren’t the central focus. Mutual funds and exchange-traded funds (ETFs), that choose a group of stocks based on common factors, are more popular with top-down investors.
The bottom-up strategy focuses on microeconomic factors that influence individual businesses.
Investors research individual companies they believe to be good investments by digging deep into their financial reports, historical trends, profit margins and customer base.
Although industry trends and market factors do play some role, bottom-up investing is about picking companies that an investor believes will perform well no matter what the market does.
Theoretically, bottom-up investing is the notion that a handful of solid, handpicked companies will bring better returns over the long run than jumping on bandwagons or trying to time the market.
Strategically, it’s a long-term, buy-and-hold proposition. And philosophically, it’s making a well-educated bet on a company’s future profits based on thorough research of its inner workings and history.
How Bottom-Up Investing Works
A bottom-up investment strategy starts with research into individual companies, but that’s a lot easier than it sounds when there are around 630,000 publicly traded companies around the world.
To narrow down that field, some investors begin with public companies that either have long and successful track records or that they already know and love. From there—and thanks to the web—the amount of information they can gather is virtually limitless.
Useful Documents for Investment Research
In the United States, companies who trade on the stock exchanges must file a number of documents with the U.S. Securities and Exchange Commission (and the public) that outline a number of financial benchmarks, such as profit margin, cash flow, and income. All public documents held by the SEC are searchable via its EDGAR database .
Here are some of the most common:
• Registration Statements: These documents are the first to be filed when a company wants to undergo an initial public offering (IPO), or “go public.” They include a prospectus, which summarizes the organization’s planned share quantity, size and price, and details on the company’s history, management, operations, current financial state and any insight into future risk.
• 10K Report: This is a company’s official (and lengthy) annual report , and it’s due to the SEC within 90 days of the end of its fiscal year. It lays out the company’s financial growth and change over the previous 12 months, as well as information about products or services, operations reviews, major markets or headlines. Often they’re accompanied by an earnings call, where the business’ top financial executive gives more details about the reports and takes questions from business reporters.
• 10Q Report: This truncated version of the 10K is filed quarterly, so it fills in the gaps between annual reports. They’re a bit less formal than the 10K reports and often review not only what’s happened in a company during the past three months.
• Forms 3, 4 and 5: Company executives who become “insiders”—directors, officers, or anyone who holds more than 10% of any class of a company’s securities, for example—are required to report any transactions they make regarding their company’s own stock. Form 3 is for new insiders and must be filed within 10 days of the appointment, Form 4 documents actual securities transactions, and Form 5 catches any transactions that didn’t meet the threshold for Form 4. For some investors, these forms give good insight into how the company’s executives feel about their own position in the market.
• Proxy Statements: This form is how investors get an inside look at a company’s executive and management salaries, potential conflicts of interest, and other perks of life in the C-suite. Shareholders aren’t allowed to vote on members of the board or approve other company actions until it’s filed with the SEC.
• Schedule 13D: If any individual or entity acquires more than 5% of a company’s shares, this form introduces them to investors and includes information like the major shareholder’s contact information, background (including criminal), the type of securities they purchased, how they purchased them, and their relationship to the company. Sometimes a 13G, an abbreviated version of the 13D form, can be filed instead, but this depends on specific circumstances.
Crunching the Numbers
An annual report is pages and pages (and pages) of pie charts, graphs, equations, and numbers, all in small font. It can be dizzying just to look at, much less to decipher.
To separate the most important information, investors employ a number of investment ratios and key indicators when evaluating a stock.
Some key ratios and values include:
• Price-to-Earnings (P/E) Ratio: The company’s market price divided by its earnings per share. It can predict how many years it will take for a company to have enough value to buy back its stock.
• Price-to-Sales (P/S) Ratio: A company’s market capitalization (the dollar value of all the company’s outstanding stock) divided by its revenue. Ideally, the P/S ratio should be one, or as close to one as possible. If the value is lower than one, that indicates an even stronger P/S ratio.
• Earnings per Share (EPS): Net income, minus any preferred stock dividends, divided by the total number of outstanding shares of common stock. An EPS on the rise over time means the company might have more money to either distribute to its shareholders or re-invest into the business.
• Return on Equity (ROE): Find this number by dividing the company’s net income by shareholder equity, times 100. For many analysts, ROE is a major indicator of a company’s growth in profit over time.
• Profit Margins: These come in three varieties: gross, operating, and net. Each measure the company’s profitability based on whether certain figures, such as operating costs and overhead expenses, are considered. These numbers give insight into a company’s efficiency and how it uses its resources.
• Future Expected Earnings: This formula which considers annual dividends and their growth rates, can’t predict the future, but it can create an educated guess on where a company’s stock might go, especially one that has historical data to draw from.
• Financial Statements: Analyzing financial statements can provide important insight into how a company operates. Common documents included in a company’s financial statements are; a balance sheet, which provides a snapshot of assets, liabilities and shareholder equity as they currently stand; a profit-and-loss statement (P&L), which looks at money coming in vs. money going out; and a cash-flow statement, which is a key indicator of whether the company is over or undervalued (a high valuation with little cash flow is a red flag.)
Yep—that’s a lot of math. But taken together, the numbers can paint a solid picture of not only a company’s past and current performance, but also it’s potential for the future as well. All of these factors can help investors as they decide which stocks to invest in.
Especially in today’s online-first world, all the good valuation in the world can’t help a company if its CEO is the star of a scandalous viral video.
For this reason, it’s just as important to keep an eye on the outside factors involving companies of interest, including personnel changes, headlines, new products or services, or marketing campaigns.
The financial world has its go-to publications, including the Wall Street Journal, Bloomberg and Investor’s Business Daily, along with a host of industry-specific publications.
Online tools employ tech to help investors play around with different scenarios, and even setting up a simple Google search on a business name can help interested investors stay in the loop.
Bottom-Up Investing: An IRL Example
Here’s a hypothetical example of how bottom-up investing works in action.
Jane is a loyal follower of The Widget Co. She’s used its products for years, is brand loyal and thinks the CEO is a visionary leader. She’s interested in purchasing Widget stock, but knows that being a shareholder is a lot different than being a consumer.
Although she likes what she has seen so far, she wants a peek behind the curtain—who holds leadership positions, its operational philosophy and how it manufactures those products she loves so much.
Her first step is Widget’s financial documents, where she looks for things like consistent upward trends in stock prices and a favorable P/E ratio. She compares Widget’s trends over time to the overall market to see its individual performance against market ups and downs.
Next, she takes to the web and discovers that The Widget Co. has a YouTube channel with behind-the-scenes tours of its manufacturing processes.
She checks LinkedIn profiles and Googles the names of the CEO and senior leadership to see their resumes, and whether they’ve ever made the news—for better or worse—and sets up news alerts with the company’s name so she doesn’t miss anything new.
Finally, to get a feel for the overall industry and the public’s feelings toward the company, she checks social media. Do other people love these products as much as she does? What are the ratings and reviews? She understands that just because one sector is popular at the moment doesn’t necessarily mean that The Widget Co. is a part of that trend.
Jane likes what she sees, but after running some numbers to determine the stock’s real value, she decides that it’s a bit too expensive to buy, for now. But if it hits her target number, she’s in.
Strategies for Success
Think of top-down investing vs. bottom-up investing as the tortoise vs. the hare (with the bottom-up approach, you’re the tortoise.) Finding success with the bottom-up investing approach is a long (long) game, so it can be important to come to the table with a double dose of patience.
It’s one reason long-term stock picks are often referred to as value stocks vs. growth stocks. Growth-stock investors go for the big risks and the big wins, while value investors (also called income investors) take a more calculated approach in hopes of steady growth over the long term.
One thing bottom-up investing is not, however, is set-it-and-forget-it. Things do change over time, and even the most seasoned companies can endure hardships—especially in the face of a changing economy and changing tech (brick-and-mortar shopping, for example.)
For that reason, it’s important for a bottom-up investor to periodically check in on their stock picks to ensure they’re still a good decision.
Things to Consider
No matter which type of investing approach is taken, it’s important to consider risk tolerance. How much would it be okay to lose if the market crashed?
Are you more fight or flight? For some investors, any dip in the stock market scares them into pulling out, and potentially missing out on even bigger returns in the future.
It’s also important to keep in mind that even the most solid companies now might see trouble in the future. What are the signs that a company is no longer a good investment?
Changes like a slowdown (or full stop) in profits, the accumulation of debt or cutting dividends are all potential watch-out for trouble, as well as any type of investigation.
Get Started With Fractional Investing
Imagine finding the perfect stock, and then experiencing sticker shock at the price of one share.
That used to be the minimum buy-in for a stock purchase, but just like ETFs have made it possible to invest into little bits of business at a time, fractional shares allow investors to buy just a portion of even the most expensive stocks out there.
Fractional Share Investing allows investors to claim a sliver of their favorite stocks, for as little as $5 with no commission fees. With SoFi, it’s as easy as opening and funding an online investing account and selecting from stocks like Amazon, Apple, Facebook, Netflix, and Tesla.
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