There are many investing strategies you can implement into your financial planning. Bottom-up investing is an investment strategy that prioritizes and focuses on individual companies and their fundamentals. Here are a few things you should know about bottom-up investing before deciding to take this approach.
Microeconomics vs. macroeconomics
How well a company is positioned to succeed can often be heavily influenced by its respective industry’s success (or lack thereof) and the overall economy. The aspect of the economy that investors focus on is what separates bottom-up and top-down investing.
Macroeconomics looks at the economy on a broad scale, which can include national and even global perspectives. Those examining the macroeconomy could look at aspects such as inflation, unemployment, government policies, gross domestic product, and other such factors that can affect a stock. Microeconomics, on the other hand, looks at the economics behind individual companies and people.
Company fundamentals to consider
Bottom-up investing involves focusing on microeconomic factors, with an emphasis on a company’s fundamentals. Because bottom-up investors generally believe that a company with strong fundamentals can thrive regardless of what’s going on in the broader market, it’s important to have a thorough understanding of the business — especially its financial health.
Financial statements like balance sheets, cash flow statements, and income statements give insight into how well a company is positioned financially. For example, a company’s balance sheet will show you how many assets and liabilities it has and give you a sense of the company’s worth. A company with too many liabilities could be a red flag for some investors.
Investors could also look at a company’s income statement to see its income and expenses and whether the company has been generating a profit or operating at a loss. This information is helpful when determining a company’s price-to-earnings (P/E) ratio — a figure that is very helpful in determining whether a stock is undervalued or overvalued compared to similar companies.
Along with financial health, bottom-up investors should have a good understanding of a company’s management team, its product and service offerings, competitive advantages, and growth potential. Having a deep insight into these details can help investors consider multiple aspects of the business and spot any potential flaws that would potentially make it a bad investment.
For instance, if a CEO has a history of corruption or bankrupting companies, you would likely want to know that before investing. Likewise, if a company’s primary product or service isn’t patented and easily replicated, you’d want to consider that because it will likely damage their competitive advantage.
The downside to bottom-up investing
While understanding how a company operates, its product and service offerings, and its financial health is important, it’s not always wise to make investment decisions based entirely on those factors that. Completely ignoring broader macroeconomic factors may cause an investor to miss something that, while maybe not currently, could negatively impact a company’s growth potential in the future. For example, if a company is in a heavily regulated industry, like healthcare or finance, changes in government policy can affect how a company operates.
Identifying and researching individual companies can also be harder for newer investors who may not be well-versed in financial statements and what to look for in a company. Unlike index funds, which allow you to invest in multiple companies at once, investing in an individual company doesn’t provide instant diversification — which is one of the cornerstones of a good investing strategy.
You can have multiple strategies
Although bottom-up investing focuses heavily on specific companies and their fundamentals, that doesn’t mean other macroeconomic factors are ignored entirely — they’re just not the most important aspect. If bottom-up investing interests you, you don’t have to solely focus on it; you can employ a balanced approach that mixes bottom-up and top-down investing strategies. Either way, investing with a plan will put you in a better position to accomplish your financial goals.
Original source: The Motley Fool