Last Updated November 25, 2012
Adjusting an investment portfolio to fit the changing economic climate is one of the most obvious things an investor can do.
During the tech-boom of the 1990s the smart money was in high tech companies; even many blue-chip technology companies posted extraordinary gains during that decade. For example, Vodafone gained 1,000% in just over three years between 1996 and 2000.
If you were fast enough, a switch to boring “old economy” bricks and mortar companies in 1999 would have been a great idea. Many of them performed fantastically well during the dot-com bust of the early 2000s.
There are two schools of thought on this question of how to pick stocks and how to manage a portfolio in order to benefit from changing economic conditions.
The first school is known as top-down investing. This school says that it is possible to spot attractive opportunities by looking at the economy, industrial cycles, emerging trends and other factors, and then to build up a picture of what is likely to do well in the next year or more.
In my opinion, top-down investing is hard – I mean really hard. You’d probably have to factor in (at least):
- The global economy – How is the current situation going to develop? Will China pull us through, or the US perhaps, or are global imbalances about to unravel?
- The local economy – Most companies operate in one or a few geographic regions, so how will they fare? Are their governments over-indebted? Do they have natural resources to fuel a boom? Can they cut interest rates?
- The business cycle – This depends on what industry you’re looking at; the business cycle for toothpaste is very different to the ones for restaurants, car manufacturers and house builders. How balanced are supply and demand? Are there any disruptive technologies on the horizon?
- The company and its competition – Even if a particular industry is set to explode (in a good way), that doesn’t mean that every company in that industry will do well, or even survive. Company level analysis is still a key part of most top-down investment analysis.
- The share price – Of course, this is the big question. Will the share price go up or down? Are you right in your analysis, and even then, will other investors buy into the same story, sending the share price spiralling upwards?
Each one of those factors contains hundreds, if not thousands of sub-factors that may need to be considered.
Despite the difficulties, top-down investing just feels right for most investors. It’s a natural way for intelligent people to think about their investments because it’s similar to how we deal with many other things in life.
But I still don’t like it. I think most private investors would do well to consider the second school.
While top-down investors start their investment research with the economy, bottom-up investors begin their quest at the other end – with individual companies.
I’m going to cheat a little bit and let Warren Buffett have the opening word for bottom-up investing:
We spend essentially no time thinking about macroeconomic factors. In other words, if someone handed us a prediction by the most revered intellectual on the planet, with figures for unemployment or interest rates, or whatever it might be for the next two years, we would not pay any attention to it. We simply try to focus on businesses that we think we understand and where we like the price and management.
Value investing has always had its foot squarely in the bottom-up school. This is partly because value investors generally accept that top-down investing is so hard as to be near impossible for most people.
In essence, it is a whole lot easier to analyse a single company than it is to look at an entire country’s economy, or even the whole world’s economy.
My preferred approach to bottom-up value investing is to look for companies that can do well regardless of the economic environment. I’ve covered this in various recent posts, including:
- 10 Questions every stock picker needs to ask
- How to find the best defensive stocks
- How to find the best high yield shares
By picking companies that are very likely to be bigger in five or ten years, and buying them at attractive valuations, the disciplined bottom-up value investor largely avoids the need to follow the economy in excruciating detail. And in many cases they don’t change their portfolios or their approach just because the economy is going into or coming out of a recession.
Although bottom-up value investors look primarily at individual companies, and Warren Buffett spends “essentially no time” looking at the economy, that doesn’t mean the economy is completely ignored.
A state of alert detachment
Ben Graham used the Zen-like term “alert detachment” to describe the difficult to attain mindset which he felt active investors should strive for.
Understanding the economy, or at least trying to understand it by keeping up to date and reading news and analysis, can be an important part of an investors on-going education. It is of course critical if you want to be a top-down investor.
For bottom-up investors like myself, reading, listening to and watching videos of investors and economists may not always be useful for making direct investment decisions; but it is useful for building up the background knowledge, experience and mental models that most top investors rely on.