Against the Top-Down Approach to Stock Selection

If you’ve ever heard fund managers talk about the way they invest, you know that most of them use a top-down approach. First, they decide how much of their portfolio to allocate to equities and how much to allocate to bonds. At this point, they can also decide on the relative mix of foreign and domestic securities. Next, they decide on the sectors in which to invest. They don’t start analyzing any securities until all these decisions have been made. If you think rationally about this approach for a moment, you will realize how foolish it is.

A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with an F/E ratio of 25 has an earnings yield of 4%, while a stock with an F/E ratio of 8 has an earnings yield of 12.5%. In this way, a stock with a low P/E can be compared to a bond with a high yield.

Now, if the earnings of these low-L/E stocks were very volatile or if they carried a large amount of debt, the difference between the long-term bond yield and the earnings yield on these stocks might be justified. However, many low F/E stocks actually have more stable earnings than their high multiple relatives. Some of them use large amounts of debt. Yet in the recent past, despite some of the lowest bond yields of the last half century, one can find a stock with an 8-12% earnings yield, a 3-5% dividend yield and literally no debt. This can only happen if investors buy bonds without taking stocks into account. This makes as much sense as buying a van without considering a car or a truck.

All investments are ultimately cash-to-cash operations. As such, they should be evaluated against a single yardstick: the discounted value of future cash flows. A top-down approach to investing is therefore pointless. Starting your research by first deciding on the type of security or sector is like a general manager deciding on a left-handed or right-handed pitcher before evaluating each player. In both cases, the choice is not only hasty but also wrong. Even if left-handed pitching is inherently more effective, the general manager is not comparing apples and oranges; he is comparing pitchers. Whatever advantage or disadvantage is inherent in a pitcher’s left-handedness can be reduced to a final value (e.g. run value). Therefore, a pitcher’s handedness is only one factor (among many) to consider, not a binding choice to be made. The same applies to the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds to all stocks (or all retailers to all banks) than for a CEO to prefer all lefties to all righties. You do not need to determine whether stocks or bonds are attractive; you only need to determine whether a particular stock or bond is attractive. Likewise, you do not need to determine whether the “market” is undervalued or overvalued; you need only determine whether a particular stock is undervalued. If you are convinced that it is, buy it – to hell with the market!

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Clearly, the most prudent approach to investing is to evaluate each security in relation to the others, and to consider the shape of the security only to the extent that it affects each individual evaluation. A top-down approach to investing is an unnecessary impediment. Some very smart investors have imposed it on themselves and overcome it, but you don’t need to do the same.