Two ways to pick stocks for your investment portfolio
Are you looking to build your investment portfolio? Are you shopping around among the listed companies on the Singapore Exchange and other overseas bourses?
If you are, then the next question you would be asking is how you should select stocks for investing. Here are two commonly used approaches to pick stocks for your portfolio.
- Bottom-up approach
- Top-down approach
The bottom-up approach focuses on the performance of individual stock. The macroeconomic analyses are ignored here and stocks are selected on the basis of past performance and future prospects of its business.
For this approach, we would evaluate the fundamentals of the company and invest in it regardless of any outside factors. The basis of this approach is to focus on the quality of an individual stock and their ability to generate returns that are higher than the market.
This approach requires an understanding of company’s business, what they sell, and their operating markets. This may prove to be difficult if you are new to investing, but help is available. For stocks listed on the SGX, you can make use of this stock screener for finding companies that match your criteria.
A bottom-up investor would rely on information – that is not influenced by market events or by the stock's current price – such as a company's market share, pricing power, innovative products, and future prospects to decide on whether to invest in a company.
This approach is favourable among long term investors, like Warren Buffett. In 2008, his company Berkshire Hathaway, bought 10% of BYD for US$230million. Market watchers were not convinced that it would be a good investment, until Buffett earned 671% in returns within 6 years.
Top –Down approach
This approach involves analysing the macroeconomic variables of the country such as GDP, currency movements, inflation, interest rate and other aspects of the economy. Based on these parameters, an investor would then identify the sectors that are performing well, taking into account factors such as sales, competition, market cycle and trends. After which, the investor would then choose to invest in the companies that are performing well within those sectors.
This approach is based on looking at big picture and then focusing on the finer details.
Let’s assume you have $10 million to invest. The World Economic Outlook report said that global GDP growth had risen to 3.5% for the period. Based on this report, and country specific GDP estimates, you decide to invest in India.
You will now have to further analyse the business climate of India, its recent market performance, and note the sectors which are performing well. Next you might narrow down your search to the energy sector and consumer discretionary sectors to invest in, based on their performance. Finally, you would narrow down your research to pick the market leading company or the best performing company within those sectors.
The biggest risk in this approach is that the research conclusions can be wrong. For example, you might expect automobile sales to grow because of the fall in oil prices. however, an unexpected geopoltical event might result in oil prices remaining high, and automotive sales remaining stagnant.
It is important to understand that top-down investing requires more research than bottom-up investing. Also, the global economic conditions can change very quickly so the sector which is most favourable today may become least favourable tomorrow. To mitigate this risk, an investor needs to stay abreast of market events and manage the portfolio accordingly.
Which approach should you use?
The downside of both approaches is that it is not possible to use both approaches together when designing a portfolio. You may think that using both of together would act as hedge but they can have adverse effect on portfolio returns during extreme market conditions if used simultaneously. Instead, you should decide which approach suits your investment goals and your risk appetite best and stick to it.
If you still wish to make use of both the approaches, you could opt to overweight one approach over the other, and adjust your holdings in favour of one approach over other whenever it is appropriate.
Both these methods have same goal of helping you to generate returns and strengthen your investment portfolio. It is difficult to say which approach is better, so choose to adopt the approach that best suits your risk appetite and investment goals.