Fundamental Analysis: Top Down Approach and Bottom Up Approach

Fundamental Analysis

A lot of newcomers misunderstand fundamental analysis as analysis of financial statements but in reality financial statement analysis is just a small part of fundamental analysis called quantitative analysis. A full-fledged fundamental analysis consists of economic analysis, sectoral/industry analysis, and company analysis. One may choose to:

1. Start from economic analysis, continue with industry analysis, and finish with company analysis or 
2. Start from company analysis, continue with industry analysis, and finish with the economic analysis.    

Based on these two major approaches have emerged as Top-Down Approach and Bottom-Up Approach. One may choose any one of the approaches or use both according to the situation. I personally use the Bottom-Up approach more often but that isn't a suggestion for you as both work equally well.

Top-Down Approach

In a top-down approach, the fundamental reason for investment may immerge from macroeconomic or microeconomic factors. Such as GDP, the growth rate of a specific industry, change in government policies, some trend changes consumer behavior, etc.

Once you get a clear idea of major economic indicators, you can try finding industries that will be direct or indirect beneficiary of the trigger. The industry that will benefit most and where a new player entry has some barriers are best to select.

Finally, you can analyze companies in that industry and invest in one or more companies. While analyzing you have to make sure the companies you are selecting will face a considerable impact of the economic trigger, are financially and mentally ready for taking this opportunity to grow.   

E.g. In 2007 Flipkart the first Indian online marketplace was launched. The first few years went unnoticed. Around 2009-2010 was the time when we saw consumers actually accepting this online shop. This was a fundamental trigger of a change in consumer behavior(Economic Indicator). Now was the time to analyze the industry that may benefit from this change. As Flipkart wasn't listed indirect beneficiaries had to be studied. One such industry that could benefit was courier and transport service provider(Industry Analysis). Finally, the leader of the segment at that time was Bluedart(Company Analysis). A debenture free, company growing at 15% cagr, with 40% market share. How do you expect the share prices to react? Prices rallied from 800 rs in 2010 to 7000 rs in 2015. Somewhere around 775% returns in 5 years or 54.31% cagr. It's also true that after 2016 prices have consistently fallen that's why I always say exits are as important as entries. We will discuss entry and exit triggers in a dedicated article.

Bottom-Up Approach

The Bottom-Up Approach to investing is exactly opposite to the Top-Down approach. Here the fundamental trigger for investing comes from some company-specific news. It may be regarding some innovation, or special license approval, etc. Once you get the trigger, analyze the company to ensure it is financially and experientially strong enough to benefit from the opportunity.

The next step is to analyze the industry. It is very hard if not impossible for any company to grow in a competitive industry with saturated growth prospects. Either the industry should be growing or the company should have some moat which can enable it to eat other's market share.

Finally, an economic analysis is carried out to make sure there isn't a big hurdle on the path of growth. An economic analysis is given a lot more importance in a top-down approach than in the bottom-up approach.  

E.g. Bajaj Finance launched EMI(Existing Customer Identification) Card in 2012. This innovative move enabled the Bajaj finance customer to get a loan in unmatched time and with the least efforts. A strong innovation trigger to invest. If one analyses the company with the numbers in 2012 there was no doubt the company had potential. Industry analysis was showing this can be a great moat to capture market share. Along with GDP numbers for India was best in the world. So industry and economy analysis were indicating a green signal. I won't calculate the returns here because the exit trigger is yet to be there. But you can always take a look at the chart for the sake of curiosity.

I hope you understood both the fundamental approaches to investing. We will go deeper into economic, sectoral, and company analysis in future articles. If you have any query please feel free to comment.

And don't forget to READ TO LEARN INVESTING.