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What is bottom up investing?
Active management of equity portfolios means looking at investment alternatives on the basis of their merits rather than their weightage in an index. A passive strategy, by contrast, is one where you don't look at individual merits of stocks and sectors, but merely replicate in your portfolio the index that you are supposed to track. There are several ways in which you can actively construct and manage equity portfolios. In the last article, we discussed 4 top down strategies; in this article we will discuss the opposite - bottom up strategies.
Bottom up means that you construct your portfolio without any preconceived ideas on sectors or themes that you would like to have in your portfolio. Each stock is considered purely in its own merits and a collection of stocks which the portfolio manager has the highest conviction in, are then put together as the short list for the portfolio. From a risk management point of view, the portfolio manager may have to abide by certain stipulations on maximum sector exposure or maximum permissible deviation from benchmark weights for each sector etc. The portfolio manager's convictions on individual stocks together with sector caps and other risk measures will then decide the individual weights of each stock and the portfolio is thus cast.
Within this generic description of bottom up equity investing, there are many variants - and these are based on how the portfolio manager comes to his decisions on stocks which he is most convinced about. The portfolio manager could look at fundamentals of the underlying businesses to make his stock selections or he could look at the technical patterns of share price movements to short list stocks. Lets look, in this article, at the popular variants of fundamentals based bottom up stock picking. There are several ways in which the fundamentals of companies can be evaluated - and depending on which way you want to look at the fundamentals, you will come up with a different set of stocks that you might short-list for further study and selection.
Growth vs Value style
A growth investor looks for high growth companies and buys them when he believes that the future growth potential of the company is not adequately discounted or priced by the market. A value investor on the other hand looks to buy stocks which are in his opinion quoting at less than their current intrinsic value - ie, where he has a margin of safety today, when he is buying the stock, rather than buying into growth prospects which may or may not materialise in the future.
Lets take an example. With the change in TV broadcasting rules in the country, set top boxes are becoming mandatory in all cities, which means that revenue leakage caused by unorganised cable operators will perhaps become history and consumers will now start paying a price based on the channel options they choose. This changes the revenue dynamics of the broadcasting business significantly, and can lead to huge revenue growth in the years ahead for the better companies in this business. This is typically the turf of a growth investor. He would be less concerned with the current earnings of the businesses he analyses, he would be less concerned with the current intrinsic worth of the businesses, but he would put a lot more emphasis on future revenue prospects of these businesses and evaluate which ones, in his opinion, are not adequately priced into the stocks already, and therefore hold promising appreciation prospects.
A value investor on the other hand may not see any margin of safety in such media companies as the current intrinsic worth of these companies may be far less than the market price, as the market price is already discounting future earnings potential. On the other hand, he may be more interested in say a shipping company whose stock price has fallen so badly as a result of depressed freight rates in a sluggish economy, that the value of the company has now fallen below the value of its fleet of super tankers. When he buys a shipping company stock at lower than the current value of its assets, he is effectively getting a significant margin of safety, as a running established business is available at less than the cost of its assets. Now, the shipping industry may never see heady rates of growth like say the media sector may see over the next 5 years as a consequence of a change in broadcasting regulations - but, the value investor is nevertheless interested as he is able to lock in value in present terms itself, rather than hoping that value will eventually come in when the growth he is projecting for a company's earnings finally materialise a few years down the road.
Both approaches are quite different, and many consider them to be opposites. Both however rely on fundamentals based bottom up stock picking - its just that the perspective is completely different. Generally speaking, one would be able to find many more value investing opportunities during a down phase of an economic cycle, as it is often in this phase that stocks get beaten down to value and deep value levels. It would be a lot more difficult to find value opportunities in a rapidly growing economy with a buoyant stock market - that would normally be when growth investors may get a lot more active.
Dividend Yield
The main parameter in this style of bottom up stock picking is to see whether the current price of the stock offers an attractive yield in terms of the annual dividends that the company usually pays out. As we all know, the two main streams of income for an equity investor are dividends from the profits of the company and appreciation in price due to earnings growth over the years. A dividend yield investor would argue that if he is able to find stocks which have a consistent track record of paying healthy annual dividends, and say the share price effectively means that he would get a dividend yield of say 6%, he is anyway getting a reasonable annual income from the stock. He can then be able to ride through the ups and downs of the market with a lot more confidence, with the knowledge that there is a reasonable income stream anyway coming to him. Over time, he will naturally be able to enjoy share price appreciation as well, so long as the company's earnings grow steadily, as market cycles always go through their waxing and waning phases. For a long term investor, a dividend yield strategy can make a lot of sense because if he identifies a company with a healthy current dividend yield and reasonable earnings growth prospects, over time, the dividend payouts will also expand with earnings expansion, and as a result, the effective dividend yield on his original purchase price can go up sizeably.
Special Situations
This is a niched strategy, where the portfolio manager looks for "out of the ordinary" circumstances in a stock that result in mispricing of a stock in the market. Mispricing could either throw up a value investing opportunity or an undiscovered growth opportunity. Going back to our broadcasting example, when the new regulations were announced, it threw up a special situations investing opportunity in that sector as it opened up a completely new growth stream for those businesses. This is not a regular growth opportunity - but one that comes once in a while. Likewise, if and when oil marketing companies businesses are finally completely deregulated, this would be a special situation for that sector. If a company that is sitting on a vast piece of real estate which appreciates due to development in the vicinity, that too creates a special situation, if the commercially exploitable value of the land is not priced into its stock price. If a merger or acquisition is in the pipeline impacting two companies, it can create a special situation for one or both the companies, depending on where value is likely to be better unlocked. If a stock nosedives very sharply due to adverse newsflow about its business, that too could be a special situation, if a portfolio manager believes that the stock's movement was grossly more than justified. In short, any "out-of-the-ordinary" circumstance that occurs either in the business of a company or in its stock price, is a potential special situation that a portfolio manager can hope to capitalise on.
Contra
We are often told that real money is made in stocks only when you think differently from the herd. A contra manager embraces exactly this line of thinking. His job is to see where the consensus opinion is and see whether there is value in thinking against the consensus. For example, when telecom and airlines stocks were in the bad books of most fund managers as the near term outlook was bleak, some contrarian fund managers decided to invest in these "out-of-favour" themes, with a view that they will bounce back sooner or later as their base businesses were sound and enjoyed strong consumer demand.
Market neutral long-short
This is a kind of bottom up fundamentals based hedging strategy, which has been discussed in some detail in a previous Jargon Buster article
To conclude
As can be seen, each of the six styles is unique in its own way, but the common thread is a ground-up or bottom-up view of identifying opportunities at an individual stock level rather than take a top-down view on the economy or on sectors. Each style has its own lens, its own prism through which stocks are viewed and short-listed for further study and then for investment. Each has its own merits, and each has its fan following from the fund manager community. There is no right or wrong style - however, each style does have its time in the sun - its favourable phase where it outshines the others. The key to achieving results from each style is to stay true to the style and have conviction in it - through all market phases.
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