Are you an investor looking for a new approach to stocks? Are you interested in diversifying your portfolio? If so, then this blog post is for you. We’re going to take a look at the top-down approach to stock selection and why it may not be the best choice for achieving long-term success.
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If you've ever heard fund managers discuss their investing methodology, you know that a lot of them use a top-down strategy. They first choose how much of their portfolio should be split between stocks and bonds. They may also choose the proportionate mix of domestic and international securities at this time. Then they choose the sectors to invest in. They don't actually start studying any specific stocks until all of these decisions have been taken. For just a moment, consider this strategy logically, and you will see how absurd it is.
The opposite of a stock's P/E ratio is that of its earnings yield. Because of this, a stock with a P/E ratio of 25 has an earnings yield of 4% while a business with a P/E ratio of 8 has an earnings yield of 12.5%. A low P/E stock is akin to a high-yield bond in this regard.
Now, the difference between the yield on long bonds and the earnings yield of these low P/E firms may be acceptable if they had highly erratic earnings or were heavily indebted. In contrast to their high multiple cousins, many low P/E stocks actually have more consistent earnings. Some people do use a lot of debt. Nevertheless, despite some of the lowest bond yields in a half-century, one could still locate a stock with an earnings yield of 8–12%, a dividend yield of 3-5%, and practically no debt. Just if investors only looked at bonds while purchasing them could this situation arise. This is about as logical as purchasing a van without also taking a vehicle or truck into account.
In the end, all investments are cash-to-cash transactions. As a result, they ought to be evaluated using just one metric: the discounted value of their potential future cash flows. For this reason, a top-down investing strategy is absurd. Selecting the type of security or the industry before analyzing each individual player is similar to a general manager selecting a left- or right-handed pitcher before beginning his or her hunt. Both times, the decision was false and not merely rash. Even though pitching left-handedly tends to be more productive, the general manager is comparing pitchers, not apples and oranges.
Any inherent benefit or drawback a pitcher's handedness may have can be reduced to a single value (e.g., run value). Because of this, a pitcher's handedness should only be one of many factors to take into account rather than a deciding factor. The type of security is the same. For an investor to favor all bonds over all equities, or all merchants over all banks, is no more necessary or reasonable than for a general manager to favor all lefties over all righties.
You simply need to decide if a certain stock or bond is attractive; you don't need to decide whether stocks or bonds are attractive in general. Similarly, you only need to decide that a specific stock is undervalued; you don't need to decide if "the market" is overvalued or undervalued. If you're certain it is, acquire it regardless of the market.
It is obvious that the most prudent way to invest is to assess each security in relation to each other, taking into account the form of the security only to the extent that it influences each individual evaluation. Top-down investing methods are unneeded obstacles. There is no need for you to take the same steps that some highly astute investors took to impose it on themselves and overcome it.
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I hope this article has helped you to understand the dangers of top-down stock picking. If you have any questions or would like to learn more about this topic, please don’t hesitate to reach out. Thanks for reading and happy investing!
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