Top-Down Approach

Firstly let us start with the top-down approach.

What is the Top-Down Approach?

A top-down approach is essentially the breaking down of a system to gain insight into its compositional subsystems.

In a top-down approach, an overview of the system is first formulated, specifying but not detailing any first-level subsystems. Each subsystem is then refined in greater detail, sometimes in many additional subsystems.

In a top-down approach, an analyst examines the economic environment, identifies sectors that are expected to prosper in that environment, and analyses securities of companies from previously identified attractive sectors.

Securities are valued with a forecast of the direction of the general economy projected against the outlook of the industry as a whole. Subsequently, we select our preferred picks from the industry that are suitably poised to make the most out of existing business tailwinds.

In this method, the investor starts the analysis by looking at the macroeconomic factors such monetary policy, inflation, economic growth and broader events, before working on an individual stock.

The investor looks for the factors, events prevailing in the market and tries to understand the opportunity that could be derived from it.

For example, The Government of India’s push for a cleaner fuel has led to a surge in Ethanol demand from Oil Marketing Companies (OMCs). With the industry outlook bullish, we will now look for companies that can seize this opportunity to the fullest. Our next natural step would be to hunt for those sugar companies that have a sizable ethanol capacity at hand or those with mega expansion plans. We now build a position in these stocks.

What is the rationale behind the Top-Down Approach?

The core rationale behind the top-down approach of security analysis can be understood from the perspective of River rafting.

Let us suppose that a river is flowing at a rate of 8 km/hr. Then as you are sitting on the raft, even if you do not use your one bladed guide stick (paddle), you will still flow at the speed of 8 km/hr. 

However, if you start using your paddle in the direction of the river flows, you can flow at 10, 12 or maybe even 14 km/hr just by giving more and more thrust.

In the same analogy, the economy acts like a river. If the economy grows at around 9% per annum, most of the industries will grow at this rate. As an analyst, it is our objective to find industries that can grow faster than the economy & there upon find companies that can grow faster than the industry.

In river rafting, the raft that exerts more pressure flows faster than the river and eventually wins the race. In the same manner, the industries that grow faster than the economy and companies which grow faster than the industry handsomely reward their shareholders.

Most top-down investors are macroeconomic investors, focused on capitalizing on large cyclical trends rather than individual equities. This means that their strategy is more about capitalizing on macro momentum and short-term gains than any kind of value-based approach to find undervalued companies.