Bottom-Up Investing Explained
Start with many, invest in one. Bottom-up investing pushes you to dig deep and find the companies you believe in.
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When it comes to investing, have you ever found a company that you really believed in?
Maybe the company had a rockstar CEO with an incredible vision. Perhaps there was something else about that particular company—it had an it factor—that really set it apart from everyone else.
If you grasp the concept here, then you already understand the most important factor in bottom-up investing. 🚀
Of course, there’s a lot more to it. Bottom-up investing involves a deep study of a company in order to make well-informed investment decisions. Investors will analyze a company’s revenue channels, business and sales strategies, and leadership team, among other factors.
If the investor likes what they see, they’re likely to invest—regardless of the state of the overall economy, or specific market the product is in. It’s this latter aspect—the separation of a company from its surrounding market, industry, and the world’s economy—which makes bottom-up investing so unique.
This approach might sound daunting since a lot of research needs to go into the company of your choice before you invest, but many investors swear by this method. According to the Financial Post, this method is also a more simple approach to investing, and also has the potential to give you a profitable edge while other investors are panicking about the market.
Here, we’ll cover everything you need to know about bottom-up investing, including the different factors that impact this method, key strategies to keep in mind, and how it compares to top-down investing (another popular investing method).
Ready? Let’s dive in! 👇
- What is Bottom-Up Investing?
- Factors That Impact Bottom-Up Investing
- Strategies in Bottom-Up Investing
- An Example of Bottom-Up Investing
- Top-Down vs. Bottom-Up Investing
- Where Bottom-Up Investing Shines
- How Bottom-Up Investing Suits You
- Conclusion
- FAQs
- Get Started with a Stock Broker
What is Bottom-Up Investing? 📚
Bottom-up investing focuses on building a portfolio by investing in a specific company rather than the industry it’s in or market trends that could affect that industry. This is known as investing based on microeconomic factors (e.g. how well the company’s sales looked year-over-year) instead of macroeconomic aspects of the economy and stock market.
Instead of investing based on predictions of whether the market will go up or down, bottom-up investing is a strategic, often long-term, investment in various individual stocks based on certain aspects of the company. What one chooses to evaluate varies investor to investor, but it typically includes a mix of P/E ratio, revenue, earnings, and analyst research reports.
Bottom-up investing has a number of unique features when compared to other styles of investing. For example, bottom-up investing can be used when an individual believes a particular company will grow in value, even if the company’s industry or market lacks performance as a whole. While bottom-up investors tend to be long-term investors, meaning they buy and hold stocks, though this method of investing can also be used by a short-term trader.
While any type of investing is inherently risky, there are those who believe bottom-up investors, because of their longer-term approach, manage risk better than investors involved in other types of trading. Additionally, bottom-up traders tend to have a more diversified portfolio than other types of investors.
A good example of a stock a bottom-up investor would take an interest in is a company like Google or Tesla, as both of these companies have historically performed well, and Google especially has proved itself to be a company that most of society uses on a daily basis that is resilient to market changes.
Microeconomics vs. Macroeconomics 👨🏫
Feeling a little confused about all this microeconomics vs macroeconomics talk? Time to break it down.
Macroeconomics is the study of the economy on a broad scale. Looking at an investment from the macroeconomics point of view will involve looking at the GDP, inflation rate, unemployment percentage, and government policies of a specific country.
Meanwhile, microeconomics is the exact opposite. An investor looking to invest based on microeconomic factors will focus on the company performance itself, as well as specific people who will play a part in the future performance of the company such as the CEO, CFO, and board members.
Understand How Bottom-Up Investing Works 🏗
Before you jump into bottom-up investing, you need to understand how this investment method works.
Most bottom-up investors begin working on their portfolios by researching several different companies. They may use stock analysis software to screen for particular attributes of a stock, such as one that is undervalued or has a particular P/E ratio.
Bottom-up investors will spend a significant amount of time researching a company they want to invest in, mostly because they usually plan to hold the stock for an extended period of time and they want to ensure they are investing in a company they believe will earn them a return.
Sound easy? Not quite, as there are over 63,000 companies listed on the stock market. And unlike top-down investing, bottom-up investors never select groups of stocks such as ETFs, as they prefer to focus on singular companies. Therefore, as a bottom-up investor, you can expect to spend a significant amount of time researching the stocks you plan to add to your portfolio.
Take the above example, say you are looking for a company with a low P/E ratio to start your search. David’s Tea (DTEA) may pop up on your radar with a P/E ratio of 1.88. But before you can open a position on this company, you will need to do further research to ensure that its organizational structure and price per share are all something you believe will gain you a return if you maintain the position for an extended period of time.
Different Factors That Impact Bottom-Up Investing 🗃
Like any other investment strategy on the market, there are many different factors that can affect a bottom-up approach to investing. Investors need to be aware of these factors before they attempt to pursue a bottom-up investing approach.
First and foremost, although bottom-up investors only take a look at microeconomic investors when placing their investment, this investment can still be affected by microeconomic factors. Even an investment as firm as one in Google has the possibility to fail if something major happens in the technology sector.
A bottom-up investor must also consider the competition. While a company like Google or Amazon may seem like a good investment because of the health of the company, tomorrow a competitor could quickly catch up and overtake either company as the primary company in the marketplace offering the same product.
Additionally, no matter how well an investor may research a stock, there is always a chance that the company in question experienced a scandal that could cause a loss of profits or market share. Take Facebook, for example, when its stock took a sudden drop by 5% after a major site outage and exposé from a whistleblower in October, 2021.
Strategies in Bottom-Up Investing 📋
Don’t let this scare you off, however, as there are many strategies you can employ with bottom-up investing that can make this a profitable and viable investment strategy. Let’s take a look at the few most common strategies in bottom-up investing.
Investing in a Company you Believe In 💰
A common way an investor gets involved in bottom-up investing is through finding a product they use and enjoy on a regular basis, and then believing others will do the same. Then, when they take a look at company financial documents and study the CEO and their vision for the company, the investor is convinced that their vision matches that of the company.
Just because the investor in this case likes the product, it doesn’t mean they will skip the analysis of the product. In fact, the SEC recommends taking a look at the following aspects of a business before making an investment, no matter what the business may be: the profit margin, cash flow, and income of the company – which can be found by combining the company’s financial statements.
Bottom-Up/Top-Down Mixed Strategy 📙
While the typical approach for bottom-up investors is to focus on one company, some prefer to create a hybrid strategy that involves studying multiple companies, or the general market itself, for a period of time before narrowing their choice down to a specific company.
For example, an investor believes electric cars are the future, especially with the ongoing global petrol crisis. With this in mind, the investor could choose to look at several companies that manufacture and sell electric cars, such as Tesla, Ford, and Toyota.
After reviewing the financial documents of each of these companies, they will then narrow down their selection to the company they believe will perform the best in the space and open an investment position in that company. The reason this is a mixed strategy is that while the investor will begin with a broader market approach (top-down) to investing, they will ultimately make their decision based on microeconomic factors (bottom-up).
Trading the News 📰
Traders and investors often use the news to inform their investment decisions; this method is commonly known as trading the news. Although this method is most common with day traders, bottom-up investors also take this approach to understand how the market’s reaction to an event could impact the company they have invested in.
Trading the news can also look like following updates on the investor’s company of choice, including revenue reports, or even positive reviews of the company’s performance or products.
Bottom-up investors can also use the news to avoid investing in particular companies. For example, if an investor discovers that the CEO has a history of bankrupting companies, then they can use that information to steer clear of investing in that company.
An Example of Bottom-Up Investing 📝
If an investor is starting out with the bottom-up approach, they might struggle with knowing where to start. To make the process easier for yourself, take a look at the large companies that are performing well in the market.
Take Michelle, for example. After experimenting with other investment strategies, she’s decided to give the bottom-up approach a try.
A quick Google search will show her some of the top companies in the market – Apple, Alphabet, Microsoft, Amazon, and Tesla. Michelle knows a lot about Microsoft and their products and had recently read an article about their impressive earnings in 2021, so she chooses to go with them.
Now that she’s chosen her company, Michelle starts reading into Microsoft’s organizational and management structure, the CEO and his vision for the company, and their financial report for the last 3 to 5 years. Her goal is to determine whether this company falls in line with her investment interests, or not.
A core factor to consider when selecting a company to invest in is to take their price per share into account. For Michelle, this also involves calculating her own financial ratios for the company—both current and past, to try and estimate whether the company will experience growth in the future. So, if Michelle finds all of this to be positive, her next step is to is compare Microsoft to other competitors in the industry.
Next, Michelle needs to look at trends in society, decide if Microsoft will offer products that will still be viable in the future, and verify they are able to adapt to changing marketplaces and consumer wants. She may also compare the P/E ratio of Microsoft to that of the S&P 500 to decide if the stock is experiencing an overall bull trend.
If Michelle gets this far, and everything aligns with her investment goals for her portfolio, she will likely decide to place an investment in Microsoft stock.
Contrast Between Top-Down and Bottom-Up Investing ⚔
Sometimes it can be difficult to tell the difference between top-down and bottom-up approaches to investing because there is an overlap between these two strategies. Below are the major contrasts between the two to help you be able to tell them apart.
The major difference between the two strategies is that a top-down approach will start by looking at macroeconomic trends, such as a country that has a good GDP, then taking a look at countries available for investment within the country. Remember, bottom-up investing rarely starts this large, typically starting at just a single company then the investor works their way up from there.
Top-down investment strategies often open positions in ETFs or index funds, as these usually align with a top-down investor’s preference for following market trends. For example, a top-down investor may notice that the technology industry is doing well overall and open an investment position with a technology-based ETF as a result.
The final difference between the two types of investing is that top-down investors tend to look for short-term gains—making investments they don’t intend to hold for a long period of time, while bottom-up investors will do just the opposite. Bottom-up investors also spend a much more significant amount of time researching individual companies than top-down investors, as bottom-up investors truly want to know all about the company they are investing in.
What Bottom-Up Investing Misses 🤔
Of course, no investment strategy can catch it all, and there are a few things that bottom-up investing misses. The most obvious of which are major macroeconomic factors that could affect the future of a company.
Tech stocks are considered risky because of how sensitive they are to macroeconomic changes. The strain on global relations, alone, have led to the sharp decline of multiple high-growth tech stocks that were performing well throughout the pandemic.
So while some of these companies have great P/E ratio, impressive revenue, and a CEO one can stand behind, focusing on these factors alone can cause an investor to miss the macroeconomic changes to the market. Misses like that can result in costly mistakes, which is why bottom-up investing must be approached with caution.
Where Bottom-Up Investing Shines 🌟
Despite these risks, there are many reasons to consider a bottom-up approach to investing. One of which is the fact that bottom-up investing helps an investor gain sufficient knowledge of the company he or she is investing in.
This means that a bottom-up investor, even though they don’t always look at the broad macroeconomic factors, is much less likely to be surprised by a scandal within the company they invest in—because they’ve done all the necessary research. It’s this same research that many bottom-up investors spend so much time on that makes them hold on to the stock for the long run.
Long-term investing allows a bottom-up investor to ignore the small fluctuations of the market and instead focus on the company as a whole. This can often be a lower-stress method of investing and require less day-to-day research than short-term investment methods like day trading or swing trading.
Bottom-up trading also makes it easier for investors to earn dividends. This is because companies that are ideal for bottom-up investing usually offer dividends because they perform well as a whole. And because a bottom-up investor is looking to hold an investment for the long-term, they will get to reap the benefits of a company that offers dividends that a day trader won’t.
Which Type of Investor is Bottom-Up Investing Best For? 💼
Different trading strategies work for different people, which is why, before you start bottom-up investing, it’s critical that you take a look at the type of person bottom-up investing is best for. You need to start by evaluating the time you have to dedicate to research, risk tolerance, and the ability to make decisions regarding a company in the future.
If you haven’t noticed by now, a bottom-up investor spends a significant amount of time researching the company they have invested in. So, if you don’t have the ability to carve out a few days a week, for at least a few hours each day, to do research (at least until you put your portfolio together) bottom-up investing probably isn’t for you.
Bottom-up investors must also have a decent amount of risk tolerance. With bottom-up investing, an investor will have a few open positions with individual companies, and it is possible one of these companies could experience an unforeseen circumstance that could cause their prices to dip. A bottom-up investor must be able to stick to their research and know their company will pull through for them rather than giving into negative trading psychology.
That being said, there may come a time when a bottom-up investor must recognize when to throw in the towel. Sometimes even the best-researched companies will come across a problem they simply can’t pull out of—such as Blockbuster when people discovered the magic of Netflix—and a bottom-up investor must know when to exit a position in order to minimize their loss.
💡 Ready to learn about other types of investing? Learn what a pure play is.
Conclusion 🏁
Overall, bottom-up trading isn’t for everyone, but if you are good at stock research, have a heart of steel, and think you can make tough decisions when needed—you may have found the perfect trading strategy for you. Just remember that bottom-up investing requires a significant amount of research and you should never plan to open a position without knowing the ins and outs of a company.
Whether you decide to employ trading the news strategy, or perhaps one that combines the top-down investing with and bottom-up methods, know that there are many ways to add bottom-up trading to your portfolio. You can even combine it with another method of investing to achieve your portfolio investment goals— after all, the sky’s the limit when it comes to bottom-up investing!
How Bottom-Up Investing Works: FAQs
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How are Bottom-Up Markets Sized?
An investor will typically size a bottom-up market by taking a look at clusters of companies that are performing well and narrowing it down further to just a single company in which they will place an investment.
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What Does Bottom-Up Budget Mean?
Bottom-up budgeting is a type of budgeting where a company will allow each department to create its own budget. They will then submit this budget to a superior for approval.
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What is a Bottom-Up Approach to Investing?
A bottom-up approach to investing is where an investor will specifically research a company rather than the market as a whole—making their investment decision based solely on the performance of the company as an individual unit.
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What are the Advantages of the Bottom-Up Approach?
A bottom-up approach to investing is beneficial to investors because it is a long-term investment strategy that needs less attention that day or swing trading. Additionally, investors may get to take advantage of low trading fees and dividends.
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Which is Better Top-Down or Bottom-Up?
Whether top-down or bottom-up investing is better for you will widely depend on the amount of time you have to devote to researching stocks as well as your ability to tolerate risk. You may even find that a mix of both methods is best for your portfolio.
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