Top-Down Approach - It is a macro-level approach to investing, also known as EIC (Economy, Industry & Company) Analysis.
Steps Involved -
Start with the broader picture of world economy and decide whether domestic and global economic scenario is conducive for investment. Once the economy is decide then examine the macroeconomic factors of that economy.
Given the Overall economic outlook, identify the profitable, growing industries/sectors within that economy.
From within such selected sectors, investors pick up the best performing stock that are likely to outperform the market.
Economic Indicators -
Economic indicators can be Pro-cyclic and Counter-cyclic, and helps in predicting future performance of the overall economy and its sector.
Pro-cyclic - A pro-cyclic economic indicator is one that moves in the same direction as the economy. If the economy is doing well, the number is usually increasing, whereas if we are in a recession this indicator is decreasing. Ex - GDP, IIP.
Counter-cyclic - A Counter-cyclic economic indicator is one that moves in the opposite direction as the economy. Ex - Unemployment rate, The unemployment rate gets larger as the economy gets worse, so it is a counter-cyclic economic indicator.
Leading Indicators - Leading Indicators are those economic series that tends to rise or fall in advance of the economy's movement. Ex - Stock Index, Index of Consumer expectation, Yield curve slopes, Capital investments.
Lagging Indicators - A Lagging indicator is one that does not change direction until a few quarters after the economy does. Ex- Unemployment rate, commercial loans outstanding, flow of foreign funds.
Coincident Indicators - Coincident Indicators are those which change at approximately the same time and in the same direction as the whole economy, thereby providing information about the current state of the economy. Ex - Personal income, industrial production, manufacturing trades and sales.
Industry Indicators -
Industry Analysis
Industry analysis studies firm's business environment, including:
Assessing the sensitivity of the industry's profits to business economic cycle.
Analyzing nature of competition, market share, entry barrier, demand-supply dynamics and regulatory policies.
Industry analysis helps investors in the following way:
Position a company against peers in same industry.
Understand firm's potential growth, competition, and risks.
Assess profit potential and future performance of the industry.
Business Cycle Analysis
Based on sensitivity of earning to business cycle, industries can be classified into Cyclical and Non-cyclical.
Cyclical industry
Company's performance (sale, profits, cash flows) depends on business cycle of economy; hence highly volatile. Example: Banking &finance, auto, construction, cement, manufacturing, metal and mining, heavy equipment, hotel, and airline industries.
Non-Cyclical Industry
Non-cyclical industries are those whose revenues and profits are least affected by fluctuations in overall economic activity.
Noncyclical companies produce goods or services for which demand remains relatively stable throughout business cycle. Examples: Food, beverage, household and personal care products, pharma, health care, and utilities.
Strategic Analysis of an Industry
Industry analysis assess the long-term profit potential and future performance of the industry by studying existing competitive conditions.
Michael Porter highlighted 5 basic competitive factors that determine the profitability and attractiveness of an industry:
Threat of entry from new competitors Rivalry among existing competitors
Price pressure from substitute products/services
Bargaining power of buyers
Bargaining power of suppliers
Porter's Five Forces enable companies to come up with strategies to reduce bargaining power of buyers and suppliers, reduce competition and the threat of substitutes, and stop the entry of newcomers.
Bottom-Up Approach - is a micro level approach to investing, it focuses on company specific fundamentals, regardless market conditions, industry factors.
This approach does not go all the way up to macro-level.
It directly starts with fundamental analysis of companies.
Investors select fundamentally strong and quality company's stock that may outperform industry and market in future.
Business cycle in the overall economy, and broader industry performance are of little concern.
Company Analysis
Company analysis enables to select fundamentally strong and quality company for the long-term investing. Broadly, company analysis is centered around assessing both
Qualitative factors - Qualitative analysis involves analyzing, Growth prospects of company & competitive landscape, Quality of company's management and governance.
Growth prospects of company & competitive landscape mainly covers company's SWOT analysis: strength, weakness, opportunities and threats.
Understand company's product/services & its business.
Assess the long-term relevance of firm's business.
Study the nature of industry that includes the company (i.e., Defensive vs Cyclical).
Evaluate firm's competition with peer in same industry.
Assesses the longevity of sustainable competitive advantage and economic moat of the company.
Investigate firm's competitive strategy, pricing power, cost structure.
Study the role of Govt. regulation in the firm's business.
Economic moat of company - Moat refers to the company's competitive advantage that one company has over the other within the same industry.
Company should have a moat, but it also be sustainable. The wider the moat, the larger the competitive advantage of the company and more sustainable the company becomes.
Economic moat helps the company in protecting the company long-term profits & market shares from competitors.
Some common sources a company's Economic Moat are : Strong brand leading to customer loyalty, Patents, Wide distribution network or service network, switching costs, proximity to key raw materials, cost advantages due to economics of scale, monopoly business.
Competitive strategies - To compete effectively, Porter has identified two important competitive strategies that a firm can employ:
Cost leadership (low-cost) strategy - In cost leadership strategy, a firm seeks to be the low-cost leader in its industry. Sources of cost advantage may be economies of scale, proprietary technology, preferential access to raw materials. The firm can offer the lowest prices and generate enough volume to make a superior return.
Product or service differentiation strategy - In differentiation strategy, a firm seeks to be unique and distinctive in its product or service in the industry in terms of type, quality, or delivery that are widely valued by buyers. Successful differentiators will have outstanding marketing research teams and creative personnel.
Quantitative factors - Quantitative analysis is based financial statement that assesses Company's financial performance and valuation. These can be analyzing the Balance Sheets, Income Statement and Cashflow statements and Comparing Peers.
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