UTS16657 Chap.9 Top Down, Bottom Up and Investment Strategy
Top Down, Bottom Up and Investment Strategy
This is the first chapter inside the examinable window, since the final exam draws every question from Week 5 onward.
Portfolio construction has two principal routes and analysts usually run a hybrid of them, taking the top-down route to pick the sector or industry and the bottom-up route to pick the asset.
Top down runs in three steps: analyse macroeconomic conditions to find sectors with the potential to outperform, beginning with the fundamentals that bear on the widest slice of the economy and its people; drill down to the sectors and industries performing best under prevailing and foreseeable conditions; then analyse the financial and managerial features of companies inside them.
Bottom up reverses the direction: start from regular operational updates across a large number of securities, which suits an analyst who already knows the sector or is required by policy to invest there; evaluate each company's return and risk from historical data; then tie the leaders' financial and risk-adjusted results back to the wider economic setting.
Both routes converge on the same published ratios.
Net tangible assets per share is total assets less total liabilities divided by shares on issue, and it functions as a book value floor for comparing companies in one industry. Earnings per share is net profit divided by ordinary shares, and the board decides how much of it is paid as dividend per share and how much is retained.
The price-earnings multiple is the share price divided by earnings per share, read as the multiple of earnings the market is currently paying, and meaningful only against a peer group or a history.
Views are formed either fundamentally, by analysing the business, forecasting earnings and discounting them at a rate appropriate to the risk, or technically, by charting past price movements for trend, seasonality, cycles and patterns.
Hedge funds trading volatile markets lean on technical analysis heavily, while academic work has found that it does not reliably beat average returns over time. How much to diversify then depends on whether the manager is active, passive, hybrid, momentum or contrarian.
What this chapter covers
- 01
The three steps of the top-down route
- 02
The three steps of the bottom-up route, and when it fits
- 03
Net tangible assets, earnings and dividends per share
- 04
The price-earnings multiple and what it needs to be read against
- 05
Fundamental analysis and the portfolio-construction problem it creates
- 06
Technical analysis: trend, seasonality, cycles and patterns
- 07
Active, passive, hybrid, momentum and contrarian strategies
Four ratios from one set of trust accounts, and what they say together
- +1Earnings per unit: 91.2 ÷ 480 = $0.190.
- +1Split it by the payout: 0.70 × 0.190 = $0.133 distributed, leaving 0.190 − 0.133 = $0.057 retained per unit for expansion or other purposes.
- +1Price-earnings multiple: 3.46 ÷ 0.190 = 18.21 times.
- +1Net tangible assets: 3,180 − 1,260 = $1,920 million, so 1,920 ÷ 480 = $4.00 per unit.
- +1Price to net asset value: 3.46 ÷ 4.00 = 0.865, below one, so the units trade at a 13.5% discount to the value of the assets behind them. Interpret rather than stop: a discount can mean the market is sceptical of the valuations, or that it is pricing something the valuation misses such as gearing, lease expiry concentration or doubts about management.
Key terms
- Top-down approach
- Choosing favourable industries from an assessment of macro drivers and industry analysis, then selecting securities within them. It typically uses sector or industry indices to track regions or sectors.
- Bottom-up approach
- Starting from a company's own operational updates and financial statements, evaluating its return and risk from historical data, then relating that performance back to the macroeconomic environment.
- Net tangible assets
- Total assets, current and non-current, less total liabilities, current and non-current. Divided by shares on issue it gives a per-share book value used to compare companies in one industry.
- Earnings per share
- The net profit of a company divided by its total number of ordinary shares. The board decides how much of it is paid out as dividend per share and how much is kept as retained earnings.
- Price-earnings multiple
- The share price divided by earnings per share, showing how many times current earnings the market is presently paying per share, used to judge relative value against peers.
- Technical analysis
- The use of historical price data and charting to predict future movements, resting on the claims that prices move in persistent trends and that recurring patterns can be identified and traded.
- Fundamental analysis
- The analysis of a company's business model, industry, competition and management, forecasting earnings from disclosed financials and discounting them at a rate appropriate to the risk.
- Momentum investing
- Timing entry and exit ahead of the herd on the view that prices take time to reach a new fair value after information is released. Its opposite, contrarian investing, buys out-of-favour assets.
Top Down, Bottom Up and Investment Strategy FAQ
Which approach should I use if the sector has already been chosen for me?
Bottom up, because that is exactly the situation it is designed for. With the sector fixed by policy or mandate, the work is examining a large number of individual securities through their regular operational updates and financial statements, computing the published ratios and their growth rates, and evaluating return and risk from historical price data.
You then relate the leaders back to the macroeconomic setting, which is the point at which the bottom-up route borrows from the top-down one and becomes the hybrid the subject describes as usual practice.
Is technical analysis respectable or not?
Both parts of the answer are in the subject materials and a complete response gives both. Large parts of the funds management industry accept it and act on what it shows, and hedge funds trading foreign exchange, commodity and derivative markets noted for high volatility rely on it heavily. Set against that, academic work has found that it does not reliably beat average returns over time.
Reporting only the industry adoption reads as credulous and reporting only the academic finding ignores how markets behave.
Why is passive management growing?
The subject names the forces: more visibility of active management results, a high failure rate among active managers, technology making market exposure easier to obtain, lower fees, less management intensity, and the elimination of any chance of materially underperforming the market.
Consolidation matters too, because active management is harder for very large pools, since beating the market is hard once you have become a large part of it. In Australia there has been some swing back toward active management driven by sustainability mandates.
Does passive mean low risk?
No, and the distinction is worth a mark. Passive removes risk measured against the market; it does not mean low or zero risk in absolute terms. A passive holder of an index falls with that index and is forced to hold weak companies at exactly the wrong moment purely to track the benchmark. Conflating relative risk with absolute risk is a reliable way to lose marks on a strategy question.
Exam move
This chapter is mostly definitional and it opens the examinable window, so it repays flashcard treatment more than calculation practice. Learn the two routes as ordered three-step sequences rather than as adjectives, because a question asking you to describe an approach is asking for the steps.
Work the four-ratio calculation once so the arithmetic is automatic, then rehearse the interpretation, since the ratios themselves are only worth a mark and the reading of them is worth the rest.
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