What Is Top-Down Investing?

Definition & Examples of Top-Down Investing

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Top-down investing is an approach that first looks at macroeconomic factors when choosing investments, then identifies areas of the market expected to perform well, and finally selects investments within those areas. It is a strategy used by global macroeconomic investors.

Take a look at how top-down investing works and how international investors can apply the principles when finding opportunities for their portfolios.

What Is Top-Down Investing?

Top-down investing begins the process of investment selection at the macro level, by first considering global markets, then sectors and industries, and finally individual companies. You can contrast it with bottom-up investing, which begins by looking at an individual company's fundamentals, then its industry, then global market conditions.

How Does Top-Down Investing Work?

The starting point for a top-down approach to investing is deciding what country represents the best climate for investors.

Emerging markets, which you may know as developing countries, often have the highest economic growth rates. However, there are other major factors to consider when weighing which country to focus on:

  • Geopolitical risk: International investors must determine if a country’s economy is being put at risk either by its own political situation or by other countries in the region that may be unstable, leading to economic or physical conflicts. For example, Russia's annexation of Crimea in 2014 destabilized the region, increasing the risk of investing in Eastern Europe.
  • Asset valuations: International investors must also consider asset valuations in the context of an economy’s growth. While a fast-growing economy may breed fast-growing companies, overvaluation of those securities will have an effect on their profit potential.
  • Disclosures and financial reporting: Another thing to keep in mind when investing in emerging markets is the risk that financial disclosures may be incomplete or even misleading. Furthermore, there aren't the same federal protections within those markets as there are with domestic companies.

In addition to these concerns, investors should consider the effects of a country’s currency on their investment. A foreign stock may seem like it’s posting strong growth rates in local currency terms, but those growth rates may disappear when accounting for the depreciation in the local currency relative to the U.S. dollar. This depreciation would be realized when the investor converted the profits into U.S. dollars at the end of the investment cycle.

Choosing a Sector

The next step for those taking a top-down investing approach is analyzing specific industries within a chosen country.

In many cases, a country or region will be experiencing the majority of its growth in specific areas of the economy rather than broadly across all segments. These areas tend to change over a complete economic cycle, with technology usually leading the way and utilities lagging behind in the cycle.

For example, a country’s economic growth may be strongly tied to a specific sector, such as retail or energy. Investing broadly across all sectors of the economy could reduce potential returns compared to targeting those sectors that are growing the most quickly, or which have the potential to grow the most quickly in the future.

A growing middle class in an emerging market, for instance, could set the stage for growth in consumer discretionary equities.

It's also important to look at whether industries are influenced by governments. For instance, some countries provide subsidies to strategically important industries. These subsidies might help boost profitability in the short-term, but may not be in place forever.

Analyzing Fundamentals

The final step of the top-down investing approach is to take a closer look at the details of an individual asset, which might include foreign stocks, American Depositary Receipts (ADRs), international ETFs, or other asset types.

On a technical level, international investors may look for assets that have rising rather than falling prices in order to trade alongside the trend. On a fundamental level, investors may seek out undervalued assets relative to both domestic securities and international securities of the same asset class and industry. These dynamics ensure that investors aren’t overpaying for a given asset.

Investors can also measure value by looking at financial ratios such as price-earnings (P/E) or price-book (P/B), as well as other factors such as cash flow and revenue growth. These figures can indicate a company's performance relative to its current price.

Finally, investors should carefully consider the expense ratios associated with international ETFs and other funds, especially sector-specific funds that tend to be more expensive. Such expenses can eat into your returns.

Key Takeaways

  • Top-down investing involves looking at a country’s economy, followed by specific industries, followed by individual assets.
  • International investors should consider a number of different risk factors when analyzing economies, including geopolitical risk and asset valuations while selecting industries that are well-positioned within the economy.
  • Individual assets are best analyzed using a combination of technical and fundamental analysis in order to determine relative and absolute valuation.