What is Top-Down Investing?
How to Analyze Investments from the Top Down
There are two primary ways that investors build a portfolio from millions of different opportunities around the world: Find the best places to invest and then find companies in those places or screen for individual companies that meet certain criteria. The former strategy, known as top-down investing, is the most popular strategy used by global macroeconomic investors.
In this article, we’ll take a look at how top-down investing works and how international investors can apply the principles when finding opportunities for their own portfolios.
Looking at the Big Picture
The top-down approach to investing starts at the most high-level starting point – deciding what country represents the best climate for investors. At first glance, gross domestic product (“GDP”) would appear to be the most logical starting point given its broad measure of economic growth, but investors will find that these figures almost always point to emerging markets as the best places to deploy capital – which isn't always true for a variety of reasons.
Frontier and emerging markets may have the highest economic growth rates, but there are at least two other major factors to consider:
- Geopolitical Risks – 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 increased 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, the market may be asking too much for the securities. Chinese property stocks, for example, became overvalued in 2016 as prices soared.
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 the Right 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 at any given time 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, like 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 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 the Nitty Gritty
The second half and final step of the top-down investing approach is to take a closer look at the details of an individual asset before purchasing it. In this case, investors should take a look at the fundamental and technical aspects of a specific asset within a country’s economy and industry subset. These assets might include foreign stocks, American Depositary Receipts (“ADRs”), international ETFs targeting specific areas, or other asset types.
On a technical level, international investors should look for assets that have rising rather than falling prices in order to trade alongside the trend. On a fundamental level, investors should seek out undervalued assets relative to both domestic securities and international securities sharing the same asset class and industry. These dynamics ensure that investors aren’t overpaying for a given asset.
Investors can measure value by looking at financial ratios like price-earnings (P/E) or price-book (P/B), as well as other factors like free cash flow and revenue growth. Often times, investors will build financial models that extrapolate cash flows out over 3-5 years and discount those cash flows to the current date to determine if a stock is overvalued or undervalued.
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.
Key Takeaway Points
- 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.