Wednesday, March 30, 2011

All About Against The Top Down Approach To Picking Stocks

By Gunawan Wibisono

If you've heard fund bosses talk about the way that they invest, you know many employ a top down approach. First, they decide how much of their portfolio to allot to stocks and how much to allocate to bonds. At that point, they could also decide on the relative mixture of foreign and domestic stocks. Next, they decide on the industries to make an investment in. It's not till all of these calls have been made that they really get down to researching any special stocks. If you believe rationally about this approach for but a second, you may recognise how really dumb it is.

A stock's earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high - yield bond.

Now, if these low P / E stocks had awfully infirm earnings or carried a good deal of debt, the spread between the long bond yield and the revenues yield of these stocks could be justified. However, many low P / E stocks essentially have steadier takings than their high multiple kin. Some do employ a lot of debt. Still, inside latest memory, one could find a stock with a revenues yield of eight 12%, a dividend yield of 3- five percent, and literally no debt, notwithstanding some of the lowest bond yields in half a century. This situation could only come about if stockholders shopped for their bonds without also considering stocks. This makes about as much sense as buying a truck without also considering an auto or wagon.

All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical. Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it's false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he's comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher's handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher's handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You needn't determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is attractive. Likewise, you needn't determine whether "the market" is undervalued or overvalued; you need only determine that a particular stock is undervalued. If you're convinced it is, buy it - the market be damned!

If you are convinced it is, purchase it the market be damned! Clearly, the most judicious approach to investing is to guage every individual security re all others, and only to think about the type of security insofar as it has effects on every individual analysis. A top down approach to investing is a pointless impediment. Some really smart investors have imposed it on themselves and conquer it ; there's no need for you to do the same.

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