Against The Top Down Approach To Picking Stocks

If you have heard fund managers talk about the way they invest,
you know a great many employ a top down approach First, they
decide how much of their portfolio to allocate to stocks and how
much to allocate to bonds At this point, they may also decide
upon the relative mix of foreign and domestic securities Next,
they decide upon the industries to invest in It is not until
all these decisions have been made that they actually get down
to analyzing any particular securities If you think logically
about this approach for but a moment, you will recognize how
truly foolish 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 125% In
this way, a low P/E stock is comparable to a high – yield bond
Now, if these low P/E stocks had very unstable earnings or
carried a great deal of debt, the spread between the long bond
yield and the earnings yield of these stocks might be justified
However, many low P/E stocks actually have more stable earnings
than their high multiple kin Some do employ a great deal of
debt Still, within recent memory, one could find a stock with
an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and
literally no debt, despite some of the lowest bond yields in
half a century This situation could only come about if
investors shopped for their bonds without also considering
stocks This makes about as much sense as shopping for a van
without also considering a car or truck
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 (eg,
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!
Clearly, the most prudent approach to investing is to evaluate
each individual security in relation to all others, and only to
consider the form of security insofar as it affects each
individual evaluation A top down approach to investing is an
unnecessary hindrance Some very smart investors have imposed it
upon themselves and overcome it; but, there is no need for you
to do the same

Tags | bond, bonds, century, earnings, handed, investors, managers, operations, pitcher, securities, shopping, stable, stocks