If you’ve been thinking about dipping your toe in the stock market, you’re not alone. Maybe you got caught up in the drama surrounding the GameStop stock story, in which a group of online investors drove the prices of the failing company’s shares sky-high while traditional investment firms were betting big on the retailer to fail. Or maybe you’re simply curious about whether you could bolster your retirement savings with a little savvy stock trading.
There are opportunities to grow your wealth with the stock market, but it requires a bit of know-how to get started. In this article, we’ll take a look at bottom-up investing. What is it, how does it work, and is it a good choice for newbie investors?
We spoke with three financial experts—David J. Waldron, author of Build Wealth With Common Stocks; Jesse Acosta of The Day Trader Chatroom; and Joseph Meyer of The Dollar Soldier—to break down the basics of this investment approach.
What Is Bottom-Up Investing?
There are two ways to approach investing: top-down or bottom-up. Most retail investors—in other words, people like you who are investing for their personal finances instead of for an organization—tend to focus on exchange traded funds (ETF). These are “baskets of securities,” according to Mr. Acosta, with “exposures to different sectors or indexes.”
In plain English, an ETF is a bit like a box of chocolates. (Cue the Forrest Gump soundtrack.) It contains a mixture of investment types, such as stocks and bonds, pre-sorted to track an index such as the S&P500. You buy your box without selecting the individual flavors and hope that you like everything—or at least enjoy a high enough percentage that you feel as though you’ve gotten your money’s worth. With ETFs, you hope that the stocks, bonds, and commodities selected for you offer an acceptable return on your investment.
ETFs are relatively easy for new investors. They’re traded like stocks and have lower fees compared to mutual funds. However, they aren’t the only way for newbies to invest. That’s where bottom-up investing comes in.
As David J. Waldron explains, bottom-up investing is a “microeconomic approach” that studies “the effects of individual human or company impacts on the economy.” Instead of looking at an entire sector, which might contain multiple industries comprised of publicly traded companies, this approach picks just one company and dives deep.
Waldron recommends looking at a company based on several factors:
- The company’s products or services. What does it offer? Does it serve a growing need?
- Their track record of returns to shareholders. Has this company been a strong performer in the past?
- The effectiveness of their management team. Has the company experienced turbulence in the C-suite recently, or does it appear to have a strong and stable leadership team?
- The valuation of the stock price. Is the stock undervalued, overvalued, or priced fairly compared to industry benchmarks?
- Overall downside risk. If the worst happens, can your portfolio absorb the potential loss?
Can You Actually Make Money as a Bottom-Up Investor?
The short answer is: Yes! In fact, Warren Buffet himself uses this approach to the stock market. If it’s good enough for him, then surely it’s good enough for the rest of us. Of course, Buffet also has decades of experience to hone his instincts.
Waldron warns that this approach might not be for everyone, though. “Bottom-up investing is for those who have the thought, discipline, and patience to build and manage a portfolio of individual stocks,” he cautions.
What does that mean for you, the novice investor? It means doing your homework, choosing companies that you believe will not only hold their value but grow, and then buying individual stocks. This is a much more hands-on approach than purchasing ETFs or investing in mutual funds. It’s potentially riskier, since you’re choosing your investments based on your understanding of a company’s prospects, but for novice investors who want to try their hand at the stock market, the bottom-up approach is easy to scale and promises rewards for those with good instincts—and good research skills.
You also need to know when to sell. A savvy stock trader develops strong instincts after years of studying the market, but as a newbie, you’re just starting to figure things out. Looking to experts like Waldron, Acosta, and Meyer is a good start! As Meyer explains it, “The goal of bottom up investing is to identify individual companies that are attractive, buy them, accumulate the position over time, and sell when the price reflects the value.”
So what makes a good prospect for your first investment? And how do you know when to sell? It all comes down to valuation.
True Value Investing
Joseph Meyer’s approach to bottom-up investing is to focus on the value of the stocks. Seems intuitive, right? Well, according to him, “growth investors take a very different approach where they look at a company’s future potential instead of its past and current performance. Growth investing might still be bottom-up, but most of the time it has a lot of top-down elements to it because it is based on projections of shifts in industries that go beyond just an individual company.”
Sometimes, the best approach is also the simplest one. By investing in companies that “trade below their intrinsic value,” Meyer explains, even newbie investors can score big wins. The trick is to narrow your focus so that you don’t get overwhelmed by the vast scope of the stock market.
“It’s an overwhelming if not impossible task to do proper due diligence for every single company publicly listed,” Meyer cautions. “That’s why bottom-up investing often starts by filtering the entire market by certain common indicators and looking for potentially undervalued businesses that way. Common indicators for this initial analysis are price-to-book-ratio as well as price-earnings-ratio.”
In bottom-up investing, it’s vital to buy at the right time—and even more important to sell at the right time. Once your stock has grown to the point that the price matches the actual value, the clock starts ticking.
Real-World Examples of Bottom-Up Investing
David Waldron gives this example of how bottom-up investing works in the real world, compared to how a top-down investor approaches the same stock:
A bottom-up value investor buys Apple (AAPL) because of a belief that it is an excellent company available at a price with potential upside. The top-down-growth investor believes that smartphones and cloud services are the future and starts buying Apple and other companies in the consumer technology space—or a related index exchange-traded fund—often without regard to fundamentals or valuation.
Beginner investors can do well by buying stock in companies they already know and whose products they use. However, it’s important not to simply buy stock in Apple or Dominos because you like what they offer. Once you’ve narrowed your focus, it’s time to do your research. How has your chosen company performed on the market? What are their prospects for the future? Don’t be shy about reading both stock market blogs and industry news to figure out how your prospective investment fits into the bigger picture.
Although bottom-up investing focuses on individual stocks, companies don’t exist in a vacuum. You need to understand the context of the investment you plan to make. Is your favorite car company preparing for a merger? Is the grocery chain where you shop struggling or thriving? Will the beloved CEO retire soon, or has the marketing department decided to roll out a risky new strategy that could hurt the brand? Those are all factors that could have a direct impact on the value of the stock.
The Bottom Line
As a new investor, the bottom-up approach makes a lot of sense—if you’re willing to take the time to research companies and educate yourself. Although it comes with a certain amount of risk, the potential for reward is also high. And, most importantly, you’re in control of your investments. Unlike mutual funds and ETFs, which tend to be “big picture” or “macro” approaches to investing, bottom-up investing focuses on the micro level. Individual investors may find that they can pivot faster to industry changes and avoid the icebergs that can sometimes sink big firms.
About Our Guest Contributors
David J. Waldron is an individual investor and the author of self-improvement books for those seeking to achieve the personal and professional goals that matter most in their life. He earned a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University. Visit his website at davidjwaldron.com and check out his book, Build Wealth With Common Stocks: Market Beating-Strategies for the Individual Investor.
Jesse Acosta—JesseW on social media—learned from his father that if he wanted to succeed in life, he needed to give his max effort every time. That’s something he has applied in his life over the past 15 years of being self-employed. He now runs multiple businesses and trades full time. Now he shares what he knows with those who want to listen at The Day Trader Chatroom. Visit him at thedaytraderchatroom.com.
Joseph Meyer is a former construction worker, salesperson, loan officer, and entrepreneur who has learned a lot about saving and managing your money during his quest to reach financial independence. It is his goal to help others reach their financial goals faster through better financial education and planning. You can connect with Joe and learn more about financial independence at thedollarsoldier.com.