Bottom-Up vs. Top-Down Investing

by: Roger Nusbaum

There was an interesting flurry of comments on Wednesday regarding sector weightings. I left a chart up from Bespoke, and made the comment that I believe in staying in touch with sector weights, and that it is necessary to lighten up when a sector gets out of its historical whack.

There were two comments by one reader saying that it makes more sense "to compare price to book of various industries with their historical norms and bet on some reversion to the mean." In a subsequent comment he said that "it doesn't make any economic sense to talk about what is the correct percentage of market cap weight for 'tech' in the S&P 500," and then repeated his preference to price to book.

Another reader sort of called him out essentially saying there is more than one way to skin a cat.

I view this whole thing much differently than the commenter, as I view the price to book belief as more of a bottom-up approach. I will not say it makes no sense, but I do believe bottom-up is the more difficult method.

In the early 1980s energy comprised almost 30% (it may have been 26% actually) of the S&P 500, and then imploded in on itself to a larger degree than tech did at the start of this decade. These two examples are extreme, and they don't happen in this magnitude very often. The financial sector is currently the largest in the S&P 500 and has been over 20% of the market for quite a while. This has been part of my thinking in not wanting to go heavy (in addition to concerns about the slope of the yield curve).

Managing this sort of thing is very subtle, and a bottom-up person probably doesn't care, but I think it can really help out every now and then.

As far as the comment on tech, I view this differently too. There is precedent for semiconductors to provide leadership early in the cycle and for software to do a little better later in the cycle. It might be worth knowing that before you load up on semiconductors at the end of the cycle. Buying this sub-sector at the wrong time creates a headwind. You might still do very well, but you are overcoming a headwind to do so.

At this point I'd like to discuss an example from financials that I used the other day. I talked about adding a little volatility in the sector once the yield curve gets right side up. In my opinion, an inverted curve, late in the cycle calls for one type of exposure, while a steep curve early in the cycle calls for another type of exposure.

This carries over to various sectors. Also, at different points you want a different average cap size in the portfolio or tilting to growth or value is the better place to be. Again, this is subtle stuff but I am convinced that I have added basis points making these sorts of decisions in client portfolios. This really is what top-down is all about. It determines a lot of the return to be had, and I think it requires being less right than owning a bunch stocks that should go up because they are cheap.