How should you research stocks?

In the previous story, we mentioned the characteristics of various market-cap categories. This story lays out how to research a company.

Bottom-up and top-down investing are basically two different ways to pick investments. While the former directly looks at individual companies, the latter first looks at various economic indicators and industry opportunities and then picks companies.

Top-down investing
This requires you to examine various macroeconomic factors and/or sectoral factors to understand some cycles or trends that would benefit some sector(s) and, in turn, a few companies. These factors include but are not limited to, interest rates, inflation, commodity prices, gross domestic product, excess/shortage of supply, etc. Successful investors like Jim Rogers, Ray Dalio and George Soros have followed this approach.

The idea is to benefit from positive trends and cyclical movements and get out of retreating ones. Let's say, you have identified that steel prices are going to rise, then you would look at steel manufacturers that would benefit the most from this and invest in them. Now, you have to figure out how long the cycle would last and when to get out.

And precisely, this is where the main problem lies. Timing the entry and exit is a vital part of top-down investing. Some trends may last for a few years but to get the maximum benefit, you will have to enter and exit at the opportune moment.

After figuring out which sector(s) will benefit, you need to pick companies. As you are playing a theme, you would pick a few capable companies in that sector. Note that analysing macroeconomic trends and figuring out how things will pan out requires rigorous analysis. You really need to be a specialist here.

Bottom-up investing
Unlike top-down investing, here you need to simply look at companies instead of the industry or the sector as a whole. You are only interested in a particular company and its business economics.

To understand the company, you need to do some basic research, like going through its annual reports, comparing it with its competitors and figuring out its growth potential and valuation. It could be the case that a sector is not performing well but a company in that sector is doing well. With bottom-up investing, you would only care about that company and not the sector.

Most investors would do well sticking with this approach. Understanding the company and its economics is far simpler than understanding and forecasting many macroeconomic variables.

Or a nuanced approach
While bottom-up investing would be ideal for you, adding some aspects of top-down won't hurt. Think about the time when the Russia-Ukraine conflict started. Prices of all sorts of commodities went haywire. Companies saw their input costs soaring. If you had some knowledge about the commodities dominating that region, you could have perhaps either taken advantage of it or bolstered your portfolio. And as you may have guessed, the top-down analysis comes really handy while investing in cyclicals.

Also in the series:
How many stocks should you own?
Which investing style is the best?
What is the right market-cap mix?