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Value Investment Philosophy: Bottom-Up
In general, value investment philosophy is made up of three parts. The first is using bottom-up strategy which identifies specific undervalued investment opportunities. Second, value investing is absolute-performance, not relative-performance based. And third, value investing is a risk-averse approach meaning attention is paid as much to what can go wrong (risk) as to what can go right (return).
Let’s look at the Bottom-Up approach. Many professional investors employ the top-down approach. This approach involves making a prediction about the future, ascertaining its investment implications and then acting on them. This approach is difficult and risky being vulnerable to error at every step. Those using this approach must accurately forecast macroeconomic conditions and the correctly interpret their impact on various sectors of the overall economy, on particular industries and finally on specific companies. The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people , all of them trying to do the same thing. And it does not provide a margin of safety. By Contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. Value investors search for bargains security by security, analyzing each situation on its own merits. The bottom-up strategy is in many ways simpler to implement than the top-down one. While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all. The entire strategy can be concisely described as “buy a bargain and wait.” Investors must learn to assess value in order to know a bargain when they see one. Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy a t large.
One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintain cash balances at all times. Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such attractive investment appear. A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investment is available. Top-down investors, by contrast may attempt to time the market, something bottom-up investors do not do. Market timing involves making a judgment about the overall market direction; when top-down investors believe the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion.
Naturally there is more to this first part. However, this is the basics. Next time we’ll address the second part being absolute-performance.
This is primarily sourced from Seth Klarman’s book entitled “Margin of Safety, Risk-Averse Value Investing Strategies for the Thoughtful Investor” published in 1991 and never published again. The book contains many valuable lessons for the value investor despite it is no longer available.
At Port Wren Capital, LLC, we specialize in picking specific undervalued U.S. stocks using fundamental analysis developed by Benjamin Graham using a five step process. We have beaten the S&P500, DJIA and NASDAQ benchmarks since we started 5 years ago on our own investments. Discover the difference for yourself. To learn more contact us today.
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