There are two ways to choose a restaurant. Either you start with the weather, the season and the mood of the neighbourhood, then pick a restaurant that "ought" to do well. Or you open the door, taste the food and look at the kitchen. On the stock market, these two methods have names: top-down analysis and bottom-up analysis.
In short: bottom-up analysis means choosing an investment by first studying the business itself (its products, profits, debts and price), rather than starting from forecasts about the economy or the markets.
Top-down or bottom-up?
- Top-down: you start from the big picture. "The economy will slow, interest rates will rise, so I'll buy this sector." You have to guess right several times in a row.
- Bottom-up: you start from the business. "It sells things people buy again and again, it makes money, it has little debt, and its price is reasonable." Everything else comes afterwards.
The two ice-cream parlours
On the same street, two ice-cream parlours sell their cones.
- Parlour A sells 10,000 cones a summer at CHF 4, each costing CHF 3 to make: CHF 10,000 profit.
- Parlour B takes care over its recipes: 12,000 cones at CHF 4.50, each costing CHF 3.20: CHF 15,600 profit.
Then comes a washout summer: both sell 30% fewer cones. A drops to CHF 7,000, B to CHF 10,920. The weather hit both, but B, in bad weather, still earns more than A does in good weather. Anyone who spent the winter guessing the weather learnt nothing useful. Anyone who looked in the kitchens already knew which to choose.
Why great investors ignore the weather
In 1934, Benjamin Graham and David Dodd laid the foundations of this method: study the accounts, profits over several years and debts, then compare them with the price. Sixty years later, Warren Buffett wrote: "We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen" (1994 letter).
Joseph Piotroski's research (2000) points the same way: simply by looking at the accounts, company by company, it was possible to sort the sturdy from the fragile among cheap shares.
The limits
Bottom-up analysis takes time and patience: reading figures, understanding a trade. And even an excellent business can fall on the stock market in a crisis. That's why it's combined with two rules we've already met: mix several investments and hold for a long time. For a family with no time to study companies one by one, a fund that buys the whole market remains a simple solution.
Try this tonight with your child
Choose two bakeries, two pizzerias or two toy shops you know well. For each one, ask three questions: "Do customers come back? Is it clean and tidy? Do the prices seem fair to you?" Then: "If it rains all week, which one will cope better, and why?"
Read also: How many years to pay back a business? · How much does it really earn?
Further reading
- Graham, B. & Dodd, D. L. (1934). Security Analysis. New York: Whittlesey House (McGraw-Hill).
- Piotroski, J. D. (2000). Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. Journal of Accounting Research, 38 (Supplement), 1–41.
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Educational content, not investment advice.