If you have heard fund managers talk about how they invest, you know many employ a top-down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is only when all these decisions have been made that they get down to analyzing any particular securities. If you think logically about this approach for a moment, you will recognize how foolish it is.
A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high–yield bond. For more information on P/E, visit Charles Schwab.
Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks have more stable earnings than their multiple high kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8–12%, a dividend yield of 3-5%, and no debt, despite some of the lowest bond yields in half a century. This situation could only occur if investors shopped for their bonds without considering stocks. This makes about as much sense as shopping for a van without considering a car or truck.
All investments are ultimately cash-to-cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top-down approach to investing is nonsensical. Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left-handed or right-handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it’s false. Even if pitching left-handed is inherently more effective, the general manager is not comparing apples and oranges; he’s comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher’s handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher’s handedness is merely one factor (among many) to be considered, not a binding choice. The same is true of the form of security. It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than for a general manager to prefer all lefties over all righties. You needn’t determine whether stocks or bonds are attractive; you need only determine whether a particular stock or bond is attractive. Likewise, you needn’t determine whether “the market” is undervalued or overvalued; you need only determine that a particular stock is undervalued. If you’re convinced it is, buy it–the market be damned!
The most prudent approach to investing is to evaluate each individual security in relation to all others, and only to consider the form of security insofar as it affects each individual evaluation. A top-down approach to investing is an unnecessary hindrance. Some very smart investors have imposed it upon themselves and overcome it, but there is no need for you to do the same. Just as important as what stock you are considering buying is how that stock fits into your financial plan and asset allocation. For more on asset allocation, visit this previous post, Asset Allocation.
For more information on selecting stocks to invest in, contact me directly. I have developed several stock screeners to find “hidden” gems that may or may not be a good fit for your investment strategy. I am available to assist those in or around the middle Tennessee area who do not mind working remotely. If you prefer someone closer to you, seek a referral from someone you know, trust their opinion, and work with a local financial advisor.
