A bottom up investing approach is different from a top down strategy because it focuses on a business rather than the greater economic picture.
Where bottom up investing can be superior to top down investing is in the fact that there are less moving pieces, and less chances of being wrong with your assumptions.
To be a good bottom up investing stock picker, you should ask yourself these questions:
- What do I understand about this business?
- Where are all possible threats of competition?
- Does this company have a moat?
- Do the financials back up the idea that the company has a moat?
- Does management seem to be a good fit for the business?
- What are the larger secular trends that could affect this business?
- Does this company have a strong balance sheet?
- Is the price of the stock currently attractive?
These aren’t the only questions to ask, but they’re some of the most common ones I find myself asking over and over again when it comes to the stocks I eventually buy and recommend to subscribers each month.
With no further ado, let’s get started with the first question.
We are going to use some real companies (like Apple and Microsoft) as examples to help us work through some of these questions in a tangible way.
1—What do I understand about this business?
First and foremost, an investor should know about the businesses they invest in. After all, in the long run, stock prices follow business performance.
While you can certainly learn about a business by using its products and services, by far the best way to get really knowledgeable about a company is by reading their annual report (form 10-k).
Publicly traded companies are required by the SEC to disclose key information to investors so that they can fully understand the business models, risks, and financials behind the stocks they are looking to invest in. It’s all found in the 10-k; a gold mine for bottom up investors.
For example, with Apple, you might be a rabid fan and really enjoy using many of their various products and services.
But until you look at their 10-k—which showed that 52%+ of their sales in 2021 came from the iPhone—you can’t really be sure whether it’s the iPhone, Macbooks, AirPods, or something else driving most of the sales for a business.
2—Where are all possible threats of competition?
If you can answer this question by digging deep in your analysis and thinking critically about future possibilities, you can set yourself miles away from the average stock picker.
A fantastic way to think about competition in business was presented by business school professor Michael Porter, who had a breakthrough theory which we now know as “Porter’s Five Forces”.
Analyzing competition is critical in investing…
This is because of the competitive nature of capitalism; as soon as other businesspeople see a company achieving massive success, they’ll tend to want a piece of that action and may enter the arena. This is why not only is it important to analyze current competitors, but you should also consider possible future threats.
The more intense the nature of competition in capitalism, in general, the greater downward push on profitability and prices (good for consumers, bad for companies).
It’s why investors should take heed that their companies have “moats”, unique aspects about their business that shield their profits from intense competition.
3—Does this company have a moat?
Like mentioned already, companies need a moat so that they can defend their profit margins from competitors and future threats to the business.
A moat is another term for “competitive advantage”; a way for companies to produce better profits than their competitors, letting them maintain successful compounding of profits.
My podcast co-host Dave Ahern wrote a fantastic article about competitive advantage which I highly recommend all bottom up stock pickers take a read at; to summarize, some of the 4 most common types of moats in the business world today include brand power, network effect, economies of scale, and proprietary technology.
The presence of just one of these moats could keep a company very successful and profitable for a long time—the more moats a company has, the better.
Just as an example of how effective a moat can be: a company with a strong brand may be able to charge its customers a higher price than its competitors because its customers love all of the value they receive from that particular brand. Apple’s iPhone is a great example (and one of their many moats).
4—Do the financials back up the idea that the company has a moat?
This is a key question to answer that can trip up lots of investors, especially because investors have so many biases that we are not even aware that we have.
It’s easy for us to become attached to a product or service that a company provides, and thus become attached to the company and think its stock is a great buy.
There’s great danger in that however—the fact of the matter is that people are so different and may have wildly different tastes, perceptions, and reality than you.
There is value in testing out a company’s product or service for yourself, but you must confirm the idea of a moat with some cold hard facts. In other words, a company’s financials should be very strong and reflect a company that is in-fact very profitable and adeptly defending its position.
Two great financial metrics to use, which I’ve heard from The Little Book That Builds Wealth and our recent podcast episode with Morningstar’s Mark LaMonica, are Return on Invested Capital (ROIC), and Gross Margin.
Pat Dorsey found in The Little Book That Builds Wealth that strong Gross Margin in the past tends to lead to strong Gross Margin in the future, so it’s a great metric to identify potential competitive advantages.
It makes sense too; if a company has a great brand and command premium pricing, the revenue side of a product or service will be higher than another company’s even if their costs are the same—leading to a higher Gross Margin than its peers. On the other side, a company that controls costs better than its competition due to its large size will see the costs side of a product or service to be lower than peers even if their pricing (and revenue) is the same—another way to achieve higher Gross Margin.
ROIC is another fantastic metric because it displays how adept management is in investing capital in order to earn returns (profits).
Companies with higher ROICs than their peers will generally find it easier to grow their profits over time, which can further enhance their competitive advantages over time. The higher a company’s ROIC is, the less (invested) capital it needs to grow (in general), usually making growth easier to achieve.
I use both ROIC and Gross Margin when analyzing businesses in a bottom up way; I suggest you do the same.
5—Does management seem to be a good fit for the business?
There are many opinions on what makes for good management for a business; it is an important question because many managers have destroyed the performance for investors by wasting profits as poor stewards of their companies.
Investors should look for managers that have integrity, smarts, and ambition.
These are obviously soft skills, and so no two evaluations are likely to look the same. There are no magic numbers here.
Simply pay attention to the actions of a manager rather than the words that they say. You won’t catch all of the bad actors when you invest in companies, but you can avoid many by simply evaluating what they do (publicly) when you can.
6—What are the larger secular trends that could affect this business?
A secular trend, by definition, is a fundamental long term trend. A great example of a secular trend would be the internet. It disrupted many businesses and created unlimited opportunity for so many more.
As you consider a company’s potential future threats, also consider any “headwinds” that may occur from secular trends that might be unraveling right before your eyes.
Again, be cognizant of your biases and rely on facts rather than feelings.
But if you can objectively consider secular trends and honestly evaluate and re-evaluate your assumptions about them, you will be a better stock picker for it. Everything from the future growth rates you assume, to the valuations you assign, can and should be affected by any secular trends that may influence the future more-so than it has the past.
An example of this is electric vehicles.
Though I’m not convinced that Tesla will take over the world like many investors (today) seem to think, it does appear obvious that electric vehicles are here, adoption is growing briskly, and the trend is here to stay.
So, I’ve actively avoided gas station operators such as Alimentation Couche-Tard and Casey’s.
Though the cash flows for these operators have been extremely healthy and growing, and especially boosted by the tragic geopolitical events we’ve seen of late, these don’t seem sustainable in a world where more people drive electric vehicles and charge them at home.
I’m happy to be proven wrong about that, but I’m not investing my money by betting against such a strong secular trend such as that. A good bottom up approach will consider that every time.
7—Does this company have a strong balance sheet?
At the end of the day, all great indicators of fundamental analysis mean dittly if a company cannot weather a storm and goes bankrupt.
The fact of the matter about the economy is that it moves in cycles, and storms in economies and industries are a common feature over the long term.
To adequately weather a storm—which frequently brings less revenues, profits, and cash flows, and less capital available to be raised—a company must have a strong balance sheet, which includes liquid assets to cover short term expenses (like cash), and adequate power to pay off large long term liabilities (like debt).
You don’t want to be the investor in a company who has to shed assets at fire sale prices, or issue shares at a pittance to the company, all because management was too aggressive and did not respect the storms that are the reality of business.
Losing 100% of your money is always a possibility in stock picking; having a weak balance sheet can greatly increase those chances.
Use commonly accepted balance sheet metrics such as the Interest Coverage Ratio and Debt to Equity as a start, and then go deeper into Contractual Obligations and Debt Covenants as you gain more experience as a bottom up investor.
8—Is the price of the stock currently attractive?
You might want to start at this point, because all of the analysis done up-to now is a moot point if the stock’s valuation is too high—even if you have a long term time horizon.
History has shown time and time again that investors have lost 5, 10, 15+ years of compounding (!) from simply buying world class businesses that were priced impossibly high (valuation) compared to what they were really worth (intrinsic value). Look at what happened to investors who bought Microsoft, Cisco, and Qualcomm before the Dot Com Bubble popped in 2000. They lost YEARS of gains.
That said, valuation should be one of the later priorities in the list of a bottom up strategy, because over the long term, it’s the business that matters more than the price.
Don’t get caught up in nickels and dimes when you have a potential 100 bagger in front of you.
Like the great Warren Buffett once said:
Also remember this one, a great quote from Jake Taylor in The Rebel Allocator:
It’s important to realize that while bottom up investing has many distinct advantages, it is not the only way to find success in the stock market.
Billionaire investors can be found on both sides of the “aisle”—Warren Buffett being the quintessential example of a successful bottom up investor and Ray Dalio being one of the most respected top down guys.
Whichever way you go, add these 8 questions to your investing checklist… and watch your skills and results improve over time.