04 Jul Investing in an uncertain economic environment
As published by Sanlam Glacier on 9 June 2023
In times of economic uncertainty, investors often turn to top-down investment strategies that attempt to predict the direction of the economy. While this approach may seem logical, it is not always the most effective way to achieve investment success. Bottom-up investing, while it downplays macro-factors, may counterintuitively be better than top-down investing when investing in uncertain times for a variety of reasons. These reasons include: (1) it is easier to develop conviction, (2) it provides an additional layer of diversification, (3) it does not attempt to time the market so it reduces the risk that you are not invested in stocks when they are poised to deliver the best returns and (4) it enables the investor to profit from market drawdowns.
Bottom-up investing is an investment strategy that involves analysing individual companies, rather than focusing on macro-economic trends or broader market conditions. This approach involves analysing a company’s financial statements, management team, competitive position, and other factors to determine whether it is a good investment opportunity. Unlike top-down investing, which is often influenced by macro-economic factors like interest rates and inflation, bottom-up investing focuses on the company’s fundamentals.
With bottom-up investing, it is easier to develop conviction
In periods of economic turmoil, macro-economic factors can be highly unpredictable, making it difficult to make investment decisions based on these trends alone. It is also difficult to know which macro variables should guide one’s decision-making as different macro variables can lead one to draw different conclusions.
Delving a little bit deeper, to infer how a certain sector will perform in a certain economic climate is also difficult to do. There are multiple drivers to this: not only the economic climate, but other factors like valuation. A further complication is that the sector that performs best in a given year rarely does so more than once in a row. This means that investors trying to jump between sectors might end up missing the boat entirely. The dispersion in returns by owning the best vs. worst performing sector is wide and therefore the risk of underperformance to the investor is huge.
Figure 1: S&P 500 Sector performance
In contrast, by focusing on the fundamentals of individual companies, bottom-up investors can make investment decisions based on factors that are more certain and predictable.
Bottom-up investors can choose relative outperformers
Another advantage of bottom-up investing is that it can provide greater diversification than top-down investing. Bottom-up investors can attempt to find the winners within a particular sector, which can help to ride out any underperformance by the sector itself.
Top-down investors are more easily swayed by market sentiment
One often-quoted statistic, which shows how dangerous it is to time markets is what the impact on long-term returns would have been if you missed the 10 best days in the stock market. However, this knowledge does not prevent investors from being over-cautious or even selling stocks when volatility is high and market sentiment is at its worst. Top-down investors are prone to errors of this nature because they are more easily swayed by market sentiment. In contrast, bottom-up investors who have chosen stocks based on their fundamental characteristics are better equipped to look through this volatility (provided their time horizon is long enough), with the result that they get to pocket the long-term equity risk premium for “free”, because it is almost guaranteed that stocks will outperform bonds in the long-term.
Figure 2: Best days in the market, Source: Strategas, Capital Investment Advisors
Volatility – friend or foe?
Downturns can lead to the undervaluation of companies, providing astute investors with a way to make money. Several factors can contribute to the undervaluation of a company, even amidst certain economic conditions. Market reactions to economic uncertainty are often exaggerated, causing stock prices to plummet and undervalue otherwise fundamentally sound companies. This presents an opportunity to acquire shares at a discounted price.
Companies that operate in cyclical industries are usually more susceptible to economic fluctuations. During downturns, companies operating in these sectors may experience temporary headwinds, leading to undervaluation. Banks are one example of this. During a downturn, they usually sell off quite strongly in anticipation of burgeoning credit losses but if investors satisfy themselves as to the strengths of their balance sheets, they can weather the storm and rebound nicely. Construction companies are a second example of an industry that is exposed to cycles within the broader economy, but will see a rebound when the economic climate improves.
Where do we stand today?
Presently, we find ourselves in a challenging investment landscape characterized by sticky core-CPI inflation and being at the tail end of a series of rate hikes which has broken records in terms of its steepness. The impact of this has been felt in many places and has even caused several banks to fail.
From a top-down perspective, market consensus is only for a small decline in the S&P’s earnings this year and a recovery next year. We consequently believe, the likelihood of an earnings disappointment, and this combined with high valuations makes equities unattractive in our view. However, given the fact that that equities outperform in the longer-term being underweight equity is a “tactical” rather than a “strategic” position, and comes with large risks that are difficult to ignore.
By contrast, from a bottom-up perspective, there are abundant opportunities and while we have seen a large recovery in the market as a whole, this recovery has been skewed towards the big names and the smaller names have not really participated.
While both have their place, we believe in what bottom-up investing offers because it gives you the opportunity to make a profit even without taking the risk that you are not invested in equities when they are set to outperform.
About the author
Gerhard Janse van Vuuren BCom
Gerhard is an equity analyst in the global team, having joined Flagship in 2022.
Gerhard completed several investment internships while concluding his degree in Investment Management at the University of Stellenbosch. Gerhard has passed Level 1 of the CFA exams and is currently furthering his studies with an Honours degree in Finance at the University of Cape Town.