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Article Title:
Against the Top Down Approach to Picking Stocks

Article Description:
If you have heard fund managers talk about the way they invest, 
you know a great 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...

Additional Article Information:
588 Words; formatted to 65 Characters per Line
Distribution Date and Time: Thu Feb  9 04:00:10 EST 2006

Written By:     Geoff Gannon
Copyright:      2006
Contact Email:  mailto:[EMAIL PROTECTED]

Article URL: 

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Against the Top Down Approach to Picking Stocks
Copyright © 2006 Geoff Gannon
Gannon On Investing

If you have heard fund managers talk about the way they invest, 
you know a great 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 not until all 
these decisions have been made that they actually get down to 
analyzing any particular securities. If you think logically about 
this approach for a moment, you will recognize how truly 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.

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 actually have more stable earnings 
than their high multiple 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 
literally no debt, despite some of the lowest bond yields in half 
a century. This situation could only come about if investors 
shopped for their bonds without also considering stocks. This 
makes about as much sense as shopping for a van without also 
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 to be made. 

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 it is 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. 

Clearly, 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. 

Geoff Gannon is a full time investment writer. He writes 
a (print) quarterly investment newsletter and a daily value 
investing blog. He also produces a twice weekly (half hour) 
value investing podcast at:



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