What is Top-Down Analysis?
Top-down analysis starts by analyzing macroeconomic indicators, then performing a more specific sector analysis. Only after that does it dive into the fundamental analysis of a specific firm. It is the opposite of bottom-up analysis, which focuses on looking at fundamentals or key performance indicators before anything else.
Breaking Down Top-Down Analysis
Gross Domestic Product
A top-down approach will always start at the highest level, that is, determining which country has the best investment climate. At this level, a commonly used indicator is gross domestic product or GDP. This indicator is a good benchmark to compare various countries. GDP is a comprehensive measure of economic growth, which is why many investors use it. While GDP is an important factor to consider, there are also other considerations that an investor must analyze.
Global investors ought to assess the political climate of a country before opting to invest in it. As an investor, you should determine whether the country’s economy is at risk. This could be due to its own political situation or situations where neighboring countries could be jeopardizing its economy. For instance, when the Russian Federation annexed Crimea in 2014, the risk of investing in Eastern Europe increased considerably.
Asset Condition Assessment
Another factor that you should keep in mind entails the asset valuations with respect to the country’s economic growth. Although a fast-developing economy can give rise to fast-growing firms, the industry may be requiring a lot for the securities. The Chinese property stocks are a perfect case in point. They were overpriced in 2016, following a rise in prices.
Local Currency Climate
Apart from these concerns, you also need to factor in the effect that the nation’s currency will have on your investment venture. It may seem like a foreign security is doing well in its local currency, but once you start assessing the depreciation in terms of the U.S. dollar, you may realize that its growth rate is not as high as you thought it would be.
Picking the Right Sector in a Top-down Analysis
Once you have the ideal place, the next step entails comparing the performance of different industries within that country. Almost always, you will find that the greatest part of growth is taking place in certain areas of the economy. Such areas experience rapid changes within a single economic cycle, often because of introducing certain technologies.
For instance, a particular nation may be heavily reliant on one specific sector such as agriculture or energy. If you diversify your investments across other sectors that are not doing well, you won’t get the high returns that you would have if you had targeted the flourishing sector.
Another way to look at this is to focus on the groups that are nurturing and fueling the economy’s growth. For example, a thriving middle class in a developing industry could be setting the pace for growth and development in consumer discretionary equities.
It’s also imperative to assess whether the markets are being affected by the federal government’s activities. The reason for this is that some governments choose to give subsidies to only a few select industries. And while this may improve the companies’ profits in the short term, this may not last for a very long time.
Assessing the Nitty-gritty of Top-Down Analysis
The last stage in the top-down analysis approach to investment entails evaluating the details of individual assets. More specifically, you should examine both the fundamental and technical aspects of the asset. Investors usually choose from a wide range of assets, including foreign stocks, international ETFs, and American Depository Receipts (ADRs).
With regard to the technical aspect, you should specifically look for assets with an increasing trend in pricing. As for the fundamental aspect, you’ll need to find assets whose value tends to be underestimated. These dynamics prevent you from overpaying for certain assets.
Should You Consider Using Top-Down Analysis?
Employing top-down analysis calls for a great deal of research. Not only do you have to compare the economies of different countries but also different sectors in the chosen state. This means that the likelihood of choosing a company that’s on a downward trend is low; hence, minimizing your risk of investment.
Another reason for using top-down analysis is that it allows you to diversify your investments across different sectors. You can even choose to diversify your portfolio across global markets. If you come across an international market that is performing well, you can allocate part of your capital to it. Diversification helps to lessen the blow in case the primary market you’ve invested in undergoes a downturn.
Since every top-down analysis begins with a global outlook of the economy, it’s highly unlikely for investors to be caught off-guard by upheavals. Ideally, this strategy requires that an investor keeps abreast of geopolitical issues and whole economies. Given the vast information such investors have regarding global events and interlaced networks, it’s easy to predict trends in different sectors.
All these advantages support the fact that top-down analysis is worth considering. However, this is not to say that you should do away with the bottom-up strategy entirely. After all, you can use a combination of both strategies. With the bottom-up technique, you’ll have a clear picture of an individual firm before deciding to invest in it. This approach enables you to access the company’s financial reports to help you determine whether it has a solid financial position.
At the same time, a top-down analysis gives you a comprehensive picture of the global economy. Keeping up-to-date with the performance of different economies can help you predict the trend of the specific industry you’ve invested in. It also gives you a chance to diversify your portfolio by investing in different markets.
The Bottom Line for Top-Down Analysis
In summary, a top-down analysis is when investors first take a broad picture of the economies and sectors they want to invest in. It means that they assess the economic growth rates of different countries across the globe. Once they have identified potential countries, they choose specific sectors that seem to be flourishing in that country. The last step is to pick firms thriving in that particular industry, which they then invest in. It is a funnel-approach to selecting investment opportunities, as the top-down analysis name implies.
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