Saturday, February 11, 2006

Top Down versus Bottom-Up

Geoff Gannon has posted two outstanding comments on the issue of top-down versus bottom up investing that I commend to your attention.

Against the Top Down Approach

Against the Top Down Approach (Again)

In particular, he highlights some really terrific performers of the last ten years, which on a macro overview basis would have been unlikely picks. However, based on individual security selection, using a discounted cash flow approach, some of these could have been part of your portfolio.

Let's imagine we were looking at some of these companies ten years ago. Genlyte (GLYT) is one of the example Geoff highlights. Back in 1995, a reasonable guess at the macro picture for lighting fixtures would have seemed to be GDP growth at best. Looking at GLYT's revenue growth back in 1995 and 1996, this would have been quite correct...revenues grew at 3.0% and 2.5% respectively. Nothing that would make your socks roll up and down!

But let's look beneath the surface at the underlying fundamentals, something that a macro view would miss. Back in 1995, that 3% top line growth leveraged its way into 10.5% operating income growth! Quite impressive, if not exciting! Let's dig a little deeper...operating cash flow growth was about 24%, FCF growth in 1995 was 62%! These trends followed in 1996 with operating cash flow growth of 29% and FCF growth of 45%.

Perhaps we would have been discouraged by the stock's valuation at this time...perhaps it reflected these dynamically improving fundamentals. NOT!!! The price/book of GLYT was a miserly 1.2 times; price to cash flow was 3 times, both measures well below the overall market valuation.

Another company that Geoff mentions is Brown and Brown, the insurance broker. Let's imagine that ten years ago,you had developed some macro notion that you would prefer investing in the insurance brokerage part of the property casualty value chain. The well-known "stars" of the industry at that time were Marsh Mac (MMC) and AJ Gallagher (AJG.) MMC, given its "star" qualities traded in 1995 at over 20 times cash flow and about 4 times book. Returns were respectable for all of these companies. AJG traded at 4.9 times book and about 14.7 times cash flow. Little BRO traded at 4 times book but only 10 times cash flow.

Though MMC had its own set of unfortunate issues and has been left behind this pack, the race between AJG and BRO was easily won by Brown.

As Buffett wisely counsels us, there are many ways to get to heaven...there are superb macro investors, and someone like George Soros, immediately comes to mind. There are some superb group rotators, who seem to have the ability to step in and out of industry groups with great timing.

But certainly, from my own experience, a bottoms-up investor with a cool contrarian hand, will often lead the long term performance charts.

In looking at that list of 17 stocks, I have been fortunate to have participated for at least part of the last decade in SCP Pool (Thank you Rusty!,) Brown and Brown, Florida Rock, Franklin Elec, Graco (the ONLY survivor in machine tools.)

I was not bright enough to see Genlyte though I had toyed with at at several times. "Moved too far too fast," is one of the really stupid conclusions that I have reached in the past, and which I continually try to shove aside now. Chicos always looked like too much fashion risk ( my favorite in this area has been Claires, which unfortunately exhibited only 1/3 of the return of CHS over the last ten years but has beaten the pants off the industry and the S&P, small consolation); Harbor always looked like a fully-priced takeout candidate...I was wrong here too!

On the bright side, owning just a few high return on invested capital stocks at reasonable prices will enliven your portfolio and build your wealth. Avoiding too much stupidity and too much trading will maintain it.

The obvious should not be an impediment to your thinking. Great companies are out there at reasonable prices. Throw out the "too far, too fast" thinking (?) that keeps you out of decent businesses. Throw out the macro thinking...there probably are decent housing, mortgage and title insurance businesses that I should be thinking about even though my gut tells me that the macro "housing" sucks. I may be exhibiting this sort of contrary thinking as I approach radio stocks...hopefully, the valuations reflect what most of us "think" is a no-growth area.

Bottom line...focus on the business itself, not the top-down picture.


At 4:03 PM, Anonymous Anonymous said...

Interesting blog.

Nice to see a CFA admit quarterly bias - I expect the employers expect it, yet it does tend to impede wealth creation for clients. (To the unfortunate extent that an aggregate analyst "sell" rating stock outperforms the broader market).

Ya, sometimes it's tough to both go with the market (too far too fast), or go against it (stock just hit new lows), yet both can be very profitable, if analyzed dispassionately.

My 2 cents ...

Jay Walker


Post a Comment

<< Home

< ? Market Blogs £ >