Top-down or bottom up? The two words sound funny, don't they?

Actually, they represent two different types of mindsets. And, in the world of stock markets, they represent two different investment approaches.

Of course, in either of the two cases, the main focus will always be to identify and buy shares of those companies that will fetch you good returns.

So, what exactly are these two methods of picking good stocks?

The top-down approach

In the top-down approach, individual investors or, for that matter, mutual fund managers study the sectors and decide the ones they want to invest in. Then, they shortlist the best companies from these sectors.

They study the macro economic factors (changes in interest rate, inflation, foreign exchange rate, gross domestic product, total demand and supply) that affect a particular sector before making their decision.

For instance, assume that international price of sugar are expected to move up and there is no restriction on Indian sugar companies to export their produce. What will you do?

Obviously, buy shares of the best sugar company in this sector. The reason: Export of sugar will increase the profits of sugar companies.

Now that you know all sugar companies are going to benefit from this move, will you go ahead and buy all of them? No. You will look at the top five companies in this sector and study their individual merits.

Ideally, you will buy share of companies that have a consistent dividend paying record, have sound managements, have made profits when other sugar companies have not and have high earnings per share.

And these are only some of the factors you will at before zeroing on the top two companies from the shortlist of five.

• Lessons in how to pick a stock

Let us take one more example of top-down investing. Currently, the price of real estate across India is increasing as if the move up will never end. The effect is companies that have huge land banks (land that can be developed by constructing malls, industrial estates et al) will see their share prices move northwards.

In such a scenario, if the government passes a policy that is beneficial to real estate companies, like forcing cement companies to reduce prices of cement, then what happens? Without any doubt, the profits of real estate companies will move upwards.

Again, a cautious investor will not buy the entire set of real estate companies available in the stock market. S/he will study each and every company in this space and ferret out the best that will help her/ him build wealth.

This is the top-down investment approach. In this method, investors first look at the sectors (like the sugar and real estate examples given above) that will benefit because of government policy, positive changes in a particular sector, etc.

That is, the sector is chosen first after which the focus shifts to individual stocks. The process of finding good picks begins at the top (choosing sectors) and then moves to the bottom (individual stocks).

Bottom-up approach

This is exactly the reverse of top-down investing. Here, attention is focused on the performance of individual stocks; the sector they belong to is not as important.

Here, a comparison is made between companies on the basis of their fundamentals (net profits, earnings per share, book value, EBITDA, dividend yield, historical returns etc) and ability to handle difficult times without impacting its profits when the business is not doing well.

The stock is chosen first and its merits studied. Study of the sector comes later.

• Smart stock-picking tips

Suppose you are looking at the top two companies, say company A and company B, in the software sector. And both pitch for a multi-million dollar contract from a multinational company.

Assuming all other things remain equal, if the chances of company B bagging the contract is high, what will you do? Without doubt, you will buy shares of company B because its potential to make profits will be higher.

Bottom-up investors look at many such companies across a number of sectors like say, petrochemicals (Reliance Industries), banking (SBI), pharmaceuticals (Sun Pharma), etc.

Irrespective of the names of the companies and the sectors to which they belong, a bottom-up investor seeks to find value in individual brilliance. They don't worry too much about the broader picture.

Blue chip companies (companies having an excellent track record in making profits, solid managements and consistent performances) are what attract the attention of the bottom-up investor.

• Spot a good stock. Win big!

Here the investor starts at the bottom (individual companies) and then moves to the top (the sector). Once they identify a good company, they run a check on the sector and other economic factors.

For instance, if you are a bottom-up investor and have identified Reliance, SBI and Sun Pharma as companies you would want to put your money into, you will then figure out which sector will benefit the most because of other factors like economic policy, climate change (for example, sugar sector stocks may not do good if the monsoons fail) and such other factors.