Video Transcript:
Alanna Petroff: If you ever get the chance to meet with fund managers, they'll often talk about their top-down or bottom-up investment approach, but what is that even mean? Joining me now is Alastair Mundy from Investec. He manages a number of funds there and we're going to specifically go through what it means to be a top-down or bottom-up investor. So, Alastair, thanks very much for coming in.
Alastair Mundy: Hi there.
Petroff: Now, let's talk about top-down and bottom-up. First, what is top-down?
Mundy: We are a terrible industry for introducing unnecessary jargon. Top-down is really for those investors who believe they can see the future in terms of economic forecasting. They know where economic growth, inflation, interest rates are going and they use those forecasts to determine which stocks they're going to buy.
Petroff: So, you're taking that macro view and then going down from there. So top-down. Okay. And so bottom-up?
Mundy: Well, at the extreme, bottom-up investors believe we've got no view whatsoever worthwhile on forecasting macro-economic futures. So, we just focus entirely on individual companies. We accept the future will have all sort of nasty things: high inflation, low inflation, economic growth, recessions. And we say we are looking at purely the specifics of the company we're investing in and seeing if those specifics are positive for us and therefore worth buying the shares.
Petroff: Okay. So, now you do bottom-up investing. How do you do bottom-up investing within your firm?
Mundy: We've got a very specific form of bottom-up investing because we're contrarian bottom-up investors, which means we're only really focused on out-of-favour stocks. So, the very first thing we do is we create a screen to highlight those most out-of-favour stocks. So, we look at the top 350 stocks in the market, by market capitalisation, press a button and find those which have fallen most from their peak over the last seven years. Incredibly unscientific. My mum is welcome to do it for us. There’s nothing intellectual behind it whatsoever.
Petroff: Easy stuff. Okay.
Mundy: It's very easy stuff.
Petroff: Okay.And then from there you pick the best of the best, the ones that you think have promise?
Mundy: Well, from there we almost pick the worst of the worst. We look at those that have underperformed the most and then say yes, ‘has it got promise?’ by looking at the company in much greater detail, by looking to see what the company does. Make sure we really understand it, be happy to admit if we don't. Understand its balance sheet, its cash-flow. Try and work out why everyone else hates this share and that's typically very easy because it's in the news at the moment, it's on the 10 o'clock news and there will be lots of obvious negatives.
Then we say to ourselves, ‘why did these people buy in the first place?’ ‘What were the positives that we're looking at three, four, five years ago?’ And we ask ourselves whether those positives have been forgotten about, and whether those positives could drive the share price in the future. And then we ask ourselves ‘what are the various different scenarios that could pan out for this company? Is the balance sheet strong enough to handle the bad scenarios, as well as the good scenarios?’ And finally and perhaps most importantly, are we being compensated for the risk that we might be wrong? So, is there a margin of safety there by buying the shares at the current price?
Petroff: And do you look at sectors or themes at all or do you just look at companies?
Mundy: There is some thematic views that we might take because if we see a lot of stocks in the same sector in our screen, we might look at those simultaneously, and we'll have to learn and just make sure we understand the industry. So, it's a mix of the two and sometimes there are some sectors or sub-sectors which we're very nervous looking at because we just don't understand them sufficiently...
Petroff: So you leave those alone.
Mundy: So we leave them alone. Yes.
Petroff: Okay. What kind of mindset does it take to do this bottom-up and contrarian investing?
Mundy: I think, the thing you really need to be is rational. We're trying to take advantage of very smart well-educated competitors, when they're making irrational decisions. And they're being irrational because they hold a share which is going down a lot and it's causing them embarrassment, humiliation, their colleagues are laughing at them and their boss is complaining and the client is probably a bit disturbed by it all. So they're selling those shares. We've got to try and remain objective and say, ‘they're selling them under pressure. Can we just look at this share rationally and objectively and see some positives and weigh out the positives with the negatives?’ It's very easy to say, it's much, much harder to do. I always compare it to eating in a restaurant on your own: it's not a pleasant experience, however easy it sounds before you go in.
Petroff: Okay. And now, how would an individual do this? I mean, it kind of sounds like okay, you screen for the worst performers and then you pick a company that you think you like, but can individuals do this successfully as well?
Mundy: In way, individual investors could have more luck doing it because they haven’t got the problem with a boss, other than their husband or wife, or clients. So, they don't have those other pressures.
They might struggle to get some of the information, but they’ve got reporting accounts and there are lots of things on the Internet that can help them with information.
I think the biggest problem individual investors might have is knowing when to stop buying, but professional investors have that problem as well. When do you admit you might be wrong or you've got enough? And secondly, to make sure you've got enough stocks in your portfolio, that you've got a well-diversified portfolio.
Petroff: Okay. So, what would you say is a key risk with this bottom-up and combined with contrarian approach?
Mundy: Yes. I think the biggest risk is obsession with a stock where you really try and improve you are the greatest investor of all time and the one stock you’ve been really highlighting is going to be the stock that goes up a lot. We don't know enough about anything to be that confident. And I always compare it to walking into a bar and having a fight. If you're going to try and beat someone up, but the first time they knock you down, move on perhaps. Don't convince yourself you can beat them up. Perhaps you're just having a bad fight.
Petroff: Just leave it.
Mundy: Leave it, move on. So, diversification is probably the most important thing for all investors, but certainly with contrarian investing.
Petroff: Okay. Thank you very much for coming in today.
Mundy: Thank you very much.
Petroff: That was Alastair Mundy from Investec. I am Alanna Petroff from Morningstar and thanks very much for watching.
