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Picking Stocks By Digging Deep

Fundamentals Help Keep Some Emotion Out of Investing

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Many investors start their approach to stock picking at the company level. They are more concerned with finding quality companies for great prices than global economic conditions.

If your approach to picking stocks is to zero in on the best companies regardless of what the economy or market is doing, you're rightly considered a bottom-up investor.

Bottom-up investors believe that superior companies will do well even if other companies in their sector are struggling.

They focus on fundamentals and product market position to make their stock selections.

This investment strategy has some strengths and weaknesses just as its counterpart, the top down investment strategy, does.

Performing Stocks

This contrasts with the top-down investor who looks at broad economic and market indicators to determine which companies have the best chance of out-performing the market.

You can read more about top-down investing by clicking on the link at the bottom of this article.

As is often pointed out, both methods seek the same end - superior performance from stock selections.

Bottom-up investors make good use of stock screens to select companies with the fundamentals they require, such as strong earnings and earnings growth.

Lots of Cash

There are many fundamentals you can use to measure the health of a company. One of the most important is cash. In particular, many investors look for a strong free cash flow.

Free cash flow is what's left over after all of a company's operating expenses have been paid. For you and me, that's having money in the checking account after all the monthly bills are paid.

For companies, free cash flow gives them options, such as acquiring a competitor or another company that adds something of value to the combination.

Companies with lots of cash can pay dividends or buy back stock on the open market, both of which add value to the company and wealth to the investor.

Low Debt

A bottom-up investor might also be interested in a clean balance sheet with little debt or low debt for the industry.

This is where comparing the company to others in the same stock sector is helpful - some industries naturally carry more debt than others. How does the company compare to its peers.

Market Position

Another key ingredient for many bottom-up investors is a dominant market position or consistent growth in market share nearing leadership in the industry.

Often called the competitive advantage or moat, this factor is an important part of identifying companies that have a good chance of being successful for years to come.

Economic moats create barriers to competitor erosion of market share. However, moats and competitive advantages are not guarantees of long-term success.

The stock market is littered with companies that once were "king of the hill" but are not "also rans" thanks to not keeping up with their market's changing needs or expectations.

Part of any assessment is the width and depth of the moat, which is a way of asking how likely is a competitor to breach the moat and will it happen quickly or slowly over time?

Strengths and Weaknesses

Bottom-up investing is not foolproof.

Strengths

  • Ignore a company's fundamentals at your own peril
  • Focusing on "the numbers" removes some of the emotion that surrounds investing
  • There are many tools to help you with the analysis

Weaknesses

  • Ignoring major economic or market trends can backfire if a company is more vulnerable to upheavals than the investor believed
  • Easy to become too numbers focused and lose sight of trending opportunities
  • Easy to focus on numbers that support your bias in the beginning

As a practical matter, investors are better off combining top-down and bottom-up approaches into a system that makes sense to them.

For more information on top-down investing, click here.

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