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[Are You A Top Down Or Bottom Up Investor?]( By Sven Carlin on April 10, 2017 - It’s best to use a bottom up and not a top down approach to investing if you want to lower your risk and increase your returns. - A value investor doesn’t like risk and invests with a huge margin of safety, is patient, happy to stay in cash if there are no bargains, constantly looks at balance sheets, and buys the present. Positive future developments in a business are just a bonus. Introduction We’ve covered more than half of Seth Klarman’s book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. I’ve received amazing feedback on the series and hope you will be satisfied with the summary and comment on the second half of the book. You can read the previous articles on the topic [here](. Today we’ll focus on Chapter 7, At the Root of a Value-Investment Philosophy, where Klarman discusses the psychology necessary to reach extraordinary investment returns and elaborates on the necessary skillset. The three central elements discussed are a bottom up strategy to finding undervalued investments, being absolute and not relative performance oriented, and that the focus should be on what can possibly go wrong (risk), more than on what could go right (return). Top Down Investing Strategy Top down investing starts by looking at the future and predicting what will happen. This is how the majority of market participants approach investing. Two simple examples are Tesla (NASDAQ: [TSLA]( and Snapchat (NYSE: [SNAP](. Both companies are hemorrhaging money every month, but investors are focused on their potential. TSLA could become the largest vehicle manufacturer in the world, while if SNAP continues to grow like it has in the last two years, it will eventually be larger than Facebook (NASDAQ: [FB](. Nobody has a crystal ball to see what will happen in the future, and therefore such a future oriented strategy is vulnerable to error at every step. For example, we can’t know—and not even Elon Musk knows—what the production cost of the Model 3 in 2018 will be because there are so many factors that influence production costs. One factor is the price of lithium, an essential component of the battery pack. The price of lithium has doubled in the last 4 years while mass electric car production hasn’t even started yet. Figure 1: As demand for lithium increases so will its price, consequently increasing production costs. Source: [Metalary](. It’s impossible to know whether TSLA will be able to get enough Lithium to produce 500,000 cars while GM, Mercedes, Hyundai, and many other companies will also want the material as they are also producing electric vehicles. On the other hand, if a recession comes along, a $40k electric car could soon turn from a cool thing to an unnecessary luxury. Figure 2: Elon Musk’s predicted sales numbers are huge. Source: [Bloomberg](. I’m not saying TSLA will miss their forecasts, I’m just saying that it’s impossible to know what will happen. The impossibility of knowing what will happen in the future increases the investing risks as a recession or higher lithium prices would be extremely detrimental to TSLA’s success story. Such a future oriented approach to investing is the opposite of what a value investor does as there is no margin of safety, your investing is based on a trend, concept or theme and it is impossible to know how much of the positive expectations are already included in the price of a stock as there is no way to assess the fundamental value of it. Going back to TSLA’s example, nobody can know whether TSLA will sell 500,000 cars in 2018, nor at what margin, nor what the financial result will be. TSLA could get to $5 billion in profits if the net profit on every car sold is $10,000, or it could get to $5 billion in losses if there is a similar loss on every sold car. Again, it’s impossible to analyze the fundamentals of a company with such uncertain outcomes. [Misunderstood Option Strategy Earns Novice Trader $41 Million In Only 3 Years]( Find out how you can use it to immediately generate substantial income when the market opens on Monday... even if you're starting with limited funds. It's safe, reliable, and can be duplicated over and over again to generate income you can use right now if you want. Or you can let it snowball into even more. [Click Here To Learn This Strategy]( [Easy-to-use Signal System Picks Stocks With Uncanny Accuracy]( Here are several stocks our system said to buy: WNC shot up 288% after system said BUY VCI shot up 233% after system said BUY ETM shot up 953% after system said BUY Plus ... get over $398 worth of valuable books, videos, and reports just for trying this system risk-free for the next 30 days! [Click Here To Try It Risk-Free For The Next 30 Days!]( Bottom Up Investing Strategy A bottom up approach to investing doesn’t look at what will happen and therefore it’s much easier to apply. The focus lies on fundamental analysis, or to go to the extreme and back to Graham and Dodd, you want to ask the question of what the business is worth dead, thus if it goes into liquidation. Such an approach would quickly show that TSLA is not an investment for the risk averse investor as its book value is $29.12, or just one tenth of its stock price. However, if TSLA’s price were $20, then the risk averse investor would buy it. If the projections don’t work out and the company goes into liquidation, you can expect to get at least your money back. If the projections materialize, then the upside is unlimited. TSLA at $20 would be a perfect example of a low risk, high return investment. Unfortunately, TSLA isn’t trading at $20, but there are many companies that are trading below their book values. A characteristic of the value investor is that they constantly analyze security by security by using the fundamental bottom up approach and invest only when they find an investment with low risk and a margin of safety, i.e. “whatever happens I don’t lose money,” and high potential returns. If there are no investments available that meet the required criteria, a value investor simply stays in cash and waits for the market to crash and create new investment opportunities. Sitting and doing nothing while the market is euphoric is perhaps the most difficult characteristic for an investor to achieve. When a bargain investment is found, the only thing to do is to buy and wait. So, on top of constantly digging through balance sheets and annual reports and not investing all the time, you also have to be patient and wait for the market to acknowledge the value you have found. From personal experience, I can tell you that this waiting period can last a few years. An Example Of A Bottom Up Strategy Just as an example of investing in what there is and not in what there might be is Bank of America Corporation (NYSE: [BAC](. Its stock price is $23.17 while its book value per share is $24.13. It has taken the stock 8 years to trade close to its book value again. Figure 3: BAC’s stock price has finally reached its book value. Source: [Nasdaq](. What’s important for the value investor using a bottom up strategy is that sooner or later the market always acknowledges value. This makes value investments extremely low risk. If something would have happened to BAC that would have lowered its book value, then a value investor would look at the numbers and change his mind on the company if necessary. A value investor doesn’t let his emotions make his investment decisions, but mere facts. This describes another characteristic of value investors, the ability to change one’s mind and accept the losses by selling a stock that isn’t what it used to be. Conclusion In the current environment, the majority are focused on relative performance and are plowing money into stocks without too much care about valuations on the basis that stocks will continue to do well. Stocks might continue to do well for a certain amount of time, but will eventually enter into a bear market. A lot of positives are currently priced into stocks so there are extremely high probabilities for error. It’s up to you to choose whether you want to follow the market or look at your portfolio from a value perspective in order to lower risks and maximize returns. It’s extremely hard to find bargains in this market by using a bottom up strategy, but it is possible. However, such an investing strategy will be opposite to the market’s sentiment and will probably lead to short term underperformance if the market continues to rally. But if investors come to their senses and start looking for protection in value, your returns are guaranteed. You just have to be patient for the market to recognize value investments but always beware of value traps that are materializing in the oil and retail sector where structural trends disable a meaningful upside. Keep reading Investiv Daily as we’ll continue to analyze Klarman’s investing masterpiece through a contemporary lens. The next topics we’ll be discussing are absolute vs. relative performance and how to approach risk. [No Comments »]( | Filed under: [Investing Strategy]( [Investiv Daily]( [Seth Klarman]( | Tags: No Tags --------------------------------------------------------------- If you are having trouble reading this email, you may [view the online version]( This email was sent to {EMAIL} by Investiv, LLC 3400 North Ashton Blvd. | Suite 170 | Lehi | UT | 84043 [Forward to a friend]( | [Unsubscribe]( Disclaimers Investing is Inherently Risky There are risks inherent in all investments, which may make such investments unsuitable for certain persons. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities. You may lose all of your money trading and investing. 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