Utilizing a Bottom-Up Approach to Stock Picking

By Stock Research Pro • April 24th, 2009

With a bottom-up strategy for picking stocks, the investor chooses companies based on such things as strong fundamentals and the quality of the management team. The investor performs this analysis without regard for the current economic climate or trends. While top-down investors analyze the “big picture”, bottom-up investors look for those companies that would seem to be best positioned to outperform their industry competitors, regardless of industry and macroeconomic factors. Bottom-up investors argue that choosing stocks based on efficiency, performance, and leadership is the best way to ensure attractive returns.

Bottom-Up Investing and Fundamental Analysis

Bottom-up investors believe that companies with solid leadership, sound financials, and a strong market position are bound to perform well, even if their industry competitors are struggling. For this reason, bottom-up investing is closely tied to fundamental analysis.

Screening for Bottom-Up Investment Candidates

Using a stock screener, the bottom-up investor (like fundamental investors) might seek the following qualities in an investment candidate:

Return-on-Equity (ROE): This measure of profitability indicates how efficiently the company is using its assets to generate earnings. Specifically, ROE compares net income to shareholder’s equity with the understanding that a company cannot grow its earnings faster than its ROE without increased borrowing. Many bottom-up investors will look for a minimum of 15% on this measure.

Price/Cash Flow Ratio (P/CF): The P/CF is used to compare the company’s market value or “market cap” to its operating cash flow in the most recent year. This is an important measure because cash flows dictate the solvency of the business. Having sufficient cash on hand ensures that employees and creditors are paid in a timely manner and keeps the business out of bankruptcy. While the average P/CF measure varies by industry, many fundamental and bottom-up investors look for a ratio of 7.5 or lower.

Debt/Equity Ratio: This provides a measure of the company’s financial leverage and is calculated by dividing the company’s total liabilities by stockholder’s equity. A high measure indicates that the company has been aggressive in funding expansion through debt. The risk is in this strategy is that the debt financing may eventually outweigh the return it generates. The average debt/equity ratio varies by industry. Capital-intensive industries often see a ratio greater than 2, while companies in less capital-intensive industries might see a ratio of under 0.5.

Revenue Growth: Generally speaking, the strongest stock candidates are those with fast-growing revenues. While the news regarding a company tends to focus on its earnings, it’s the company’s revenues that drive those earnings. The revenues are measured on a quarter v. quarter basis and a minimum of 20% growth is seen as desirable.


The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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