The Dividend Cafe - Bottom-up vs. Top-Down Investing

Episode Date: February 8, 2019

Topics discussed: Bottom-up and Top Down Investing Market sector allocation Politics and markets Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. and then get back down to some meetings. You can tell I'm in a hotel room, actually up in Beverly Hills here in Southern California, and part of a two-day set of meetings with the folks at Hightower and also participating in the investment forum here, a lot of money managers speaking and things like that. So a really useful annual event, a lot of kind of business maintenance things going on with our company. And then certainly a lot of investment discussions taking place. And a couple of the other guys on our investment committee are here with me. And it's a nice time, but also very busy.

And so I'm recording here Thursday morning. Market has just opened and I'm going to get rolling here soon enough. Be back in the office this afternoon. Listen, the market's kind of acting normal this week, which is interesting. We were up about three or four hundred points coming into Thursday. As I'm recording right now, we're down about 100 points, and I don't know what will happen the rest of Thursday or on Friday, but you kind of have a couple up days this week and a couple down days, but neither side being really dramatic. And so the up volatility and

down volatility is somewhat subdued, which I think is good, normalizing. One of the things I kind of talk about this week at Dividend Cafe is the environment for a bottom-up fundamental investor like us that are trying to buy individual companies on their own investment merits. The less that macro circumstances, top-down macroeconomic events are impacting things, the better. We have a lot of confidence in letting the micro elements of what we're investing in take hold and drive investment results. But that's not reality. There is constantly monetary policy, geopolitical circumstances, macroeconomic, you know, events that will impact how things play out, certainly in the short term and sometimes longer. And so with the Fed now kind of sidelined for what I expect should be most of 2019,

it does subdue some of the macro impact and allow for a bit more breathing room with the micro. Now, that's not to say that the macro has been totally sidelined because we still have no resolution on the trade war. There is still significant vulnerability around the economic circumstances in China and even economic stability in Europe. And so there's global issues that we kind of have to continue factoring in. And of course, you can see, you know, as we get ready to go into the election year next year, we have the State of the Union address this week, I think that political element lingers out there. It's less significant in the markets than any, like the Fed would have been a very significant element because of the relevance of monetary policy to credit markets,

which drives so much of economic activity. But my point is that we're in earnings season right now. Earnings season is going very well. The earnings recession talk is more and more going away, partially because it was really not very thoughtful to begin with, but also just empirically, the results are outperforming those earnings expectations. And I think that this creates a bit less volatile of a market environment to be investing in. Now that macro can come back in violently and suddenly, and it's done that for different reasons throughout market history.

But the Fed being off the list of things that I expect will have a tremendous impact on markets, at least in the short term. You know, there's no question monetary policy is in a circle back around again. You know, there's no question monetary policy is in a circle back around again. But right now, I am in the school of thought that says that both from an interest rate standpoint and dollar liquidity standpoint and the rate at which they impact excess reserves in the banking system, all these kind of more technical things, but that actually have a pretty profound impact in credit markets. I think the Fed is sidelined. That takes away a big macro circumstance in the way markets are performing.

At DividendCafe.com this week, I go through a kind of longer explanation of the difference between a top-down investor and a bottom-up investor. Bottom-up being someone who is really looking to the merits of an individual company, let's say an individual bond, an individual investment, what cash flows they believe it can generate, and the various metrics and valuations and economic realities of an individual company or individual security. And that happens to be the school of thought that we come from, but no bottom-up investor is ever pure because there's always an impact of what we call top-down circumstances, more macroeconomic ones that impact things.

And we talk about macroeconomics as a top-down circumstance I just got done talking about for the last five minutes. We talk about countries, you know, what the environment is in Italy or Japan. And as American investors, we're used to talking that way. We don't talk necessarily about ABC company in Italy, but we talk about the Italian economy. And we do talk about the American economy, but we also talk about ABC company in America, and we get why we do that. However, the sector discussion is something that I think a lot of people believe drives investment results. And for bottom-up investors like the Bonson Group, I think it's important that you understand we have an allocation into, let's say,

the energy sector, into the financial sector, because at the end of the day, we picked individual companies. And when you total it all up, those companies equal a certain percentage of a sector. But there's a very big difference between an incidental allocation, like just the math of what you did happens to be you have 14% here and 20% there. And actually creating to that allocation saying, hey, I want to have 14% in financials. What companies are we going to have to fill that in? I want to have 20% in energy. What companies are we going to fill that in with? We have what's called an incidental sector allocation.

We are not managing to an allocation. So we're finding the companies that we want. And then within that sector allocation, we want to manage for risk. And so if we believe, well, you know what, this is too concentrated. So like a lot of technology investors in the year 2000, a lot of financial investors in the year 2008 would have been wise to have just, even if they were wrongly fond of the companies, they could have mitigated the risk by just limiting what the allocation of the sector was. Now, we will go to 0% in sectors. I've spent the bulk of my career at or near a 0% weighting in consumer discretionary because intrinsically, the sector sector possesses certain risk circumstances and debt leverage and non-dividend propensities

that we generally don't really find companies that fit in that world. But there are exceptions that have been exceptions and there always would be. But my point being, we can and do go to zero in a given sector. And we generally will limit on the upside of how high we'll go in a sector to somewhere between two and two and a half times that sector's weighting in the S&P 500. That's somewhat arbitrary but it's a rules-based governor for risk mitigation. So you may wonder why I'm bringing all this up. I think that when you don't have the Fed making a huge announcement and when you had like 180 point up day one day this week and 100 point down day, it's a great week to try to use those circumstances of somewhat less noise in the markets to actually talk about things that are more important. I would rather talk about the basics of contrarianism,

which is another thing I talk about this week at Dividend Cafe, to talk about our philosophy of bottom-up versus top-down sector allocation. I'd rather do that in a week where there isn't a whole lot of noise in the markets and so forth. On a politics and money front, there was State of the Union Justice Week. There is this bill being pushed by Bernie Sanders and Chuck Schumer to basically eliminate companies or drastically restrict or regulate their ability to buy back stock. It's not going to go anywhere.

The political impact to markets, we down talk it a lot for good reason. But it varies between being a zero percent factor and then some other kind of low percent factor. But that movement from zero to whatever the number ends up being, you know, that can be a move higher that can catch people off guard. I think that we're going to learn more in 2019 what the likelihood of various changes might be in 2020 with the election year. There's certain things on a, again, bottom-up basis. We're watching the pharmaceutical price-fixing discussions, warrant evaluation. That discussion's been on the table for a number of years. And, of course, a big farmer last year actually in a tough market had a really, really good year.

So people get a lot of this stuff wrong. But my point being that we believe that the political environment right now is interesting from a political standpoint, but has very minimal impact in the markets. But there are certain side narratives that we're watching. And I talk about that at Politics and Money. I do need to get going here. So unfortunately, I have to stop. I hope I've given you something this week that you find interesting. And I do know that at Dividend Cafe, there are a number of charts I would love for you to see. I absolutely love our chart of the week this week showing the kind of growth curve increase that the Congressional Budget Office has priced in around the tax cut impact and the pro-growth benefits that are coming out of the tax reform bill that passed a year ago.

And there's plenty of other stuff there as well I would encourage you to look at. So reach out to us with any questions as always. We hope you've had a wonderful week and we always do thank you for watching and listening to The Dividend Cafe. Thank you. The data and information referenced herein are from sources believed to be reliable. Any opinion, news, research, analyses, prices, or other information contained in this research is provided as general market commentary. It does not constitute investment advice. The team at Hightower should not be in any way liable for claims and make no express or implied representations or warranties as to the accuracy or completeness of the data and other information or for statements or errors contained in or omissions from the obtained data and information referenced herein.

The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the team and do not represent those of Hightower Advisors LLC or any of its affiliates.