Components of the Top-Down approach
As a rule, the top-down approach starts from the big picture and narrows down the focus area to find the good stock.
To serve this purpose, there are three components in the top-down approach to find the good stock. These are:-
- Economic Analysis
- Industry Analysis
- Company Analysis
1. Economic Analysis
It is the first and foremost part in an ultimate top-down approach that confines to study the macroeconomic factors such as inflation, interest rates, GDP growth etc. As a result, an investor is able to find the right time to invest in the market.
But, the outcome is dependent on the quality of input data. Thus, if the input data is accurate, the outcome gives a clear picture of the current economic situation else it will lead to the wrong direction.
Moreover, the economic situation can find on the basis of two factors. These are:-
- Business Cycle
- Government Statistics
a) Business cycle
The business cycle is a cycle that consists of ups and downs trend in the economic growth direction.
There are 5 phases involved in the business cycle which shifts over time. These are:-
It is a first phase in the business cycle which is a sign of the rise in demand. In this case, this phase is occurred because of the development of new products or services which is well accepting by the consumers. Moreover, the interest rates are also low to support this phase.
A peak is the second stage in a business cycle which signifies by the maximum level of economic growth. Hence, the market becomes overvalued during this phase.
It is the third stage which denotes by declining demand. Here, the main reason for the drop in demand is due to the overvalued products and services.
It is the fourth stage and shows a rock bottom point of a business cycle with the bad news all around. During this phase, the sentiments are low and down.
It is the fifth and final stage in a business cycle which leads to the reverse of the low turning point into the rise of the demand. Thus, this stage is important for the long waiting investor to enter the market.
b) Government Statistics
The government statistics is one of the most important sources of information to give a clear picture of the current economic, demographic and social situation.
In spite of being an important source, it is the most accurate source for information to evaluate and assess the current economic situation.
The government statistics consist of two types of data. These are:-
- Gross Domestic Product
i) Gross domestic product (GDP)
GDP is an important indicator to see the overall health of an economy and GDP value is dependent on the consumption, investment, government spending and export-import data.
Inflation is an indicator to see the increase or decrease of the purchasing power of a common man to buy the available products and services and It’s value is dependent on the Consumer Price Index, Producer Price Index, and wages.
For instance. if the inflation is high then the common man can buy a 1 Kg apple can buy @ 100 Rs whereas if the inflation is low then the common man can buy the same 1 Kg apple @ 80 Rs.
2. Industry Analysis
Industry analysis is a second component of the ultimate top-down approach whose main focus is to study about the different industries and their performance. The industries can either show the rapid growth or decline due to the impact on two main factors. These factors are:-
- Market Size – It denotes with the approximate number of buyers in a market segment to analyse the potential of a market.
- Demand and Supply relationship – The demand and supply relationship model is helpful to find the price of product and services is as per standard or not.
Furthermore, the industry strength finds by using two popular models. These are:-
a) Porter’s model analysis
The porter’s model was introduced by Michael Porter in 1980 which proves the 5 dominant forces are behind the performance of any industry. These are:-
i) Threat of new entrants
In the first place, new entrants get attracted towards the profitable and low barrier business but the market segment with a high barrier is free from such a threat. For eg:- Oil refinery enjoys the benefit of a high barrier for new entrants.
ii) Bargaining power of supplier
Supplier power can be increased if the quality of their product differentiates from others. Thus, a quality gives power to the supplier to fix the credit terms, prices, etc on their own terms.
iii) Bargaining power of buyer
Buyer power can be increased if the supply is more and demand is low in the market but if the supply is low and demand is high then the buyer has to accept the defined terms.
iv) Threat of substitute
Substitute can be defined as an alternative of real product or service. If the substitute is able to fulfil the demand of the market then it will impact the sale of a product. For example. Coffee is a substitute for Tea.
v) Industry Rivalry
Industry rivalry mainly exists when the product is not categorised by its quality rather in term of prices. Hence, Industry rivalry can only minimize if the products can differentiate from others on technological and quality factors.
b) SWOT Analysis
It is another popular technique to identify four aspects of businesses. These are:-
The characteristic of a business which acts as an advantage for it. For example. Service support capability.
The characteristic of a business which is the weak point and requires improvement to compete with others. For example. Limited offices in the region.
The favourable chance to get maximum from the available resources. For example. Tender specs in favour of the company’s strength.
Threats can also denote by the fear for the business which may impact the business growth in future. For example. Exemption for the entry of new entrants in new government policy.
3. Company Analysis
It is not necessary that if the economy is doing well or the industry is performing at its peak then all the companies can replicate the same results.
Therefore, it is important to analyse the company performance, financial health and future growth.
There are various ways to analyse the company. These are:-
- Growth and profit of a company with the help of financial ratios
- Cash flow
- Research and development capability
- Future projects
- Advantage over competitors
The company analysis is the last step but it is the most important step as if the company has high potential then it can even perform during the bad times but a low potential company cannot perform well even in good times.
The top-down analysis method is ultimate as it is designed in such a way that an investor can quickly identify the best stocks by following the structured hierarchical approach.
However, the only point keeps in mind that the input data should be accurate.