Top-down investing is the voting machine in action

There’s a tremendous amount of money that trades based on top-down market relationships, like sectors and industries – and we’re seeing this play out right now in the market. Investors look at stock charts and see money moving from one segment to another, prompting others to follow suit. Often, these investors focus on making money over the next 3 to 6 months. They essentially “date” the market and are ready to dump an investment and move onto the next new fling at any time. ETFs make this kind of top-down investing easier than ever.

This strikes us as very different from stock picking, because top-down investing treats all companies in a given segment as the same. Investors may want “more small caps*”, but within that universe of hundreds of companies, there are businesses that are thriving and businesses that are struggling. There are businesses that never made a profit and others whose profit growth is accelerating. The top-down investor treats them all the same. They’re all in the same category, and the investor wants more of that category. 

Right now, money is moving into areas like “Consumer Staples” (think Coca-Cola, Procter & Gamble), many of which have slower growth rates and relatively high valuations, and piling out of “Software,” where many companies have high growth rates and reasonable valuations. But the top-down investor doesn’t care about profit margins, profit growth, or price per unit of profit growth. All companies in the same category get treated the same. 

Buffett’s “in the short term the market is a voting machine, but in the long term it’s a weighing machine” applies directly here. Some stocks look strong because sentiment is strong. Others look strong because their underlying economics are strong. Over time, these crucial distinctions get weighed. In the near term, they are often ignored entirely. 

Part of the reason why we’ve done well over the years is that we’re playing the weighting game, which often also means playing the waiting game. 

We see profit growth accelerating across the vast majority of what we own, growing at rates well in excess of the general economy, with valuations coming down and rampant pessimism among these names. These are the exact conditions that give the long-term investor confidence that better days are ahead. 

Will that be this month? This quarter? This year? That’s for the voting machine to decide. We think our scales are well calibrated and will be used in due time.

Best regards,

Evan McGoff