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Think of top down investing as a “big picture” strategy.  The big picture is the global market and all it encompasses.  If you think of the global market as a forest, if it looks green and healthy, you enter the forest looking for the healthiest trees.  When you find a grove of healthy trees, you look for the best-looking tree in the grove.

That’s a simplistic description of a complex strategy.  In reality, the top down investing approach often involves using multiple investing strategies.  To see how you can make Top Down Investing work for you, let’s begin by listing the formal steps in the process:

1.    Evaluate global market conditions, trends, and extraordinary events.

2.    Identify strongest or weakest sectors based on the global condition.

3.    Analyze and identify the strongest or weakest shares within the sector.

4.    Analyze the best time to begin investing, spacing your purchases.

Global Market Conditions

Perhaps you have read somewhere you begin Top Down Investing by studying macroeconomic conditions – an academic term for the big picture.  Think of yourself not as an amateur economist sorting through facts and figures, but as an amateur sleuth; a Sherlock Holmes scouring for clues, most notably signs of anything out of the ordinary.

If China reports an unexpected spike in inflation, that’s a macroeconomic condition with significant implications for world share markets.

If the unemployment rate in the United States drops more than expected, that is a macroeconomic condition as would be a default of one of the Euro Zone countries.

Other macroeconomic conditions used in Top Down Investing include interest and exchange rates, GDP (Growth Domestic Product) growth rates, and energy and commodity prices.

Note that the macroeconomic clues that pop up can be positive or negative in nature.  Even a negative condition can yield sound share market investment opportunities. 

A case in point is the recent flooding in Australia’s principal coal-producing region – a macroeconomic event that will go far beyond affecting commodity prices.

Identify Strongest/Weakest Sectors

Here is where the amateur sleuth quality to this investing strategy comes into play.  It doesn’t take a professional share market analyst to predict that the share price of Australian coal producers will go down while shares of the best coal producers in the rest of the world will go up.  Indeed, shares of United States and Chinese coal producers started to go up within minutes of the realization of the stgastating impact of the flood.

While some investors would see Australian companies like coal producers BHP and RIO, and coal transporters like QRN as shares to avoid, other investors see opportunity.  There is a market timing strategy called bottom feeding that looks for shares of companies whose share price has fallen due to conditions having nothing to do with the company itself.  BHP and RIO didn’t cause the flooding and their share prices have already begun to recover.  Investors bold enough to have bought on the dip following the flood have been rewarded.

The obvious sectors affected by this macroeconomic event are the mineral and transportation stocks.  Perceptive investors, however, noticed other possibilities here.  The destruction wrought by the flooding will be repaired.  Who will benefit from the recovery?

Recovery sectors include construction, basic materials, and home improvement.  Bridges, homes, streets, and other infrastructure components will need repair.  The amateur sleuth can sniff out another sector that could see a positive bump – home hardware and furnishings.  Once the damage is repaired, consumers will be looking to replace the possessions lost in the flood. 

Identify the Strongest/Weakest Shares within the Sectors

Here is a point where differing approaches to analyzing shares come into play.  Most investors will use fundamental analysis to study the soundness of each individual company’s operating efficiency.  Some will look at the price movements of the shares as well as price fluctuations within the market through technical analysis.  Some will use a little of both.  But everyone begins at the same place – with a list of potential shares to analyze.

So here is a list of eight shares from the sectors that might benefit from the flood recovery process:

•    BLD  (Boral Limited) – a manufacturer of cement and cement products

•    ABC  (Adelaide Brighton) – a lime producer and concrete and masonry products.

•    CSR  ( CSR Limited) – a building products company.

•    JHX  (James Hardie Industries) – a manufacturer of fibrous cement products

•    WOW  (Woolworths Limited) -home hardware/consumer electronics retailer.

•    WES  (Wesfarmers Ltd) – a hardware/home improvement retailer.

•    JBH  (JB Hi Fi) – a consumer electronics retailer.

•    HVN  (Harvey Norman Holdings) – a consumer electronics, appliances, home furnishings  retailer.

How do we sort through theses shares to find attractive buys?  We’ll start with one component of the fundamental analysis investing strategy – quantitative analysis.  This approach uses ratio analysis to look at the current and future health of the company.  Some proponents of technical analysis – the study of price movements – see ratio analysis as little more than “mindless number crunching.”

While ratio analysis does “crunch numbers” reported in a company’s financial statements, it is hardly mindless.  Making sense of the numbers requires comparison – against the company’s own past performance, against its direct competitors, and against other companies in its sector.

There are a host of ratios investors can use to analyze individual shares, including liquidity and debt ratios, profitability and operating performance ratios, cash flow ratios, and the category favored above all others – valuation ratios.

The table below shows three key valuation ratios, used by many investors to make their share purchase decisions:

 Stock code Price to Earnings Ratio Price to Book Ratio Price/Earnings to Growth Ratio
 BLD 28.8 1.16 0.17
 ABC 14.06 2.41 1.31
 CSR 13.83 1.44 10
 JHX 35.52 -21.37 0.38
 WES 20.61 1.61 0.71
 WOW 15.76 4.42 1.63
 JBH 16.23 7.09 1.02
 HVN 12.37 1.58 6.95

Next week we will review how to make the most of these ratios and their comparisons.  A few investors swoon over low P/E ratios and buy on that basis alone.  There’s more to ratio analysis than finding shares with low P/E ratios, as we will see next week.