Investing Club: Here's how to combine top-down and bottom-up views when picking stocks

Published Fri, Mar 4 20224:04 PM ESTUpdated Thu, Mar 24 20229:46 AM EDT

The major stock benchmarks closed lower for the week as the Russian invasion of Ukraine intensified and overshadowed solid earnings and strong jobs reports. With earnings season now largely in the rearview mirror and geopolitical tensions front and center, it's important to take a moment and discuss the concepts of top-down and bottom-up analysis — something we touched on briefly Thursday evening in our Marvell Technology (MRVL) earnings analysis. Top-down analysis As the name implies, top-down analysis starts by analyzing the big picture and working your way down. Think about taking a world view — something members know we believe every investor must do — that incorporates everything from geopolitical events to monetary and fiscal policy and macroeconomic data points. From there one might ask what this world view means for various sectors of the economy: Is it boom times with rising rates that require you to own more economically sensitive sectors like energy, financials and industrials? Or are we slowing, possibly heading into a recession that requires a more defensive posture with a focus on sectors like consumer staples and healthcare? By the same token, this bigger picture thinking may dictate whether you can own high flying stocks based on price-to-earnings or price-to-sales, or if a much stricter adherence to valuation is warranted. One step deeper and we can focus on which industries inside of those favorable sectors may deserve the most focus . For example, within the energy sector we have the oil, gas, the consumable fuels industry (think Devon Energy ) and we have the equipment and services energy (think Haliburton ). Members who saw our monthly call know that we were looking to gauge Devon Energy's appetite for production growth to help decide if we wanted in on Haliburton. But Devon's strict adherence to discipline caused us to pass on Haliburton, at least for now because Devon's cash flow is coming to us, the shareholders, rather than Haliburton to increase production capacity. The industrials offers another great example of how a top-down analysis may work. This sector has many industries to choose from including the airlines, aerospace & defense, railroads, construction, machinery and more. With the crisis in Ukraine intensifying, the airline industry has taken a beating. Take a look at the U.S. Global Jets ETF , down 10% over the past month. Who wants to travel to Europe when Russia is attacking a nuclear facility? Meanwhile, iShares U.S. Aerospace & Defense ETF , which represents aerospace & defense, rose 7% over the same period. Bottom-up analysis Bottom-up analysis works in the opposite direction. Here the focus is on the individual companies and the valuations placed on their stocks. From this angle, we attempt to incorporates a focus on business fundamentals, quality of management and competitive moats. We do this a number of ways, including tracking corporate filings, investor events, research reports and of course, studying quarterly earnings releases. By combining the top-down view with the bottom-up view, the hope is to identify "great houses, in great neighborhoods." Or to put it another way, the best run companies in the industries and sectors that benefit the most from the broader macroeconomic operating environment. Of course, sometimes you find yourself loving the individual company due to the bottom-up analysis but in a hard-hit sector. You can't just rush in to the stock and pay whatever the market is asking for at the time. After all, a great house in a bad neighborhood rarely offers a promising risk-reward profile. This is the case we found ourselves in following Marvell's earnings release as the report left us with even more conviction that we are sitting on a long-term winner. We even noted that given the secular growth end markets it is exposed to and the company's growth rate, the stock's valuation was more than justified given peer valuations. However, we concluded that none of that mattered, not at the moment, not in this market where the world view, characterized by inflation, energy shortages and fears that a wrong move could spark World War III, has investors demanding energy, utilities and defense stocks along with the safety offered by healthcare and to some extent the staples. So, what do we do when posed with this dynamic? When the bottoms-up view says to buy but the top-down says to avoid? Well, patience is a virtue and that's exactly what we do, we remain patient and wait for the broader macroeconomic and geopolitical environment to become more favorable and for those that want out of stocks no matter how good the companies they represent are doing dry up. And if you think the prices being thrown at you are simply too good to ignore, as we do every now and then when we decide to step into the market when it is looking especially ugly, you do it with "wide scales" by making sure that every buy counts. By "wide scales" we mean spacing out the buys a little more than you normally would (if you usually by every 3% to 5% down, you might now target every 7% to 10% lower before adding) and by "counts" we mean that you want to make sure that you aren't repeatedly buying at the same level (a trap easy to get sucked into in a choppy market such as this) and that each buy is helping you reduce your overall cost basis. Sure, you may not catch the bottom – nobody ever does without a good deal of luck – but in this environment, protecting your downside is exceedingly more important than trying to capture every single tick to the upside. (Jim Cramer's Charitable Trust is long DVN, HAL, MRVL. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

A trader works on the floor of the New York Stock Exchange.

NYSE