BottomUp Analysis

Proven experts such as Warren Buffett generally favor a bottom-up approach to investment selection. Bottom-up ETF investors conduct extensive research on industries and countries to build value-based opinions. Economic factors do matter, but fundamentals matter more. In fact, a downturn in the stock market may provide bottom-up investors with the safety margin they need to buy an attractive industry ETF.

Fundamental analysis is a dynamic exercise that includes studying earnings growth drivers, product competitiveness, return on equity equations, and dividend yields. An important aspect of fundamental analysis is the growth potential of the industry or a country over the next few years. Ideally, investors want to own ETFs in industries or countries with underappreciated growth prospects.

Here are some points of analysis for bottom-up industry ETF investors:

Sales, Earnings, and Book Value: Current price-to-sales, price-to-earnings, and price-to-book ratios are compared to the average long-term ratios for the industries. Industries to accumulate are trading below historic averages and industries to avoid are trading substantially above their historic averages.

Balance Sheet: Clean or improving corporate balance sheets are a factor in bottom-up industry investing because they show management effectiveness and prudent allocation of capital. Industries with decreasing debt relative to equity are favorable. Companies with increasing debt loads relative to equity should be avoided.

Cash Flow: Strong free cash flow in an industry shows that companies in that industry are able to fund their operations without adding more debt, and leaves room for potential dividend increases in the future.

One method of bottom-up industry analysis involves rankings using a comparison of relative fundamental criteria. Table 19.3 represents an example of bottom-up sector rotation strategy using a scoring system. Each industry receives a score in each category. A score of five means an industry is trading at its normal long-term valuation. A score below five means the industry is trading above its normal valuation and a score above five means the industry is trading below its normal valuation. Industries with the highest total scores are considered attractive, based on bottom-up fundamental analysis.

Investment styles (large/small/growth/value) can also be measured using relative valuation. When a style is trading above its normal valuation, it is thought to be expensive and when it is trading below its normal valuation, it is thought to be inexpensive.

Figure 19.3 illustrates the ratio comparing the price-to-book ratio (P/B) of small cap stocks versus large cap stocks. The valuation of large company stocks became very expensive relative to small company stocks during most of the 1990s. By early 2000, the valuation of large cap was the highest it had ever been relative to small cap. Prices cannot climb to the moon, however. Large cap stocks underperformed small stocks for five years following the peak, and a comparison of P/Bs actually fell below historic norms.

It is very difficult to time the exact tops and bottoms of industries and styles using fundamental analysis. Even though the data are telling you a style or industry is attractive, it may be years before

Table 19.3 ETF Industry Rotation using a Bottom-Up Strategy

Basic Materials

Cyclical

Energy

Financials

Industrials

Real Estate

Services

Technology

Transportation

Utilities

Price to Sales

4

5

3

7

6

2

7

9

7

6

Price to Earnings

3

5

3

6

7

3

8

7

8

4

Price to Book

4

6

4

7

6

4

7

5

5

4

Free Cash Flow

5

6

7

8

5

4

8

7

4

5

Dividend Yield

6

6

5

6

3

4

6

5

5

5

Debt to Equity

5

7

5

4

4

1

9

5

3

6

Return on Equity

5

4

7

5

5

3

8

7

4

5

Total Average Score*

4.6

5.6

4.9

6.1

5.1

3.0

7.6

6.4

5.1

5.0

' Buy highest score, sell lowest score. Source: Portfolio Solutions, LLC

' Buy highest score, sell lowest score. Source: Portfolio Solutions, LLC

Figure 19.3 The Ratio of Russell 1000 P/B to Russell 2000 P/B

Source: PortfoIio SoIutions, LLC

Figure 19.3 The Ratio of Russell 1000 P/B to Russell 2000 P/B

Source: PortfoIio SoIutions, LLC

a reversal takes place. Be prepared to underperform the markets with your portfolio while other people continue to make money in overvalued sectors. Eventually, you will probably be correct in your evaluation. But to make money doing this type of active investing, you have to have conviction and unnerving patience.

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