If you've heard fund managers talk about how they invest, you know that a lot of them use a "top-down" method. First, they figure out how much of their portfolio to put in stocks and how much in bonds. At this point, they may also decide how much of each type of security they want to buy. Next, they choose which industries to put their money in. After all of these decisions have been made, they start to look at each security. If you give this way of doing things even a moment of thought, you'll see how stupid it is.
The earnings yield of a stock is the P/E ratio turned around. So, a stock with a price-to-earnings ratio of 25 has a 4 percent earnings yield, while a stock with a price-to-earnings ratio of 8 has a 12.5 percent earnings yield. A low P/E stock is like a high-yield bond in this way.
Now, if the earnings of these low P/E stocks were very unstable or if they had a lot of debt, the difference between the yield on long-term bonds and the earnings yield of these stocks might make sense. But many stocks with a low P/E have more stable earnings than those with a high P/E. Some people do use a lot of debt. Still, not too long ago, you could find a stock with an earnings yield of 8–12%, a dividend yield of 3-5%, and no debt, even though bond yields were at their lowest levels in 50 years. This could only happen if investors only looked at bonds when they were shopping for money. This makes about as much sense as shopping for a van without also thinking about a car or truck.
In the end, every investment is a cash-to-cash transaction. As such, they should only be judged by one thing: the value of their future cash flows after they have been discounted. Because of this, investing from the top down makes no sense. If you start your search by choosing the type of security or the industry first, it's like a general manager deciding whether a pitcher is left-handed or right-handed before he looks at each player individually. In both cases, the choice is not just quick, but also wrong. Even if it's true that left-handed pitchers are better, the GM isn't comparing apples and oranges; he's comparing pitchers. Whatever advantage or disadvantage a pitcher's handedness has on its own can be reduced to a single number (e.g., run value). Because of this, a pitcher's handedness is just one of many things to think about and not a hard-and-fast rule. The same can be said about security. It is neither more important nor more logical for an investor to prefer all bonds over all stocks (or all retailers over all banks) than it is for a general manager to prefer all lefties over all righties. You don't have to figure out if stocks or bonds are attractive; you just have to figure out if a certain stock or bond is attractive. In the same way, you don't have to figure out if "the market" is undervalued or overvalued; you just have to figure out if a certain stock is undervalued. If you think it is, buy it no matter what the market says.
Clearly, the smartest way to invest is to look at each security in relation to all the others and only think about the type of security when it affects each evaluation. Investing from the top down is a wasteful way to do things. Some very smart investors have put it on themselves and gotten through it, but you don't have to.
