The Lowdown on Bottom-Up Investing

Professional stock pickers—especially mutual-fund managers—often fall into one of two camps when it comes to investing: "bottom up" or "top down."

You may be able to figure out their meaning by name alone. Bottom-up investing emphasizes individual stock research, as opposed to the top-down strategy, which relies on big-picture analysis—such as the direction of the economy—to guide stock selection.

Notable bottom-up investors include Warren Buffett, who won't invest in a business he can't understand, and Peter Lynch, whose principle is "invest in what you know." Masters of the top-down approach include Ken Heebner and Tom Marsico. (Marsico technically uses a combination of both.)

Recently, I asked Sam Dedio, manager of the Julius Baer U.S. Smallcap fund, why he uses a bottom-up strategy in his $7 million portfolio. (Check out his small-cap stock pick here.)

Says Dedio: "I've always felt that you have an advantage if you can understand a company's product, technology, or the service it provides, and if you understand why anyone would want to buy that product earlier than other investors."

Handbag maker Coach is a good example. "If you had predicted Coach would broaden its demographic appeal and parlay that into sales growth, you would have had an advantage," he says.

What does this mean for investors who like to do their own stock picking? "I think individuals can make decent calls on consumer products if they're on the bell curve of mainstream and can find a product or service that changes behavior—and can recognize pop and fizz stories like Crocs," Dedio says.

Next week, I'll take a closer look at top-down investing from the perspective of an international fund manager who uses the approach to select countries.