Be Wary of Top-Down Investing

Investors often ask me a question that follows this pattern: “I think X industry is going to be very big in the future, so I want to invest in Y stock. What do you think?”

The X industry is usually something like biotech or green energy or perhaps biotech using green energy. In any event, this thought process towards investing is a mistake. First, X industry may in fact turn out to be a big winner in the future, but that doesn’t mean Y will follow. .

Embryonic industries are notoriously difficult sectors to invest in. There’s a great deal of innovation, prices are plunging and anyone not in first is quickly left behind.

A century ago, if you thought automobiles were the wave of the future, you would have been correct. But, as Wikipedia notes, “there were over 1,800 automobile manufacturers in the United States from 1896 to 1930. Very few survived and only a few new ones were started after that period.” Think on that.

The problem with top-down investing is that it misses that point that profits can be found anywhere. Profits are made wherever a good or service intersects with a need. It’s just that simple; there’s no magic formula. The trick isn’t finding that special industry. Rather, it’s finding that special stock.

Consider the stock of Donaldson ($DCI). What does Donaldson do? I’ll let Hoovers explain:

Grime fighter Donaldson is cleaning up the industrial world. The company makes filtration systems designed to remove contaminants from air and liquids. Donaldson’s engine products business makes air intake and exhaust systems, liquid-filtration systems, and replacement parts; products are sold to manufacturers of construction, mining, and transportation equipment, as well as parts distributors and fleet operators. The company’s industrial products include dust, fume, and mist collectors and air filtration systems used in industrial gas turbines, computer disk drives, and manufacturers’ clean rooms. Founded in 1915, Donaldson now operates in 43 countries worldwide and has 39 manufacturing plants.

My apologies to anyone in the filtration biz but I have to confess that it sounds rather dull. Now imagine that it’s 1989 and you’re trying to think of companies that would be the “wave of the future.” I doubt filtration systems would have been at the top of your list. Yet, Donaldson’s stock is up 50-fold since then and that doesn’t include a dividend that’s risen every year since 1996.

The reason Donaldson has done well is that it’s a very good company. But you only could have known that through analysis that’s bottom-up. For the most part, don’t worry so much about the industry. First, find a very good company.

Posted by on January 8th, 2013 at 12:28 pm

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