Top-Down Approach is a strategic method that aids investors in making informed investment decisions by analysing the broader trends of the underlying asset. This approach emphasises the growth potential of countries, allowing investors to make decisions based on macroeconomic factors. It involves three key steps:
- Economy
- Industry
- Firm
By thoroughly evaluating these levels, an investor can develop a strong conviction to invest in a particular asset.
What is an Economy?
An economy is the system by which a country operates, encompassing the production of goods and services that are bought or sold within the nation. This economic activity generates revenue and contributes to the wealth of the country. The economy is influenced by two major policies:
- Fiscal Policy (Created by the government)
- Monetary Policy (Created by the Central Bank)
Fiscal Policy
Fiscal policy involves the government’s decisions on receipts and expenditures during the financial year to achieve desired objectives. It is a visionary statement outlining the government’s plans for the next 12 months. In India, the government issues a budget annually, detailing expenditures and receipts, which constitutes the fiscal policy.
Components of Fiscal Policy:
- Expenditure:
- Revenue Expenditure (Wasteful): Funds used for societal welfare activities, such as government schemes, free utilities, medical insurance, and emergency situations.
- Capital Creation (Asset Creation): Funds allocated for creating assets, like maintaining and improving services of Indian Railways (IRCTC).
- Receipts:
- Revenue Receipts (Free Income): Income collected from businesses and individuals, primarily through taxes like Goods and Services Tax (GST).
- Sale of an Asset: Income from selling government assets to private entities, such as the sale of Air India Airlines to Tata Group.
Conclusion: For a country to grow, its fiscal policy should prioritize capital creation expenditures and revenue receipts over revenue expenditures and the sale of assets. Financial markets favor governments with higher capital expenditure and revenue receipts.
How Fiscal Policy is Made
Fiscal policy is structured around two main components: expenditures and receipts.
Expenditure
- Revenue Expenditure (Wasteful): These are expenses that the government incurs for the welfare of society, such as:
- Government Schemes
- Free Water and Electricity
- Medical Insurance
- Free Gas
- Tax Rebates
- Emergency Situations like War
- Capital Creation (Asset Creation): These are expenses aimed at creating assets for the country, such as:
- Infrastructure projects
- Maintenance and improvement of services like Indian Railways (IRCTC)
Receipts
- Revenue Receipts (Free Income): This includes income collected from businesses and individuals, mainly in the form of taxes like GST.
- Sale of an Asset: This involves revenue generated from selling government assets to private companies. For example, the sale of Air India Airlines to the Tata Group.
Summary of Terms in Fiscal Policy:
- Expenditure:
- Revenue Expenditure: Wasteful spending on welfare activities.
- Capital Creation: Spending on creating and maintaining assets.
- Receipts:
- Revenue Receipts: Free income primarily from taxes.
- Sale of Assets: Income from selling government properties.
In the fiscal policy, it is crucial to ensure that capital creation and revenue receipts exceed revenue expenditures and asset sales to promote economic growth.
What is Monetary Policy?
Monetary policy is the Central Bank’s tool to influence credit creation, mainly through interest rates, to meet economic objectives. The policy is influenced by:
- Inflation: The rise in prices of goods and services based on demand and supply. Moderate inflation benefits the country by increasing spending power and per capita income.
- Rate of Interest: The percentage decided by the Central Bank for loans to the public and businesses. Significant changes in interest rates can affect the demand for sectors like automobiles and real estate, impacting the country’s financial growth.
What is an Industry? (In context to Top-Down Approach)
An industry is a group of companies operating in the same sector. Major industries in the Indian financial markets include:
- IT
- Energy or Power
- Banks
- FMCG
- Pharma
- Auto
- Auto Ancillaries
- Petrochemical
- Finance
- Metal
- Capital Goods or Engineering
- Telecom
- Cement
- Real Estate
After understanding the economic potential, an investor should study various industries to pick the right asset.
What is a Firm?
A firm is a company listed in the financial market with shares available for buying or selling. After researching the economy and industry, an investor can select a firm by examining its fundamentals, history, and growth potential.
Also Read: What are Futures Markets: A Comprehensive Guide
Conclusion
The Top-Down Approach involves a deep dive into three levels: economy, industry, and firm. By following this approach passionately, an investor can make informed decisions leading to significant wealth accumulation. Remember, stocks can increase in multiples if the right ones are held for the long term. This knowledge transcends traditional books, offering a psychological advantage for creating generational wealth.
Disclaimer: While India shows great investment potential until it reaches a $30 trillion economy, this is not financial advice. Conduct your own research before investing.
FAQs
1. What is the primary focus of the Top-Down Approach? The primary focus of the Top-Down Approach is to evaluate the broader economic trends, industry potential, and firm-specific factors to make informed investment decisions.
2. How does fiscal policy impact investment decisions? Fiscal policy impacts investment decisions by outlining the government’s expenditure and revenue plans. A policy favoring capital creation and revenue receipts can indicate a growing economy, making it favorable for investments.
3. Why is the rate of interest important in monetary policy? The rate of interest affects the cost of borrowing for individuals and businesses. Changes in interest rates can influence demand in sectors like real estate and automobiles, thereby impacting the overall economy.
4. How should an investor choose the right industry? An investor should study the economic potential and growth trends of various industries, considering factors like market demand, technological advancements, and regulatory environment.
5. What factors should be considered when selecting a firm to invest in? When selecting a firm, an investor should consider the company’s fundamentals, historical performance, growth potential, competitive advantage, and management quality.
By following the Top-Down Approach and considering these FAQs, investors can make well-informed decisions to achieve long-term financial growth.