Question

1-What are some advantages and disadvantages of top - down versus bottom - up investing styles?

2- Discuss the advantages and disadvantages of the following forms of managerial compensation in terms of mitigating agency problems , that is , potential conflicts of interest between managers and shareholders .

a . A fixed salary .

b . Stock in the firm .

c . Call options on shares of the firm .

Answer 1

1)Top down investing style focuses on broader picture of the economy while investing.This approach analyse how the macroeconomic factors such as GDP, inflation rate , interest rate, etc. are driving the market and ultimately Stock prices. In top down investing, investor focuses on overall industry or sector and conclude that if the sector is doing well so is the individual stock.

Advantages :

Useful for less experienced investor who do not have in depth understanding of financial statements.

Time Saving as investors are looking at overall economy and industry and not specific stock.

Disadvantage of this approach is investor loose potential to generate return from outperforming stocks during the period of decline.

Bottom Down investing approach focuses on individual stock selection based on PE Ratio , Earnings, Growth, Dividend Yield, etc.This is stock specific approach that focuses on identifying quality stocks based on fundamentals of the company.

Advantages :

Help investor in choosing quality stock that can outperform the market even during the period of decline.

Investors can identify and invest in undervalue stock ( stock which are trading at less then their intrinsic value ) and thus generate potential return.

Disadvantages of this approach is time consuming and not work for less experienced professional.

2) Advantages and disadvantages of following managerial compensation in terms of potential conflict of interest :-

a) A fixed Salary

Advantage is fixed salary is not linked to profit.Disadvantage does not motivate manager to generate more and more business and more profit.

b) Stock in the firm

Advantage is motivate the manager to generate more profit and thus upsurge share price ultimately results into shareholder's prosperity.Interest of manager is aligned with shareholder , thus result in more cash flow generation.Disadvanatge - lower the incentive of manager.

c) Call Options on share of Firm

Advantage is interest aligned with the shareholders.Disadvanatge - Manipulation of financial statement to drive the stock prices upward and to maximize compensation.