This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Why invest in stocks at all? That seems like a pretty reasonable place to start for those thinking about equity investing.
Of course the easy answer to that is "making money." And in most cases, it'd more specifically be "making more money." After all, we could all just invest in Treasuries and hope that the fixed return will be enough to allow you to retire someday (cough, unlikely, cough).
Over the next several weeks, my fellow Fools will illuminate various investing strategies that can help you find your way to making more money. But before we get to that, I'm going to cover two very basic realities of investing that will help with pretty much any specific investing strategy you choose.
Before we begin: The semantics of investing
The word "investing" gets thrown around an awful lot, and it makes sense to make sure we're on the same page when we use that word.
Merriam-Webster defines "invest" as simply "to commit (money) in order to earn a financial return." That's a fine definition, but I'm going to be a bit more specific, particularly when it comes to time frame. When discussing the stock market, I use the word "invest" when I'm talking about committing money to an investment over a significant period of time -- rarely less than a year and generally three years or longer. Conversely, when someone is buying a stock with the expectation to sell it in a matter of months, days, or even minutes, I usually opt for the word "trading" over "investing."
This may seem nitpicky, but it will increasingly make sense as you learn more about investing. Investing luminary and Warren Buffett's guru, Benjamin Graham, liked to say that "in the short run, the market is a voting machine, but in the long run it is a weighing machine." That is, over short time frames, investors' emotions can push around stock prices in ways that make no sense, but over longer stretches, stock prices move in ways that are more logical. For that reason, we like to stick to the long run.
Now, without further ado, on to the good stuff.
Behind the paper curtain: Investing in a business
The first thing you need to remember when investing is that you're investing in a business. Sure, what you're actually buying is a slip of paper (or an electronic book entry as the case may be), but what that slip represents is an ownership stake in the company in question.
Publicly traded companies come in all shapes and sizes, so an illustration may be helpful here.
Ford (NYSE: F ) is a relatively easy one. The company sells Ford and Lincoln brand automobiles in the U.S. and around the world and has a financing arm that lends money to its customers. Not surprisingly, Ford makes money by selling lots of cars and trucks. Since late 2009, Ford has been doing this quite well, but investors need to be familiar with the underlying business to understand how the bottom line will change in the future.
Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) is a well-known company largely because of its CEO, Warren Buffett. From a business perspective, it's a little more complicated because it's actually a huge collection of operating businesses -- from GEICO insurance to RC Willey Home Furnishings and See's Candies. So to understand how Berkshire Hathaway makes money, you have to dig in and understand all of the businesses that comprise the conglomerate. The bright side of that setup is that when an industry like housing may hamper some companies (Benjamin Moore and Acme Brick, for instance) others (like electronic components distributor TTI, shoemaker H.H. Brown, and food and beverage distributor McLane) can pick up the slack.
Moving from the tangible to the somewhat less tangible, Annaly Capital (NYSE: NLY ) is a real estate investment trust that invests in mortgage bonds. Unlike Ford or many of Berkshire's businesses, it's highly unlikely that you'll run into Annaly outside of the stock market setting. This company makes its money by collecting the difference (aka "spread") between the interest rate on the mortgage bonds it buys and the interest rate on the money that it borrows to buy them. That business model has worked fantastically in our low and falling interest rate environment, but an investor in Annaly better have a good understanding of interest rates and how they move over time.
The tie that binds all three of these companies is that they're all reasonably large, publicly traded companies that you can quickly and easily buy shares of with a click of the mouse. However, as you can see, the businesses that you're buying into with those shares are very different.
So the first thing to always remember when investing is that if you're going to buy a stock, you better understand the business behind that stock.
How much is that doggie in the window: Price versus value
Now that we know that a stock is a business, and not just a slip of paper, we can start to talk about the difference between price and value.
Going back to Graham again, in his 2008 letter to Berkshire shareholders, Buffett quoted Graham as saying, "Price is what you pay; value is what you get." For any given stock you look up, you'll find that the market has a price tag attached to it. All that represents is the most recent price at which a buyer and seller were able to agree to make an exchange.
As we discussed above, there's a difference between the piece of paper that gets traded and the company that the paper represents. Similarly, there's a difference between the price that the paper sells for and what the underlying company is worth. No matter what type of company you're looking at -- a large conglomerate, a high-growth tech company, or a biopharma start-up -- there's a value, or range of values, that we can work out for the company.
In some cases, buyers and sellers may have a good, rational view on what a company is worth and the price will accurately reflect the value. At other times though, the market may be overly optimistic or pessimistic about a company -- or simply be going crazy broadly -- and stick a price tag on the stock that makes no rational sense.
The gold standard for investing is having a sense for the value of a company and only buying shares of that company when the current market price is below the company's value.
Dare to be different
What I've reviewed above are basic principles that have been behind the success of many of the very best investors. Unfortunately, they're often not the principles that you'll hear, see, and read in much of today's market coverage. In a 24-hour world where there's intense competition for reader and viewer eyeballs, it pays for the media to focus on daily or hourly time frames.
The frantic, do-or-die immediacy of much of the stock market coverage can seem exciting, but to create a solid foundation for your investing, your best bet is to shut off all of that noise and focus on the basics outlined above. You could call it wise, sage, or enlightened investing, but we like to simply think of it as Foolish.
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.