The Only 2 Things That Matter in Investing

The financial world is full of strategies and opinions. Some experts can analyze a company and point out several compelling reasons to buy, while others can look at the same set of data and reach the exact opposite conclusion.

For the novice investor, listening to all these opinions at once can be confusing. But it doesn't have to be. There are only two factors that matter in investing: The quality of the company and the price you are paying.

Really, it's that easy ...
Even better, all stocks can fit into one of the following four categories:

1. Weak company, expensive price
2. Strong company, expensive price
3. Weak company, cheap price
4. Strong company, cheap price

Granted, these are broad categories. But before you get bogged down in analytical minutiae, take a minute to determine in which category a prospective investment might fall. By doing so, you'll have a better idea of what to look for in your research.

You paid how much?
It goes without saying that we should quickly rule out anything that is even borderline "Weak company, expensive price," while scouring the market for those select few stocks that fall squarely in the "Strong company, cheap price" category.

The decision-making process for the other types of stocks is much less cut-and-dried. Things might work out, they might not -- and you shouldn't always take that chance.

Remember that all investment decisions can be boiled down to our assessment of just two factors: the strength of the company and the price of its shares. Unfortunately, many investors spend too much time dissecting a firm's fundamentals and far too little on its valuation. As this chart shows, even strong companies can lead to disastrous returns if you pay too much:

Skimming through this chart, you probably noticed two things:

• Few would quibble if I called any of the six companies here the "right" place to have put your money 10 years ago. All have been among the best performers in their industries over that span.
• There has also been a decidedly "wrong" time to invest in any of these stocks, with steep calendar-year losses ranging from 14% at Starbucks to 47% at American Eagle Outfitters.

The rise and fall and rise of American Eagle
To illustrate this core investing principle, let's take a closer look at American Eagle Outfitters, a highly successful mall-based apparel retailer. Over the past decade, income soared from a net loss to more than $300 million on sales that expanded from $340 million to $2.4 billion. That growth has translated into tremendous rewards for shareholders. Since August 1996, the stock has surged from a split-adjusted $1.49 per share to yesterday's close of $36.51.

However, those who bought the stock at the end of 2001 lost nearly half of their money over the next 12 months. Some of the decline can be pinned on the brutal bear market that ravaged many stocks that year. However, at least some of the problems were company-specific, considering that the average stock in the clothing industry actually finished the year with a modest gain.

Looking back, we can see that just before the pullback, the stock was trading at a price-to-cash flow ratio of nearly 19 -- one of the highest multiples of the past decade and 50% more than the S&P's 12. Now, I'm not suggesting that excessive valuation in itself precipitated the decline -- the 6% drop in same-store sales that year might have had something to do with it -- but it certainly exacerbated the selloff.

The Foolish bottom line
Most investors are on an ongoing quest to find great companies with great prospects. Call these the next American Eagle Outfitters.

But even if you discover the next great growth story, if the stock is overpriced, then the best move might be to run in the other direction -- at least until the risk/reward profile becomes more favorable.

Of course, I'd be remiss not to mention that folks who bought shares of American Eagle at the end of 2001 are in the black today. In fact, they've seen a 184% gain. But consider if they'd waited until the price was right. American Eagle's gain since its 2002 lows is more than 500%.

So if you're ready to get started buying strong companies at cheap prices, join Motley Fool Inside Value free for 30 days. Philip Durell's team spends considerable time in search of fundamentally sound companies that have been sharply underpriced by the market. Click here to take a peek at the stocks that have made the cut.

Fool contributor Nathan Slaughter does not own shares of any company mentioned. Starbucks, Shuffle Master, and American Eagle are Stock Advisor recommendations. The Fool has a disclosure policy.