Humans are hardwired to love stories. They help us create connections between bits of information, bringing order to the random jumble of daily life.
This hardwiring can be a pro or a con for investors. Stories, after all, have their advantages. Peter Lynch encouraged investors to know the two-minute story for any stock they're thinking about buying. If you can boil down a company's story so that even a child could understand it, Lynch wrote, "then you have a proper grasp of the situation."
But stories can have the exact opposite effect in other cases. Sometimes the story is so good that investors fail to see the big picture. A great story doesn't necessarily make a good investment.
A horror story
One problem with stories is that they end happily -- and investors frequently focus too much on the best-case scenario.
That was one reason why investors looked at Cisco Systems (NASDAQ:CSCO), Nortel Networks (NYSE:NT), and JDSU (NASDAQ:JDSU) in 2000 and decided that these companies were worth hundreds of billions of dollars. The Internet was transforming the world, and these companies were the infrastructure. As the Internet grew, so would the infrastructure. What could go wrong?
In this case, the story was so convincing that investors valued these stocks far above what was reasonable. While the Internet was indeed growing rapidly, so was capacity. In fact, a glut was forming.
We all know how the infrastructure story ended.
Find a romance
There's a simple way to weed out the steak stories from the sizzle stories. For any prospective investment, focus on:
- A company's competitive position.
- Its valuation.
If you find a compelling business story together with a slew of competitive advantages and a reasonable price tag, then you're looking at a promising long-term investment.
Take master investor Warren Buffett and the stocks he buys, for example. Companies such as American Express (NYSE:AXP), Burlington Northern Santa Fe (NYSE:BNI), and Procter & Gamble (NYSE:PG) not only have compelling business stories -- rising credit card penetration rates, the need to ship goods as oil prices rise, and accelerating growth in international markets, respectively -- but also competitive advantages and reasonable valuations.
The Foolish bottom line
By investing in solid values alongside good business stories, you're putting the odds in your favor when it comes to beating the market over the next few decades. Remember: A good story can't get it done alone.
If you're looking for some compelling stories trading at equally compelling valuations, our Inside Value investing service focuses on these types of situations -- and it's beating the market by 8 percentage points since its 2004 inception. You can check out all of our research and current recommendations with a 30-day free trial.
Fool contributor Richard Gibbons' story is one of overwhelming ecstasy, bleak despair, and chocolate-covered croutons. He does not have a position in any of the stocks discussed in this article. The Motley Fool has a disclosure policy.
