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There is a simple secret to all great investing. And I’m going to share it with you.
To be fair, this isn’t really a secret. Lots of investors know it. But considering how few investors consistently put this front and center in their investing, it might as well be a secret.
This isn’t something I just learned. It’s something that I’ve known for a long time but need to be reminded of periodically. That reminder can come through reading — or rereading — good books on investing like The Intelligent Investor, One Up on Wall Street, or The Most Important Thing. It can also come through examining investing mistakes I’ve made, since they typically stem from misusing this element — or not using it at all. Or, my reminder can come as it did this past week, by listening to great investors talk about their process.
The secret is this: Great investing comes from figuring how much a business is worth and paying less than that true worth.
If you’re underwhelmed or annoyed that I’ve highlighted that as the key to all great investing, step back and consider why you’re having that reaction.
Is it because you think great investing is about finding great businesses?
You’re absolutely correct: A great investing approach can focus on finding and buying great businesses. A quality business can deliver large and growing profits over a long period of time and be a boon for an investor.
However, the quality of a business is a major component in determining how much that business is worth. A high-quality business is worth more. But there’s still a value to that business, and as an investor, you still want to pay less than that true worth.
Is it because you don’t consider yourself a value investor?
You don’t have to consider yourself a value investor. In fact, you can call yourself any kind of investor you want. Motley Fool co-founder David Gardner is one of the best investors operating today, and he doesn’t consider himself any particular flavor of investor — in fact, he detests labels like “value” and “growth.”
Yet even the growthiest of growth investors — assuming, of course, that they’re actually good investors — are following the rule I’ve expressed here. They’re simply looking for situations where the true growth potential of a company is underappreciated by the market, and, therefore, the company is worth more than the market’s price tag.
At times, this can be true even when the stock carries a sky-high valuation multiple. For example, it can be hard to swallow the valuation multiples at Amazon.com (FRA: AMZ) , and that’s been true for years. But many investors contend that the massive growth potential of Amazon’s business and its ability to scale back spending and extract profits from the business makes it worth these massive multiples.
Is it because you don’t believe a business can be accurately valued?
Valuing a business means looking into the future and determining the value that business will create. The future is inherently unpredictable. Therefore, it’s impossible to value a business. Right? Not really.
It is true that coming to a single, precise, down-to-a-decimal value for a business is impossible. But that doesn’t mean we can’t have a sense of how much a business is worth.
As is often the case, Warren Buffett has put it well. When asked how he values businesses, he quipped:
You don’t pinpoint things. If somebody walks in this door and they weigh between 300 and 350 pounds, I don’t need to say they weigh 327 to say that they’re fat.
An understanding of what makes businesses tick, some basic knowledge of statistics, and a healthy respect for your own fallibility are among the ingredients that can help you triangulate a rough value or range of values for a business and, using that, determine an attractive price for buying that business.
The real problem with this secret
At the most basic level, though, the real reason many investors either reject this basic investing truism, or just end up ignoring it in their investing, is that it’s just not that exciting.
We all — myself included — like the new. What I’m saying isn’t new or particularly novel. Most of us like things that are exciting. This certainly isn’t exciting. And we find shortcuts and secrets particularly intriguing. But, as I noted, this really isn’t much of a secret, and it’s certainly not a shortcut.
What it is, is something that requires work. Work to understand the business: its operating model, its management, its products, and its potential for the future. And it’s something that requires patience — waiting for the right price isn’t always easy.
Above all, though, it requires the willingness to recognize that a better, easier, sexier way of going about this isn’t coming along. Like any skill that you pursue, getting results in investing require that you diligently apply the basics well over, and over, and over … and over, again.
And for the record, I wrote this because I thought this would be helpful to investors who read it. But I also wrote it so that I would read it. As much as I’d love to be immune to the siren song of the search for the easier, softer way, the search for success always leads me back to this unspectacular “secret.”
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This article was written by Matt Koppenheffer and originally appeared on Fool.com on 9.2.2014.
The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com.