I wanted to learn how to breakdance, so when I was 14 I paid a kid $15 to teach me how.
I paid him out of my hard-earned newspaper route money.
I saw him in the street, spinning on a piece of linoleum. He had three friends with him, all of them were good at their own particular style of breakdancing.
One kid was good at doing the backspins, windmills, and headspins.
Another kid was good at doing all the above floor stuff: like popping, etc.
Another kid was good at waving. Like his body was made out of rubber.
I had recently lost a contact lens and was afraid to tell my parents they needed to spring for a new pair.
So for the entire summer, way back in the mid ’80s, I practiced breakdancing every day and I could only see out of one eye. Maybe the best summer of my life. Certainly the most embarrassing when I now think back on it.
In every spare moment I either hung out with my new friends, having no issues abandoning my other friends who weren’t cool enough to understand the finer subtleties of the windmill, or I practiced in front of a mirror.
It’s even embarrassing writing these words down…
All this brings me to investing.
I invested my hard-earned money into this group of kids ($15 to 14 year old me was a lot of money), hoping for a return.
It may not be the first rule of investing, but it might be the most important.
Always pay the “right” price.
Of all of the variables that investors face when deciding what stocks to buy — industry growth, potential competition, company leadership, historical performance, etc. — the only one that we can actually control is the price we pay.
Think about it…
When you make an investment in a company, you’re making a compromise between what the company is actually worth and what the market thinks it’s worth.
That’s the price you pay for each share.
Sometimes this works to our advantage, and a stock is priced below what its fundamentals are worth. That’s a bargain.
But sometimes the flip side is true, and a stock ends up overvalued based on any number of things, usually future growth expectations.
Amazon is a good example here, with its 300+ price-to-earnings ratio (P/E) and minimal profits trading at $697 per share. That P/E means that investors are effectively paying more than $300 for every $1 Amazon earns.
If you think a stock is worth $50 a share and the market has it priced at $100, either your math is wrong and the company is worth more than you think it is, or the stock is overpriced (it’s usually the latter, don’t feel bad).
Investors who buy overpriced stocks shouldn’t be surprised to see lackluster performance from them. There just isn’t as much room for upside when a stock is already overpriced.
Buy valuable stocks when they’re on sale, and you’ll always do well.
This is exactly the approach that Warren Buffett takes when he looks at potential investments.
“We have no master plan… we don’t sit around and talk about the future of industries,” he told a group of investors at Berkshire Hathaway’s annual shareholders meeting. “We have no reports or staff. We just review what comes in and look for companies with a durable competitive advantage at an attractive price… The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.”
Where is the “right” price?
It depends on the company, and it depends on what you as an investor view as its long-term potential.
When I paid $15 to that group of kids, I looked at my long-term potential of being able to impress girls. I thought that by learning how to spin on my back and do other random contortions with my body I would, of course, meet girls in clubs.
You don’t even need to go big to make money in the stock market. If imitating the investment results of the greatest investor in history — Buffett — is what you want to do, you don’t even need to pay a bargain price.
A fair price will get you there.
You don’t need to buy an endless string of bargains to get rich, you just need to know what the companies you’re buying are really worth and then pay no more than that.
Most people don’t do this.
They look at price charts and try to predict the stock’s price one year away, or one month, or one week.
It’s totally unnecessary. Prices go up and down every day, but the underlying value doesn’t change.
Study a company long enough and you’ll start to see the trends.
You’ll learn how the market values it based on its fundamentals, you’ll see what the usual price is, and you’ll be able to spot when it is “on sale.”
Oh, and when the time is right, you buy. And you win.
So was my investment all those years ago worth it?
I may not have met hundreds of girls in clubs or won a dance off…
But if you threw out a piece of linoleum and wanted me to spin on my back, I can still do it, although when I do it in front of my kids they laugh at me.
It was a great investment.
Editor’s note: James recently gave a talk about his recent investment in a California startup. You can watch it here.