Own The Business, Not The Stock

By Sham Gad | May 30, 2012 AAA

The biggest mistake an investor commits occurs when he or she forgets that they are actually buying into a business, not a stock. By all accounts, I would guess that around 85% of the individuals who own stocks assume they are investing in companies when they are indeed speculating on stocks.

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A Fundamental Difference

The difference between investing in a business and speculating on a stock is significant and expensive. Facebook (Nasdaq:FB) is a perfect example of what can happen when individuals mistaken investing for speculation. Buying into the Facebook IPO at a roughly $100 billion valuation was a pure gamble on the hope the someone would be in line after you to buy in at a higher price. Even if the IPO had valued the company at $75 billion, owning Facebook was a big gamble at those prices. Despite Facebook's fast growth and future potential, the company's revenue model is still new and untested.

So to pay $100 billion for a business that earns less than $1 billion in profit and the future profit potential is still widely uncertain was act of stock speculation, not business investment. Now FB shares are down over 20% from the IPO price and many investors are screaming mad looking for someone to blame. Several months ago, investors were warned when social buying site Groupon (Nasdaq:GRPN) had a much hyped IPO that has turned out terribly. Shares in Groupon now trade for $11, well below its IPO price of $20. Both Groupon and Facebook now trade at or near their lowest prices and those prices could easily head lower.

SEE: How An IPO Is Valued

A Time Tested Approach

Truly investing in a business via buying the stock requires a lot of conditions that serve to eliminate many investing mistakes. First, when you invest in a good business, you are likely going to hold on to it for many years, as good investments are quite hard to come by. Whether is a blue chip giant like Coca-Cola (NYSE:KO) or a smaller name like AutoZone (NYSE:AZO), these excellent businesses have created magnificent value for investors who were content to hold on to them for years. It's no coincidence that Warren Buffett has held on to his Coke investment for nearly 30 years now and hedge fund wizard Eddie Lampert bought a huge chunk of AutoZone over a decade ago and still retains a sizable interests. These are excellent companies that anyone would be lucky to own outright for decades. Thankfully, owning stock, or a partial interest in the company is the next best thing.

The Bottom Line
Understanding the fundamental difference between owning a business and speculating on a stock is essential to creating long-term investment value or risking making very expensive speculative choices.

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At the time of writing, Sham Gad did not own shares in any of the companies mentioned in this article.
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