As you should know if you have been following along on this website, a stock is not a lottery ticket, but a share of a real business.

And every business has a story.

Peter Lynch describes it like this:

‘Getting the story on a company is a lot easier if you understand the basic business. That’s why I’d rather invest in panty hose than in communications satellites, or in hotel chains than in fibre optics. The simpler it is, the better I like it. When somebody says, ‘Any idiot could run this joint,’ that’s a plus as far as I’m concerned, because sooner or later any idiot probably is going to be running it.’

Lynch later equates ‘the story’ to what he calls his ‘two-minute drill’ – a brief explanation as to why this particular stock makes a good investment.

If you cannot put together a brief, simple explanation as to why you should be investing in a company, then you have no real case for investment. Or as Lynch says, ‘Once you are able to tell the story … so that even a child could understand it, then you have a proper grasp of the situation’.

These days, the story is often referred to as the investment thesis.

Some stories offer the promise of great reward. But the rules of risk and reward dictate that these investments will also have a significant potential for failure.

Take the case of two companies. Westport Innovations and Tesla Motors.

Westport designs and makes fuel injector systems that allow engines to run on natural gas instead of diesel. In the early part of 2012, crude oil prices were $111 a barrel and natural gas was trading at less than $2 per Mcf. The practical consequence of this was that the cost of running a truck on natural gas was considerably cheaper than the cost of running on diesel.

The downside was that a truck equipped to use natural gas was significantly more expensive. But as most trucks are used heavily, a truck running on natural gas instead of diesel would achieve a payback in less than 2 years.

With a considerable economic incentive to convert to natural gas, many forecasters were projecting that a large percentage of heavy trucks would convert to natural gas from diesel – resulting in huge growth for Westport. The share price was trading at over $42, with some analysts predicting huge gains.

Truck owners are conservative by nature, and progress in converting to natural gas was slow. The engines Westport supported were not quite the right size. Demand slackened as the market waited for bigger, more efficient engines to become available. Then the price of oil began to fall…

Westport’s bright hopes all but evaporated. The company struggled to limit cash burn and contain costs. In early 2016, the share price had fallen from over $42 to less than $2.

The original investment thesis was sound. But subsequent events conspired to turn a potential multi-bagger investment into a financial catastrophe.

At around the same time Tesla Motors was ramping up production of its new electric car – the Model S.

Earlier electric cars had failed, because it was uneconomic to produce a battery large enough to give the car meaningful range. Tesla’s strategy was to produce a high-end car, competing with expensive BMWs and Mercedes. Because the car was already expensive, the cost of the battery would be less significant in proportion to the overall vehicle.

Tesla’s strategy was extremely risky. How could a company with no experience of designing cars hope to compete with companies like BMW and Mercedes? And on top of that, they would have to convince customers to put up with the inconvenience of a slow-charging battery with limited places to charge. When the price of oil started to fall, many skeptics concluded that Tesla’s prospects were bleak.

But the critics were confounded. Demand for the new Model S was huge. Shares in Tesla traded at around $27 at the beginning of 2012. By the middle of 2015 they reached a high of over $280 – a tenfold increase in just over three years!

Yet, at the outset of 2012, many a thoughtful investor would have given Westport a much greater chance of achieving success than Tesla. The case for Westport was based on simple economics. Tesla needed to convince customers to radically alter their approach to motoring – a much tougher ask.

The lesson here is that however sensible a story might seem, there is no guarantee of the outcome – or at what point another twist might happen. Who knows whether in ten years time Westport will have grown into a huge business and Tesla may have withered on the vine? Unlikely, but not impossible.

In hindsight, you might conclude that Tesla had one great advantage in their favour – their visionary CEO Elon Musk – yet another reminder that the importance of leadership cannot be overstated.

One common thread shared by Tesla and Westport is that neither of them were making money.

The company with the better ‘story’ – Westport – was the company that failed to reach its potential.

Companies that are all ‘story’ with no earnings are fraught with risk. Even the most compelling story can fall apart when unforeseen difficulties arise and funds dwindle.

Warren Buffett is not immune to sometimes making an outside bet on a company with a good story – he invested in a Chinese electric car company for heaven’s sake! But the vast majority of his capital is deployed investing in businesses with solid, growing earnings.

Lynch puts it succinctly, ‘ … it always comes down to earnings and assets. Especially earnings’.

In ‘One up on Wall Street’, Lynch sets out the story behind one of his favourite investments. La Quinta hotels was building hotels without wedding areas, conference rooms, reception areas, kitchens or restaurants. They situated the hotels next to 24-hour restaurants – so that the residents had ready access to food. Sound familiar? There are numerous ‘express’ hotel chains exploiting this concept today, but back in the late ‘70s it was unheard of.

Lynch saw that by doing this they could offer rooms of equivalent quality to ‘The Holiday Inn’, charge 30% less and make a greater return. Furthermore, the company was already showing great earnings and growing like a weed.

This is a fine example of a good story – simple to understand, great earnings, no debt and limited risk.

In the last chapter we looked at the various qualities that a company should possess in order to qualify for investment.

But investing is about the future, and attributes of excellence in themselves hold no guarantee of what lies ahead. There were many stage coach builders, gramophone makers, and floppy disk manufacturers that were all excellent in their day.

We have seen here how all these attributes should be wrapped up in a story. A story that makes sense, is simple to understand, and leads to growing earnings.

This topic concludes our formal introduction to investing. If you are interested in discovering more, such as:

• Understanding Accounts
  • Income Statement
  • Balance Sheet
  • Cash Flow
• Valuation
  • Multiples
  • Discounted Cash Flow
• Risk Management
• Derivatives
• Selling

You can find more detail in Ian Richards’ book, How to Make a Million.

You may also want to check out  the supplementary articles on this site, which deal with a number of interesting topics, and also discussion on individual stocks.

Have fun investing!