It is tempting to think of stocks as lottery tickets. Every day the stocks jostle with each other as their prices go up and down. Picking the stocks that will go up seems just like going to the races and picking the winning horse.

Each stock has a ticker symbol, such as AAPL, FB or  MCD (Apple, Facebook, McDonalds). The similarity with lottery tickets strengthens – the ticker symbols are like ticket numbers. Feel like a gamble? Let’s try to pick the winning ticker!

Some traders favour a stock with a price chart that is going up. They assume that the trend will continue. Others are drawn to a stock that has been in decline. It must be due for a turnaround!

If you treat the stock market like a lottery, you may have some fun. But your chances of long-term financial success are pretty close to zero.

The most successful investors have an entirely different outlook.

Peter Lynch sums it up nicely, ‘Invest in companies, not in the stock market’.

Buffett puts it like this, ‘Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business’.

Shelby Davis worked for the New York State insurance department, and as such became intimately involved with the financial details of many insurance companies. It was his knowledge of the business that enabled him to identify undervalued companies and that gave him his edge.

Davis worked this to great advantage using a technique known as the ‘Davis Double Play’. An undervalued business will often trade at a relatively low stock price in the market. For example consider a fictional company ABC that makes $1Million a year. The company trades at 10 times earnings so it has a value of $10Million. (A company’s value on the stock market is referred to as its Market Capitalization – or Market Cap). If the company has 10Million shares, they will trade at a share price of $1 each.

Imagine that the company does well and doubles its earnings to $2Million over the next year. The market sees the company doing well, and more investors pile in, with the result that the company now trades at 20 times earnings. The market cap becomes 20 times $2Million: $40Million – representing $4 per share. So a doubling of earnings results in a quadrupling of the share price. This accelerated return is the ‘Davis Double Play’ – a trick which Davis used extensively. It largely accounts for how he was able to build his wealth so quickly.

All of the great long-term investors have a ‘business first’ approach.

Many of us, if we had the chance, would be quite happy to own a share in a thriving local business – maybe a busy convenience store, hair salon or automotive service centre. If you held a 50% stake in such a business how would you look after your investment?

Perhaps you might check on the accounts every six months. It would be wise to pop in every now and again to make sure that trade was brisk and that the customers were happy.

Would you be constantly checking trade magazines to find out the current resale value of convenience stores, hair salons or service centres?  Not likely. If you did, and you found that you could have purchased your 50% stake slightly cheaper would you be tempted to sell out immediately in case the value of your half of the business declined further? Almost certainly not. As long as the business was doing well and profits were rolling in you would be quite content to remain a part owner for the long-term.

A business with thriving trade, and making good profits, will surely be worth considerably more in a few years’ time, irrespective of any day-to-day fluctuations in market value.

Ownership of a stock in a publicly quoted company is no different in principle than a part ownership in a local business. The only major difference – and it is a significant difference – is that the price of the stock in the public company is published every day for the whole world to see. And the price may fluctuate wildly in response to interest rates, political uncertainty, the performance of the Chinese economy – or any number of other things that are highly unlikely to have any bearing on the long-term performance of the business.

Given access to this information, investors are liable to react emotionally and decide to sell out or trade their stake for another stock, which in turn will have its own gyrations and produce further anguish.

The successful investor learns to tune out this ‘noise’ and is content to focus solely on the performance of the business, holding for the long-term and deciding to sell only if there is a genuine change in the business itself.

This concludes the series of topics on Investing Approach. Next Topic: Analysing Stocks