Smart Investors Know This One Thing Before Buying a Stock

The Motley Fool recommends owning stocks for the long haul. But in order to do so, you must be able to find the best businesses that are out there. This is easier said than done, of course, because the future is uncertain and the competitive landscape is constantly changing.

However, there is one thing you can do to stack the odds in your favor before you decide to buy a stock. And it will certainly help you to become a better investor over time. I'm talking about seeking out companies with competitive advantages.

Here's why this is so important to your investing success.

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What makes a company special?

Warren Buffett, the Chairman and CEO of Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B), calls it an economic moat. He looks for companies that possess some kind of attractive characteristic that allows them to outperform rivals while at the same time discouraging new upstarts from entering the industry. This moat also helps to protect a company's profitability, which is always under constant threat by other businesses trying to steal market share.

It boils down to one basic, fundamental question: what makes this company special?

There are four main types of competitive advantage. Benefiting from intangible assets, such as strong brand recognition, patents, or technological know-how, is one. Another is high switching costs, a situation where customers are locked into using a specific company's product or service because changing providers would be disruptive or time-consuming.

A third competitive advantage is known as the "network effect." This occurs when the addition of another user increases the value to all other users of a product or service. This is arguably the most powerful competitive advantage because once a business reaches a certain point, it's like a virtuous cycle that is extremely difficult to stop. Lastly is size. Larger and more experienced companies benefit from scale and process advantages, which allow them to sell products or services at lower cost thanks to efficiencies built up over time.

It's worth pointing out that some of the best companies have multiple competitive advantages, thus strengthening their ability to fend off rivals and increase their chances of long-term success.

Some excellent examples

You can see that a competitive advantage takes on many different forms. As you start to develop and use this mental framework, it'll help you separate the great businesses from the mediocre ones. Here are two apt examples.

Etsy (NASDAQ: ETSY), the booming e-commerce marketplace for unique and handcrafted goods, benefits from network effects. As of June 30, the platform had 5.2 million active sellers and 90.5 million active buyers transacting on the site. As Etsy attracts more sellers, it becomes more valuable to buyers who want a wide selection of items ranging from beauty products and apparel to home decor and collectibles. And as more buyers join, sellers seeking a huge potential customer base will want to do business on Etsy's platform. You can easily understand how this positive feedback loop can lead to rapid growth. It's no wonder Etsy's stock has skyrocketed 1,270% over the past five years.

As the world's largest home-improvement chain with sales of $41.1 billion in the last quarter alone, Home Depot (NYSE: HD) has the kind of massive scale that supports its competitive position. An incredible 90% of the U.S. population is located within 10 miles of one of the company's approximately 2,000 U.S. stores. In an industry where professional contractors need tools and supplies as quickly as possible to complete urgent renovation projects, this strategically located physical network is absolutely critical. Home Depot's operating margin expanded substantially from 8.6% in fiscal 2010 to 15.6% in fiscal 2020, a clear indication of the scale efficiency that's been achieved.

Beating the stock market is hard. But you can increase your chances of outperformance by identifying businesses that possess valuable competitive advantages. This will also eliminate the subpar companies from your watchlist, something that's extremely vital to investing success.

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Neil Patel owns shares of Berkshire Hathaway (B shares) and Etsy. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares), Etsy, and Home Depot. The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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