One type of competitive advantage is a cost advantage — namely, a company that operates more efficiently than its competitors. The other major category of competitive advantage is a quality advantage. If a product is truly better, or even thought to be superior, consumers will pay more for it.

Finding a company with a competitive advantage is not enough, however. You must also determine that its advantage is sustainable. If the company has a lower cost structure, is there a way that its competitors can catch up? If the company has a superior product, can the product be duplicated?

5. Cash Is King

Once you’ve narrowed your list of possible purchases to those few with competitive advantage, give some thought to what their stocks are worth. For this, your focus should be on cash flow, not on reported earnings.

The earnings that a company reports each quarter are precise — they’re just not terribly accurate. These earnings are determined by accounting rules, some of which don’t reflect reality and others of which get twisted to reflect a false reality.

Reported earnings can be useful to an investor, but what really matters is cash. When you buy a stock, you put up cash. In exchange, for as long as you hold that stock, you own a piece of a company’s future. You have a claim on a stream of future cash earned by that company. The challenge is in making a reasonable estimate of how significant that cash flow will be.

When you analyze financial statements, pay particular attention to the Statement of Cash Flows in a company’s annual filing (known as the 10-K), which reviews results for the prior three years. Look at the “net cash provided by operating activities” and subtract the “capital expenditures” (sometimes called the “expenditures for property, plant and equipment”). This is a company’s free cash flow, which will give you a pretty good idea of a company’s financial success. If nothing else, you want to make certain that the free cash flow has been positive over the past three years.

6. Be Contrarian

The goal is to find stocks that are out of favor. At any given time, stock prices are driven by fear and greed, and both emotions tend to the extreme. When people are most afraid the greatest opportunities make themselves available.

To help identify a potentially good investment, look up a stock quote at a web site, then click on “Analyst Ratings”  to see how many  analysts are recommending that stock.

As a practical matter, look for stocks where the “Strong Buys” are fewer than the “Holds.” These are the stocks that are more likely to be underpriced and more likely to surprise on the upside.

7. Have the Courage of Your Convictions

For most people, this is easier said than done. But as a true investor, you have two advantages. First, by focusing on great companies, you can have confidence when the news is anything but reassuring. You can give these companies the benefit of the doubt.

Second, if you invest a certain amount every quarter or every year (known as dollar cost averaging), you will automatically be buying more shares when stock prices are low and fewer when prices are high.

Decide how much of your savings you want to invest in stocks and how much you are comfortable adding each year.

Will Rogers wasn’t too far off the mark," You should buy good-quality stocks, and hold them. And if they don’t go up, be ready to buy more."