Overstock.com (OSTK): Part Six – A Final Analysis

In the final analysis, an investment decision is always about weighing the opportunity against the risk.

The upside to Overstock.com is, frankly speaking, understated. If the company can meet or exceed that $45 million earnings number in the next two years, producing two or three consecutive quarters of surprises for the analysts, I can see its valuation going far in excess of 15x.

This analysis didn’t even touch on the potential for investors to benefit from Patrick Byrne’s legal crusade against certain hedge funds and Wall Street banks. The awards have the potential to be huge and to increase the cash position of the company. Also, what is the upside of Overstock’s investments in its self-described “innovation cycle”? By increasing its technology staff (i.e., operational expense structure) and giving it room to experiment with new concepts, the company is pushing into new areas of the business with little requirement for invested capital (car buying, real estate, vacation deals, etc.). While I wouldn’t lump any of this into the Overstock valuation, any upside becomes a free option.

I’ll confess, there’s a part of me that wants to throw caution to the wind; that wants to abdicate the judgment call to an investing icon like Prem Watsa. Surely he must grasp the risks of Overstock.com better than I and (by virtue of his large investment in it) he obviously still sees more reward than downside.

But it was the risks that kept me awake at night. I did not feel comfortable in my own ability to analyze Overstock’s business risks. I did not feel I could make an informed bet, based on my current knowledge, that Overstock’s business is secure over the next few years. As such, I couldn’t handicap the opportunity.

But again, I welcome the chance to learn more from either other investors or people whose contacts that might have deeper insights into Overstock than I do. The upside potential here is strong, and I’m very open to learning more.

Why write this much about a business I don’t even end up investing in? Excellent question. Because the practice and the process are more valuable than the outcome. And though it can be difficult to sustain concentration on an opportunity once your analysis begins to reject it, we learn as much (if not more) from our decisions of omission.

I wrote at the outset of this analysis that I’m willing to find new ideas from any source, but I’m not willing to let anyone else create my models, do my thinking, or make my final decisions. The practice and process expand my ability to think about valuations, grasp business models, and own the decisions.

I may invest in Overstock in the future. (And perhaps it’s because a reader helps me assess the risks better than I’ve been able to do on my own.) But even if I don’t, this process has made me think hard, made me struggle with priorities, made me extend my insights across industries, and ultimately – I believe – made me a better investor. 

Overstock.com (OSTK): Part Five –The Thinking Part (Competitive Advantage & Risk)

There is something almost self-hypnotizing about running scenarios through highly-tuned valuation spreadsheets. Just a tweak to this variable, a rub on that number, a slight nudge here and hit calculate…

Behold! I have wrought a thing of beauty! It is my child. I am proud of it. It can do no wrong.

It is easy to convince ourselves that these models can accurately distill an entire business – in all its complexity – into a simple sensitivity matrix. This represents all possible variations of the future, we tell our beaming selves, as we put a particularly thick border around the cells containing the middle-option valuation. The middle-option, not too bold and not too conservative, is always the right one.

Yes, we’ve uncovered some impressive ROIC numbers in this business. Yes, we’ve seen how it shouldn’t be too wild an assumption to see earnings grow near or above that $45 million threshold we set. And yes, we’ve supplied this nice, conservative 15x multiple that even a loan underwriter might stamp with his approval.

But now we must step away from our precious model and actually think. We must ask ourselves, are we really considering the right things here? Have we adequately weighed the big risks that face Overstock.com and, by association, our investment? How are we protected?

I wake often in the middle of the night. A two year old daughter is not without culpability. Last night was the norm, and as I attempted to settle back into sleep my brain began mulling through the big risks to Overstock’s business.

I was thinking to myself, the internet sure is a great place to do business. Just consider, you can become a $1 billion retailer without ever opening a storefront. You never fight over real estate in power shopping centers with the most wealthy patrons. You don’t have to hire all those expensive employees. You don’t have that pesky shrinkage problem. Distribution is so much easier. You build a relatively inexpensive ecommerce system. You cobble together a network of suppliers. You run a few Super Bowl ads. And you just watch the money role in.

It sounds so easy, anyone could do it.

Wait! That’s not good. That doesn’t say much for barriers to entry. If anyone could do it for very little invested capital, how defensible is Overstock’s business?  That reminds me of an industry article detailing Amazon.com’s use of fulfillment partners…and Buy.com…and now Sears.com…and (gulp) Wal-Mart.com. They all like the idea of selling merchandise on the web without ever paying for the inventory.

I’m recalling now how Overstock’s business tanked from 2005-2007. Customer demand fell off a cliff because of a disastrous ERP implementation. If the debt and equity markets had not allowed Overstock to raise more cash, it would have been lights out. While that cloud had a nice lining – it did lead management to change the inventory model and significantly reduce capital needs – it still speaks to the tenuous hold the company has on customers. You just don’t get much margin of error…if you don’t execute with precision, shoppers go elsewhere and it’s very, very hard to get them back.

Despite the better expense structure, less invested capital, and a couple years of net earnings, can we really say with confidence that another snafu wouldn’t send customers bolting, revenue falling, and losses mounting?

On top of that, could I really feel any confidence in the valuations scenarios I ran based on the previous two years of operating results? If this is a competitive industry, two years doesn’t tell you much if you don’t have that moat. And as I’m now in a more critical frame of mind, look at those variables…they’re all over the place! The expense structure ranges from 2 to 11% annual growth. The direct business revenue shrunk 13% one year (though it would seem as part of a concerted effort to move investment burden over to their partners for certain categories). And the fulfillment business has a pretty wide range of sales growth that probably can’t be estimated conservatively by averaging out one year of 21% and one year of 10% growth.

I’m wide awake now.

So, what’s the competitive advantage anyway?

Is it Overstock’s relationship with the fulfillment partners? The company depends on them peddling their wares on its site and not going somewhere else. What is Overstock providing that makes them happy? Some thoughts: 1. A marketplace of buyers; 2. $60 million of annual marketing to keep traffic up; 3. IT systems to manage their catalogs, selling, credit cards, performance statistics, etc.; 4. Customer support services so they don’t have to do that part; and 5. Management of all product returns.  There’s a lot of value there, right?

Okay, how could any of the big players start taking that away? Let’s play devil’s advocate and pick on Amazon.com.

For beginners, it could create better terms for the partners. If Amazon offers comparable services and decides to give its outlet partners a bigger piece of the action (hypothetically charging 10% instead of 12% fees on all purchase transactions), that might entice sellers to at least consider jumping ship. And looking at Overstock’s margin needs (i.e., the gross profit they must get from fulfillment partners to cover operating expenses), it doesn’t look as if they could afford a protracted battle with Amazon that depresses gross profits. Amazon, with its $9 billion in cash, has considerable more staying power than Overstock.

Second, Overstock depends heavily on Google search engine optimization and keywords purchases. Management suggests a big chunk of its marketing budget goes there, and Q1 2011 results took a hit when Google put Overstock in its “penalty box” for SEO rule infractions. (Indeed, Patrick Byrne estimated that two months in the penalty box, where Overstock results were excluded from regular Google searches, cost the company 4 to 5% of its quarterly sales. That was the difference between break-even and turning a profit.)

This suggests to me an unhealthy dependence that competitors could exploit. My own experience shows that products sold by Amazon tend to get ranked very high in natural Google searches. And it’s very rare that Amazon products don’t go to the top of the paid search results. The company spends a lot on search words, and it can afford to do it. So, if Amazon puts Overstock in its sights, it begins carrying more of the same products and throws more resources at ensuring those products are search engine optimized and/or at the top of the paid list. Amazon could, without breaking a sweat, outspend Overstock many times over to ensure best Google placement.

Third, if Overstock and Amazon are selling the same or similar products, and Amazon wants to target Overstock to take away market share, the company with deeper pockets has no compunction with starting a price war. I cannot see that Overstock can keep customers without offering an equal or better price.

Now I recognize that this list of risks might just highlight my lack of knowledge about the nature of Overstock’s business. These doubts are, I admit, very likely given my unfamiliarity with the dynamics of the surplus goods market. Perhaps Overstock (for reasons I haven’t been able to imagine in this exercise) has such a dominant position as the buyer/partner of preference among surplus goods sellers that it has a sustainable competitive advantage that Amazon can’t reasonably penetrate. (Overstock’s 19% gross margin on fulfillment partner business suggests it charges its partners higher commissions than either Amazon or the others. That would point to some degree of loyalty from its partners, since they don’t jump ship, which could be a competitive advantage. Up to this point, however, I haven’t been able to confirm this as accurate.)

And perhaps Overstock.com has created such loyalty among its customer base that it wouldn’t fragment even for slightly better pricing. (Q1 2011 numbers show new customers down 15% over the same quarter in 2010, yet revenue was flat, and gross margins were up 6%. It does look like existing customers are repeat buyers.)

But in my research, I was unable to connect with any Overstock fulfillment partners to get a sense of their relationship with the company. Nor do I think the recent customer data is sufficiently long in the tooth to be bankable. (If readers understand the business better than I do, please share your insights! I’m not wed to my risk conclusions here if facts or better interpretations prove me wrong!)

Finally, I fear there are few constraints in the world of internet retailing that prevent a single player from achieving near ubiquity. It truly could be a winner-take-all kind of market. Unlike in traditional retailing where competition plays out in matches of real estate chess, distribution strategies, and the ability to satisfy local preferences, a single internet retailer could dominate by becoming the marketplace of choice for nearly all products and for nearly all buyers. This is especially true if you take away the cost of inventory (a working capital constraint to growth) because fulfillment partners are carrying that burden for you.

It certainly mirrors my own experience as a shopper. Amazon is my default. If I want to buy something, I search for it there. Like most of the country, I’ve been buying from Amazon for 15 or so years. I like the user experience. I’m comfortable with the interface. I trust its security measures. And I’m confident that I’ll get timely delivery of my orders. It would take something very compelling to lure me away.

Charlie Munger, vice chairman of Berkshire Hathaway, notes the competitive strength scale, brand and familiarity can bring to business with the following example:

“If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is 40 cents and the other is 30 cents, am I going to take something I don’t know and put it in my mouth, which is a pretty personal place after all, for a lousy dime?”

If Amazon achieves this status, I don’t want to compete with it unless I have a distinct advantage that protects me in case the giant wakes up and decides he doesn’t want me around anymore. Maybe I’m too small for him to even care – indeed, maybe the giant would just prefer to buy me, brushing off the gadfly in the process – but I’m not sure I’m comfortable putting real money behind that bet.

With Overstock, I’ll confess that I do SUSPECT that an advantage exists. But the ability to confirm that advantage falls too far outside of my circle of competence to turn a suspicion into a conviction.

Overstock.com (OSTK): Part Four – Earnings Based Valuation Exercise

Let’s start at the end. Let’s run through an exercise to see if Overstock’s business is worthy of a valuation high enough to even consider an investment.

Because Overstock is not a blue chip company with the most durable competitive advantages protecting its earnings, I want a minimum doubling of my investment to make the opportunity worth the risk. At roughly $14/share at the time of this writing, that means I must find a clear and conservative path to $28 within the next few years if I’m to part ways with my hard-earned cash.

EPS Multiple

I’ll use net earnings and just try a 15x multiple. Why? It’s well below Overstock’s current 24x and WAY below Amazon’s 70x+. My gut tells me that a growing internet-based retailer with high-ROIC  and earnings growth will find a much more sympathetic Mr. Market than 15x, but I only want to build the model off conservative assumptions. If they don’t work, we’ll take a pass. (Conversely, if we don’t see a reasonable path to growing earnings, we’ll assume the company isn’t worth anything and move on.)

Assuming a steady share count around 24 million, this means Overstock would need to produce $45 million in net earnings, $31 million above its previous high mark last year. ($1.88 earnings per share * 15 multiple = $28.20.)

OSTK Earnings—Take One

It’s tempting to drop straight to the bottom line of Overstock’s financial statement and wince at the 1.3% profit it posted for 2010. $14 million of earnings on almost $1.1 billion in revenue? That doesn’t blow anyone away.

How would that get us to $45 million in earnings? Assuming everything scales proportionally to 2010, revenue would have to grow to $3.5 billion. Forget driving a truck through it… a wild-eyed optimist couldn’t squeeze a pancake through that.   

But as discussed previously, profit margin is not the story of this company. Running a nearly frictionless business where minute amounts of invested capital produces $880 million in fulfillment partner revenue with nearly 20% gross margins plus a slowing expense structure…that’s where the story starts. Let’s go in a little deeper.

Gross Profit & Expense Structure

Does the business produce a defensible gross profit? I like consistency here. It speaks to pricing power (or at least the avoidance of damaging price wars) and the stability of input costs (raw material or, in the case of retailers, merchandise). But most importantly, a consistent gross margin creates a predictable bucket of dollars upon which a company can build its expense structure.

Fluctuating gross margins, on the other hand, make it almost impossible to create rational expenses needed to support the business. Management has to scale expenses to invest in the business when margins are high, only to rein them in hard when margins decline. Earnings bob around as a result, and it makes it very hard to get operations hitting on all cylinders (i.e., you’ll see a lot of restructuring and turnaround initiatives in companies that don’t have dependable gross margins).

I want to see that a company produces enough gross margin to comfortably cover its nut (fixed operating expenses) and have plenty left over for its variable operating expenses. We look at the former first because it’s hard to reduce fixed costs very quickly. In case of the latter, variable costs can usually be cut if you need to pare back.

I go so far as saying that I don’t necessarily care what a company’s gross margin percent is. I want to see the dollar amount covering the expenses. After expenses are paid for, I’m all for selling more product or service at any gross margin percent as long as that doesn’t hurt the franchise, the business’s long-term prospects, or increase expenses. Why? After your expenses are paid for, each additional $1 of gross profit drops straight to the earnings box regardless of whether you sold it at 20% or 1% margin.  Percentages be damned! That’s cold, hard cash.

     

Some businesses will need 70% margin to cover expenses; others maybe only 15%. It depends on the industry, the business model, and the unique needs of the company. As Michael Porter has shown in various studies, the ability to function on a low gross margin can give you a powerful competitive advantage in the form of lowest price (especially when you reach scale and your competitors cannot follow). The $420 billion flowing through Wal-Mart’s bank accounts each year is pretty convincing evidence of taking the concept to the nth degree.

OSTK Earnings – Takes Two Through Four

Now let’s reconsider Overstock’s earnings in light of its gross margin and operating expense structure to see whether we reach an earnings number upon which we can base a decent valuation.

In 2010, Overstock generated a $167 million gross profit from its fulfillment partner business alone. Its total expenses were about $175 million. That leaves an $8 million gap for the company to hit breakeven if fulfillment were a standalone business. As we know, Overstock also sells its own inventory. That piece of business created about $22 million in gross profits and pushed overall net earnings into positive territory near $15 million.

So we don’t value this company based on growing revenues and using the same net profit (1.3%) to find a path to $45 million in earnings. We value it based on keeping expenses in check while growing revenues at a high enough rate to carry more dollars through the gross margins.

From 2008 (when it’s clear that Overstock has made the full transition to the fulfillment partner model and its reduced capital requirements) through 2010, the business went from $10 million loss to $15 million gain. Revenue grew from $834 to $1,090 million (31% increase), and gross profit went from $143 to $190 million (33% increase, but staying nearly flat as a margin at about 17% of overall sales). Expenses grew from $154 to $175 million (14% increase). 

If we play with those variables to create a variety of growth scenarios, we can generate the following possibilities for Overstock’s compounded growth for the next two years:

Scenario One:  We assume the business compounds for the two years 2011 through 2012 at the same pace it grew in 2010. (Gross margin is the average of 2008 through 2010 for each scenario.)

	Annual Growth Rate	New Revenue #	Gross Margin	Results
Fulfill. Business	21%	$1.29B	19%	$245M
Direct Business	39%	$405M	12%	$49M
Total Expenses	11%			($215M)
EARNINGS				$79M

Divided by 24 million shares, that is $3.29 EPS. At 15x, that creates a value of $49.38 per share. That’s a 250% premium to Overstock’s current trading price.

Admittedly, it’s also pretty rosy to take the results of the company’s best ever year for earnings and assume the future will look the same. Let’s try tamping it down a little…

Scenario Two: Here we assume that the business will compound at the two year averages of 2008 through 2010.

	Annual Growth Rate	New Revenue #	Gross Margin	Results
Fulfill. Business	16%	$1.18B	19%	$225M
Direct Business	13%	$268M	12%	$32M
Total Expenses	7%			($200M)
EARNINGS				$57M

Divided by 24 million shares, that is $2.38 EPS. At 15x, that creates a value of $35.70 per share. That’s a 155% premium to Overstock’s current trading price.

And here’s one more look…

Scenario Three:  This is a repeat of the 2008 to 2009 growth rates compounding for 2011 and 2012.

	Annual Growth Rate	New Revenue #	Gross Margin	Results
Fulfill. Business	10%	$1.07B	19%	$202M
Direct Business	-13%	$159M	12%	$19M
Total Expenses	2%			($181M)
EARNINGS				$40M

This creates to most conservative growth rates for the business lines (even shrinking the direct business rather dramatically). Of course, management did an excellent job that year holding expenses in check.

Divided by 24 million shares, that is $1.67 EPS. At 15x, that creates a value of $25.05 per share. That’s a 79% premium to Overstock’s current trading price.

Even at the worst of the two year performance scenarios, Overstock looks pretty enticing. It’s not quite the $45M earnings we said we needed, but if this is truly conservative thinking I wouldn’t disregard the opportunity.

So, we’ve thumbnailed some rough valuations by making a stab at normalizing earnings. Next, we need to consider what sort of competitive advantages Overstock has in place to give us confidence in these projections. 

Overstock.com (OSTK): Part Three – Business Synopsis

Finally, back to Overstock.com…

Overstock charged out of its IPO gate by stringing together three years of 100%+ revenue growth. It went from $40 million in revenue in 2001 to nearly $500 million in 2004. It was plowing every penny back into growth, issuing additional shares and taking on debt to fund inventory expansion, warehouse space, marketing spend, additional personnel, etc.

These were heady times.

Management’s stated goal was to operate right at the break-even point, but they were ambitious and when decisions about growth faced off against decisions of tighter expense management, growth won.

The company went on a technology investment tear in 2005, adding over $70 million to overhead expense on software, IT projects, and supporting personnel. They were building the infrastructure, CEO Patrick Byrne said, to support a $2 billion business.

At that point, Overstock was nearer to the traditional model of retailing than it is today:  it bought goods, put them in warehouse inventory, and shipped them out as they sold.  More demand from shoppers meant plowing back more cash into working capital (to buy the inventory and pay for the personnel to manage it) and into capital expenditures (expanding warehouses and IT systems).

Total invested capital at the end of 2005 was $164 million. Most of that sat in inventory; much of the remainder was fixed assets like an expanded warehouse to house the growing inventory.

Then the growth just stopped. 2005 still looked good with 63% higher sales, but they were expecting to be closer to a billion. Losses started mounting. The technology projects were implementation disasters, hitting in the worst time possible for a retailer…holiday buying season. They couldn’t handle the transaction levels and they couldn’t replenish their warehouses and get stock back up on the website.

On that $164 million of invested capital, Overstock produced a net loss of about $25 million. ROIC? Negative 15 percent.  But even if they managed to produce a $14M profit as in fiscal year 2010, on that capital base the ROIC would still be a paltry 8.5% (acceptable for some industries, but not this one).

More to the point, they burned through over $50 million in cash and things weren’t looking good going into 2006 where revenue would shrink for the first time and gross margins would drop as they tried to get rid of bad inventory from 2005 (i.e., they had to sell it cheap to get people to buy the stock in the warehouse).

The survival of the business was at stake, and Overstock went into overdrive to revamp its business model. It did all the traditional dirty work to cut expenses, but the real transition came from reconfiguring its relationships with suppliers. Rather than acquiring inventory from them, paying them on 30 day terms, selling the goods in about 60 days, and financing the difference with its own cash, Overstock asked them to become fulfillment partners.

What does that mean? These partners would continue selling through Overstock, but they would retain the inventory (and the costs/risks of owning it) until a purchase was made. Overstock would get the credit card payment, the partner would ship the product to the buyer in a nice-looking red “O” box, Overstock would handle any customer service issues, and then Overstock would issue a payment to the partner minus a “commission.” Fulfillment grew to become over 80% of company revenue.

Overstock now gets a payment from customers before it has to pay its suppliers. Inventory dropped from a peak of $100 million at the end of 2005 to a 2010 average of less than $30 million. It has produced two consecutive years of net income. It has built over $100 million of cash reserves. It has very little debt.

Patrick Byrne, the CEO, makes strong suggestions in earnings calls that Overstock’s market value is disconnected from his view of its intrinsic value. He is bullish about the company and, since bringing it to profitability, has begun increasing the expense structure to invest in what he calls Overstock’s “innovation cycle.”

There is little question that the change in capital investment needs has been impressive. No doubt, the Overstock management has done a remarkable job bringing the company back from teetering on the edge. Should we share his enthusiasm? Does Overstock.com represent a strong value investment opportunity?

Return on Invested Capital: Part Three – Competition & Competitive Advantage

In capitalism, competition is unrelenting. I don’t intend that as a generic statement of economic theory. It is a reality of an ecosystem in which entrepreneurs naturally gravitate to open niches, seeking to exploit profit opportunities, and in which established competitors attempt to suffocate upstarts that threaten their market share.

While unrelenting, competition is never perfectly efficient. Profit opportunities will always exist (and at times the window can be quite large), but as the opportunity becomes more publicized and better understood, strong competitors move in, the rules of the particular market become established, and a sort of homeostasis sets in. The profit potential either decreases (e.g., price wars deflate margins and force out the less efficient players) or certain actors establish competitive advantages that protect their market share and rates of profit.

It is truly Darwinian, and it is the environment in which a high-ROIC business must compete and try to continue producing the earnings that made it such a high-ROIC company to begin with.

So, the investor must ask himself: how sustainable is this company’s earnings? I find that companies popping up on my high-ROIC radar tend to have one of the following three characteristics:

Characteristic One: Durable Competitive Advantage

This is the gold standard. When you find a business with an ability to grow earnings at a high rate of ROIC, while simultaneously fending off the competition, you have a bona fide compounding machine. And if the price is right, back in the truck and load up.

Here is a shortlist of competitive advantages (ideally, the company has multiple combinations of these): strong brand equity, high product quality, pricing efficiency, corporate culture, customer loyalty, network dominance, control of distribution channels, patent rights, etc…these are all examples of very identifiable moats behind which businesses can make it exceedingly difficult for competitors to steal market share.

It is rare, however, to find such high quality businesses on sale. But it does happen from time to time when either the company has a fixable slip-up that causes earnings to fall temporarily, or the market fails to understand some part of the company’s business and punishes the stock price, or the larger market is subject to panic selling and equities take a hit irrespective of their quality.

Sir John Templeton loved to buy in the last of those circumstances. The time to buy, he was known to say, is when there is blood in the streets. He would research companies, identify the price at which they would be a compelling value, and place standing orders with his broker to make a purchase if the stock ever hit that point. He put it on cruise control. Sublime!

While I think an investor could build an impressive portfolio over time by waiting for these opportunities, the following sorts of high-ROIC companies can offer better returns and offer it more quickly…but not without challenges.

Characteristic Two:  Good-But-Not-Great Advantage

The measure here is whether there is sufficient advantage to keep the bigger dogs at bay long enough to string together multiple periods of increasing earnings on a low base of capital. If it can hold out long enough, the markets will get excited by the business performance, and its price will rise.

Let’s be clear, these are not Berkshire-Hathaway businesses.

For a business to enter Warren Buffett’s circle of competence, he must believe he understands what the economics of the business will look like a generation or more into the future. I won’t take umbrage with Buffett’s philosophy (who can?), but I understand that he has an image to protect: Berkshire as the retirement home for all the best cash-generating businesses.  Active trading would not help this image. And so while he almost always buys at great values, he often sticks with stocks that he knows are astronomically overpriced. (See KO in early 1998.)

The rest of the value investing world has slightly lower standards (and considerably less new cash flowing in each year that we must put to work in some way, shape, or form). While I don’t recommend short-term trading, our time horizons can be considerably shorter than “forever.”

When assessing a high-ROIC company, I want to feel confident that I understand its competitive position (or, to be more precise, its ability to generate a certain level of earnings) over the next few years. And I want to feel confident even after making excessively conservative estimates about the company’s future.

Make no mistakes, this is tricky and can involve a tremendous amount of work. You must consider the company’s ability to increase its revenue, manage its cost of sales, control its expense structure, hold-off competitors, protect its capital, and make shareholder friendly decisions.  

To invest in these sorts of opportunities, I want to see a reasonable (better yet, conservative) path to a minimum 15% compounding returns, and I want to produce a strong argument that the downside potential is limited. I see plenty of businesses that look exciting when you play with their earnings potential, fantasizing about the possibility of high multiples and excellent investment returns. But for the vast, vast majority, it’s too hard to see their competitive advantage. So I bail out. I’ll trade plenty of upside potential to protect against downside risk that I can’t understand or handicap.

I’ve borrowed no small part of the philosophy from Joel Greenblatt. I mention that as segue to the following (known to be one of his favorite investment warnings):

“Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

Characteristic Three: Flash in the Pan

Plenty of companies can show up on high-ROIC screens that are flashes in the pan. They will show the ROIC but it’s an illusion brought on by unsustainable, one-time earnings growth or by a temporary reduction in costs or expenses or by a change in their capital structure.

Either way, you should catch these by looking at multi-year ROIC records and by digging deeper with your analysis to understand what the company’s true competitive advantages are.

Last thoughts on ROIC before returning to Overstock.com:

To paraphrase Joseph Heller, just because you’re paranoid doesn’t mean you shouldn’t be. Be assured that other companies will gun for the low-investment, high-return opportunity your idea represents. Those competitive pressures are unrelenting without some sort of moat. If you don’t understand how your company can protect its earnings for at least a few years, just turn around and walk away.