PaulD

To really twist the knife on value investing and our focus on price...what about companies that show very low returns on capital because they're sinking all available cash into growth, leaning into investments in capital and expenses (marketing, personnel, R&D, etc.). It's hard to normalize their earnings to get a sense for how profitable they could be if they slowed down their growth. But when these unprofitable companies (and therefore low ROIC and negative P/E) have a competitive advantage that protects them from competitors while they grow, they can be some of the most exciting opportunities.

I like these businesses too. The idea of low investment to continue growth. It reminds me of the reason Moodys was once one of the greatest businesses to invest in. It could grow and grow without having to plowback much money to achieve that. It could pay everything out while expanding its operations and earnings. But I have a hard time understanding the competitive advantages these low-investment businesses possess. It's obviously there. They're huge and profitable. I'm curious how you might describe their competitive advantage?

There was a great quote from Tom Secunda, co-founder of Bloomberg, regarding their development of the NEXT platform. By way of background, Bloomberg has absolutely been eating Thomson Reuters lunch of financial data and information. In the past several years, Bloomberg has jumped from 25 to 31% market share since 2005 while TRI has dropped from 37 to 31%. The quote: "Our business model is that we keep our price fixed but we dramatically increase the value of our product." I wish Bloomberg were publicly traded. There is lots of growth in financial services and it's growing aggressively into the media part of the business. The advantage provided by the near-addiction to its terminals is incredible. TRI has been killing itself trying to displace them with its Eikon toolset. Add to that a mindset where its willing to charge the same price to its customer while investing heavily to improve the products? That's a fanatical approach to business. Hard to compete with that mindset. It's so much more difficult for public companies to do this. Because it's hard to show the consistent profit growth Wall Street demands while investing hard in your offerings. So...big market to grow into + competitive advantage + profitable economics + delighting customers with product, service and stable price = FRANCHISE.

I'm curious to get the board's take on a thought exercise I've been working through these past few days. I think it could make for an interesting discussion. Imagine that you get to own the five companies whose characteristics most fan the flames of your capitalist desires. You will own each for ten years. This will take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...you get the idea. So, suspend your disbelief and let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise...what five companies would you pick? My thought is that in eliminating price as the main consideration you force your mind to focus on those variables that drive earnings growth. Namely... 1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth; 2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price); While putting the following control in place: 3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.) So, is anyone game? What five companies would you pick? Why do you think they could compound at a high rate? I issued the same challenge on my blog, adjacentprogression.blogspot.com as a thought challenge to value investors. I look forward to a spirited discussion.

I've followed the board discussions on OSTK for a few weeks and just finished diving into the business myself. What I'm finding intrigues me, and I'm eager to get the forum's input. Please humor me this mini-analysis and let me know if you have any insights into the questions of Overstock's competitive advantage (or lack thereof) at the end. I'll confess I'm pretty much in love with the economics of its fulfillment partner business. Nearly 80% of revenues come at no cost to the company. Fulfillment partners own and manage the inventory and ship orders in the company's nice "O.co" boxes. Overstock keeps up the website, pays $60M/year for marketing, collects the cash, and takes their roughly 20-25% piece of the action before reimbursing the suppliers. It's almost entirely frictionless, and the pre-tax ROIC is 48% on what should be deflated earnings numbers. In 2010 OSTK did $880M revenue this way, producing $167M in gross margin dollars. That covered all but about $8M of its operational expenses. (Its much smaller and less profitable "direct" business brought in another $23M in gross profit and pushed the company over the line for about $14M net earnings.) The fulfillment business has grown from $660M to $880M in two years while remaining steady at about 19% gross margins. If this sort of growth can continue, it's no stretch to see Overstock post some impressive earnings numbers in the next 1-2 years. Conservatively, I see them passing $40M net earnings, and it's not hard to imagine that number being closer to $80M. At a 24M share count, they don't need a crazy EPS multiple to see the price take off. If... If this happens, I think it's is all done on the back of the fulfillment business. Ignore the lawsuits, the auction business, the cars, real estate, vacations, etc. At best, they're free options if the fulfillment business succeeds. If... My "if" is ...if the fulfillment partner business is sustainable. The big boys of internet retailing also like the idea of hanging onto their capital and letting partners pony up for inventory costs. (See this article if you're interested: http://ak.buy.com/buy_assets/marketplace/IR_Mag_Sep_2010.pdf.) So, if they start gunning for the opportunity, does Overstock have any moat to offer protection over the next few years? First, it would seem that Overstock's relationship with the fulfillment suppliers is absolutely key. Why do they stay loyal to Overstock? It seems as if it would be very easy to bolt to, say, Amazon and sell on its outlet site. The fact that they don't could be critical. I estimate that Overstock charges its suppliers 20-25% commissions. Amazon claims to charge only 12-15% for most merchandise categories. To Overstock's credit, that mark-up is akin to holding pricing power. Any insights into why this might exist? Second, are there dynamics unique to the surplus/overstock business that would prevent suppliers from selling through Amazon, Buy.com, etc.? At the very least, would they not want to hedge bets by selling on multiple sites? I confess I know very little about those industry dynamics. Finally (and related to the second question), if Amazon really decided to chase down Overstock, why couldn't it just offer the same merchandise selection, promote it more heavily, and price it to match or barely beat Overstock? There seems to be an element of the sleeping giant at play here. If Overstock's growing success wakens Amazon, can the giant dig into its $26B chest of cash and obliterate Overstock at will? There are reasons Fairfax is in this. There are reasons Sanjeev likes this business. The upside is obviously exciting, but I have a hard time seeing either of them buy into an exciting story without having a strong sense of protection from the downside. Any insights into what that downside protection might be?