Breaking Down the Overstock Discount

This column was originally published on RealMoney on March 20 at 11:02 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

It doesn't require a lot of effort to follow the crowd when investing in the stock market. You don't have to think independently. You don't have to ask a lot of questions. You don't have to carefully consider and evaluate data.

It's particularly easy to follow the crowd when negativity is involved. The easy path is to accept negativity at face value. The difficult path is to sort through the criticism and compare it to relevant data in an effort to distinguish fact from fiction.

As I said in my column on Overstock(OSTK) last week, despite an "avalanche of negativity," this is a severely undervalued stock. The criticism directed at Overstock revolves around three issues: earnings, liquidity and management.

In this first installment of a two-part column, I begin a detailed look at these issues.

'Overstock Is Losing Millions'

My review of the Overstock operating model and competitive moat indicates that this oft-repeated criticism is misleading. Earnings are a minor variable in the value equation at this juncture in the company's history. Market share is the critical variable. That's because this company is on the cusp of capturing a winner-take-all retail category.

The excess inventory category is similar to the online auction category. The No. 1 player in this category, once they become entrenched, is set up to dominate for a very long time. In online auctions, it's eBay(EBAY). In excess inventory, it's Overstock.

Traditional bricks-and-mortar retailers engage in a competitive battle from town to town, from one community to the next. A traditional retailer like Borders(BGP) may grab a competitive advantage (e.g., the best location) in one town, while Barnes & Noble(BKS) may gain the upper hand in the next town.

In the case of eBay and Overstock, though, there aren't hundreds of competitive skirmishes spread across the country. There is only one battlefield, in just one town -- the online community. It's sobering to consider the stakes in a winner-take-all online contest. You either win the No. 1 position early in the game, or you're destined for oblivion.

Consider some of the names that jostled for position in the early days in the excess inventory space. Some of these companies had access to much more capital than Overstock, but now they're just "also rans": Ubid, eCost, Smartbargains, Buy.com, Mercata, Andy's Garage and MobShop.