Mark Sellers: Why greatness can beat expectations

When Google (GOOG) completed its initial public offering in August 2004, the stock seemed overpriced. Even after reducing its IPO price from $108 to $85, the company’s trailing price/earnings ratio was well over 200. Journalists, analysts and market pundits said Google was the most overpriced IPO in years, and warned investors to avoid it.

Soon after the IPO, analysts picked up coverage but were confused about how to model the company’s earnings. The average analyst estimate for Google’s first quarter as a public company was 56 cents a share but the range of estimates was all over the map. Clearly, there was no “consensus” earnings number. Most analysts were cautious.

When Google reported for the first time as a public company in October 2004, its earnings per share were 70 cents a share and the stock jumped 15 per cent in a day. In the next few weeks, analysts increased their estimates for the next quarter but again were too cautious. In the next quarter, Google beat the average analyst estimate by 15 cents, earning 92 cents a share compared with estimates of 77 cents. In the next quarter after that, Google earned $1.29 compared with the average estimate of 92 cents.

As it turned out, Google’s stock was incredibly cheap at its IPO price of $85. In the year after its IPO, Google’s actual (not estimated) earnings per share were $4.27. This meant it was priced at just 19.9 times its forward earnings on the date of its IPO, although no one knew that at the time.

We can learn something valuable from this historical analysis – great companies are often treated by the market as if they were merely average companies when they first go public. In the first four to six quarters expectations rise as analysts come to understand the company better. At the same time, analysts’ estimates become more clustered around a consensus, which gives investors more certainty about the company’s earnings outlook.

These two factors cause a “double whammy” effect – not only do earnings expectations rise, lowering the forward p/e ratio, but the risk premium priced into the stock falls. In other words, both the earnings outlook and the p/e ratio go up. These two factors work like a slingshot, causing the stock price to rise dramatically. Google shares rose from $85 to $280 in its first year of trading as earnings estimates rose and the p/e ratio expanded.

There are many other examples. The Chicago Mercantile Exchange went public in December 2002 at $42 a share, which was about 18 times trailing earnings per share. That seemed a fair price to many pundits who said the stock was fully valued at that price. But in its first quarter as a public company, the Merc earned 77 cents a share compared with analysts’ estimates of 64 cents. In the next quarter, the company earned $1.03 a share against analysts’ estimates of 93 cents. In this period, analysts grew increasingly bullish and confident in their estimates, and investors responded with a willingness to pay more for a dollar of earnings than they were on the IPO date. The stock price rose more than 700 per cent in the next three years.

Then there is Moody’s Investors Service, which was $13 a share when it was spun off from Dun & Bradstreet in September 2000. In three years, the stock rose 120 per cent as analysts raised estimates and the market became more comfortable with Moody’s business outlook, thus awarding the company a higher p/e ratio. Or Morningstar, which went public in May last year at $18 and rose more than 100 per cent in the next year as analysts’ estimates rose and investors became more comfortable with the business model.

There are two fundamental factors all these companies share. First, they have an “economic moat” allowing them to generate high returns on capital. Second, they have lots of operating leverage (as opposed to financial leverage). In other words, a 10 per cent rise in revenue translates into far more than a 10 per cent increase in bottom-line profits. Analysts usually underestimate operating leverage when they are not familiar with a company.

When a company with these traits begins to trade publicly, analysts are usually too cautious. Investors can play this to their advantage by buying and holding great companies when they go public, ignoring what analysts say. Excess returns come from buying an asset when market expectations are too low and selling when expectations are too high. Never are expectations off so much as when a great company first trades publicly.

My investment fund holds the shares of two companies that are at the beginning of this “increasing expectations” cycle – MasterCard International and Chipotle Mexican Grill. Both are recent IPOs, both crushed analyst expectations in their first quarter as public companies and both have high operating leverage. I expect them to outperform the broader market in the next couple of years.

Mark Sellers, formerly of Morningstar, is a hedge fund manager with Sellers Capital in Chicago.

msellers@sellerscapital.com