Mark Sellers: Take advantage when good companies come to market

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

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

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The interaction of these two factors causes 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, for instance, saw its stock rise from $85 to $280 in its first year of trading as earnings estimates rose and the p/e ratio expanded.

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There are two fundamental factors all these companies share. First, they have an “economic moat”, or natural defence against competitors, 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 increase in revenue translates into far more than a 10 per cent increase in bottom-line profits. Operating leverage is almost always underestimated by analysts when they are not very familiar with a company.

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When a company with these two traits begins to trade publicly, analysts are too cautious at first. They do not know the company that well, so their estimates are all over the place. Investors can play this to their advantage by buying and holding great companies when they go public, ignoring what pundits or analysts say and betting that analyst estimates will rise and become more clustered, causing the p/e ratio to rise at the same time as earnings expectations.

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Excess investment returns come from buying an asset when the market’s expectations are too low, and selling when expectations are too high. Nowhere are expectations off so much as when a great company first trades publicly.