Saturday, March 01, 2008

Mark Sellers: Great Franchises Often Undervalued At IPO

Fund manager Mark Sellers had a great column in the Financial Times a few days ago that discussed the opportunities for investors to buy great businesses at attractive IPO prices given the market's inability to see a company's ability to ramp up performance through operating leverage and maintaining an economic moat.

Sellers talks about several examples of IPOs that have turned into homeruns including Google, Mastercard, the CME, Chipotle, and Morningstar.

In each case "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."

Seller's Two Main Characteristics of Great IPO Candidates:

"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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