According to the AFR, a lot of the interest and buying of Guzman was from retail investors -specifically, Gen Z investors. This is following the Peter Lynch philosophy of buying shares in companies you know.

When trying to figure out a business and the competitive forces in a particular industry it is a lot easier to explore products and services that you use. It allows you to think about what are the factors that cause you to buy a particular brand over a competitor and to think about the competitive advantages that might be at play for a company. 

However, using a product or service does not necessarily maketh a good investment.

The episode goes through a simple framework that investors can use to evaluate a share, and whether it may make a good investment. We use Guzman y Gomez GYG as an example.

Listen on:

For a deeper analysis, you can find a summary of our pre-IPO report.

You are able to find the transcript of the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark Lamonica: Okay. So, we have an announcement, Shani, but I think you should make the announcement. It's not really our announcement.

Jayamanne: No. Well, Google Podcasts is closing. So, we have quite a lot of subscribers on Google Podcasts. So, if you do subscribe to us via Google Podcasts, if you could find us on another platform so you can keep following and listening to each episode each week, that would be awesome.

Lamonica: Yeah, and there's actually a rumor that because we get so many listens that Google had to shut down their podcast app.

Jayamanne: We were taking too much bandwidth.

Lamonica: Yeah, they didn't want to invest all this money in new servers. And I did check Google has $108 billion in cash on their balance sheet right now, but even that is not enough to deal with the traffic from Investing Compass.

Jayamanne: Well, there you go. We have one more announcement, which is about Spotify. So, all very admin related. We have quite a lot of people leaving comments for us and asking questions on Spotify, but we're not able to reply. So, if you do have a question about the podcast and not just a comment, you can find Mark's email in the episode notes. So, you can email us there and we'll respond to you.

Lamonica: Okay. So, those are all our announcements, right?

Jayamanne: Yes.

Lamonica: All right. Nothing else to do. So, Shani just got back from her trip. So, I think we talked about this on our previous episode. So, Shani was in Europe for a month. You were in Italy and Greece and I'm not going to ask you about the trip because…

Jayamanne: It's depressing.

Lamonica: Yes, I don't think it was a depressing trip. Just depressing for us who are still here.

Jayamanne: Yes.

Lamonica: But while you were eating all of this amazing Italian food on your trip and I guess a little bit of Greek food – not that you were avoiding it, you were just in Greece less. At any point, did you think back to your favorite thing to eat in Sydney, which of course for people who know Shani, is Guzman's nacho fries?

Jayamanne: I wouldn't say it's my favorite thing to eat in Sydney. I mean, the thing is, before you leave, I was thinking I'm in Italy. I could never get sick of pizza and pasta, but of course I got sick of pizza and pasta and I really, really wanted a curry. So, I walked across a motorway in Verona to go to an Indian restaurant and get some dal. So…

Lamonica: Well, there you go. Sampling the local cuisine.

Jayamanne: Yes. I did also think about Guzman nacho fries because it is a tradition that – it's the first thing I eat when I land back in Sydney, but I landed at 5 am, so it wasn't to be.

Lamonica: Okay. In the AFR actually – and we're of course doing this episode on Guzman. This is why we are talking about Guzman – but the AFR sent their food critic to Guzman.

Jayamanne: Yeah, we were just talking about that. So, what was her verdict?

Lamonica: Yeah. I mean, I think she sort of wrote what her editors wanted her to write. So, she bashed the quesadilla. She said the burritos just tasted like rice and beans and Will agreed with that beforehand and says he does not order the burrito there. And she really liked the frozen margarita. So, she gave it a 6 out of 10. And then she spent all this time as sort of the fine dining critic would kind of waxing poetically about eating tacos served off the back of a motorcycle in Mexico City.

Jayamanne: I feel like it's really unfair to send a fine dining critic to a fast-food Mexican restaurant, if you can call it Mexican.

Lamonica: I mean, I agree, but this Guzman IPO was a big deal. So obviously, they brought out everyone. So, Guzman is obviously not fine dining. And I will say it's not even really Mexican food, which we alluded to with your nacho fries. That is not actually a thing that you find in Mexico. But yeah, I don't know. I like Guzman. I think not being Mexican is good. Maybe Trump will let it into the U.S. because that's a big part of their expansion plans. But yeah, we'll see what happens. Well, we'll talk about what we think is going to happen today.

Jayamanne: I think the podcast would be much better if we just talked about food. But we have mentioned Guzman because the topic today is the recent IPO. And everyone has been very excited about the IPO, which isn't unsurprising since this is one of the rare companies that goes public that is not only well known, but also a company a meaningful number of Aussies have been customers of. So, since I missed the IPO, why don't you give a 30-second summary of it, Mark?

Lamonica: Okay. Well, the first thing to say is that – and we'll talk about this today – our analysts issued a pre-IPO report. And in that report, they set a fair value of $15 a share. So that was below the IPO price of $22 a share. And during the first day of trading, the shares went up to $30. So, double what we think it's worth.

Jayamanne: And according to the AFR, a lot of the interest in buying of Guzman was from retail investors and specifically Gen Z investors. And as we mentioned earlier, this might be following the Peter Lynch philosophy of buying shares in companies you know.

Lamonica: Yeah. And I certainly agree with that philosophy from Peter Lynch, who was a famous fund manager at Fidelity. When trying to figure out a business and the competitive forces in a particular industry, it's a lot easier to explore products and services that you use. It allows you to think about what are the factors that cause you to buy a particular brand over a competitor and to think about the competitive advantages that might be at play for a company.

Jayamanne: I agree as well, but we both think that this needs to be more than a simplistic linear argument that you like the food, so the shares must be a great investment. Today, we're going to dive a bit into Guzman, but do it in a little bit of a different way than we normally do a share deep dive. This stemmed from an email Mark got on the IPO day. So, why don't you tell us about that, Mark?

Lamonica: Okay. So, four hours, literally four hours after the market opened.

Jayamanne: I did see this email.

Lamonica: Yeah. On the day of the IPO, I got an email and the email said that our valuation was wrong because the shares had jumped so much. So today, we're going to talk about how any investor can do a back-of-the-envelope exploration of a share to see if the price it is trading at is in any way reasonable. So, we'll sprinkle on some views from our analyst report, but really, this is just a commonsense check on a share price.

Jayamanne: There are two underlying frameworks we're going to use during this episode. The first is related to short-term moves like the jump in Guzman's share price versus long-term potential for a share. And everyone needs to remember that investing is the opposite of life. I'm reasonably certain what I'll do tomorrow. Anything could happen, but chances are tomorrow will mostly go as planned. I have less of an idea what I'll be doing on tomorrow's date one year from now. I have no clue what I'll be doing on the same date in 10 years.

Lamonica: And when we turn to investing, the opposite is true. I have no idea what any share I own will do tomorrow. Any number of factors could influence how a share performs on a given day. Most of those factors have nothing to do with the company that I partially own. Some of those factors has nothing at all to do with the share market. The explanations of why the market or a particular share went up or down in a single day is just a guess. We can't know what motivated each buyer and seller. Over the long term, what will impact share prices is how a company performs. Simple as that.

It's not easy to predict how a company will perform over the long term, but it is impossible to know what will happen with a share price tomorrow. So, I choose, and I think all of you should choose, to focus on how a company will perform over the long term because it's better to spend your time on something challenging than something impossible. And this is why the approach that I think we both take in our portfolio and Morningstar takes is just common sense.

Jayamanne: So, we're going to focus on Guzman over the long term. We're also going to focus on the three places that returns come from – changes in valuation levels, earnings growth and dividends. We can eliminate dividends for Guzman. With ambitious growth plans, it's unlikely Guzman will pay a dividend any time soon. So instead, we're going to focus on valuation levels and earnings growth.

Lamonica: Okay. So, our analysts in that pre-IPO report that we mentioned, they expect Guzman to earn $0.03 a share in 2024. Shares are currently trading at around $30 a share. So that is a price to earnings ratio of approximately 1,000. So obviously, this is off the charts, but it's not completely unreasonable for an IPO. More than 83% of IPOs are unprofitable according to research by University of Florida professor Jay Ritter. So, I guess at least Guzman is profitable, Shani.

Jayamanne: What matters for an IPO like Guzman is earnings growth. And Guzman has ambitious growth plans to expand from 183 stores in Australia to over 1,000. Our pre-IPO report states our belief that Guzman can open 40 new stores a year. So, this is a plan that would take over 20 years to accomplish. This assumes that Guzman can find enough areas where a profitable store can open.

Lamonica: And the earnings growth, of course, is important because Guzman will not be trading at 1,000 times earnings forever. And this doesn't necessarily spell doom for the company. If earnings grow faster than the drop in valuation, the share price will still rise. We can calculate the amount of earnings growth needed to counteract the inevitable fall in valuation.

Jayamanne: And we can look at earnings growth in relation to an inevitable drop in the valuation level. To get to a price to earnings in line with McDonald's current ratio of 21 in a decade would require earnings to grow to $1.43. That would require earnings growth of 54% annually over a decade. If you think a P/E ratio of 21 is too low, how about 50? That is roughly in line with Domino's current valuation. That would require earnings to rise to $0.60 in a decade. Earnings would have to grow 39% a year. This is similar to the earnings growth forecast by our analyst Johannes and Lochlan in their pre-IPO report. This is plausible.

Lamonica: The problem is that in both the McDonald's and Domino's scenarios, we've assumed the shares are still trading at $30 in a decade and that's not an ideal situation for investors.

Jayamanne: If we assume 8% annual returns, Guzman's share price would be roughly $60 in a decade. In that case, earnings growth would have to be higher. The McDonald's scenario of 21 times earnings would require 66% annual growth in earnings. The Domino's scenario of 50 times earnings means 51% annual earnings growth.

Lamonica: And when considering that level of earnings growth, it is important to consider what type of business Guzman is in. This isn't a scalable tech company where the same software can be sold to more and more customers. Growing earnings means opening new locations. This takes time and it takes money.

Jayamanne: We can once again do some back-of-the-envelope math. To earn an 8% annual return and trade at 50 times earnings means growing earnings from $0.03 a share to $1.20 in a decade. Earnings would have to be 40 times higher than they are now. With 183 current stores on a store-by-store basis, this would mean 7,320 Guzman locations in a decade.

Lamonica: But of course, we do need to assume that Guzman will increase margins and more of each burrito sold will flow to the bottom line as the company grows. In our pre-IPO report, Johannes and Lochlan assumed margins would more than double. If margins double, that means 3,660 stores. If margins triple, it is 2,440 stores.

Jayamanne: And the math just doesn't add up. To get to an 8% annual return from a share price of $30 requires 51% annual earnings growth with a tripling of margins. It means opening somewhere around 225 more stores each year for a decade. Given Guzman's own projections, 1,257 of those stores will have to be overseas. Our analysts think they can open 40 stores a year. They would have to be very wrong.

Lamonica: And opening stores will cost money. Johannes and Lochlan estimate that approximately 40% of Guzman stores will be corporate-owned, as opposed to franchisees. In that scenario, we just mapped out it would mean that Guzman would need a little more than $2 billion to open just under 1,000 corporate stores. Company took in about $200 million for expansion from the IPO, and that money needs to come from somewhere.

Jayamanne: And all of this to match an 8% return that historically has been achievable with an index fund.

Lamonica: So, nothing that we did today should be confused with the rigorous analysis of the company. We didn't forecast revenue and earnings. We didn't put any thought into how many stores could be opened and the drivers of demand and profitability. We did not arrive at an estimate of the fair value for Guzman. We didn't even put too much thought into what valuation level the company should trade at, other than comparing it to peers. All we did was use the work done by Johannes and Lochlan to sense check if a $30 price is reasonable for the shares. And I think to me, I don't know about you, Shani, it just isn't.

Jayamanne: And the lesson for investors is that over the short term, hype may rule markets. Over the long term, commonsense has a way of imposing itself on that hype. We don't know what Guzman's future holds but think carefully if the shares should be included in your portfolio at this price.

Lamonica: All right. Well, thank you very much for listening to our many announcements and our back-of-the-envelope review of Guzman. Have any questions? As Shani said earlier, my email address is in the show notes. And of course, you can also give us a rating and a comment in your podcast app. Thank you very much.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)