Motley Fool’s “Peter Lynch-Style Super Investment”

By Travis Johnson, Stock Gumshoe, January 29, 2008

Ah, another one from the Motley Fool! Like mother’s milk, it nourishes the Gumshoe so to pore through a ponderous Fool tome in search of clues to great stocks.

Today, we’re blessed with a teaser letter for the Hidden Gems newsletter, with the letter coming from Bill Mann, who runs that newsletter in partnership with Fool brother Tom Gardner (Bill Mann also does the Global Gains newsletter, so we’ve run across him a few times before).

And the teaser this time is based on the glory to be had by following the Peter Lynch style of investing, the strategy that led Lynch to incredible market-beating returns when he was helming Fidelity Magellan (a fund that has stunk ever since he left, pretty much, but remains among the largest funds in the country — and recently re-opened with a promising new manager).

Essentially, the Lynch style of investing has been distilled over the years to mean, “buy what you know” — he famously picked La Quinta inns after staying at several of them, Taco Bell after eating there, and he followed the shopping decisions of his wife to choose some other winners. He also popularized the PEG ratio (stock price divided by earnings per share divided by growth rate — any number under 1 is possibly a bargain), but what he’s really remembered for (not that he’s dead — he’s not) is the notion that ordinary people can use their personal expertise and consumer experience to find companies that might be extraordinary investments.

Lynch seems to be something of a God to the Motley Fool folks, up there with Warren Buffett in a relatively small pantheon, so it’s no surprise that he gets a lot of mention in their newsletter ads and in the free content on their website — not that there’s anything wrong with Lynch or Buffett, of course, the Gumshoe will stipulate the he likes ’em both just fine, too.

But we had a point here, no? Ah, yes, the next great Peter Lynch-style investment!

Hidden Gems is a small cap service, by which they generally mean companies with market caps under $2 billion when they first recommend them. They are also value-focused, though they take growth into account. They look for lots of things, including insider ownership, depressed share prices, spinoffs, unknown companies, and dividends in making their recommendations. They try to avoid fads, high-PE speculative stocks, and value traps. As do we all.

And to be fair, Hidden Gems has had great performance — at one point last year they had the best 12-month record of all the newsletters Hulbert follows, and they have significantly beaten the S&P over the life of the newsletter (I know this because, unlike most newsletter publishers, the Fool actually publishes performance figures and tells you how it arrived at them). They also have a lot of subscribers, so each new pick of theirs definitely brings a pop in the stock price, at least temporarily. Given the market cap of this one, I expect it’s been in their portfolio for a while and is probably not a new recommendation.

In their words, “The small straightforward businesses will become the stock legends of tomorrow ….”

Thankfully, our friends at the Fool are generous with their clues — as one might expect when they have to fill 10 pages in a teaser ad. I’ll pull out a few of the clues here to share with you, though some of you might already have guessed the stock we’re dealing with:

The company’s product is described as “gourmet food you eat with your hands” — with naturally grown meat and organically raised vegetables….”

The stock has more than doubled over the last eight months. “And will likely double again, and again, and again.”

Bill Mann runs down the Lynch rules and claims that this company has …

a “boring or ridiculous name” … a simple business … a niche … a consumable product … and it’s a spinoff of a larger company (and therefore may be ignored or misunderstood, or may have potential to blossom with its independence).

A few other specific clues:

“It has one store for every 82,000 people in Colorado (its most saturated market), but only one location for every 445,000 people in California (its largest market) … Plus, it has barely touched New England, New York, or Pennsylvania.”

“The company’s stores cost about $900,000 apiece to build and have a year-one return on investment of nearly 37%.”

“The company has only $4 million in debt and $168 million in cash on its balance sheet, allowing it to be extremely aggressive if it wants.”

So … enough clues? The Gumshoe’s Thinkolator is practically percolating, and the answer bubbling out the top is …

Chipotle Mexican Grill (CMG, CMG-B)

This is one that is in the Gumshoe’s personal portfolio, too, so you might consider all of this to be colored by my greedy opinion, and therefore to be possible balderdash.

Chipotle is indeed from Colorado. It is a spinoff from parent McDonald’s, who invested in what was then a small chain of about 15 restaurants back in, I think, 1996, and went public as an independent company about two years ago. It has had a remarkable stock market run since then, though a volatile one — I think it closed at about $44 on the day it went public, and has since been up to $155 and back down to the current price, around $120 for the common shares.

The argument here is that Chipotle still has a huge amount of growth potential, and that it inspires loyalty and many return visits from its customers, both due to quality food and their “green” policies and initiatives (organic beans, naturally raised meats). Plus, it’s pretty cheap to eat there, so college students and lunching 9-to-5ers love it (if the line at my local Chipotle is any indication).

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Valuation is certainly not cheap, since this is not an undiscovered company and everyone has noticed that it’s growing rapidly.

If you are interested, I would strongly urge you to take a look at the B shares — they currently trade at a 20% discount to the standard shares, but are no different except that they get stronger voting rights and have lower volume. I would be shocked if Hidden Gems didn’t specifically recommend the B shares, too.

The B shares are what McDonald’s gave up when they got entirely out of the business in mid-2006 — they exchanged them with MCD holders at a 10% discount to the then-CMG share price, so I imagine that’s the beginning of the reason for the discount, senseless though it may be. This is the only instance of super-voting shares being worth less than the common shares that I’m aware of, though there are probably other examples out there somewhere.

The mystery of CMG vs. CMG.B or CMG-B (different services use different tickers) has perplexed many investors — there is no reason, in my mind, to pay a 20% premium for the common shares unless you’re a fast trader who depends on high volume, or unless you want to specifically match options to your equity stakes (you can get options on CMG, but not on the B shares). Some folks are working on pairs trades to short the common and go long the B shares on the theory that they have to converge at some point, or that Chipotle might abandon their dual share structure, but the gap has actually widened over the past year, so that might be either a great opportunity now … or still somewhat risky.

I consider Chipotle to be firmly in the Starbucks/Whole Foods firmament — convenience and quality and a modern environmentally-friendly appeal of do-gooderness and social responsibility, but of those three it is the only one that focuses on very low price points — I think a $6 burrito is unlikely to be skipped due to recession fears or gas prices, but a $4 coffee or a $3 apple might be. Then again, the coffee is somewhat more addictive.

Chipotle also has significant growth potential, in my opinion significantly more than Whole Foods or Starbucks, just because it has barely started to expand outside the major cities and college towns, and in many cities it remains far from a saturation point (check out the map on their website — they have a tiny number of stores compared to other national chains, and virtually none outside of the major cities and a few college towns). They learned about efficient service and expansion from the masters at McDonald’s, which I think gives them a bit of an advantage on that front.

I own the company, so clearly my opinion is quite in line with the Motley Fool’s — what are the negatives about Chipotle?

There is plenty of competition for the low-cost dining-out dollar.

They have supplier constraints — they are doing the right thing by pushing natural products, but there is always the possibility for backlash because they can’t get enough of the natural/organic stuff to supply their growing store base. So far, it seems they go region by region to get stores “greenified,” but they’re up to only about 25% of their pinto beans being organic, for example.

This might be a fad, and they might be supplanted by the next big idea — it hasn’t happened yet, and they don’t appear to be suffering at the hands of Baja Fresh, which seems near collapse, or any of the other smaller “fresh Mex” chains or local burrito shops that are trying to compete. But it’s certainly possible.

But the simple fact is, Chipotle has been hitting on all cylinders, and the price reflects that (even here, off of it’s highs by 20% or so) — if they hit a hiccup, and they very well might, the shares could suffer mightily because of their premium valuation. If Peter Lynch were looking at this, he might stay away — the PEG ratio is over 2, which often indicates a too-ambitious valuation. There’s quite a larger short ratio, too, though it’s hard to tell how much of that is related to the pair trade that’s aimed at the CMG-B discount.

Then again, the last restaurant chain that the Hidden Gems folks teased heavily as the “next Starbucks” was Buffalo Wild Wings — and that had a nice run for a brief while in the Spring last year, but if I remember correctly they continued teasing it into the $40s last Summer and it has since fallen to about $23. So the Foolies are far from infallible. They also are reluctant to sell, and I expect some of their subscribers still probably have a profit in BWLD even at $23, since they first picked it quite some time ago.

Actually, if you look at the Chipotle B shares instead of the common, the PEG ratio goes down a bit to a little under 2 — still not a bargain by that metric, but it technically avoids the “too expensive to buy” label that some folks, like Jim Cramer, put on a stock with a PEG over 2.

So what do you think about Chipotle? Too rich for your blood? Underappreciated? Salsa too spicy? Let us know.

Full disclosure: as noted, I do own shares of this one … and I’m more likely to buy more than to sell. I won’t trade in the shares during the next week, as is my policy for sleuthed stocks that I publish here.



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January 30, 2008 11:12 am

just a t est

Pete E
Pete E
January 30, 2008 12:37 pm

Restaurant stocks at high PEG ratios and a PE of 64 are just too vulnerable here in a potentially slowing economy. May be a great company but the the risk reward is poor in this environment. Any miss on the earnings side no matter how slight will send this stock down 50% or more.

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January 30, 2008 6:32 pm

IMHO, there is not much more growth to be had because there is too much competition for quick mexican dining. Peter Lynch’s theory said watch what you and those around you are buying. When my co-workers want mexican food, there are probably seven different places to get that $6 burrito. Chipotle rarely wins out because the other places all supply free chips and salsa with your meal. You have to buy them at Chipotle for $2. To some people, that extra $ makes a difference.

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January 30, 2008 7:40 pm

Interesting post, you’re right CMG-B is about 20% lower than CMG – I wonder if a hedge/arbitrage opportunity:

Long CMG-B and Short CMG.

This way when CMG-B and CMG converge you make money up or down.

What do you think?

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Gravity Switch
Gravity Switch
January 30, 2008 10:04 pm