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 visit