Why We Sold This Market Darling

Stock returns come in three stages, according to Million Dollar Portfolio associate advisor David Meier:

  1. Mispricing. When a company's stock rises to its estimated intrinsic value.
  2. Value creation. When a company's intrinsic value rises, along with its stock price, because of strong operating performance.
  3. Market darling. When excessive optimism drives a company's stock to a sky-high premium multiple.

The company I'm writing about today is in the "market darling" stage.

Before I share its name with you, explain why selling is a smart move, and list three other market darlings you might want to sell, let me begin with some of the history we Fools have with the company.

What they saw
In October 2008, this restaurant company was dirt cheap. Its stock was down nearly 70% from its 52-week high because of rising food costs. But it was generating a ton of cash, and trading for less than nine times free cash flow.

The economics of the business were outstanding. It cost roughly $900,000 to launch a new franchise, and stores generated an average of $1.7 million in sales each year. With 22% operating margins, the store paid for itself in less than three years.

Even better, the company's visionary founder owned a significant portion of the company -- nearly $35 million worth, meaning his interests were fully aligned with shareholders.

During the third-quarter conference call that year, the company's CFO announced that the company planned to buy back up to $100 million worth of shares. His rationale? "Because they are on sale."

So, following his lead, the Million Dollar Portfolio team bought shares of the company.

As the company's stock dropped over the next few months, the MDP team bought even more shares, bringing their total allocation to 3%.

What they received
During 2009, the company's stock rose drastically. As it rose, the Million Dollar Portfolio team gradually sold blocks of shares to lock in the gains they achieved.

Just more than a month ago, the team closed out its entire position, making for a total gain of 158%.

Today, Chipotle Mexican Grill (NYSE: CMG  ) is up more than 400% since its IPO in 2006, and it continues to reach new 52-week highs.

True, it's still firing on all cylinders. But at today's price, too-optimistic growth expectations heavily factor into its share price. Here's a rough picture of Chipotle's valuation: Analysts project 20% growth over the next five years, or approximately half of the company's price-to-earnings and price-to-free cash flow ratios.

Though Chipotle is young and growing, these competitors are much cheaper, and they all come with the safety of a dividend:

Company P/E Ratio P/FCF Ratio
McDonald's (NYSE: MCD  ) 17 21
Yum! Brands (NYSE: YUM  ) 22 24
Darden Restaurants (NYSE: DRI  ) 16 13
Chipotle 42 39

Data from Capital IQ, a division of Standard & Poor's.

That's not to say that investors' optimism won't continue to drive up the price of Chipotle in the short term. But this sort of guessing game is a risky investment process. More importantly, when Chipotle's growth slows, the potential downside could be disastrous if you continue to hold.

Plus, co-CEO Steve Ells sold over $12 million of shares in early September, a move that can indicate an overvalued stock.

The crucial takeaways
There are three important lessons to learn from this example:

  1. Sell in stages. The Million Dollar Portfolio team sold their stake in Chipotle over several months. They saw shares were getting overvalued, but they realized that there still could be more upside. Partially selling over time ensures that you secure your gains, while still taking advantage of further gains that might come thanks to the market's irrationality.
  2. Remain unemotional. The Million Dollar Portfolio team loved (and still love) the company, even as they sold. I've never seen seven guys eat more burritos than these folks did, dismissing the calories as "research." But though you love a company, its business plan, and its products, you have to be able to distance yourself from all that, and the profits you've earned by investing in it.
  3. Continue to monitor the company. The Million Dollar Portfolio team made it clear that they're not done watching Chipotle. In fact, if it takes a huge hit at any point, I'm convinced they'll open up a position again -- or at least add it to their watch list. Just because you sell a company, don't let all your research go to waste -- simply continue to keep an eye on it. Often the price will eventually return to your comfort zone.

These lessons are especially important because Chipotle's not the only market darling out there today. Here are a few other companies that might be market darlings, trading near 52-week highs with hefty multiples:

Company Current price 52-week high P/E Ratio P/FCF Ratio
Apple (Nasdaq: AAPL  ) $310.12 $319.00 20 17
Panera (Nasdaq: PNRA  ) $91.46 $95.41 27 15
Buffalo Wild Wings (Nasdaq: BWLD  ) $48.71 $52.99 24 54

Data from Capital IQ.

I think it's just a matter of time before investors get nervous with these companies (and their products) as well.

Lastly, it's important to have a sounding board for both buying and selling decisions. I'm convinced that's why the Million Dollar Portfolio team is so successful (they're outperforming the S&P 500 by 6%).

We're about to open up the doors to Million Dollar Portfolio for the last time in 2010. To find out more about how you can benefit from their research -- and follow along with their real-money buys and sells -- simply enter your email address in the box below.

Chipotle Mexican Grill is a Motley Fool Rule Breakers pick. Apple is a Motley Fool Stock Advisor recommendation. Buffalo Wild Wings and Chipotle Mexican Grill are Motley Fool Hidden Gems selections. The Fool owns shares of Apple and Yum! Brands.

Adam J. Wiederman owns no shares of the companies mentioned above. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (21) | Recommend This Article (93)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 03, 2010, at 5:43 PM, Pandorabelle wrote:

    By your own logic of insider sales at the executive level portending trouble and a reason to get out of CMG, you should also be recommending the sale of Netflix (NFLX) --- another over-valued "market darling." As if the continuing massive insider sales by CEO Hastings and others at the top was not reason enough, the low float, recent debt, extension of time from 2 weeks to a month on free sub offers, using subscription enticements for points on Facebook, the subsequent inclusion of free sub numbers to inflate growth appearance in the Q3 ER, the use of paid actors to portray actual satisfied NFLX subscribers, and the growing competitive landscape - most recent being CSTR/Redbox - full of many deeper pockets, it's time for a reality check.

    I have respect for your analyses and have followed your recommendations on NFLX for over three years, but I think it's time for you to face facts and call them out the same way you are calling out CMG. Netflix had a good run, but its future is in jeopardy. Assuming you have no other agenda regarding your NFLX core position, you owe your readers a truthful assessment right now.

  • Report this Comment On November 03, 2010, at 5:58 PM, Borbality wrote:

    I have to agree (not not as angrily) with Sundolly in that the NFLX comparison seems valid.

    Also I find it odd that AAPL is mentioned as having a hefty multiple. I'm not holding AAPL (don't remind me!) but a 20 p/e seems pretty reasonable for a company that keeps destroying the projections.

  • Report this Comment On November 03, 2010, at 6:17 PM, SwiperFox wrote:

    So-so burritos. That's all I can say. This is not good Mexican food. Headed for a fall.

  • Report this Comment On November 03, 2010, at 6:23 PM, mtracy9 wrote:

    Netflix is much more overpriced than Chipotle with a price to earnings ratio of 65. Another Motley Fool Stock Advisor pick that is way overpriced is Titanium Metals with a price to earnings ratio of 80.

  • Report this Comment On November 03, 2010, at 9:28 PM, Jbay76 wrote:

    TIE was a steal 2 years ago at $4, no pun intended

  • Report this Comment On November 03, 2010, at 10:21 PM, wolfhounds wrote:

    You state the MDP is 6% ahead of the S&P. What you don't state is that MDP is minus 11% since it's opening. Not that I don't agree with your CMG analysis, but include all the info when you're trying to recruit new sucscribers.

    I sold my CMG a little early, but will hold AAPL because it is leader in technology that people want. Forward earnings P/E is estimated about 16 which wouldn't make this a overvalued stock.

  • Report this Comment On November 03, 2010, at 11:03 PM, mikecart1 wrote:

    Most overpriced stocks: AMZN, AAPL, NFLX, CMG, GOOG, and AIG.

    No dividends and bunch of run-up, I stay away!

  • Report this Comment On November 04, 2010, at 7:35 AM, afamiii wrote:

    These competitors are much cheaper? Please!

    CMG -

    Growth

    67% EPS growth year over year.

    42% EPS growth this qtr vs. same qtr last yr,

    33% EPS growth last qtr.

    Quality of earnings

    Revenue growth 23%

    RoE 23%; RoA 17%

    Free cash flow growth +300% !

    Sustainability of earnings growth

    Potential to more than double restaurants domestically and perhaps another 50% internationally.

    Bal Sheet

    $270mn cash, $4mn debt

    Is it overvalued? Growth companies are difficult to value using the traditional tools of Benjamin Graham, et. al., More of their value is in the future than in the present, and the future is not only unknown it is unknowable. My unreliable view is that it is at the higher end of potential valuations (between 160 and 200,) but by no means out of the ball park.

    Does it have the potential to correct? Definately down to 190. Possibly down to 160.

    Has it topped? I doubt it, though I wouldn't be a buyer at this price. Much better to buy with a signficant margin of safety (or following a steep correction.) But I'm sure not a seller either.

  • Report this Comment On November 04, 2010, at 9:47 AM, TMFDonauschwaben wrote:

    Sundolly --

    I agree with your assessment that NFLX falls into the same category.

    Thanks for your comment.

    Adam

  • Report this Comment On November 04, 2010, at 9:52 AM, TMFDonauschwaben wrote:

    afamiii,

    Thanks for your comment. I agree that it's difficult to value growth companies, but I think my article made clear that I (and the MDP team) think that Chipotle's phenomenal historical growth rates might be slowing in the near term, especially now that they've hit the 1,000 store mark.

    Evidence that the store is subtly acknowledging it's near a critical mass? This recent announcement that they're moving away from their core, proven restaurant concept into Asian cuisine: http://www.qsrmagazine.com/articles/news/story.phtml?id=1198...

    True, it might be as wildly successful in that market as it was in calorie-rich burritos and today's price might be a bargain, but for every success story like this, there are tens of failures. At these prices, I think betting on success of Chipotle in ventures like this is a risky move and those who hold shares are probably better taking some money off the table and locking in the gains they've achieved.

    Adam

  • Report this Comment On November 04, 2010, at 10:16 AM, SkippyJohnJones wrote:

    I have to agree with the other commenters on AAPL. 2 years ago, it would have been a perfect fit on the darlings list. The price was 50% lower than today's, but the multiples (both forward and TTM) were much higher. A multiple of 20 doesn't seem unreasonable given the growth projections and the fact that nearly 20% of the company's market cap is sitting in cash on the balance sheet.

  • Report this Comment On November 04, 2010, at 11:02 AM, TMFDonauschwaben wrote:

    SkippyJohnJones,

    I understand where you're coming from on AAPL. But again, like with CMG, I think continuing to hold at this point is a risky bet.

    One failed product launch, or the entrance of a competitor that quickly gains a cult following, and AAPL will likely lose favor with investors.

    Sure, they have a huge chunk of cash on their balance sheet, but has management proven they know what to do with it? Acquisitions usually don't turn out well for any company, if that's what you're speculating. And as far as I know, they haven't hinted at paying a dividend or buying back shares. And I'm not aware of a top-notch investor at the company they're hoping can manage the money and generate huge returns. So in my opinion, management isn't acting in shareholders' best interests by just letting this wad of cash sit around.

    Adam

  • Report this Comment On November 04, 2010, at 11:41 AM, geo11zak wrote:

    AAPL is the greatest company in the world ,buy it now it will double in 5 years. PNRA can become the Mcdonald of carbohydrates as opposed to meat which is a healthier menu,both cos are cheap at current levels

  • Report this Comment On November 04, 2010, at 1:16 PM, afamiii wrote:

    Adam: Point taken and as I said the future is unknowable. However, I will paradoy Philip Fisher on this one. Some companies are fortunate and able; some are fortunate because they are able. I suspect CMG is a bit of both. Hence Asian Cuisine (I also understand the concept came out of strong customer feedback) and international expansion.

    I've had a great run over the past two years, and I'm comfortable staying put until I see a 30% overvaluation against any conceivable value or an unwarranted multiple expansion up to 50 to 60 PE or a techincal correction that pushes it below its 12 month average on strong volume (and keeps it there - in which case you will have been right and I would have given up 20% of my winnings) or until QE ends, the bubble bursts and all asset prices go back to the gutter.

    As for the posts on AAPL. This is a tough one. The second most valuable company in the world (tough one to swallow,) with a PE of 20 (for sure its earnings yiield of 5% is very reasonable compared to US treasuries - or any other treasuries for that matter.) The mobile internet is going to be bigger than the desktop internet by a wide margin (global penetration of smart phones/tablet type devices will top 50% - yes close to 4 billion devices - within 10 years - take this from me, I was one of the marketing bods who launched the first GSM phone in the UK back in mid 90s and I won all the bets on adoption levels) and Apple is the leader, a formidable innovator (even if a one man show - there is something wrong with all good investments and anyway this didn't stop the rise of Berkshire Hathaway) and a superior ecosystem (for now.)

    The real question is whether Steve Jobs is going to blow it all the way he did back in the 80s, thinking that he and his company can control the market, the user experience, the software people run and keep it all to himself or at least under his thumb (he can't.) And in doing so let an inferior user experience, but a more open ecosystem ultimately dominate the market. This is my worry about Apple. And I say this with some emotion, I was the last of my colleagues to give up my Power Mac in 1997, and I still regret the loss of my Apple Newton to burgulars.

    Getting back to the point. I don't believe that Apple have the mind set to compete as the market becomes very mass market (as opposed to top end and early adopters), the market will head down to lower price points, margins will drop and Apple will be slow to drop prices (too protective of its margins and short term earnings,) accelerate its share decline and see developers and add on manufacturers focus more on other camps.

    In the mass market platform war the battle is for market share and at the end game it is winner takes all (profits will follow,) as Bill Gates so ably demonstrated (a true and remarkable business man)

  • Report this Comment On November 04, 2010, at 5:20 PM, dstb wrote:

    Apple has a hefty multiple? I think not. Given its success it's just starting to be valued where it should.

  • Report this Comment On November 05, 2010, at 11:47 AM, Truth2Power wrote:

    Re. NFLX: Why does every comment thread invariably circle back to NFLX?

    I've heard many diverse views on this one, even from within Fool HQ, and although the general consensus seems to be to start selling (and thanks, Sundolly, for your concise summary of all the reasons why), there are one or two notable exceptions (1/2 of the Gardners, e.g.).

    I'm hanging onto NFLX, less because of its prominent by-mail business but because of its status as "first mover and shaker in an important, emerging industry," i.e. direct video streaming. Redbox can put up a great fight at the DVD kiosk, but discs are on the way out, and I think NFLX is better positioned than any competitor to take advantage when they finally give up the ghost.

    Just my $.02.

  • Report this Comment On November 05, 2010, at 11:58 AM, mikenpdx wrote:

    apparently the author is not a Rule Breaker.

  • Report this Comment On November 05, 2010, at 12:02 PM, TMFDonauschwaben wrote:

    Truth2Power,

    True, the Gardners do have a different philosophy than me on NFLX.

    David tends to hold onto his winners. And it's worked for him -- that's how he's accrued a large stable of 1,000%+ stock picks. Unfortunately I can't say the same for myself. So maybe he's on to something.

    But one thing's for sure, I wouldn't be a BUYER of NFLX at these prices.

    Adam

  • Report this Comment On November 05, 2010, at 12:03 PM, TMFDonauschwaben wrote:

    frogdog30,

    You're right -- my personal investing style is not akin to David Gardner's Rule Breaker style. That's not to say I'm right and he's wrong, or he's right and I'm wrong. We just have different views. Absolutely nothing wrong with that!

    Adam

  • Report this Comment On November 05, 2010, at 12:32 PM, NinjaHamster wrote:

    Bubbles always burst - AAPL will become a bubble ... someday in the future. For now, they are a "Market Darling" for a reason - their performance ... and at this stage I believe they are still UNDERvalued. I'll leap off whenever that changes, but for now I am confident this ride is continuing upwards.

  • Report this Comment On November 12, 2010, at 12:49 PM, ziq wrote:

    @Borbality: I didn't sense any anger in sundolly's tone at all. It seems like a sensible analysis.

    I've unloaded a lot of NFLX over time simply because it was getting to be such a huge part of my port, a "problem" I wouldn't mind seeing more of, but I'm not ready to divest. I agree with Adam about not buying at its present price (though obviously we could all live to regret it).

    AAPL is another thing. Trends change so fast in that industry and so much seems to depend on Jobs, who is too secretive about the state of his health. My current holdings reflect my lower comfort level--but I still own some, and I've done well with both.

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