David Einhorn's Dangerous Advice

Shares of Chipotle Mexican Grill (NYSE: CMG  )  were getting walloped yesterday on the news that hedge fund champion David Einhorn called the brand overvalued. Investors responded by pulling out of the company, for reasons that are still a bit unclear to me. I'm assuming that nothing secret and odd changed for the chain overnight, and that Einhorn isn't a mystic with access to information that no one else has. So what's going on here?

The case against Chipotle
Just so we're clear on what's happened, let's lay it out. Einhorn was speaking at the Value Investing Congress, and he indicated that Chipotle was overvalued because Yum! Brand's (NYSE: YUM  ) Taco Bell just launched a new upscale menu that's going to kill -- according to Einhorn -- Chipotle. You can go look at the intraday chart to see how the stock was affected; it's an interesting sight. At midday, it had rallied a bit to get to 4% down on the day.

Now, we'll get to the other problems that Chipotle has in a second, but let's start with this sell-off on the idea that Chipotle is overvalued. First a few more facts. Yesterday, Chipotle was trading at a P/E of 38 while the restaurant sector average is around 20 , but it takes Einhorn saying something for people to worry? This is one of the things that drives me crazy about the herd mentality, and after I talk about why Einhorn is probably right, I want to address this.

Why he's probably right
While the fact that Taco Bell has this new menu is getting most of the press, Einhorn actually talked about two other, more important factors. First of all, commodity prices are going to stomp on Chipotle's face. The difficult grain season will have an impact on both corn and meat prices. Chipotle's use of higher-end meat means that it's already paying more than its competitors. An increase in grain cost will likely have a higher impact on its meat prices than it will on its competitors, who use low-grain/high-supplement-fed meat.

Second, one of the many stipulations in the Affordable Care Act is that companies with more than 50 employees have toprovide health care to those employees. Chipotle employs over 30,000 people, so it's going to have some new costs. Einhorn is right to point out that these costs are going to eat into Chipotle's 18% operating margin, making it a less attractive investment.

I'd steer clear of Chipotle until these costs get sorted out, but nothing in Einhorn's list would get me out of the stock if I were already invested. These are not long-term problems, and as much as people love Taco Bell, Chipotle continues to offer something that a slightly fancier Taco Bell menu doesn't.

The herd mentality
The underlying problem with yesterday's fall is that it highlights two disturbing things. First, look how quickly investors are willing to discount their own research in the face of a Respected Gentleman's opinion. Have we forgotten about all the cases of these guys saying things that were good for them with no regard for ourselves? Did we forget that even the best investors are only right about 60% of the time? I know he nailed Green Mountain Coffee Roasters (Nasdaq: GMCR  ) last year, but let's all just calm down.

The second problem I have with this, and almost every other celebrity hedge fund investment, is that the person making the recommendation is often nothing like the other investors, and knows nothing about their positions and goals. It's one thing for a value guy to talk to other value guys and convince them that he's right, but I have some sneaking suspicion that most Chipotle investors -- keeping that P/E of 38 in mind -- aren't value guys.

Can you imagine the reverse situation? Some growth champion says Facebook is going to the moon and for some reason all the value guys jump on board? Of course not. That talking head only knows why he would invest, not why you would.

The bottom line
None of that is to say that Einhorn is wrong, or that Chipotle won't get canned by Taco Bell. It's all to say that as investors, we have to have some conviction. You have to trust your own research, and know that no one else knows your financial desires and needs better than you do. If being a better investor is more important to you than just doing what another guys tells you to do, you should check out my colleague's series on becoming a value investor. Michael Lewis -- not that one -- has a great eye for unpolished gems, and his series is a good foot in the door.

 
 

Fool contributor Andrew Marder doesn't own any of the stocks mentioned here. The Motley Fool owns shares of Chipotle Mexican Grill. Motley Fool newsletter services have recommended buying shares of Chipotle Mexican Grill and Green Mountain Coffee Roasters. Motley Fool newsletter services have recommended creating a bear put spread position in Green Mountain Coffee Roasters. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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  • Report this Comment On October 03, 2012, at 10:49 PM, promommyfool wrote:

    You both may be right, but CMG at the end of the day is still over $300.00 a share and it only dropped 7 bucks. That's not getting killed. That's getting a light push down the hall. its 52 week spread, however, is rather ugly. Why people were suddenly worried after one person bad-mouthed the company doesn't make sense, but I've seen it before to my sorrow.

  • Report this Comment On October 04, 2012, at 9:45 AM, buffalonate wrote:

    I would like to buy CMG but it is still over-priced. When you consider how large the company is it is highly unlikely that their growth rates will be maintained.

  • Report this Comment On October 04, 2012, at 1:34 PM, txwonk wrote:

    I wonder if Einhorn has actually done the taste test between CMG and Taco Bell menus. There is no comparison that CMG is far superior. So.....meanwhile, Einhorn behaves like a wet blanket. If CMG is as bad a company and overvalued, why not just let things take their natural course----oh yeah-----market manipulation in his favor....duh! Meanwhile, all the little guys get screwed.

  • Report this Comment On October 04, 2012, at 2:40 PM, EquityBull wrote:

    Taco Belle is not in a vacuum. They will have the SAME input costs going up like chipotle will. Grain and meats will affect TB just the same.

    Next the healthcare act will also affect taco belle. So TB will either have to RAISE prices or cut their margins. If they raise prices then the difference in their price and chipotle narrows or perhaps chipotle gains additional pricing power as all competitors are forced to raise prices to cover increased input costs.

    Einhorn makes it sound like the cost structure changes are unique to Chipotle. Why he thinks TB is immune to all this is beyond comprehension.

    Either way Einhorn had 50,000 puts controlling 5 million shares. A nice 30 point drop gets him 150M profit. He knows a mere mention of any stock he'll get a pop so he'll play this game as long as the lemmings follow him over the cliff

  • Report this Comment On October 05, 2012, at 9:03 AM, txwonk wrote:

    Einhorn had 50,000 puts on CMG and then makes a pronouncement that influences the stock and gains him 150M? And how is this legal? Isn't this what he was doing in the U.K. that caused him to be banned there? Why is he tolerated in the U.S. for doing the same thing?

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