In One Up on Wall Street, Peter Lynch famously declared that "An amateur investor can pick tomorrow's big winners by paying attention to new developments at the workplace, the mall, the auto showrooms, the restaurants, or anywhere a promising new enterprise makes its debut." While Lynch is quick to clarify that an investor should never invest prior to doing sufficient homework on the company's earnings and growth story, this "buy what you know" (or perhaps more accurately, "research and consider buying what you know") philosophy is a great way for individual investors to pick winning stocks. The combination of a favorable customer experience, promising growth, and sound financials can truly give an individual investor an edge in picking market-beating companies.
Finding multi-baggers, one lunch at a time
One of the easiest ways to "buy what you know" is within the restaurant industry. Investors do not need to be culinary experts to be able to judge how a restaurant is doing. Was the food good? Was the restaurant crowded? Was the facility clean and nicely furnished? These questions don't require a degree in hospitality. Plus, daily lunch outings are part of the culture for much of corporate America. As a result, doing a little scouting for investing opportunities doesn't require any additional effort. This simple process of being alert for investing opportunities can yield a wide range of fast food and fast casual restaurants.
Restaurants with multi-bagger potential need to be relatively early in the process of expanding across the country (or internationally). This statement is not intended to imply that a company like McDonaldsis a bad investment, but realistically the stock is not likely to double or triple in the near future with over 34,000 restaurant locations already in operation. To identify high-growth restaurant stocks, it is critical to identify proven concepts that haven't saturated the market quite yet.
Understand the growth trajectory
Once a restaurant passes the initial consumer test (e.g., a pleasing experience and high customer traffic), it is time to start doing some homework and developing an investment thesis. As noted above, growth potential is a key factor to consider when searching for multi-bagger returns. Here is a quick look at the restaurant count and market capitalization for a range of casual and fast casual companies:
Market capitalization (in billions)
While there are differences in each company's strategy for maintaining a mix of owned and franchised restaurants, the key takeaway from this table is that each of these companies has a long runway for continued growth. Chipotle Mexican Grill's (NYSE: CMG) 1,500 locations and Panera Bread's (NASDAQ: PNRA) 1,700 locations may sound like large numbers, but even these companies have significant room for growth.
Chipotle, for example, is expected to reach at least 3,000 locations in the United States. Additionally, the company can fuel further growth based on the initial success of its international expansion and a roll out of its second restaurant concept, ShopHouse Asian Kitchen. In short, Chipotle is expected to double in size based solely on the company's domestic expansion plans, and has even more potential upside if international expansion and ShopHouse contribute meaningfully to future growth.
Understand the financials
Finding an appealing restaurant concept with growth potential is a solid start, but it isn't quite time to start buying shares. It is critical to understand the financial health of the company and how reasonable the current valuation is relative to the growth prospects of the company.
Debt to equity ratio
TTM price to earnings ratio
5 year expected growth rate
Source: Yahoo! Finance-9/5/13
This very limited set of financial metrics provides a lot of information that Lynch would look for when evaluating a growth company for investment. First, Chipotle and Panera have no debt. Having a pristine balance sheet indicates that the company has been able to fund past growth with earnings rather than debt, but also provides the company with significant flexibility and stability going forward. In contrast, Einstein Noah Restaurant Group, (NASDAQ: BAGL) has $125 million in debt, which dwarfs the company's $13 million cash balance . The likelihood of expansion without incurring even more debt is questionable, and having more debt than equity is an additional risk factor.
On the earnings front, none of the stocks in this group appear cheap based on trailing metrics. Factoring in growth using a PEG ratio doesn't make the situation much more appealing at today's prices. This is particularly true with Noodles & Company (NASDAQ: NDLS) ; the company became public in June, and significant hype has built surrounding the successful fast casual concept with less than 350 stores. The phrase "the next Chipotle" has been used more than a few times in reference to Noodles, but while Noodles has plenty of room to grow, it will need to start growing faster than the 13 new locations it opened last quarter before it reaches 1,500 locations.
What to buy now?
While the valuation discussion above may dissuade investors from researching further, there are reasons to give Panera a deeper look. First, the recent share price pullback from $195 to $165 per share provides one of the more attractive entry points that has been available in recent years. Second, analysts' estimated 17% growth rate may be a bit conservative considering that Panera has increased earnings by more than 29% over the past five years.
Perhaps more importantly, there are no signs that the growth story at Panera is winding down. The company retains the flexibility that its debt-free balance sheet provides, the number of locations continues to grow at a steady pace (37 bakery-cafes opened in the most recent quarter), and the company continues to ride the larger consumer trends toward fast casual and health-conscious dining. With such a solidly formed investment thesis, a trailing P/E of 26 does not seem unreasonable at all; it may not be a ten-bagger going forward, but market-beating, multi-bagger returns are certainly a realistic expectation.
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Brian Shaw owns shares of Chipotle Mexican Grill and Panera Bread. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. Try any of our Foolish newsletter services free for 30 days. 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.