- Instead of immediately investing in an IPO, it's possible to get great returns at a later date because good investments compound shareholder value for years.
- Chipotle faced risks and there was good reason to initially wait to see how things developed.
- After one year, a couple metrics for Chipotle suggested it would make a great long-term investment, making it a calculated bet instead of a risky gamble.
Among market-beating stocks in 2020, Chipotle Mexican Grill (NYSE:CMG) needs no introduction. With over 2,700 company-owned locations, chances are good you've at least seen one before. And considering this company has generated around $5.8 billion in revenue over the past 12 months, it's likely you've even sampled some of its ethically sourced, hormone-free food at some point.
Before it was generating billions in revenue from thousands of locations, Chipotle was a relatively small chain that McDonald's had invested in. If you had invested $10,000 in its 2006 initial public offering (IPO), you'd be sitting on market-crushing returns, as we'll see in a moment. But would that have been an irresponsible gamble or a calculated bet? In other words, can it ever be a safe move to make an outsize investment in a small-cap IPO stock?
Investing in IPOs
Chipotle's IPO priced at $22 per share. But buying an IPO stock at the IPO price isn't guaranteed; most of us have to wait until shares begin trading on the open market, when they might have a significantly different price. In Chipotle's case, its shares closed the first day around $44.
Assuming you invested $10,000 at $44 per share, you could have purchased 227 shares, worth around $300,000 today.
Some investors frantically purchase an IPO stock, feeling compelled to rush in or risk forever missing out on the upside. But great companies compound shareholder returns for years and decades, not days and months. If an IPO stock is really a life-changing investment opportunity, there's plenty of time to calmly evaluate the company from the sidelines before investing.
In Chipotle's case, there were legitimate concerns. For example, McDonald's still held 88% of the voting power after the IPO, leaving substantial doubt over who was really in charge and what the priorities were.
Suppose you waited to invest in Chipotle, evaluating its performance and power structure for its first year as a public company. After one year, you could have bought Chipotle stock for about $60 per share. Sure, you missed out on its 36% market-beating gain in 2006. But $10,000 at $60 per share would still be worth over $200,000 today -- life-changing returns.
Investing in small-cap stocks
A small-cap stock means the company's market cap (the aggregate value of its shares) is between $300 million and $2 billion. These are considered intrinsically risky by many investors due to their reputation for volatility. But they're also good hunting grounds for market-beating stocks.
Chipotle was indeed a small-cap stock at its IPO. At $44 per share, where the stock traded on day one, its market cap was about $1.1 billion.
And besides the volatility risk all small caps face, the company had a new challenge to overcome that developed during that first year. Somewhat surprisingly, McDonald's sold 100% of its interest in Chipotle. This clarified the company's structure but was potentially bad for business. After all, Chipotle benefited from its ties to McDonald's. For example, it received favorable pricing from Coca-Cola and used McDonald's supply chain.
Many investors find small-cap stocks too risky, and some certainly avoided Chipotle given the risks.
Making a calculated bet
Chipotle stock wasn't a sure thing, but here are a couple of reasons why you could have made a calculated bet on its success.
1. Rapid revenue growth: In 2005, the year leading up to the IPO, Chipotle's revenue grew 33% year over year. The following year, revenue grew 31%. For perspective, when revenue growth compounds this quickly, it doubles in just over two years. And this growth was reasonably priced. The stock traded at just over two times trailing sales at the end of 2006 compared with its price-to-sales ratio over six today.
2. Expanding profits: Many small-cap companies don't have profits to go along with growth, but Chipotle had both. Not only that, but its profits were also expanding. One way to measure this is with operating income: what's left over after paying the bills necessary to run the actual business. In 2005, the company's operating-income margin was 4.8%. In 2006, it was 7.5%, making that incredible revenue growth even more valuable.
A final thought
I probably would have put Chipotle stock on my watch list initially, as I do with other promising IPOs. But with investing, it's important to not only look at what could go wrong but also what's going right. Chipotle had the makings of a solid investment. To those who pushed fears aside to invest big, here's to you. To the rest of us, tomorrow's Chipotle-esque returns are out there somewhere, just waiting to be found.