When a craving for a Panera Bread Caesar salad strikes, I have my choice of five restaurants within 10 minutes of my Pittsburgh home.
More importantly though, it exemplifies the extent to which the restaurant industry overexpanded throughout the past two decades. According to the National Restaurant Association, the number of restaurants and bars has grown from 361,000 to 537,000 since 1990.
Consumers' access to easy credit and businesses' generous expense accounts supported the heady growth. Restaurant chains found themselves caught up in frenzied spending, but the trend was unsustainable. Like the housing market, the restaurant industry has overbuilt. Without credit cards, consumers can't afford to eat out as often. And recessionary times have required corporations to slash extraneous expenses -- particularly food -- from their budgets.
Food, food everywhere
Simply put, there are too many places to eat. The ratio of restaurants to people has widened dramatically. Since 1990, population in the U.S. grew just 23%, in comparison to the 49% growth in restaurants noted above.
Faced with rapidly waning demand, food establishments are taking desperate measures to stay in the game. Starbucks
These tactics may be effective in the short run. Eventually, though, supply and demand will be forced into equilibrium.
Too tasty to fail?
Absent some initiative that makes restaurants eligible for government bailouts, you can expect to see the restaurant industry experience some failures. Several chains have already been forced to start closing underperforming locations. Some establishments will be forced out of business all together.
Investors are sitting on pins and needles wondering which firms will emerge as winners from the large pool of contenders. Hot grower Chipotle
Food for thought
Investors must purchase restaurant stocks with the utmost caution. Attractive menu prices that provided meals a step above fast food drew middle-class families to casual-dining locations in droves over the past several years. Just about any restaurant could grow just by expanding into new locations.
Times have changed. In the current market, restaurants will achieve growth via market share gains. Those that lack a distinct competitive advantage that adds value to the dining experience -- such as superior customer service or unique dishes -- will struggle to survive.
The challenge is especially strong for middle-tier restaurants. Upscale establishments such as Morton's Restaurant Group and McCormick & Schmick's may be struggling through the recession, but they at least offer unique experiences and ambiance that allow them to stand out. They also don't line every suburban strip mall.
For investors with an appetite for attractive valuations, I advise sticking to chains that have robust business models that thrive in any kind of economic environment, and have a proven ability to stand out above their competitors. McDonald's
Similarly, Buffalo Wild Wings
Like any other sector that is currently wringing out the excess, there will be a few strong winners that will prevail in the casual-dining sector. There will also be an abundance of failure. Restaurants that lack a distinct competitive advantage and healthy financials face the greatest risk of getting eaten alive.
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Starbucks has been recommended by Motley Fool Inside Value and Stock Advisor. Chipotle is a Rule Breakers selection. Try any of our Foolish newsletters today, free for 30 days. The Fool owns shares of Buffalo Wild Wings, Chipotle Mexican Grill, and Starbucks.