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:

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:

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.