Remember When…Imagine If…
William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
These are interesting times for a value investor. Last week has been a reminder that investing in stocks with high valuations is akin to climbing to the top of a mountain the size of which you see in the Colorado Rockies with nervous investors who are ready to disperse out from underneath you at the first sign of trouble. I am reminded of a comment by Warren Buffett that he is like a kid in a candy shop when stock prices are falling.
Chipotle Mexican Grill (NYSE: CMG) is a classic reminder of what happens when you invest in companies that were once riding a momentum wave based on excellent fundamentals. Its stock price has fallen 34% from its 52-week high in the past 3 months. It’s a long fall to the bottom once a mountain built by nervous investors starts to crumble.
With all of this in mind I am going to take you through a mental journey.
Remember when the stock market was all the rage and the stock market was just shooting through the roof. It seemed that any stock that you bought was making you money. It didn’t matter whether the company you invested in had profitability or not, if it went public, huge short-term gains were assured. The time was 1999.
Let’s picture an individual. Let’s call him Jolly Momentum. He was smart enough to know that if a company wasn’t profitable that it wouldn’t last long, but unfortunately he had a problem. He always wanted to jump on bandwagons and was also looking for a quick buck. He looked in the newspaper and observed that Microsoft (NASDAQ: MSFT) was going up and up and up. Never mind that the p/e ratio was also going up and up and up. So in December 1999, he decided to buy some shares at around $58 per share. The p/e ratio was 84 based on 1999 earnings. Microsoft gained $0.38 and then the stock market collapsed. To this date Microsoft hasn’t seen that high of a price, and poor old Jolly Momentum is sitting on a -5.6% per annum return not including dividends.
Let’s picture another individual. Let’s call him Fred Fundamental. In 1999 he decided to stay out of the market all together. There were too many stocks with expanding p/e ratios. Years later, in March of 2009, he knew that stocks were especially cheap. He saw that Microsoft had a p/e ratio of around 9 based on 2008 earnings. He bought some shares at $18 per share and is sitting on a 15% per annum gain not including dividends. Fred saw a value opportunity and was rewarded.
In 2006 Chipotle Mexican Grill was spun off from McDonald’s Corp. Earnings growth and free cash flow growth has been stellar with 22% and 110% annual growth rate, respectively. The total debt to equity ratio of this company is currently an impressive 31%. Wall Street knew this and gave the shares a p/e ratio of around 61 based on 2011 earnings.
Jolly Momentum jumped all over this paying $440 a share for his Chipotle shares. Fred Fundamental decided to stay away from Chipotle Mexican Grill because it looked like a water balloon ready to bust and he didn’t want to get wet.
Then, on July 20, 2012, Chipotle came out with an earnings report that disappointed investors. Chipotle fell 28% in 5 trading days from around $403 to $290 per share as of market close on July 26. Jolly Momentum is not so jolly any more.
Imagine if Chipotle is the Microsoft of 1999. Will Jolly Momentum experience more years in the red on his Chipotle investment just like his Microsoft investment? Fred Fundamental is still staying away from the Chipotle because he still thinks the company is overvalued. From 2006-2011 Chipotle’s net income grew 39%. In 2011 the net income was $215 million. Let’s say 5 years from 2011 the net income grows at a lower rate of say 20%. That gives Chipotle a 2016 net income of $535 million.
Let’s say for the sake of argument that Chipotle doesn’t do any share repurchases. Divide $535 million by the current weighted diluted shares outstanding of 32 million shares and you arrive at a diluted earnings per share of $16.71. Assuming that Mr. Market decides to downgrade Chipotle’s p/e multiple to 17 over the next few years, that would give Chipotle a share price of $284 or about $6 less than it is now. That works out to -0.5% per annum for 4 years based on today’s price, based on Jolly Momentum’s price of $440 that works out -10% per annum. Poor Jolly.
Imagine if Chipotle Mexican Grill falls to say $80 per share or 82% from Jolly Momentum’s price in the next month. That would give Chipotle Mexican Grill a p/e ratio of 12 based on 2011 earnings. Now Fred Fundamental is frothing at the mouth with a company with such strong fundamentals trading at such a low valuation. If the stock price goes from $80 per share to the $284 per share projected above, Fred Fundamental will have a return of 37% per annum and satisfaction that he patiently waited for the right price.
This is why Warren Buffett is like a kid in a candy store when stock prices are lower. Price and good fundamentals matter in determining long-term gains. Jolly Momentum likes to buy when prices rise because he feels he is missing out. Fred Fundamental likes to wait for Mr. Market to go crazy and start marking down prices in the discount store of businesses: The Stock Market.
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