Warren Buffett famously said that, " the first rule of investing is not to lose money. And the second rule is don't forget rule number one". This statement struck me as strange -- shouldn't the first rule of investing run something like, "don't pay too high a price", "look for a company with a durable competitive advantage" etc. why does Mr. Buffett look at it from the perspective of protecting the downside, instead of looking for the upside?
I believe we can find two explanations to this. First, by protecting the downside you protect your principal which allows you to compound your money. Second, when investing in a business, a lot of times if you protect the downside the upside will take care of itself. While I cannot offer a quantitative example for this second reason, I have thought about it and I think it holds water.
This investing perspective has served me well in a recent investment I made. Last summer I started researching CapLease (LSE) when it traded at ~$4/share. At the time, investors threw a lot of cold water onto LSE because it held too much debt relative to its peers. I didn't find this reason all too compelling and I laid out my thoughts in an article I published in September 2012. I didn't spell out in the article (even though it implicitly guided me) that one of the most important features of LSE remained their downside protection. Meaning, even though they held a lot of debt, they had safe future cash flows from durable assets (real estate), which would surely continue to protect the stock. Moral of the story, earlier this month American Realty Capital (ARCP) acquired LSE for $8.50/share.
Through this lens of taking precautions to protect the downside I would like to contrast two restaurant companies -- McDonald's (MCD), and Chipotle (CMG). Specifically, I will show that for various reasons that I don't think the investing community fully appreciates, MCD offers investors an effective way to protect on the downside and offer nice gains on the upside. CMG, on the other hand, does not offer investor these downside protections, thus leaving investors very vulnerable to possible dips in results.
McDonald's Business Overview
MCD operates 35,000 restaurants worldwide, 20,000 of which the company owns and operates, and 15,000 of which they franchise out to partners. Uniquely, MCD owns (or has a capital lease) on all of these properties, a feature will we examine in more detail shortly. From these restaurants, the company generates revenue both from its own restaurants and from the fees it charges franchisees. MCD has a unique fee structure with its franchisees -- not only does it take a percentage of sales, but by dint of owning the property it charges the franchisee rent, and also has the ability to receive more rent based on sales figures.
The average McDonald's restaurant measures 4,000 square feet, multiply that by 35,000 restaurants, and we find that McDonald's owns 122mm square feet of real estate. Based on this metric, MCD would rank as the third largest REIT -- behind Simon Property Group (SPG) and General Growth Properties (GGP), who have 242mm and 139mm sqft of real estate, respectively. Put differently, MCD generated $5.86bn in rent last year, using this metric, MCD would rank as the largest REIT in the world.
Bottom line, by owning these assets, and generating significant revenues from them from these franchisees, MCD has successfully enabled itself to find reliable revenue streams, which can protect the company during a downturn. By having these income producing hard assets, MCD investors can successfully guard their principal from permanent impairment.
Now we will turn our attention to Chipotle , who does not carry these characteristics, yet trades at a significantly higher multiple than MCD.
Unlike MCD, Chipotle only has company operated stores, and does not franchise out to third parties. Additionally, CMG does not own any of its stores, and has very few assets to speak of. In its most recent 10-Q Chipotle reported total assets of $1.6bn, which doesn't sound too shabby. However, when you dig deeper you find that around $1bn of these assets (before depreciation) are capitalized costs of store renovations. These assets, as opposed to MCD real estate, do not have much value to anyone except for CMG, and thus forcing us to reconsider the true value of CMG's assets.
For the moment, CMG has established itself as the "cool restaurant", but you would find yourself hard pressed to try to predict what people will find cool in the next 10 or even 5 years. Investors banking on this factor need to contend with changing trends (as mentioned), and more importantly, CMG continuing to execute on its growth strategy without hitting too many hiccups along the way. Namely, at the end of 2012, CMG had 1,140 restaurants open, and it plans to expand an additional 168-180 restaurants this year. Expanding will expose the company to quality control, and distribution risks which could affect both new and old restaurants. Considering CMG doesn't have the same level of brand equity as other more well established restaurants a faulty rollout could inflict significant damage to the company.
Despite all of this, CMG trades at a 40 p/e, but MCD trades at an 18 p/e! CMG offers no downside protection, and little more than the promise to continue to ride the wave of popularity that has brought the company this far. Bottom line, MCD offers downside protection, a global franchise network, and a longer brand history. CMG falls way short of MCD in all these categories, and as such, making it almost impossible to justify its price at this point.