After looking at different industries and comparing average return on equity to average price-to-book ratios, the restaurant industry appears overvalued. Restaurant stocks appear promising for constructing net-short positions because, in aggregate, restaurants produced below-trend ROE for their average price-to-book ratio. Using this top-down approach to choose industries for a net-short position, attractively-priced and overpriced picks were identified among restaurant stocks.
Alpha hunters might consider net short positions in industries trading at indefensible multiples, market neutral positions for fairly valued industries, and net long positions in industries with attractive valuations. If they are willing to hedge their positions, they can find more investment opportunities than they would by just hoping to find the best industries or stocks to buy today. Instead, they can use fully or partially hedged positions to bet on the mean reversion of different stocks in an industry while minimizing or reducing exposure to industry and market volatility.
Plots of companies within the restaurant industry reveal that there are some stocks which are more attractively priced than others:
In each of these graphs, a measure of quality or growth is plotted on the y-axis as a function of a measure of cheapness on the x-axis. Historical price-to-earnings multiples, price-to-book multiples, and price-to-sales multiples were used as measures of cheapness. Analyst estimates for earnings growth, historical return on equity, and historical sales growth were plotted as measures of growth or quality. More attractive stocks are found up and to the left while less attractive stocks are found down and to the right.
In the context of history, many of these valuations are simply indefensible. Historically, a price-to-earnings multiple near 15 is considered reasonable, yet there are several restaurant stocks which exceed this rule of thumb.
Two above-trend restaurant stocks are presented in bold and three below trend short picks are listed in red:
Arcos Dorados Holdings
Bob Evans Farms
Buffalo Wild Wings
The Cheesecake Factory
Cracker Barrel Old Country Store
Chipotle Mexican Grill
Krispy Kreme Doughnuts
Papa John's International
The Wendy's Company
DineEquity and Krispy Kreme were found to lie among stocks in the upper left of these plots (higher quality, undervalued stocks) while Chipotle, Yum! Brands, and AFC Enterprises were found to lie at the lower right of these plots (lower quality, overvalued stocks). Krispy Kreme's lackluster position in the sales growth/price-to-sales plot was allowed based on its excellent positions in the other two plots. Based on this work, a net short position in the restaurant industry can be constructed by buying DIN and KKD shares while hedging with a larger total short position in CMG, YUM, and AFCE shares.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.