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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:

(click to enlarge)ROE vs. PB

(click to enlarge)Sales Growth vs. PS

(click to enlarge)Earnings Growth Est. vs. PE

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:

Ticker

Company

Country

P/E

P/S

P/B

Growth Est

Sales Growth

ROE

AFCE

AFC Enterprises

USA

22.2

3.5

25.5

12.0%

0.1%

221.9%

ARCO

Arcos Dorados Holdings

Argentina

27.0

0.7

4.2

24.3%

17.8%

15.1%

BJRI

BJ's Restaurants

USA

35.5

1.7

3.3

20.6%

21.1%

10.2%

BOBE

Bob Evans Farms

USA

16.4

0.7

1.7

8.0%

0.0%

10.6%

BWLD

Buffalo Wild Wings

USA

26.9

1.6

4.2

20.2%

23.0%

17.2%

CAKE

The Cheesecake Factory

USA

18.9

1.0

3.2

14.1%

6.0%

17.8%

CBRL

Cracker Barrel Old Country Store

USA

17.2

0.6

4.4

10.3%

1.9%

28.8%

CEC

CEC Entertainment

USA

10.5

0.7

3.8

10.0%

1.2%

34.5%

CMG

Chipotle Mexican Grill

USA

34.8

3.6

7.2

21.9%

22.5%

23.8%

DIN

DineEquity

USA

11.0

1.0

4.5

11.0%

25.2%

69.9%

DRI

Darden Restaurants

USA

14.4

0.8

3.6

11.9%

7.5%

25.2%

EAT

Brinker International

USA

18.4

0.9

8.4

12.8%

-6.8%

40.4%

KKD

Krispy Kreme Doughnuts

USA

3.4

1.2

2.2

26.5%

-2.7%

95.9%

MCD

McDonald's

USA

16.7

3.3

6.4

9.6%

5.3%

37.9%

PZZA

Papa John's International

USA

22.0

1.0

5.7

12.0%

4.0%

27.2%

SONC

Sonic

USA

17.9

1.1

11.9

14.6%

-4.7%

78.2%

THI

Tim Hortons

Canada

19.5

2.6

6.8

13.2%

11.5%

35.3%

TXRH

Texas Roadhouse

USA

18.5

1.0

2.3

14.5%

13.2%

13.0%

WEN

The Wendy's Company

USA

144.0

0.7

0.9

14.7%

14.4%

0.7%

YUM

Yum! Brands

USA

19.7

2.2

13.5

13.3%

5.7%

77.6%

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.

Source: Restaurant Stocks: 2 Longs And 3 Shorts