Since you clicked this article, I guess you're aware that Chipotle (NYSE:CMG) has been under severe pressure, and that there have never been so many eyes following every move of the company before.
Recent news and latest figures considering Chipotle and the so-called "E. Coli outbreak" have caught a lot of attention, and I've noticed that many investors have been whining that the stock is still too expensive and didn't fall low enough, as they were hoping to get in at a lower point.
Today, you'll find out why I bought some Chipotle at US$400 without blinking, and why I simply don't care about the latest E. Coli outbreak.
As an investor, I strongly believe its my job to be learning and reading all the time. One little book could lead to an idea or an insight that might lead to a fortune. Ergo, the intrinsic value of a good book is almost always at least 10x higher than its book value. Funny how that goes. Since the return on investment of this little hobby is so large, reading books has become one of my favorite hobbies. It's a workout for the mind, and it makes me richer in a non-material way (although sometimes also in a material way).
Recently, I listened to the audiobook "Rule #1". A book that taught me how I should invest in qualitative growth stocks and how I might want to calculate a nice margin of safety price before getting in. The book promises mostly that if you follow the rules, you're very likely to get 15% annual returns.
I'm not going to describe everything in detail here, but in short, these were the rules or the steps (in random order) Phil advised me to follow in his book:
- Find a company that is related to your passion/expertise/knowledge.
- Check the figures (debts, EPS growth rate, FCF, ROIC, sales growth rate, book value growth rate).
- Check if management is "owner-oriented".
- Determine a margin of safety price of 50% and buy it at that price or below.
As one can see, most of this stuff is old-school and looks like it's the outcome of a magical fusion between Buffett and Peter Lynch's philosophy.
I followed all the above steps, and a few days later, Chipotle happened to be in my portfolio (although not at a 50% margin of safety price).
Applying the rules/steps to CMG:
Using my passion/expertise/knowledge
Next to reading books, eating delicious foods is also one of my favorite hobbies. Finding out what's delicious and what isn't is definitely within my expertise.
After doing some intensive tasting research, I've discovered that I'd pick a Chipotle over any other popular mayor restaurant chain any day.
Checking the figures
From book value per share and EPS growth rates of 30%, on average, during the past 10 years, to return on invested capital figures of 22%, Chipotle's figures are a delight to look at. Also note that the company has zero debt. Hence, it can't go bankrupt.
|Averages CMG||10 years||7 years||5 years||3 years||1 year|
|BVPS growth rate||30.6%||20.9%||23.8%||24.7%||30.8%|
|EPS growth rate||50.5%||31.1%||29.2%||27.7%||35.6%|
Checking if management is "owner-oriented"
Steve Ells, the original founder of Chipotle, remains the company's chairman and co-CEO. This is a positive. However, Steve Ells has been a little greedy and apparently sold a lot of shares ever since the stock went public. This is clearly something I don't like, but I guess I'll have to live with that.
After all, he stills treats the company like his child, and still does a pretty good job at running Chipotle. Plus, he focuses on the core. He also isn't someone who seeks attention in the media or acts like a macho/glamorous rich boy. These are all attributes that I find important and can appreciate.
The margin of safety price
In order to calculate the margin of safety price of a company, one goes to work as follow: First determine the future EPS and P/E ratio, then discount that figure by the minimal rate of return we'd like to have on our investment, and then multiply it times 0.50 to obtain a 50% margin of safety.
With Chipotle, I used a 20% EPS growth rate for the next 10 years, as I'm seeing massive growth opportunities for the company in Europe and Asia. This figure seems fair when considering that the average growth rate of its book value per share and EPS was more like 30% in the past, but since the company has to spend lots of money on getting customers back to its US stores, growth of EPS during 2016 and 2017 will most likely be heavily impaired and thus lead to an average of 20% during the next decade.
For P/E purposes, it's quite normal to use the double of the EPS growth rate. In this case: 40. However, let's be conservative and use 35, as it is a relatively more conservative figure when looking at the average P/Es Chipotle received in previous years.
The assumptions made above give me a possible future share price of US$2625.18. When discounting the minimum accepted rate of return that we want to achieve on our investment (15% per year), we get a current sticker price of US$516 at which we could get in.
However, since these are rough times, I'm also quite happy with a 12% per year return for the next decade. Thus, when discounting this, we get a current sticker price of US$713.
Of course, things almost never go as planned, and thus, we have to get in with a huge margin of safety. What if the company doesn't grow its earnings by 20% per year?
When applying a margin of safety of 50% (as is recommended), I should have waited until the stock was at US$356 before opening a position. However, since I love Chipotle and its strong brand moat plus no debt, I was prepared to get in at a margin of safety of 44% (a US$400 share price).
As with everything, you can play with these figures as you wish and determine for yourself what EPS, P/E or margin of safety you're comfortable with.
I believe Chipotle can become the McDonald's (NYSE:MCD) of a new generation (a healthier and more critical generation). 2000 restaurants might seem a lot, but it is still nothing compared to the 37,000 restaurants McDonald's has.
In order to grasp the potential of Chipotle, I urge you to take a look at the maps (of Europe) below:
Map #1: McDonald's
Map #2: Chipotle
The growth potential of Chipotle is obviously enormous, and a doubling in its number of restaurants during the next decade seems the next logical step. This would indicate a total of 4000 restaurants that could be generating US$10.4 billion in total sales if the company is able to keep its sales per restaurant at US$2.6 million.
If Chipotle were then to get McDonald's current valuation of 4.17 times its sales, it would be worth >US$43 billion, or US$1387 per share. This would also indicate a CAGR of around 12% (13.2% to be exact) when counting from US$400. Management's intention to open 200 restaurants (+10%) next year confirms these prospects.
Considering all of the above, I really don't care about the short-term prospects: I'm aware that management will spend more (on marking and higher safety measures), and also that that this will lower the company's margins in the short term. But it will make Chipotle's customers come back, make the brand even more valuable, will lay the foundation for further growth, and might offer new buying opportunities for investors who think long term.
Next time Chipotle hits US$400, you know what to do.
Disclosure: I am/we are long CMG.
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.