Berkshire Ruminations

Thursday, May 03, 2007

Paying for Growth: The Value Investor's Quandary

This is the story of two great growth stocks, one that I bought, one that I should have bought and both of which just released blowout earnings of (coincidentally) 38 cents a share.

The one that I bought is Green Mountain Coffee Roasters (GMCR), one of my all-time favorite companies (see “The Best Investment I ever made”). The one that I should have bought is Chipotle Mexican Grill (CMG), one of my all-time favorite restaurants.

GMCR reported fantastic numbers this morning for its second quarter. Net income doubled over the year ago quarter on sales growth of about 77%. Analysts had expected EPS of $0.34, and GMCR came in with $0.38. This represents an ROE of 13.4%. The stock shot up 10% this morning. As I have written about before, this company has some of the most level-headed and seemingly honest folks running it of any company with which I am familiar. After a decade of watching the company grow at a fast, but not ridiculous, rate I am now witnessing a true explosion of value.

There are at least two factors at work here. The first is that GMCR has created itself a niche that is protected by intellectual property rights. This gives it a wide moat that competitors, even those as strong as Starbucks, will have trouble penetrating. I am referring to their development and acquisition of the patented Keurig K-Cup brewing system. A K-Cup is plastic container, about the size of a shot-glass, that is filled with Green Mountain Coffee and sealed on the top with foil. When used with the (also patented) Keurig brewers, the cup is pierced and the coffee is brewed in the cup, producing one serving of perfectly brewed coffee. This has proven extremely popular in office settings, where the dreaded “coffee-burn” phenomenon has hindered the appeal of coffee pots for years.

The second factor is the company’s new relationship with McDonald’s. McDonald’s launched its “Premium Roast Coffee” campaign last summer with great success, immediately challenging Starbucks on taste and convenience. The coffee is usually branded under the McDonald’s name, but in a select number of stores in the northeast McDonald’s actually sells Green Mountain’s Newman’s Own Organic Coffees as such. Not only does this position Green Mountain to potentially supply the largest restaurant chain in the world, it also gives the coffee exposure to a constituency it otherwise wouldn’t.

The market seemingly has high hopes, as the stock has traded at very lofty multiples for several years now. This can be difficult for the value investor to accept. GMCR must grow at its current clip to justify its valuation, and that simply introduces a great deal of risk in to the investment. Should I, as a value investor, really take a position in a company that trades at PEs upwards of 50? Usually I won’t. In fact, this is exactly the reason I failed to dive in to the stock of my favorite lunch destination, Chipotle Mexican Grill.

At this university, I think most people would agree that Chipotle is unequivocally the most popular place to eat on or around campus. Every day a long line stretches around and towards (sometimes out) the door – both at lunch and dinner time. Friends of mine eat there every day. I even recall an article in the student newspaper entitled something like “I love Chipotle.” The food is delicious and the customers are loyal. I know this because when a similar Mexican food competitor opened next door, hardly anyone switched. The lines at Chipotle remained just as long as they had ever been.

So when I heard McDonald’s was selling its interest in Chipotle, I was immediately interested. For several months I watched for updates at chipotleipo.com, but was disappointed when the IPO was announced. The stock would go public at about 30 times earnings. For a company posting a return on that new equity balance of only 10.5%, this seemed to be too dangerous. High multiples like this make the cost of equity very high, and force comparably high returns if value is to be created.

Nevertheless, I have watched from the sidelines as the stock nearly doubled. It doesn’t take much research to figure out that the reason is that the company continues to expand and grow at rates higher that even Wall Street’s lofty expectations. Compounding the stock’s growth is the treasured “multiple expansion,” the market’s reaction to its realization that growth may be even better than it thought. Whereas the P/E of 30 sounded high to me a year ago, CMG now trades at a ttm P/E of over 50! The forward P/E may look more reasonable, but is still high at about 44.

So am I just hardened by the tech-bubble crash when high-multiple stocks suddenly fell to more normal levels, or should I really be considering these high-growth, but correspondingly high-priced, stocks? It is a test of discipline. CMG is very expensive, but it also is a very strong company. Thus, I need to convince myself that it is creating value despite its lofty price. I cannot convince myself of that, since the returns that it is earning are simply not high enough to offset the high cost of equity capital implied by the current stock price.

FD: I own shares of GMCR, but have no position in CMG or MCD.

6 Comments:

  • Just wanted to say that I am a big fan of the blog. I took a look into GMCR a couple months ago due to a previous post of yours. However, I was unable to justify a purchase due to its high P/E. And now I am sorely kicking myself.

    By Blogger Matthew, at 04 May, 2007 05:49  

  • Thank you Matthew. I can't say that I blame you for passing. Growth investing and value investing are very different, but both can generate good results. It is frustrating, though, when the stock you passed on does well, especially when the already high price was your reason.

    By Blogger Andy Kern, at 04 May, 2007 13:48  

  • Andy:

    Regarding Chipolte and Green Mountain Coffee, I suggest doing the real research like I have which lead me to buy these stocks back in January so I benefited from the current spikes to enjoy a hefty short-term gain of over $20 per share for each of these stocks. Its easy to tout these stocks when they have incurred some great activity in the last two weeks. I would look for you to push stocks that are undervalued and primed for growth and not be an amulance chaser.

    By Blogger badger, at 05 May, 2007 06:27  

  • Badger, I don't really understand your hostility, particularly since I am not "pushing" anything. I am not a professional investor nor would I have any reason to push Chipotle since I don't even own it. However, I suggest you do some research on my blog, as you would see I wrote about GMCR in December and thus don't really qualify as an "amulance" chaser. I am happy your "real research" yielded you a short term gain, but I am much more content with the 1300% gain I have on GMCR since my original purchase.

    By Blogger Andy Kern, at 05 May, 2007 13:45  

  • Hey does this blog have an RSS feed with it? I enjoy reading it and would be great if I could put it into google reader or something

    By Blogger Jamie, at 17 May, 2007 23:43  

  • Hey Andy

    I was brought to your blog by 247wallstreet and have to say I like it very much. I have a basic background in investing and am always looking to increase my knowledge of the subject. I have started a blog (www.wikiwealth.blogspot.com) and wouldn't mind if you checked it out every now and again. Good luck

    By Blogger Chisoccer, at 22 May, 2007 09:28  

Post a Comment

<< Home