Should You Buy Chipotle Shares?

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Investors have been extremely bullish on Chipotle Mexican Grill (NYSE:CMG). The company has been one of the fastest-growing restaurant chains in the country. This has been reflected in the company’s annual earnings, which have skyrocketed from less than $2 per share in 2006 to more than $10 per share today. This success story also has anecdotal backing — we hear stories of how Chipotle stores see long lines of people trying to get a large, gourmet meal for under $10.

As a result, investors have bid up Chipotle shares more than 1,200 percent in the past 10 years, and the uptrend appears to be intact. Furthermore, the shares continue to outperform despite the fact that the stock market has been neutral this year. And despite the fact that some of the higher-momentum stocks have started to reverse course, Chipotle shares have risen nearly 7 percent year to date.

But while investors anticipate continued outperformance from Chipotle, I think there are some risks.

The first is valuation. Growth stocks are a rarity in this market, and so investors have irrationally bid up the shares of the few growth companies that they can find. Chipotle’s shares trade at a whopping 44-times 2014 earnings estimates. While the company has been growing its earnings at about 27 percent annually since 2006, this growth doesn’t justify a 44-times earnings multiple.

Generally, a good rule of thumb is that a company offers good value when its growth rate equals its earnings multiple. If Chipotle trades at 27 times earnings, then its shares would be valued at just 61 percent of their current valuation, or at about $350 per share.

But the valuation picture gets worse. The company’s growth has been slowing, so that over the past four years, growth has been just 22 percent. This means that the shares become attractive at about half of their current value, or at about $285 per share.

Second, I think there is an added risk that the company’s growth could continue to slow. There are a couple of reasons for this.

First, while the company’s earnings growth has been slowing, it has had falling agricultural commodity prices as a tailwind. However, the prices of agricultural commodities have begun to turn around, which means that we could see Chipotle’s margins decline. The company will be forced to decide whether to raise prices or to eat the losses.

Second, the restaurant industry is incredibly competitive. There are restaurants everywhere, and while Chipotle has certainly carved itself a niche, I am not sure the company will be able to retain it for very long. Furthermore, there are simply a lot of restaurants. For instance, there is a Chipotle about two-and-a-half blocks from where I live.

It is down the street from a Starbucks (NASDAQ:SBUX), across the street from a Jimmy Johns (a fast food sandwich restaurant), across the street from a Boston Market, and across a major intersection from a McDonald’s (NYSE:MCD) — the list goes on.

Given this competition and given the other risks, I think it is very difficult to make a long-term investment case for a restaurant company, especially one that has already established itself as popular. If, for instance, Chipotle offered the same value proposition but it didn’t have as many locations and it wasn’t popular yet, I could see buying the shares. But at this point, expectations are elevated, and the risk that these expectations aren’t met doesn’t justify the reward.

With that being said, if Chipotle continues to execute, its shares will continue to outperform. Furthermore, a lot of people are short or advocate a short position. Therefore, despite my somewhat bearish sentiment, I don’t think shorting the stock or even selling all of a long position is justified. The best strategy might be to ride the uptrend for the time being and share the market’s high expectations, but at the same time use a stop order so that your losses are limited should the aforementioned risks come into play.

However, as a value investor and as an investor who eschews companies in highly competitive sectors, I am simply staying on the sidelines.

Disclosure: Ben Kramer-Miller has no position in Chipotle shares or in any of the other companies mentioned in this article.