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Quarterly Letter to Clients

July, 2015

Indices at quarter-end (June 30, 2015):

Dow Jones Industrials: 17,619.51 2Q'15 -0.88% YTD -1.14%

Standard & Poor's 500: 2,063.11 2Q'15 -0.23% YTD +0.21%

Determining an acceptable value for a stock or bond is crucial to investment success. But an acceptable price in today’s market may or may not prove to be a good value in tomorrow’s.

Calculating the value metrics of a given company is not all that difficult, even though modern accounting does it’s best to obscure reality. We have “GAAP,” generally accepted accounting principles, and you should look no further.

Twice a year the financial publication "Barron's" conducts a "Big Money Poll," asking opinions of various money managers. I have been a contributor for many years now.

In the April poll, amongst questions about the economy and markets, was a section asking me to name one overvalued stock. While there were numerous possibilities, the company that I selected was Chipotle, the Mexican restaurant chain. Barron's later asked me to expand on that selection, and they printed my comments in their April 27th edition. (The numbers that follow are as of April. Also please understand that I am not criticizing the company, only it's stock price.)

My valuation assessments always begin the same way, a sort of "back of the envelope" calculation. I look first at the balance sheet, where Chipotle does shine, with no debt and over $400 million in cash. My next look is at growth, and again Chipotle impresses, though a slowing is expected.

Then I look at the valuation, the price of the business, and it is here the problems begin: the price-earnings multiple is 48, meaning that a buyer of the stock is paying 48 times what each share earns. Think about it this way: consider your own annual income multiplied by 48. Would you rather sell or buy at that price?

Chipotle has a market capitalization of about $21 billion. I arrive at that figure by multiplying the number of shares outstanding by the price of the stock (there being no debt to add in). After doing that I divided the market cap by the number of restaurants to arrive at a value of $12 million per restaurant. Each restaurant (or "store") costs the company about $850,000 to build; each store generates about $2.3 million in sales and roughly $250,000 in annual profit.

So a buyer of Chipotle shares is paying 14 times what each store cost the company. He is paying 5-plus times gross sales. And he is paying 48 times what each store (and the whole company) earns. Compared to many other established restaurant chains Chipotle sells for twice the price.

Because the company is debt-free it deserves a premium. It also deserves a premium for its growth. But as I told Barron's, this isn't a cure for cancer, it is a burrito chain. Their heady, historic earnings metrics are very likely to come down going forward. Of course, it is possible that the stock stays elevated while the earnings catch up to the price, but I have made a career of buying companies at reasonable prices. It is always a matter of risk versus reward.

Stock prices are a moving target. Valuation of stocks may be an ephemeral goal. In a market that itself is priced at 16 to 20 times earnings, a company selling at that level might seem reasonable. Within such a market you will find companies selling at 12-15 times earnings as well as at 40-50 times.

As for me, I will certainly avoid the latter. It is very difficult to find success at 40 times earnings.

Acceptable valuation levels will change with market sentiment, and extreme high or low multiples can continue for years. But there are a few things that are a constant key to success in all markets: growth in earnings and dividends; and stability and consistency in those two items. Whether the company is large or small, regardless of the industry it is in, if those factors are present there is a good likelihood of a rising stock price over time.

And most importantly, it is time that is the investor's best friend. If your investment process looks for gains over shorter periods you will be disappointed. Rather, look to performance over decades. This is a lifetime business, and patience is rewarded.

Jim Pappas