Beating the Street (42 page)

The potential for restaurants was proven to me in 1966, early in my career as a Fidelity analyst, when one of the first companies brought to my attention was Kentucky Fried Chicken. Kentucky Fried Chicken was created out of desperation after a superhighway diverted traffic from Colonel Sanders's country restaurant. Facing bankruptcy due to a shortage of customers, this enterprising 66-year-old took to the road in his battered Cadillac, offering his chicken recipe to better-situated restaurants in exchange for royalties. He wore a dark suit, not the white planter's costume that later became his trademark.

KFC stock went on sale in 1965. Before that, Dunkin' Donuts had come public in Massachusetts (it's had 32 years of continuous up earnings since), and Howard Johnson, the pioneer of the turnpike eatery,
had traded on the New York Stock Exchange since 1961. Bob Evans Farms, famous in the Midwest, followed in 1963, and by the mid-60s, McDonald's and Shoney's also made their stock-market debuts. Hundreds of thousands of customers who could see that these places were very profitable had a chance to profit from the observation.

At the time, Wall Street would have scoffed at the idea that a bunch of donut shops and hamburger joints could compete with the famous Nifty Fifty stocks, mostly technology issues that proved to be highly overrated, while Shoney's became a 168-bagger (rising from 22 cents a share, adjusted for splits, to a high of $36⅞), Bob Evans Farms an 83-bagger, and McDonald's a 400-bagger. Howard Johnson was a 40-bagger by the time it was taken private, and Kentucky Fried Chicken a 27½ bagger when it was acquired by PepsiCo.

If you invested $10,000 in these five issues, putting your money where your mouth was, by the end of the 1980s you would have become a millionaire at least two times over, and you would have become a millionaire four times over had you put the entire $10,000 into McDonald's alone. McDonald's has been one of the most rewarding stock-market performers in modern history, due to its refusal to rest on its laurels and its constant restructuring of its menu with new McDishes, as well as its practice of exporting its golden arches.

Hamburger joints, cafeterias (Luby's, Morrison's), family steak houses (Ponderosa, Bonanza), all-purpose eateries (Denny's, Shoney's), ice cream places, yogurt places, domestic food restaurants, international food restaurants, coffee bars, pizza parlors, smorgasbords, and buffets have each produced one or more gigantic winners in the stock market, under the noses of an entire nation of investors. We all know which places are popular and well maintained, which are disheveled and passé, which have reached the saturation point and which have room to grow.

If you missed the restaurants in the 1960s, when the baby boomers were getting their first drivers' licenses and turning their cars into portable lunch counters, you could have made up for it in the 1970s by buying International Dairy Queen, Wendy's, Luby's, Taco Bell, Pizza Hut, and Jerrico when Long John Silver appeared on the scene. You would have done especially well had you invested after the bear market of 1972, when solid franchises were selling for a pittance. Taco Bell, which had never had a disappointing quarter, dropped to $1 a share, promptly rebounded to $40, and then was acquired by PepsiCo, which likes to own food companies because they help sell Pepsi's soft drinks.

In the 1980s you might have discovered Cracker Barrel, with its popular gift shop and delicious seafood and biscuits; or Chili's, which came public in 1984 and I foolishly ignored; or Sbarro (1985), Ryan's Family Steak Houses (1982), and Uno Restaurants (1987). Chi-Chi's was another rewarding investment—eventually it was bought out.

Every region of the country has been the incubator for one or more of these small-town successes that went on to capture the stomachs and wallets of the country: Luby's, Ryan's, and Chili's in the Southwest, McDonald's in the Midwest, Chi-Chi's and International Dairy Queen in Minneapolis, Sbarro in New York, Dunkin' Donuts in New England, Shoney's and Cracker Barrel in the Deep South, Sizzler and Taco Bell in the Far West.

A restaurant chain, like a retailer, has 15–20 years of fast growth ahead of it as it expands. This is supposed to be a cutthroat business, but the fledgling restaurant company is protected from competition in a way that an electronics company or a shoe company is not. If there's a new fish-and-chips chain in California and a better one in New York, what's the impact of the New York chain on the California chain? Zero.

It takes a long time for a restaurant company to work its way across the country, and meanwhile there's no competition from abroad. Denny's or Pizza Hut never has to worry about low-cost Korean imports.

What continues to separate the triumphs from the flops among the restaurant chains is capable management, adequate financing, and a methodical approach to expansion. Slow but steady may not win the Indianapolis 500, but it wins this kind of race.

The tale of two hamburger franchises, Chili's and Fuddrucker's, is instructive. Both started in Texas (Chili's in Dallas, Fuddrucker's in San Antonio). Both featured the gourmet burger. Both created pleasant and distinctive surroundings, although Chili's had table service and Fuddrucker's was cafeteria style. One became famous and lost a fortune, while the other achieved both fame and fortune.

Why? One reason was that Chili's diversified its menu as hamburger went out of style, while Fuddrucker's stuck with the burgers. But the key difference is that Fuddrucker's expanded too rapidly. When a company tries to open more than 100 new units a year, it's likely to run into problems. In its rush to glory it can pick the wrong sites or the wrong managers, pay too much for the real estate, and fail to properly train the employees.

Fuddrucker's fell into this trap and went the way of Flakey Jake's,
Winners, and TGI Friday's, all of which moved too fast and suffered for it. Chili's, on the other hand, has maintained a sensible pace of adding 30–35 new units a year. Revenues, sales, and net income have grown steadily under the experienced eye of Norman Brinker, founder of this chain as well as Steak & Ale and Bennigan's. Chili's expects to reach a ceiling of 400–450 restaurants in 1996–98, which it hopes will produce $1 billion in sales.

There are several ways a restaurant chain can increase its earnings. It can add more restaurants, as Chili's is doing, or it can improve its existing operations, as Wendy's has done. Some restaurants make money with high turnover at the tables and low-priced meals (Cracker Barrel, Shoney's, and McDonald's fit this category), while others have low turnover and higher-priced meals (Outback Steakhouse and Chart House are recent examples). Some make their biggest profits on food sales, and some have gift shops (Cracker Barrel). Some have high profit margins because their food is made from inexpensive ingredients (Spaghetti Warehouse), others because their operating costs are low.

For a restaurant company to break even, the sales have to equal the amount of capital invested in the operation. You follow a restaurant story the same way you follow a retailer. The key elements are growth rate, debt, and same-store sales. You'd like to see the same-store sales increasing every quarter. The growth rate should not be too fast—above 100 new outlets a year, the company is in a potential danger zone. Debt should be low to nonexistent, if possible.

Montgomery Securities in California keeps regular tabs on the entire restaurant group and produces excellent reports. Its latest analysis is that hamburger joints such as McDonald's and Wendy's are suffering from overexposure (the top five chains have 24,000 locations in the U.S.), and that the baby boomer generation is turning away from fast food. The momentum has shifted to niche restaurants such as Au Bon Pain and Spaghetti Warehouse, and medium-priced family restaurants that offer a varied menu.

If you had bought the top eight stocks on Montgomery Securities' recommended restaurant list at the beginning of 1991, you would have doubled your money by December. These winners were as follows:

Bertucci's

Cracker Barrel

Brinker International (Chili's)

Spaghetti Warehouse

Shoney's

Rally's

Applebee's

Outback Steakhouse

Several of these stocks may be overpriced as of this writing, with p/e ratios of 30 or higher, but it's worth keeping in touch. The restaurant group as a whole is growing at only 4 percent a year (soon this will be another nongrowth industry), but the superior operators with strong balance sheets will prosper in the future, as they always have in the past. As long as Americans continue to eat 50 percent of their meals outside the home, there will be new 20-baggers showing up in the food courts at the malls and in our neighborhoods, and the observant diner will be able to spot them.

Au Bon Pain is one I've spotted—where else? In the Burlington Mall. It started in my own neighborhood, Boston, in 1977 and went public in 1991 at $10 a share. I can't pronounce it correctly, but it's a great concept. You may have seen an Au Bon Pain in an airport or at a food court. It's a croissant and coffee shop that managed to combine French sensibility with U.S. efficiency.

Here you can get a plain croissant for breakfast, or a ham-and-cheese-filled croissant for lunch, or a chocolate-filled croissant for dessert, all in less than three minutes. The bread is made at one central location and is sent uncooked to the outlets, where it rises and is shoved in the ovens so it comes out hot and fresh baked.

Lately, Au Bon Pain has introduced fresh orange juice and fruit salad, and it's about to launch the state-of-the-art bagel. If it's a choice between investing in the state-of-the-art computer chip and the state-of-the-art bagel, I'll take the bagel any time.

By early 1992, the stock had doubled in price and carried a p/e ratio of 40 (based on expected 1992 earnings), which is why I decided not to recommend it. But nine months later, the price had fallen to $14, or less than 20 times 1993 earnings. Any time you can find a 25 percent grower selling for 20 times earnings, it's a buy. If the price dropped any further, I'd back up the truck. This company is doing well in a recession and can grow for a long time without running into itself. It has a lot of potential overseas as well.

A healthy portfolio requires a regular checkup—perhaps every six months or so. Even with the blue chips, the big names, the top companies in the
Fortune
500, the buy-and-forget strategy can be unproductive and downright dangerous.
Figures 21-1
,
21-2
, and
21-3
illustrate the point. Investors who bought and forgot IBM, Sears, and Eastman Kodak are sorry that they did.

The six-month checkup is not simply a matter of looking up the stock price in the newspaper, an exercise that often passes for Wall Street research. As a stockpicker, you can't assume anything. You've got to follow the stories. You are trying to get answers to two basic questions: (1) is the stock still attractively priced relative to earnings, and (2) what is happening in the company to make the earnings go up?

Here you can reach one of three conclusions: (1) the story has gotten better, in which case you might want to increase your investment, (2) the story has gotten worse, in which case you can decrease your investment, or (3) the story's unchanged, in which case you can either stick with your investment or put the money into another company with more exciting prospects.

With this in mind, in July 1992 I did a six-month checkup on the 21 selections I made in
Barron's
in January. As a group, these 21 had performed extremely well in a so-so market. The “portfolio” had increased in value by 19.2 percent, while the S&P 500 had returned only 1.64 percent. (I've adjusted all these numbers for the various stock splits, special dividends, etc., that were declared in this six-month period.)

FIGURE 21-2