David Einhorn's Dangerous Advice
Shares of Chipotle Mexican Grill (NYSE: CMG) were getting walloped yesterday on the news that hedge fund champion David Einhorn called the brand overvalued. Investors responded by pulling out of the company, for reasons that are still a bit unclear to me. I'm assuming that nothing secret and odd changed for the chain overnight, and that Einhorn isn't a mystic with access to information that no one else has. So what's going on here?
The case against Chipotle
Just so we're clear on what's happened, let's lay it out. Einhorn was speaking at the Value Investing Congress, and he indicated that Chipotle was overvalued because Yum! Brand's (NYSE: YUM) Taco Bell just launched a new upscale menu that's going to kill -- according to Einhorn -- Chipotle. You can go look at the intraday chart to see how the stock was affected; it's an interesting sight. At midday, it had rallied a bit to get to 4% down on the day.
Now, we'll get to the other problems that Chipotle has in a second, but let's start with this sell-off on the idea that Chipotle is overvalued. First a few more facts. Yesterday, Chipotle was trading at a P/E of 38 while the restaurant sector average is around 20 , but it takes Einhorn saying something for people to worry? This is one of the things that drives me crazy about the herd mentality, and after I talk about why Einhorn is probably right, I want to address this.
Why he's probably right
While the fact that Taco Bell has this new menu is getting most of the press, Einhorn actually talked about two other, more important factors. First of all, commodity prices are going to stomp on Chipotle's face. The difficult grain season will have an impact on both corn and meat prices. Chipotle's use of higher-end meat means that it's already paying more than its competitors. An increase in grain cost will likely have a higher impact on its meat prices than it will on its competitors, who use low-grain/high-supplement-fed meat.
Second, one of the many stipulations in the Affordable Care Act is that companies with more than 50 employees have toprovide health care to those employees. Chipotle employs over 30,000 people, so it's going to have some new costs. Einhorn is right to point out that these costs are going to eat into Chipotle's 18% operating margin, making it a less attractive investment.
I'd steer clear of Chipotle until these costs get sorted out, but nothing in Einhorn's list would get me out of the stock if I were already invested. These are not long-term problems, and as much as people love Taco Bell, Chipotle continues to offer something that a slightly fancier Taco Bell menu doesn't.
The herd mentality
The underlying problem with yesterday's fall is that it highlights two disturbing things. First, look how quickly investors are willing to discount their own research in the face of a Respected Gentleman's opinion. Have we forgotten about all the cases of these guys saying things that were good for them with no regard for ourselves? Did we forget that even the best investors are only right about 60% of the time? I know he nailed Green Mountain Coffee Roasters (Nasdaq: GMCR) last year, but let's all just calm down.
The second problem I have with this, and almost every other celebrity hedge fund investment, is that the person making the recommendation is often nothing like the other investors, and knows nothing about their positions and goals. It's one thing for a value guy to talk to other value guys and convince them that he's right, but I have some sneaking suspicion that most Chipotle investors -- keeping that P/E of 38 in mind -- aren't value guys.
Can you imagine the reverse situation? Some growth champion says Facebook is going to the moon and for some reason all the value guys jump on board? Of course not. That talking head only knows why he would invest, not why you would.
The bottom line
None of that is to say that Einhorn is wrong, or that Chipotle won't get canned by Taco Bell. It's all to say that as investors, we have to have some conviction. You have to trust your own research, and know that no one else knows your financial desires and needs better than you do. If being a better investor is more important to you than just doing what another guys tells you to do, you should check out my colleague's series on becoming a value investor. Michael Lewis -- not that one -- has a great eye for unpolished gems, and his series is a good foot in the door.
- Easy Steps to Becoming a (Better) Value Investor: Part 1
- Easy Steps to Becoming a (Better) Value Investor: Part 2
- Easy Steps to Becoming a (Better) Value Investor: Part 3
- Easy Steps to Becoming a (Better) Value Investor: Part 4