So what do China and Chipotle (NYSE:CMG) have in common?
I mean, beyond the first three letters of their names, their liberal use of rice and the fact that “consumption” is behind their success the past few years …
If you said impressive growth rates, you’re close. China remains the biggest driver of global GDP growth. Despite a “lower” forecast of 8.2% GDP growth in 2012, according to the World Bank, after a 9.2% rate in 2011, it’s hard to argue that this country is doing anything other than booming. Chipotle’s rise also is impressive, with a five-year earnings growth rate of almost 40%, and a stock price that has soared more than 575% since early 2007.
But beyond the high growth rates, what Chipotle and China share is something more sinister: the burden of unrealistic expectations, and the pressure to keep up unsustainable growth curves.
First, let’s look at China.
Consider that the gross domestic product growth in China was 9.2% last year, slowing from 2010’s 10.4% growth rate. Even in 2009, the country managed to top the 9% mark. The reality is that 8.2% GDP growth for 2012 is indeed considerably better than peers like the U.S., but it’s not historically where China has been.
In fact, if the 2012 forecast stands, China could see its slowest annual growth rate since 2000, when growth was 8%.
Is China growing? You bet. But the problem is that with a high-growth, high-momentum investment opportunity (colloquially called “bubbles”) you have investors who jump in with sky-high expectations. Everyone wants to get in and ride the surge. That builds buying pressure and results in more gains. More investors watch the profits from the outside and decide to jump in. The cycle continues.
Until the music stops, that is. Because nobody wants to be the last one to realize the growth is slowing down. Momentum, after all, can be just as fast on the way down.
Click to Enlarge Of course, talk about a “hard landing” or other slowdowns in China is hardly new. The vast majority of investors have begun to adjust their expectations down and already are planning an exit strategy. But it’s worth looking at the last decade of red-hot China growth via four very different companies that all illustrate the China bubble in a different way. They are China Mobile (NYSE:CHL), China Life Insurance (NYSE:LFC), China Petroleum & Chemical (NYSE:SNP) — also known as Sinopec — and the Aluminum Corp. of China. (NYSE:ACH).
As you can see, despite the very different industries these companies represent — and clear divergence after the 2007 peak for China equities — they all have crashed hard. There was life in Chinese stocks back in early 2010, but that seems to just be a “dead-cat bounce.” Even Sinopec, despite a nice 16% gain in the past six months on rising crude oil prices and stronger energy demand, remains well off its peak.
The takeaway: During the bubble, these stocks kept going up because they kept going up with no real differentiation between winners and losers. When expectations came crashing back to earth, so did the stocks. Only in the last year or two have we started to see divergence between these disparate businesses — as well we should. The idea of a telecom, aluminum stock, energy stock and financial company moving in lockstep is pretty silly considering the very different business models and risks.
By now I’m sure you’re wondering what all this has to do with Chipotle.
Well, the first connection I’d like to make is that the idea of momentum investments isn’t limited simply to China. Wall Street is littered with the carcasses of high-growth stocks that stopped growing as fast as their investors hoped, leading to painful crashes. Think Crocs (NASDAQ:CROX) or Netflix (NASDAQ:NFLX) for recent examples — or more particularly, think of the many fad restaurant chains that see big growth as they expand and then hit a wall after they can’t open up shops fast enough to sustain momentum.
Click to Enlarge Four stocks in particular I’d like to show are Krispy Kreme (NYSE:KKD), Red Robin Gourmet Burgers (NASDAQ:RRGB), P.F. Chang’s China Bistro (NASDAQ:PFCB) and Cheesecake Factory (NASDAQ:CAKE). Those with discerning palates or business sense will recognize that all of these chains have different brand identities, customer segments and other unique features.
However, the one thing that they all share is that after a few years, they hit critical mass — and crash.
Some crash sooner than others. And some bounce back after a few years like CAKE did, while others languish at the bottom like KKD. But the fact is all of these restaurants saw a big run-up followed by a big crash.
Why? Well, because you can only juice earnings and sales for so long by opening up new restaurants. After all, retailers always reference sales at locations open for at least a year as their benchmark for a reason. “Grand opening” hype and promotions naturally inflate sales for any enterprise — and a fashionable new restaurant opening up new locations every week is riding its novelty much more than its core business model.
And when stores can’t open up fast enough and the bloom is off the rose, that initial surge wanes. It doesn’t matter if the restaurant is profitable or growing substantially — it’s all about expectations. And if expectations remain persistently high, the sad reality is that the growth eventually is going to fall short.
Which leads me to Chipotle’s chart.
And Chipotle’s earnings performance against forecasts.
Sure, CMG is still growing. But it’s barely keeping up with expectations. And as history has shown, you don’t want to be the last investor to learn that the company has peaked and is on the downswing. These momentum stocks crash fast when they stumble.
I’ll readily admit that I have been dead wrong on Chipotle for some time, including a bonehead call that CMG was a short back in December. Shares are up 28% year-to-date, proving me painfully off target with that call.
I’ll also admit that some momentum stocks keep their mojo — most notably Apple (NASDAQ:AAPL), which always manages to find a way to beat expectations and suck in even more sales and profits despite its already massive reach. A rapid run-up isn’t always a sign of disaster.
However, CMG isn’t reinventing the smartphone here. It’s dishing up burritos and opening up new restaurants. So you have to ask yourself what it is beyond the rapid share appreciation and the previous sales growth that is really attractive about this stock.
Because as China has proven to us, simply growing and delivering profits isn’t enough. In the end, it’s all about whether Wall Street expects things to go up from here — and I remain convinced that by the end of 2012, investors will realize that the red-hot run of Chipotle has run its course.
What goes up must come down. Don’t be stuck holding the bag.
Jeff Reeves is the editor of InvestorPlace.com, and author of “The Frugal Investor’s Guide to Buying Great Stocks.” Write him at email@example.com, follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the aforementioned stocks.