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Chipotle Stock Crash Was Overdue

Well, that spicy growth stock Chipotle (NYSE:CMG) has finally gone “weak sauce,” as the kids say.

Despite continued growth and impressive earnings — profits soared 61% for its second quarter, year-over-year — the stock is down almost 20% in early trading. That’s because total revenue “only” increased 21% to $690.9 million vs. a forecast of $704.8 million. And missing that key revenue mark sent shares reeling.

You might be wondering why in the world a stock like Chipotle could get punished so badly for a relatively small miss like this. After all, its earnings are growing at a clip of 31% annually for the past five years.

Shares were up (before today’s crash of course) more than 520% since the beginning of 2009, 340% since the beginning of 2010 and 71% since the beginning of 2011.

But the thing about a momentum stock like this — especially one in retail or restaurants, where rapid expansion is the name of the game — is that the momentum eventually has to end. So it’s not about past success anymore, but the very high expectations for future growth.

This time around, Chipotle couldn’t meet the lofty expectations of investors. After all, this stock had a forward price-to-earnings ratio of over 36 based on fiscal 2013 numbers! Mature restaurant McDonald’s (NYSE:MCD) are sporting a P/E of around 15. Yum! Brands (NYSE:YUM) is around 17 and Wendy’s (NASDAQ:WEN) is 22.

Obviously, Wall Street had a much higher bar, and Chipotle has a much more painful descent when it misses the mark. That’s because at the first sign of trouble, panic-striken investors elbow each other out of the way to get out.

And then you get days like today.

The problem for Chipotle (and all momentum stocks) is how to find growth once the initial momentum wanes and the company matures. And the problem for investors is trying to find the one or two signs of stress that indicate the stock is slowing down — and it’s time to jump ship before shares flop.

Let’s take the recent example of Green Mountain Coffee Roasters (NASDAQ:GMCR), which is off 80% in the past 12 months. Its challenge was what came next after everybody and their brother already owned a Keurig single-serve coffee system, and how to protect profits as some of the technology was going off-patent. The stock was brutalized at the beginning of May after reducing guidance — and investors panicked, rushing to the exit. And strangely enough, that race for the door proved wise since shares are down about 30% from the initial crash this spring as numbers have failed to firm up.

Chipotle isn’t a one-to-one comparison with GMCR, but it’s worth noting that the idea of a “critical mass” for momentum stocks. Eventually, the expectations become too great and there simply aren’t enough customers to continue the breakneck growth with the percentages investors demand.

Specifically, CMG will have a tough time moving the needle simply by opening new stores. It operated 1,316 stores across the country as of the end of the quarter — and yes, it expects to add 155 to 165 new restaurants for the full year. That’s 11% growth, but clearly investors were demanding much higher figures than that. So it has to squeeze more and more from existing operations each quarter.

As we found out today, it couldn’t squeeze hard enough.

The lesson from Chipotle should be clear: Momentum swings both ways. When times are good, traders are eager for a piece of the profits and pile into stocks like CMG — sending share prices soaring. But when times are bad, they panic and scurry for the exit to drive the price to new lows.

If you want to play these stocks, you have to understand this is the nature of the game — and you must always be on guard for a sign that the ride is over.

For the record, I had been afraid the ride was slowing down for a while in CMG. Case in point, a story from December where I called CMG one of five “surefire shorts” for 2012. Obviously that was premature; before the bell, Chipotle had been up 20% year-to-date. But my overall thesis — that inflation would start eating at margins and the breakneck growth simply couldn’t keep pace with expectations — seemed right on the money.

I revisited the idea again in April and warned investors of the risks of Chipotle — comparing CMG to other red-hot fad investments that burned traders. Those included Chinese stocks like China Mobile (NYSE:CHL) and China Life Insurance (NYSE:LFC) during the late 2000s, or other sizzling restaurant stocks from P.F. Chang’s China Bistro (NASDAQ:PFCB) to Krispy Kreme (NYSE:KKD).

I’m not trying to toot my own horn here, just trying to point out that Chipotle’s crash did not come out of left field.

Those who were watching the stock knew it was only a matter of time.

Jeff Reeves is the editor of InvestorPlace.com, and author of “The Frugal Investor’s Guide to Buying Great Stocks.” Write him at editor@investorplace.com, follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks mentioned here.

Article printed from InvestorPlace Media, https://investorplace.com/2012/07/chipotle-stock-crash-was-overdue-cmg/.

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