Why You Should Avoid Shake Shack's Stock

Great Burger, Pricey Stock.

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 The hardest part of retail investing is using a "buy what you know" strategy correctly. Yes, the strategy can help you to find good businesses that have some sort of edge. But those businesses will only make good investments if you buy the stock before Wall Street catches on. 

Finding a good business is never enough; you have to do the homework on a stock. If you don't, if you simply buy a stock because you like a product, "buying what you know" can turn against you.

I believe that Shake Shack is about to prove this point. 

The trendy, millennial-friendly, burger joint  doubled in its initial IPO day in 2015 and it doubled again in short order. Along the way the "shack" has done plenty right, but the stock may not deliver tasty returns to investors buying today. Here's why.

Valuation

You don't have to be a valuation expert to see that Shake Shack's stock is a tad pricey.

  • The stock trades at a price to earnings (P/E) multiple over 1,000 and its forward P/E is 550. By any measure, that's an absurd valuation. The current P/E for the S&P 500 is 20! The P/E for Chipotle, the king of the fast casual sector, is 40. 
  • Today, Shake Shack has a market capitalization around $3 billion. By comparison, Brinker International, the profitable parent company of Chilis and Maggiano's Little Italy, also has a market cap around $3 billion. Shake Shack has 63 restaurants, Brinker has 1,622. The market is telling us that each Shake Shack restaurant is worth 25 times more than each Brinker restaurant; this isn't backed up by earnings, revenues, or any other metric. 
  • The average analyst estimate for Shake Shack's stock price, by year's end, is around $45. While analysts are often wrong, when estimates are this far off something may be fishy.

I could go on, but you get the point, by any measure the stock is too hot. What investors need to ask themselves is: why has the stock gone so high and can it continue?

 

Artificial factors and hype drive Shake Shack

It is my opinion that a number of unsustainable factors have driven Shake Shack's stock price to date.

  • The stock has a very small number of shares outstanding, yet huge short interest. When any good news hits, the short sellers get squeezed out and the stock price is exaggerated upward because there are so few shares. This wouldn't be the case if Shake Shack had issued more shares, or if it had fewer short-sellers.
  • The stock has cashed in on the trend of fast casual IPOs  like Chipotle, Potbelly, Noodles & Company, and Zoe's Kitchen. Of the group, only Chipotle has truly lived up to its hype. The rest have soared as IPO's, reported a few good quarters, and then come back down to earth. This doesn't mean that Shake Shack can't prove different, but at least its initial IPO bump was driven on pure hype.
  • The stock has risen on rumors and speculation. When it recently filed to trademark the name "Chicken Shack," the stock rose on speculation of a new concept or product. When its CEO said he wouldn't rule out acquisitions, the internet buzzed again. This is natural, the stock is popular right now and articles need to be written about something. But buying the stock on these rumors requires investors to take huge leaps of faith (like assuming an acquisition or chicken concept will be successful). That's just foolish. 

    Don't get me wrong, there are plenty of good things happening at Shake Shack. The burger chain just released a monster quarter in which same-store sales jumped 11.7% and revenue was up 56.3%. It has a wonderful niche, a quality product, and a cool atmosphere, not to mention a cult following. It's just that the stock price has soared way beyond any reasonable growth expectations. 

    History tells us that the restaurant industry is uber competitive and that Shake Shack will have set backs. It has other "better burger" competitors (Five Guys for example) that are well established. If it continues to have success, more competitors will come and the law of large numbers will drag on comparable sales growth. The stock is priced for expansion, yet the company hasn't proved its concept will work outside of large, affluent, cities like New York and Chicago.

     

    Sure, Shake Shack will continue to grow, but it won't be in a straight line. The stock is simply priced for results that few restaurants, even great ones, can live up to.