Throughout the second quarter, several gurus have increased their positions in restaurants, including Cheesecake Factory Inc. (CAKE, Financial) and Starbucks Corp. (SBUX, Financial). As these companies have high profit margins, the restaurant industry offers good value opportunities to investors.
As discussed in previous articles, Peter Lynch and Warren Buffett (Trades, Portfolio) invest mainly in undervalued companies that have predictable earnings growth and high profitability. Based on five separate factors, including operating margin, the profitability rank measures how profitable a company is and how likely the company’s business will remain profitable in the short term. Companies that have a profitability rank of at least 7 are likely to stay profitable, resulting in high value potential.
The best industries to invest in based on historical profit margins
To determine which industries have the highest profitability potential, we can rank the industries based on current profit margins relative to historical profit margins. The investing score, as discussed in the previous article, measures how likely the industry will offer good investing opportunities relative to all companies trading on the New York Stock Exchange and the Nasdaq.
The following statistical study considers the company’s operating margin, net margin, gross margin and pretax margin. For each industry, we compare the current margins to the historical median margins, and assign the following values:
- Since the operating margin most likely explains the company’s profitability, the industry scores 2 if the current average operating margin outperforms the historical average median operating margin. Otherwise, the industry scores 0.
- For the other three profit margins, the industry scores 1 if the current average margin outperforms the historical average median margin and 0 otherwise.
We repeat the above process for both the average and median margins for each industry, and take the sum of all the scores to get the industry’s investing score. Thirty-two industries, including the restaurant industry, have an investing score of at least 8 as of September 2016. These industries have a median operating margin of 13.64 and a median net margin of 8.47.
Gurus increase positions in high-performing restaurant companies
The “Good Margin Growth” Screener bought Starbucks in January 2013 and The Cheesecake Factory in January 2014. Among these companies, Starbucks currently has the highest gross margin. This suggests that the specialty coffee retailer has durable competitive advantage, one of four criteria for Buffett-Munger companies. The company’s operating margin is near a 10-year high, and outperforms 89% of global restaurant companies. Additionally, Starbucks has returns on equity and returns on assets in the top 5% of its industry. With high margins, returns and three-year EBITDA growth, the coffee retailer has a profitability rank of 8.
As the company offers high value potential, four gurus took a stake in Starbucks: Steven Cohen (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Caxton Associates (Trades, Portfolio) and Louis Moore Bacon (Trades, Portfolio). Cohen, manager of Point72 Asset Management, purchased 711,000 shares of Starbucks at an average price of $56.86. During the past five years, the guru once owned over 4 million shares of Starbucks.
Despite having modest gross margins, The Cheesecake Factory has a slightly higher financial strength rank than does Starbucks. The upscale casual dining company has high Piotroski F-scores and Altman Z-scores, suggesting a strong business outlook. Additionally, the company’s valuation ratios are near three-year lows.
The Cheesecake Factory has seven good signs, including expanding operating margins and consistent per-share revenue growth. The company’s return on equity and return on assets are near a 10-year high, and its return on invested capital outperforms its WACC. Furthermore, the company has a 4.5 star predictability rank.
Jeremy Grantham (Trades, Portfolio), Steven Cohen (Trades, Portfolio) and Joel Greenblatt (Trades, Portfolio) invested in The Cheesecake Factory during the second quarter. With 950,000 shares, Ron Baron (Trades, Portfolio) owns the highest number of CAKE shares. Mario Gabelli (Trades, Portfolio) comes in second with 889,465 after slightly trimming his position in the company.
Conclusions and see also
The “Good Margin Growth” screener lists the company stocks that score at least 7 for both the financial strength rank and profitability rank, and have an operating margin growth rate of 5%. Additionally, this screener only considers the 32 industries that are discussed above. Based on annual rebalancing, a screen date of January 2006 and up to 50 stocks, the strategy returned 129.60% overall when the portfolio ranked companies by decreasing financial strength.
You can find good investing ideas from gurus using Sector Picks and Consensus Picks. The former lists the guru buys within a sector while the latter lists the company stocks that multiple gurus have bought in the past three months. Premium members have access to all the value screeners and over 150 gurus’ portfolios. The premium plus membership further gives access to the Manual of Stocks of all U.S. companies and up to 10 years of backtesting in the All-in-One Guru Screener. Please sign up for a free seven-day trial.
Disclosure: The author has no position in the stocks mentioned in this article.
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