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The Science of Hitting
The Science of Hitting
Articles (494) 

Living With Individual Stock Volatility

Some thoughts on investing in small companies for the long run.

June 04, 2018 | About:

Zoe’s Kitchen (ZOES), a small restaurant chain specializing in Mediterranean food, recently reported financial results for the first quarter of fiscal 2018. The results were disappointing, with the stock falling about 40% to less than $9 per share. The company’s stock price has fallen all the way from a high of roughly $45 per share, which it reached in in July 2015.

Obviously, the results caught investors by surprise. It’s never fun to wake up and find yourself holding a stock that’s now worth significantly less than it was yesterday. That 40% drop is the kind of move that makes you want to immediately sell, regardless of how cheap the stock may appear. Get that red ink off your portfolio statement ASAP and never mention the name again!

That desire to cut the cord for the sake of not feeling dumb is even more acute when you’re an investment advisor with clients to answer to. But as we know, the easy emotional decision isn’t (necessarily) the right investment decision. This setup can lead to interesting opportunities for investors who can stay levelheaded and focus on the only thing that truly matters (price to value).

But this article is less about Zoe’s Kitchen, and more about setting realistic expectations around market volatility. As I thought about the company’s results and the subsequent reaction by Mr. Market, something dawned on me: If you own a small company like Zoe’s Kitchen for long enough, significant drawdowns are highly likely to occur. Maybe it won’t be a 40% sell-off, but there will be days where you wake up and find the stock down 10% or more.

That partly has to do with the nature of being a small company generally and a small restaurant chain specifically. In this business, comparable store sales (comps) drive much of the discussion and are subject to meaningful changes in trend over relatively short periods of time. That’s a dangerous combination. When you extrapolate quarterly comps and their impact on margins, unit economics and the long-term opportunity for a chain to add locations, you will see some huge swings in your fair value estimate. The range of outcomes spans from dire to euphoric; where you land largely depends on last quarter’s comps.

For that reason, significant volatility in the stock price for a company like Zoe’s should be expected. So here’s the next question that came to me as I thought about Zoe’s: If you’re 100% convinced that this chain will be successful over the long run, how much volatility should you expect in the early years as the company is growing its footprint and trying to establish the business?

If we're looking for a successful restaurant chain, the obvious choice is Chipotle (CMG).

But a comparison to Chipotle comes with one major caveat: the company was privately financed and free from Wall Street’s scrutiny during its formative years. McDonald’s (MCD) invested roughly $50 million in Chipotle in 1998 and eventually owned 92% of the company. Its cumulative investment in Chipotle was roughly $350 million, which fueled growth for the fast casual chain in the early 2000s. By the time Chipotle went public in 2006, it had more than 500 locations and was generating roughly $750 million in annual revenues. As we think about Chipotle in its early years as a public company, it’s worth recognizing that it was already a much more mature business than Zoe’s (which reported $276 million in revenues from roughly 200 units in 2016). Based on that fact, it seems reasonable to assume that the volatility experienced by Chipotle in its early years as a public company was less than what you should expect for Zoe’s Kitchen.

With that said, here’s what I’m interested in figuring out: What was it like being a Chipotle investor in those first few years after it went public? With the benefit of hindsight, we know that this has been one of the most successful restaurants in recent memory – and a highly lucrative investment for people that got in after the IPO. But how much volatility would you have had to weather if you held Chipotle shares through its first five years as a public company (Jan 2006 - Jan 2011)?

First, let’s start with the price chart:

As you can see, the stock moved around a lot in the early years. It more than tripled within two years after the IPO (the stock started trading at $45 per share), but then declined sharply during the financial crisis. From peak to trough, CMG was down by roughly 75% at its lows in early 2009.

As we dig deeper, we can see that significant daily moves for the stock were common as well. According to Yahoo Finance data, there were 1,259 trading days from the end of January 2006 through the end of January 2011 (a five year window). Here’s the frequency of significant moves in the stock price to the upside or the downside over that period:

As you can see, CMG made a 3%+ move up (13.7% of the time) or down (10.2% of the time) about 25% of the time during this period (those numbers are inclusive of the larger moves). Focusing on the downside, we can see that the stock was down 5% or better more than 40 times, or about once every six weeks. Finally, we can see that Chipotle’s stock price fell by more than 10% on five separate occasions from 2006 to 2011 (once a year). The worst of those moves was in September 2008, when CMG shares fell by 20% in a single day (there was also a period a month later in October 2008 when the stock fell by roughly 10% on two consecutive days). As you can see, the stock was pretty volatile during this period.


Here’s the point: If you’re going to invest for the long term in small companies still trying to put themselves on solid footing (like Zoe’s today or Chipotle 10 to 15 years ago), you should expect periodic bouts of gut-wrenching volatility. What you have to ask yourself is whether you’re okay with that short-term pain; will you be able to weather those kind of moves? If the idea of a huge red number in your brokerage account is unbearable, you want to recognize this before the damage occurs, not after.

Of course, even companies widely perceived as safe can have their fair share of volatility. Just last month, Phillip Morris fell 16% in one day on weak results. Trying to avoid “risky” investments like Zoe’s may be part of the answer, but it’s not the only consideration. This requires some thought on the portfolio construction process as well (finding a proper level of diversification).

As with most things in investing, what works for you or me will probably be different. The important thing isn’t finding the optimal solution. It’s finding a solution that works for you.

We’re many years into a bull market that has given equity investors all they could possibly ask for. But as we all know, the good times won’t last forever. The time to think about whether you are appropriately positioned to handle distress is now – not after disaster has struck.

Disclosure: None.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (7 votes)



Thomas Macpherson
Thomas Macpherson premium member - 7 months ago

Great stuff Science. Loved the article and supporting data. I ran a report when I was at Nintasi and I had 570 days when individual portfolio holdings were down more than 10%. That's a lot of Alka Seltzer. Thanks for posting this. Best - Tom

Stephenbaker - 7 months ago    Report SPAM

Science, you hit the nail on the head as usual. One should expect volatility with thinly traded, small cap stocks. Volatility is not the issue, the REASON for the volatility is what ultimately matters. If volatility is the consequence of some real, underlying problem, it is not the volatility that matters as much as the problem itself. If the volatility is the symptom of a significant investor's impatience or the like, that on the other hand is a value investor's best friend. If you (or I) cannot decifer the reason for the volatitiliy, my inclination is not to be an investor in the first place.

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Thanks for the kind words Tom! It's probably worth noting (for people who don't know) that Nintai has had impressive long-term results despite those 570 days. This is a reality of investing, even for those who are above average. Thanks again for the comment!

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Stephen - And now you hit the nail on its head! :) Thanks for the comment.

Dr. Paul Price
Dr. Paul Price - 7 months ago    Report SPAM

What was amazing with Zoe's (ZOES) was not that it fell from $46.61 to under $10 but that it was ever up near those highs at all.

ZOES lost 58-cents per share in 2014, It earned just 6-cents in 2015, then 9-cents in 2016. The firm regressed to losing 10-cents a share in 2017.

Why should anybody have paid $30 - $40 for that crappy company before the drop? Why is it worth even $9 - $10 today?

Thomas Macpherson
Thomas Macpherson premium member - 7 months ago

As usual Paul - direct, fact-based, and astute questions. Why $10 indeed! Hope you are well. Best. - Tom

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Dr. Paul - Presumably people are willing to pay $9 - $10 per share because they do not believe that the current income statement reflects where the company will be in 5-10 years. You can look at the historic financials for a company like CMG if you want to appreciate how the economics could evolve IF the Zoe's successfullly expands the base and improves unit economics. Whether that's a smart bet at the current valuation is another question. Thanks for the comment!

Thomas Macpherson
Thomas Macpherson premium member - 7 months ago

Hey Science. I noticed that the latest Graham & Doddsville newsletter (Spring, 2018) had a joint interview with Michael Mauboussin & Tom Digenan. In it they mention Michael's paper "Managing the Man Overboard Moment" which does a terrific job discussing how to make an informed decision after a large price drop. The article can be found here and the newsletter can be found here. Just thought I'd at that to the discussion. Thanks again. Best - Tom

Stephenbaker - 7 months ago    Report SPAM

Tom, as a 57 year old individual and having lived through several large price drops including 1987 and 2008 among others, I would question why the decision-making process should be any different than usual after a price drop? Prudent behavior would dictate that decisions as to what to do after a large price drop be made before a price drop; afterwards one simply needs to act on the predetermined decision or course of action. When emotions are taken out of the decision-making process, decisions are easier and likely much more financially rewarding.

Thomas Macpherson
Thomas Macpherson premium member - 7 months ago

Hi Stephen. I'll let Michael and his team explain the purpose/scope/recommendations of the article, but the gist is that the procss IS the same, but executing on it after a 10% drop is where the difficulties lie. I think you will find that you, Michael, and I are coming at this from a unified standpoint. My best wishes. - Tom

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Thanks for the links Tom! I have some reading to do now :)

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