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6 Great Restaurant Stocks

My two longtime favorites are Chipotle and Starbucks, which have franchises built for Americans' changing eating habits.

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I’m lucky to have eaten at some of the best restaurants in the world. But when I dream about great food experiences, what I remember most is chomping down on my first Five Guys hamburger nearly 30 years ago. Caramelized crust, juicy interior, great bun.

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At the time, there was just one Five Guys, a carry-out place with no tables in a dingy shopping center in Arlington, Va. In 2002, the founders, the Murrell family, decided to expand beyond the Washington area. The franchises were a huge hit, and now more than 1,000 Five Guys outlets grace 47 states and six Canadian provinces.

Here’s the bad news: You can’t invest in Five Guys. The company is privately owned, as are Chick-Fil-A and In-N-Out Burger, two other great chains. Still, Five Guys provides lessons for investors interested in owning shares of restaurant companies. First, great chains can come out of nowhere and grow rapidly. Second, the winners keep it simple. At most of its locations, Five Guys serves burgers, hot dogs, grilled cheese sandwiches, fries and drinks. That’s it. Third, quality counts. Five Guys makes delicious food from excellent ingredients. Nothing is frozen.

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The Bizarro World version of Five Guys is McDonald’s (symbol MCD, $100). The first key difference is size. With more than 36,000 restaurants worldwide, McDonald’s growth potential is limited. Second, McDonald’s menu, engineered by its brilliant founder, Ray Kroc, to be simple and easily processed, has become rococo. McDonald’s Web site reveals 96 items, not counting breakfast dishes. Third, as the taste of Americans has improved, the taste of McDonald’s food has not, in my view. (Share prices are as of July 31.)

McDonald’s is losing business to rivals, such as Five Guys, Panera Bread (PNRA, $204) and Chipotle Mexican Grill (CMG, $742), that offer better food at slightly higher prices in hipper surroundings. (Stocks in boldface are those I recommend.) McDonald’s new CEO, Steve Easterbrook, wants to improve the quality of the food, but he also wants to make breakfast an all-day event, thus enlarging an already bloated menu.

McDonald’s has such a powerful brand—the sixth-most-valuable in the world, according to Forbes—that if Easterbrook can’t solve the company’s problems, it’s a decent bet that the next CEO will. If McDonald’s stock were depressed, I would be tempted to make what I call a faith-based recommendation. But the stock is trading at about where it was in late 2011, a year when both sales and profits were higher than they will be in 2015. I would stay away.

Impressive recovery. Restaurant stocks took a big hit during the 2007–09 bear market, even though most of the companies held up reasonably well. Starbucks (SBUX, $58) is a good example. Earnings dipped from 44 cents a share in the fiscal year that ended in September 2007 to 36 cents the following year. But by the 2010 fiscal year, profits reached a record 64 cents per share. Analysts expect the company to have earned $1.58 a share in its 2015 fiscal year. Meanwhile, sales have tripled in a decade. And Starbucks, with more than 22,000 stores worldwide, still has room to grow. At Papa John’s International (PZZA, $76), the pizza chain, earnings have risen every year since 2003 in what I call a beautiful line. At Cracker Barrel Old Country Store (CBRL, $152), the beautiful line begins in 2000. (For more on Cracker Barrel, see 7 Great Stocks That Keep Raising Dividends.)

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Some of the stocks have been sizzling. Consider Shake Shack (SHAK, $68), started in 2001 by Manhattan restaurateur Danny Meyer as a hot dog cart in Madison Square Park. With its small menu, tasty food and rapid growth, Shake Shack shares some key characteristics with Five Guys, though I think Five Guys offers superior burgers and fries. Shake Shack went public in February at $21 a share and hit $93 in May before retreating. But with a market capitalization of $2.5 billion, the shares look awfully expensive for a firm that’s expected to generate sales of $213 million and earnings of less than $10 million in 2016.

Additional headwinds for restaurants: rising rents, big increases in the minimum wage in some states and cities, and softness in the economy of China, which is critical for the growth of such companies as McDonald’s and Yum Brands (YUM, $88), owner of KFC, Pizza Hut and Taco Bell.

I’d avoid most restaurant stocks until the next significant market downturn (a drop of at least 20%), but I am fond of a few tried-and-true companies. One is Cracker Barrel, which operates 634 restaurants with gift shops attached, mostly along highways. The stock trades at 21 times estimated year-ahead profits. That’s reasonable for a chain that has consistently generated double-digit-percentage profit growth. Plus, the stock’s dividend yield is 2.9%, well above the market’s yield of 2.1%.

Also tasty is Cheesecake Factory (CAKE, $58), which operates 189 restaurants and provides baked goods to other outlets as well. And I like Ruth’s Hospitality Group (RUTH, $18), which got clobbered in the recession but has made a sprightly turnaround and trades at a modest price-earnings ratio of 21. (I used to eat Ruth’s sizzling sirloin strip at Ruth Fertel’s first restaurant, in New Orleans.) Among newer entrants, my top choice is Del Frisco’s Restaurant Group (DFRG, $16), which, like Ruth’s, is a steakhouse chain. Earnings are expected to rise 17% next year, and the P/E, based on estimated year-ahead profits, is a reasonable 17.

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My two longtime favorites are Chipotle and Starbucks, which, unlike McDonald’s, have franchises built for Americans’ changing eating habits: growing interest in Latino foods and the desire for something spon­taneous at a place to read and work. Both companies offer decent food, but there’s plenty of room for improvement. Imagine Starbucks with pastries that are actually tasty. I’m betting on it.

James K. Glassman, a visiting fellow at the American Enterprise Institute, is the author, most recently, of Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence. He owns none of the stocks mentioned.