Investors are fattening their portfolios on restaurant stocks

More confident U.S. consumers are eating out again, while innovative corporate restructuring has improved cash flow

Harveys employee serving a burger

Harvey’s owner Cara Operations served up a 43% gain on its first day of trading. (Trevor Terfloth/Chatham Daily News/QMI)

Investors are usually ill-advised to try the flavour of the month, but something’s definitely bubbling in the food-service business. Despite the well-publicized challenges faced by established chains like McDonald’s (NYSE: MCD), Olive Garden (NYSE: DRI) and Quiznos, the S&P 500 Restaurants sub-index is up 14% since Jan. 1. Here in Canada, investors have eagerly snapped up new offerings such as Cara Operations and Restaurant Brands International.

Why the outperformance? The simple answer is improving consumer confidence, says Paul Taylor, BMO Asset Management’s senior vice-president and chief investment officer for asset allocation. As the memory of the recession faded in the U.S., people were spending again. “After the crisis, people hunkered down and deferred new purchases,” he says. “It was the same with eating out, but the consumer is starting to feel better.”

There’s more to the story, though, says Will Slabaugh, a research analyst with Stephens Inc. Many companies have put a renewed focus on franchising, which shifts some of the operating risk from the company to the franchisee. Wendy’s Co. (Nasdaq: WEN), for instance, owned 23% of its locations in 2012 but has steadily been selling them off. It eventually wants to own only 5% of its stores. Over the past 12 months, the company’s stock has risen 26%. “The franchise model is better perceived by Wall Street right now,” says Slabaugh. “You get a more steady cash flow stream, and it takes away some of the expense, commodity inflation and labour risk on the income statement.”

There’s also a rising cohort of chains that seems to be getting the recipe just right. Chipotle (NYSE: CMG) and Shake Shack (NYSE: SHAK) have demonstrated a new-found taste for a more upscale fast-food experience. Mediterranean restaurant Zoe’s Kitchen (NYSE: ZOES) went public in 2014 and is up 64% since. These smaller operations can grow outlets by 25% annually and same-store sales by 5% to 10% a year, Slabaugh says. “That’s an attractive growth opportunity for small-cap investors, who haven’t had a lot of options in the restaurant category.”

In Canada, meanwhile, many institutional investors have been overweighting cyclical sectors as they lighten up on commodities. That contributed to the demand for shares of Cara Operations, owner of Harvey’s, Swiss Chalet and Milestones, Taylor says. The stock burst out of the gate in April, rising 43% on its first day. We will likely see more restaurant IPOs in the future, he adds. A lot of the best food-service companies are private but will either go public to take advantage of the markets’ appetite or get purchased by publicly listed operators.

One caveat: At the moment, the sector is more expensive than its historical norm; a quickly growing company should be trading at around 20 times EBITDA, but some are trading at 40 times or higher. That should make investors both cautious and picky. Before buying, have a clear picture of how the firm plans to grow its earnings. That includes seeing same-store sales initiatives and growth in franchised locations, says Slabaugh.

The food and service have to be high quality as well, adds Taylor. But he thinks this dinner rush is far from finished. “This is an ongoing growth story, especially in the Canadian market,” he says. “And this is a market that is starved for growth.”