Expand Your Palate

 | Jun 13, 2012 | 12:30 PM EDT
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With markets so complicated right now with respect to Europe's banking crisis, the U.S. monetary policy and global politics, it's understandable that investors are losing confidence in the markets. But macro-level complexity should not over shadow a basic truth in investing. Above all else, long-term stock price performance responds to growth in earnings. Apple (AAPL) has been a home run because it's minting money. AutoZone (AZO) has been a big success because it's minting money. A second truth is that less is more in investing; when fewer eyes are on a stock, the opportunity for price to value discrepancy is greater. By default, less attention is given to smaller cap issues.

The restaurant industry is often misunderstood. Because the U.S. has millions of restaurants, all restaurants are often categorized as unattractive low margin businesses with low barriers to entry. Indeed, one usually thinks of technology companies or other monopolistic type business when thinking about high margins and return on equity. Consider this math: spend about $800,000, generate an average of $2 million in sales and $550,000 in operating cash flow each year translating into a return on investment of nearly 60%. These numbers are not fiction; they are the unit economic model of each Chipotle (CMG) restaurant. Is it any surprise that shares have nearly tripled during the "recession"?

I wish I could find the micro-cap equivalent of a Chipotle. On the other hand, there are some tasty restaurant stocks that are off the radar of Wall Street because they are too small; its more profitable to sell research for names such as Apple and Chipotle than it is for a name like Ark Restaurants (ARKR), which owns and operates 22 restaurants and bars as well as 28 fast-food concepts and catering operations. The restaurants are located in dining meccas that include New York, Las Vegas and Washington D.C. Shares trade for $14, the company has no debt and generates a return of equity of 11%. Shareholders are treated to an annual dividend of $1, good for a 7% yield.

Kona Grill (KONA) owns and operates upscale casual dining restaurants offering fresh American cuisine, sushi, and a strong bar business. The company has 23 restaurants across 16 states. The company has a market cap of $75 million and generates nearly $100 million in sales. Kona is positioned as an upscale restaurant with an attractive average check price of $25 per person. It's positioned to serve young professionals and others who are less sensitive to economic changes. Customers earn higher incomes and demonstrate a higher frequency of dining out. Management recently announced a $5 million share buyback and the CEO owns 15% of the company. EBITDA has jumped from $4 million in 2008 to $9 million in 2011 and expected to top $10 million in 2012. The balance is pristine with no net debt.

Restaurants by default have a huge market opportunity: Most Americans eat out two to three times every single work day. Plus, regardless of the economy, dining out is a favorite pastime in America. Whether it's a simple family visit to a McDonald's (MCD) or young professionals and working adults visiting their favorite hot spot for drinks and food, good restaurants are attractive and stable cash-flow producers. The above micro-cap names are two exciting concepts that, if they were any bigger, would be Wall Street darlings.

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