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Summary BITE is the first ETF to target the restaurant industry. This ETF currently has 45 holdings (most mentioned in this article) and includes many of the “best” eateries. This ETF may be the best way to invest in what can be a mine field of stocks. I have never felt compelled to invest in the restaurant industry. To start with, I’m not sure which kind of “restaurant” I would be interested in investing in. To begin with, there are so many eateries around that it helps to subdivide the industry into categories , but even then it can be difficult to classify some of the companies. Typical categories might include: Upscale: Ruth’s Chris Steak House / Ruth’s Hospitality, Inc. (NASDAQ: RUTH ) Casual: Ruby Tuesday, Inc. (NYSE: RT ) Fast Casual: Noodles & Company (NASDAQ: NDLS ) Entertainment: Dave & Buster’s Entertainment, Inc. (NASDAQ: PLAY ) Family: Bob Evans Restaurants ; Bob Evans Farms, Inc. (NASDAQ: BOBE ) Ethnic: Chipotle Mexican Grill, Inc. (NYSE: CMG ) International: The Olive Garden 1 Regional: El Pollo Loco, Inc. (NASDAQ: LOCO ) 2 Regional Atmosphere: Texas Roadhouse, Inc. (NASDAQ: TXRH ) 3 Upper-Scale Burger: Red Robin Gourmet Burgers, Inc. (NASDAQ: RRGB ) Mid-Level Burger: Steak ‘n Shake 4 Fast-Food Burger: McDonald’s, Inc. (NYSE: MCD ) Drive-Thru: Sonic Corp. (NASDAQ: SONC ) Pizza: Pizza Hut 5 Pizza Delivery: Domino’s Pizza, Inc. (NYSE: DPZ ) Chicken: Popeyes Louisiana Kitchen, Inc. (NASDAQ: PLKI ) 6 Bakery: Panera Bread Co. (NASDAQ: PNRA ) 7 Donuts: Dunkin’ Donuts 8 Café-Style: Starbuck’s Corp. (NASDAQ: SBUX ). It is not easy to categorize some restaurants, however, so we end up almost needing to make a separate category for each eating establishment. It can also be difficult to find out just what company to invest in, as many restaurants are owned by holding companies that may own several restaurants and/or restaurant chains 9 – and maybe some non-food related businesses as well. 10 It is also possible to invest in franchisees. Besides investing in McDonald’s, one can also invest in Arcos Dorados Holdings, Inc. (NYSE: ARCO ) – the largest McDonald’s franchisee in the world. 11 As well, one can invest in Burger King restaurants through parent company Restaurant Brands International, Inc. (NYSE: QSR ) 12 and also through Carrols Restaurant Group, Inc. (NASDAQ: TAST ), the largest Burger King franchisee in the world. 13 The All-Restaurant ETF There are other reasons why I am reluctant to put my money into restaurants, and we will get to them. For the present, we can try to address the issue of just how many restaurants, types, styles, menus, etc., there are. On 28 October 2015, ETF Managers Group issued a new ETF: The Restaurant ETF (NASDAQ: BITE ), the first ETF to focus exclusively on the restaurant industry. Its current portfolio of 45 companies contains all of the companies mentioned so far in this article, making it right there very impressive. It would be excessive to try to list all 45 holdings – not to mention even more boring than it has been already – so I will say only that the remaining holdings are just as impressive as those listed. 14 The Index The fund’s index is managed by Solactive A.G. , which uses the following five criteria for eligibility for inclusion in the index: 15 The entity must derive the majority of its assets or revenues from the operation of restaurants (the entity may be from any sector of the restaurant business). The securities involved must be U.S.-listed common equity stocks. ADRs are eligible. The entity must have a free-float adjusted market capitalization of at least $200 million , and must maintain that minimum. Constituents must has a three-month average daily turnover of at least $1 million to ensure adequate liquidity . Holdings are equal-weighted . In fact, it would be difficult to use market-cap weighting or many other weighting systems. As it is, the four largest companies in the fund ( McDonald’s , Starbucks , Chipotle and Yum! ) account for 68.67% of the total market cap for all companies in the portfolio. A market-cap-based weighting would be hard to use with the 25%-maximum-per-holding restrictions that are imposed on ETFs. 16 Rebalancing and reconstitution are performed semi-annually , in June and December. Any holding that warrants being dropped from – or added to – the portfolio would also be accomplished during these adjustments. 17 Dividends If you look at the table above, you will note that this is not likely to be an ETF that makes large distributions to its shareholders. Of its 45 holdings only 20 pay dividends, and the average dividend is 2.61% – not bad, but it amounts to a gross income yield (Inc. Yld.) on NAV of 1.14% . After expenses, the net return on NAV (RoNAV) is 0.39% ; 18 that is the income that is left with which to pay out dividends to shareholders. 19 Let me remind readers that these figures are my own, not those of the fund’s managers; all income I have considered is derived from dividends paid by the holdings. ETFs also distribute income from other sources – notably capital gains and interest received – that are not able to be estimated in advance of their receipt. Therefore, my estimates tend to be less than actually distributed, to a greater or lesser extent. Any dividends are to be paid out quarterly, with capital gains paid at least annually. 20 Performance As usual, I like to run a test on the holdings of a new ETF in order to get an idea of how the fund’s performance might have been had it already been in existence a few years ago. This was something of a challenge with BITE , as many of its holdings have had recent IPOs. Nearly 10% had IPOs in the past year – nearly 20% in the past two years. I opted to begin the test on 14 April 2011 , when two-thirds (30 companies, in all) of the portfolio were available for trading. The test was begun with a $20,000 initial stake with equal weighting applied, with quarterly reconstitution and rebalancing. Since dividends do not figure heavily in this fund they are not reflected in the results. As this is the first ETF to track the restaurant industry there are no ETFs to which to compare BITE ; therefore, I have adjusted the S&P 500 to $20,000, with that index being used for comparison. The following chart shows the performance for the BITE portfolio: (click to enlarge) Outside of the recent drop that affected the entire market, the BITE portfolio has performed quite well, although it clearly has very distinct periods of negative performance. Overall, however, the portfolio has performed with a CAGR of 18% (compared to a CAGR of around 11% for the S&P). 21 Making the Restaurant Investment Safer As I alluded to earlier, I have never felt compelled to invest in a restaurant, and, at first glance, BITE looks to be one way of taking the anxiety out of this industry. At the very least, the fund gives broad access to the restaurant market – all of the companies mentioned so far in this article, or the holding companies that own them, are BITE holdings. Can BITE resolve other concerns about the restaurant market? Here are some of the risk factors that I have about restaurants, and how this ETF could take a bite out of them. 22 Failures : It is estimated that approximately 90% of new restaurants fail in their first year. This may be an exaggeration, although a study by The Restaurant Brokers confirms this figure for independent restaurants; chain restaurants tend to do (slightly) better. Beyond the first year, approximately 70% of restaurants will close before their fifth year of operation (no distinction between independent or chain). Beyond the fifth year, 90% of restaurants tend to stay open a minimum of 10 years . 23 Reasons for failure? Undercapitalization is common for the first year. Beyond that, inability to differentiate from the competition and inability to identify and adjust to changing trends seem to be significant reasons. 24 A risk that is particular to chain outfits is that of market saturation , a pet peeve of mine. 25 Most of BITE’s holdings are established companies, and even many of those which have held IPOs in the past two years (approximately 20%) were in operation well before entering the stock market. Statistically, at least, the portfolio seems to be reasonably safe on this score. Competition : Drive down any major street in a city and you instantly get a feel for the level of competition that exists among restaurants – particularly the fast-food burger eateries. McDonald’s and Burger King mix it up with places like Wendy’s Co. (NASDAQ: WEN ) and Jack In The Box, Inc. (NASDAQ: JACK ). And that barely scratches the surface, considering the fast-food restaurants that are not included in BITE . In fact, every restaurant in BITE ‘s portfolio, in every category, faces stiff competition – some of the stiffest coming from other holdings in this fund. Denny’s and Ruby Tuesday, for instance, are challenged by International House of Pancakes and Applebee’s Grill & Bar , respectively. 26 Even Ruth’s Chris finds competition in the portfolio from Del Frisco’s Restaurant Group (NASDAQ: DFRG ). 27 Of course, all ETFs are going to have holdings that are competition for other holdings in that portfolio, but in terms of a restaurant-centric portfolio, that competition is going to look cutthroat. The eatery that appeals to the greater audience will have the advantage, unless one is talking about a large metropolitan area with lots of mouths to feed. 28 It might also be a concern that local, independent, restaurants (which would presumably have a better sense of the area’s tastes) put extra strain on out-of-town chains. 29 The restaurant industry is not a zero-sum game where competition implies that one company’s win translates into another company’s concomitant loss. Competition does help to improve companies, and although BITE does hold shares of competing firms, its overall diversification within the industry should mute any adverse effects on share values. Volatility : On 31 October 2015, Chipotle ( voluntarily ) closed 43 stores in Oregon and Washington when as many as 45 people became ill from E. coli , and the infection was traced to the restaurant chain. In response, Chipotle closed all restaurants in the affected area and conducted a thorough cleaning of the facilities. The restaurants re-opened on 11 November. It was the third food-borne illness to affect the company in three months. 30 Chipotle is not the first restaurant to experience an outbreak of food-related illness, but it does give a rather stark example of how such an outbreak can effect share value. On 13 October, Chipotle reached a high of $750.42/share. The following chart shows what happened to the company’s value as the extent of the outbreak was revealed: (click to enlarge) Over the one-month period from 13 October through 13 November, Chipotle dropped $157.53 in value, a decrease of 20.99%. Of course, it would be a mistake to assume that all of that loss was attributable to the outbreak. That four-week period was rather volatile for markets as a whole, and the restaurant industry (along with the retail industry) saw particularly dramatic losses during the fourth week of that period. The following graphic breaks down the losses suffered by the restaurants in the BITE portfolio for the period in question: (click to enlarge) During the first three weeks of the period, when the BITE companies suffered an average loss of -2.69%, Chipotle saw losses of – 18.39% ; over the entire four-week period – when Chipotle dropped by – 20.99% , portfolio holdings saw an average loss of -8.07%. However, while portfolio holdings averaged a -5.46% loss over the fourth week of the period, Chipotle lost only – 3.19% . By the week of 9 – 13 November, then, the major impact of the E. coli outbreak would seem to have mostly played out, with Chipotle seeing something of a “comeback” of sorts. There are many questions we might ask about this incident, as far as share value is concerned: was there any complementarity between market perception of Chipotle and the restaurant industry as a whole (keeping in mind that there have been several food-related outbreaks in the past few years),where Chipotle’s losses were influenced by the general market downturn and/or vice versa? 31 In any event, the restaurant industry is high-visibility, and constitutes a significant portion of daily life. Bad press invariably results in dropping stock values , and there seems to be no lack of bad press, lately. This volatility has the potential of affecting not only individual companies, but could affect the portfolio as a whole. Labor : the past couple of years have seen a growing concern and dissatisfaction with wages paid to part-time workers, and the bulk of labor in the restaurant industry is part time. There are over seven million hourly wage earners in the food preparation and serving occupation, approximately 20% of whom are paid at or below the federal minimum wage. 32 Across the country there are states and cities that are trying to boost the minimum wage to anywhere from $10.00 to $15 .00 per hour. This may stress restaurant costs, with an increase in food prices a likely result. An increase in labor costs could also affect franchisers. In 2014 the National Labor Relations Board ruled that McDonald’s was a “joint employer” of workers in its franchised restaurants, making franchisers responsible for working conditions heretofore assumed to be the franchisee’s responsibility. This would extend to the wages paid by franchisees. 33 Needless to say, a rise in labor costs will result in a decrease in profits, whether from additional costs being taken from an existing level of revenue, or a decreasing stream of revenue brought about by increasing prices, which could dissuade some diners from eating out. 34 Evaluation I am undecided as to whether I would invest in BITE . However, let me say that if one is going to invest in the restaurant business, this ETF is definitely an excellent alternative to buying shares in a few eateries. The portfolio is loaded with high-profile companies and proven performers, so I am not overly concerned about a high turnover rate with the portfolio. At the same time, there are a couple of concerns that I have. Narrowly targeted industry-specific ETFs carry with them a level of risk that is not present in a more diversified portfolio: industry-related influences can, and frequently will, affect the entire portfolio, for good or bad. Given the high profile the restaurant industry has, and its vulnerability to several risk factors, one wonders if diversification across the spectrum of eateries is enough. Next, those readers who are familiar with my non-ETF-related articles know that I have a thing for fundamentals. I don’t usually worry about the fundamentals of a portfolio’s holdings when dealing with ETFs, but for some reason curiosity got the better of me here. I compared the restaurant industry averages for a few fundamentals with the average for BITE’s holdings. The following chart gave me “pause for the cause.” 35 (click to enlarge) Except for the average quick ratio, the BITE portfolio does not perform as well as the industry average. I am satisfied with the average ROE, but on the other four measures, BITE ‘s portfolio does not impress me. This may be because several of its holdings are rather new (or have recent IPOs); several of the companies in the portfolio have expanded; Fiesta Restaurant Group, Inc. (NASDAQ: FRGI ) was formed out of restaurants shed when Carrol’s chose to focus on Burger King. 36 There are undoubtedly good reasons for any given company to be underperforming at the present time. This does not mean that BITE is not a good ETF, but it might be an ETF that should be watched for as much as a year before investing. At the very least, this would be a candidate for a gradual approach to buying. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from Yahoo! Finance . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. —————————————– 1 Darden Restaurants, Inc. (NYSE: DRI ). Darden also owns LongHorn Steakhouse , Bahama Breeze Island Grille , Seasons 52 Fresh Grill , The Capital Grille , Eddie V’s Prime Seafood , and Yard House . 2 It has restaurants only in the southwest – Texas, Arizona, California, Utah and Nevada. 3 The company was founded in Clarksville, Indiana, and is currently headquartered in Louisville, Kentucky. Not that it’s important – just struck me as interesting that it wasn’t founded in Texas. 4 Biglari Holdings, Inc. (NYSE: BH ). BH also owns Western Sizzlin’ restaurants. 5 Yum! Brands, Inc. (NYSE: YUM ), which also owns Kentucky Fried Chicken and Taco Bell . 6 The restaurants are known as Popeyes , Popeyes Louisiana Kitchen , Popeyes Famous Fried Chicken and Popeyes Chicken and Biscuits . The restaurant is named for “Popeye” Doyle, the character in The French Connection (according to the company website ). I always thought it was Popeye the sailor . I am disillusioned. Also, for the grammar-conscientious reader, I think it should be spelled Popeye’s with an apostrophe, but the company, throughout its website, spells it without the apostrophe. So now I am disheartened and disillusioned. 7 The company still goes by the original name, St. Louis Bread Co ., in its home city. 8 Dunkin Brands Group, Inc. (NASDAQ: DNKN ), which also owns Baskin-Robbins . 9 Darden, for instance, owns seven restaurant chains (see 1, above) – and used to own Red Lobster , which became private in 2014. 10 Biglari (see 11, above) also owns Maxim Inc. (the magazine), First Guard Insurance Company , Biglari Real Estate Development Corp. , and Biglari Design Inc. 11 The company, which operates in 20 countries in Central and South America and the Caribbean, accounts for 6.7% of McDonald’s business globally. 12 The Canadian company also owns the Tim Hortons restaurants. The Burger King and Tim Hortons merger was completed in December, 2014. 13 Carrols used to own the chains Pollo Tropical and Taco Cabana , but sold those holdings to focus on Burger King; the two restaurants are now part of the Fiesta Restaurant Group, Inc. 14 A full listing of BITE ‘s holdings can be downloaded here . Or you may visit BITE ‘s website . I try to limit my examples and restaurants/holding companies to those represented in the ETF. 15 BITE The Restaurant ETF Index Methodology , p. 2. 16 In cap-weighted systems, the standard method for handling companies that would otherwise exceed the 25% limit is to distribute the excess capital among the remaining holdings. Applied to BITE’s portfolio, that would leave McDonald’s and Starbucks with 25% each, YUM with nearly 10%, and Chipotle with 6.25% – giving the top four holdings 66.14% of the assets, leaving the remaining 41 companies with an average weight of 0.83% each. 17 Kona Grill, Inc. (NASDAQ: KONA ) may be the first test of this requirement. Recent losses have left it with a capitalization of $172.36 million – nearly $28 million shy of the minimum. 18 Keep in mind that these figures are my estimates based on dividends currently being paid by the fund’s holdings, and reflect the fund’s NAV and expense ratio. Much of this is subject to change, and is provided only to give potential investors an idea of what may reasonably be expected. 19 “Inc. Yld.” and “RoNAV” are used to compare the fund’s gross and net income to the fund’s NAV (RoNAV may be thought of as the fund’s operating margin). One may note that RoNAV is the same as the dividend yield. Due to the closeness of an ETF’s “market cap” and its NAV, this is to be expected, as the net income is where the dividends come from. The only difference would arise where the fund is trading at a noteworthy premium or discount to NAV. 20 BITE The Restaurant ETF Prospectus , p. 10. 21 Readers are advised that the performance of these holdings over the past years is not an indication of how they will continue to perform in the future. The test is only intended to provide an indication of how these stocks would have performed as an aggregate since April 2011. 22 I’m sorry. I just couldn’t help myself. 23 Cited in “The Average Life Span of a Restaurant,” Hannah Wickford, azcentral.com . 24 Wickford. Lousy cooking doesn’t get mentioned. It should. 25 Or maybe market blitz – where a chain opens several stores in an area in quick succession, without adequately determining what that particular market will bear. This tactic usually results in the closure of several stores, and can result in the chain pulling out of the area completely. Einstein Bros. Bagels was an example of the former result, and Winchell’s Donuts ‘ attempt to move into the mid-west is an example of the latter. Both chains are now subsidiaries of private companies. 26 Both IHOP and Applebee’s are owned by DineEquity, Inc. (NYSE: DIN ). 27 This company owns high-end restaurant “concepts” Del Frisco’s Double Eagle Steak House , Del Frisco’s Grille and Sullivan’s Steakhouse . 28 Determining and targeting one’s best consumer base is almost a science in itself, as restaurants try to build customer loyalty. This can be especially important for large national chains. “Restaurant Selection Criteria: Understanding the Roles of Restaurant Type and Customer’s Sociodemographic Characteristics,” Soyeon Kim and Jae-Eun Chung. PDF available here . 29 “Independent vs. Chains Studies” by Main Street America ( preservationnation.org ) contends that local businesses generate two to three times as much local economic activity as chains. This idea is challenged by Bob Bradley, in his article “The Chains are Winning, and it’s all in the Marketing,” available at restaurantreport.com , here . The truth probably resides in the attitude of the players. Chains have advertising, larger capitalization, “proven” menus; while locals have recognition and familiarity, closer community contact, a more targeted menu. It becomes a matter of how well the independent (and the chain) approach the immediate market they serve. “How Independent Restaurants Can Beat National Chains,” Matthew Sonnenshein, Gourmetmarketing.net . 30 Chipotle to reopen restaurants shuttered in E. coli outbreak in northwest,” Aamer Madhani, usatoday.com . Previously, Minnesota Chipotles experienced a salmonella outbreak, while Simi Valley, California, experience a norovirus outbreak traced to the restaurant. 31 Needless to say (so, why am I saying it?), in any industry, a generalized trend will tend to influence all companies in that industry. Thus, in a period where restaurant stocks in general trend in a particular direction, it is to be expected that any given company in the restaurant business will follow suit. 32 “Characteristics of Minimum Wage Workers, 2014,” Bureau of Labor Statistics , here . 33 “McDonald’s loses big on labor ruling,” Claire Zillman, Fortune , 29 July, 2014. The decision as it stands cannot be appealed, as it was made by general counsel Richard Griffin. The full board has not ruled, and the issue is still before the NLRB . The main impact of the decision for now is that McDonald’s can be made a defendant in any action against one of its franchisees (“McDonald’s can’t appeal NLRB franchise decision,” Sean Higgins, Washington Examiner ). 34 This claim would likely start arguments among some people, but I side with James Sherk (Senior Policy Analyst at The Heritage Foundation), who argues that – next to food and supplies – wages are the second-highest cost item for the average fast-food restaurant. These restaurants have a low profit margin, so an increase in labor costs would result in – unavoidably – higher food costs; higher food costs would translate into reduced sales. 35 Restaurant industry data from CSIMarket.com . 36 See note 13, above. Scalper1 News
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