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For restaurant stocks, the party's going very, very long

The Exchange

After an extraordinary run for restaurant stocks in 2013, the food-service industry has gotten off to a much slower start this year a turnabout that, if not due, is certainly understandable.

The group, which has grown accustomed to beating the S&P 500 during the post-crisis rally, trails the index since Dec. 31. Though that's arguably a tenuous reason for concern, it isn't out of line to question whether the group is cooling off. Eventually, competitive pressures, hard-to-come-by sales growth and uneven guest traffic have to catch up with at least some of these stocks; they haven't, on the whole, retreated since 2008.

With a big assist from an ever-climbing broad market, money managers' giddiness over the fast-casual subset's expansion and a media that doesn't tire of food-related buzz, you would have almost certainly made money of late drawing a restaurant name out of a hat. That could be changing, if traders finally choose specific winners and abandon the has-beens or those that operationally aren't doing much particularly plaudit-worthy.

Though it is early in the year, the publicly traded restaurants, names from McDonald's (MCD) to Cheesecake Factory (CAKE), aren't quite as lustrous as they were only a few weeks ago. Of 38 names we looked at, 23 are down so far this year. In total, the industry had lost 3.3% as of midday Feb. 12 vs. the S&P's 1.6% pullback.

Clearly, every market is different, but a year ago at this time, the restaurants were enjoying an upbeat time, climbing 7.2% through the first five weeks, outpacing the 6.4% rise in the S&P. Only three stocks in the group showed a loss. By the end of the year, that number hadn't changed 35 stocks rose for the year, giving the restaurants a gain of 54.7%, well above the market's 29.6% advance. Ruby Tuesday (RT), Romano's Macaroni Grill owner Ignite Restaurant Group (IRG) and pizza, sandwich and beer shop BJ's Restaurants (BJRI) missed out.

Dessert time

That the restaurants on the whole would surpass the S&P in 2013 wasn't a surprise. In each of the five years through 2012, they did so every time, by an average of 20.1 points. Last year, however, it was a greater margin at 25.1 points. The magnitude of the increase appears even more pronounced when you note it exceeds the restaurants' average 22.3% move up by 32.5 percentage points. Taking out 2008, when the group shed 38.1%, roughly in line with the S&P, last year was still better than the average of the prior four years by 17 points.

Of the 30 restaurant stocks with at least five full years of trading history, 20 hit all-time highs last year. Continuing that momentum, six have done so again this year. For some, it's been the pull of the market overall, as the S&P and the Dow Jones Industrial Average surged to record levels in recent months. For others, it's specific. Chipotle (CMG) has run ahead as investors sought to profit from the fast-casual frenzy, whereas Wendy's (WEN) got a boost from expanding its franchise component companies opting for the clarity of franchise flows over the cost of corporate-run stores have been hailed by traders.

Regardless, almost all were winners last year, posting their best annual performance since 2009, when they rebounded from the financial meltdown with a 63% rally. As a result, they got on the pricey side, and they probably still are, even after some of the shares were clipped in the past couple of months. Despite sitting 14% below their 52-week (or multi-year, as the case may be) highs, the 27 restaurants with data available on FactSet carry a next-12-months price-to-earnings ratio of 22.2, exceeding the 17.5 average for the past five years. Only two, Einstein Noah (BAGL) and Krispy Kreme (KKD), have forward multiples under their average.

In comparison, the S&P has a 15. Over the past five years, it's averaged 13, according to FactSet. (This, in fairness, should be viewed as a guide. The S&P overall is weighted to account for company size, while the restaurants are equal-weighted in our calculations. Still, one interpretation here is that the expansion of that spread, to 7.2 points from the 4.5 average, suggests Wall Street is counting on further outperformance.)

Considering how generous traders have been, they may need new impetus to keep bidding up shares here. Should the market stay sluggish, the selloff in the restaurants may in fact hasten as stockholders move to book their still-enviable profits.

No room for error

Buffalo Wild Wings (BWLD) is instructive. In our survey period of 2008-2013, it's one of two restaurant operators that didn't have a single down year (Panera Bread (PNRA) is the other). With elements of sit-down and fast-casual, it's grown sharply in the past few years. Sales have gone from $422.4 million in '08 to $1.27 billion last year. Its store count has jumped. Through 2012, it averaged a yearly gain of 27.7%. Last year, its stock soared 102.1%.

Now, in 2014, it's down 10.3%, influenced heavily by an earnings report that saw revenue barely fall below Wall Street's estimates. Though some analysts and commentators felt the post-report slide was driven by uncertainty about wing prices and minimum wages, those are known risks to the business. More likely was that traders long the name weren't willing to risk even a minor hiccup. When it came, they took their cash and bolted.

Among the stocks that have remained positive this year – 15 of the 38 – some are notable for strong numbers, such as the aforementioned Chipotle. For Chuck E. Cheese owner CEC Entertainment (CEC), it was a buyout deal. An upgrade Monday improved the fortunes of Red Robin (RRGB), one of last year's top performers that's been flagging in '14. For the other rich stocks, the message seems clear: Missteps won't be tolerated. Not at these valuations, not this year.

Of course, should the market turn in yet another win, reasonable skepticism can be made to look very foolish.