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El Pollo Loco Lives Up to Its Name

This article originally appeared on on Sept. 4, 2014 at 12:30 p.m. To read more content like this AND see inside Jim Cramer's multi-million dollar portfolio for FREE... Click Here NOW.

How do you play stocks that are crazily mispriced on fundamentals? Carefully.

Long-term cult stocks such as Amazon  (AMZN) and Tesla Motors  (TSLA) have burned short sellers who had been sure those shares would fall back to earth. Investors have given those companies a free pass on valuation and on any need to show earnings per share that justifies their lofty share prices.

More mundane companies are typically held to a higher standard, and that has proven especially true in the restaurant industry. Hot initial public offerings have often turned into cold gruel within months. Sandwich maker Potbelly  (PBPB - Get Report) , for instance, gapped up initially from its IPO price, but then traded down more than 63% from its recent high as of Wednesday's close.

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Fellow restaurateur Noodles  (NDLS - Get Report) experienced a similar pattern. The post-IPO surge didn't last long. Noodles has already given up about 64% from its 2013 peak.

Enter El Pollo Loco  (LOCO) , which is due to report earnings after the bell on Thursday. Management had been justifiably thrilled to get $15 per share as an IPO price, as the firm had been nearly bankrupt not too long before that point.

Momentum traders didn't care about that when they pushed El Pollo Loco to as high as $41.70 on Aug. 1. Three weeks later, the stock fell below $30 before rebounding to just under $35 on Wednesday.

Analysts expect full-year EPS of around $0.54 and growth to $0.61 next year. It's hard to see how those numbers support anywhere close to the current price. El Pollo Loco is clearly not "the next Chipotle  (CMG) ."

Even the benefit of the doubt would leave Pollo Loco's fair value well under its current quote.

I rarely recommend naked call writing, as this strategy allows for theoretically unlimited risk.

However, I made an exception in this case because this stock appears so grossly overpriced. I've been selling naked El Pollo Loco March 2015 calls -- with $32, $35 and $37 strike prices -- on strength. The last trades on the higher strikes were at $4.10 and $3.60, respectively.

That provides breakeven prices of $39.10 and $40.60 while providing enough time for the market's temporary insanity to pass. Maximum profit is 100% of all premiums collected. As noted earlier, maximum risk is unlimited should El Pollo Loco somehow continue to defy gravity.

I'll be watching intently when the results are released, but I plan to hold on to my short call positions regardless of any short-term volatility. I'm guessing that El Pollo Loco will be significantly under $32 well before my March 20, 2015, expiration date.

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At the time of publication, Price was short LOCO March 2015 $32, $35 and $37 strike naked calls.

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