The fund manager factor

PORTFOLIO POINT: OrotonGroup's recent price slip could be the result of an enforced sell-down by a fund manager. Overall, the company is still well-positioned for growth.

One of the lesser discussed dynamics of the equity market is the effect from the movement of fund management contracts between fund managers. Asset consultants and fund trustees dynamically manage their fund managers. Therefore, they constantly review a manager’s performance against benchmarks or performance targets. Ultimately, mandates are granted or lost at the discretion of these parties.

Sometimes, a decision by a high-performing individual to move from a large funds management company can cause a significant response from trustees and consultants. In its most extreme case, this may involve the instruction to liquidate a portfolio and transfer the cash to another manager. Thus, investors need to be aware of fund manager movements, the consequent loss of mandates and the enforced sell-down of stock holdings.

Right now, there is another dynamic emerging and that is the development of "in-house" funds management operations inside large industry funds. These "in-house" managers will soon be receiving funds that were previously with external managers. This too will cause the liquidation of some portfolios prior to their transfer.

Why is this observation important for investors? Quite simply, it may give an investor a real insight into why a company’s stock price is suddenly going through a sharp price correction without a profit warning from the company. For example, in recent weeks, Thorn Group Limited (ASX: TGA), a favoured stock of MyClime, suffered a sharp price correction leading into its reported result. A sharp price drop led to rumours of a profit downgrade that never came. In fact, TGA reported a result that was slightly higher than consensus, with an increased dividend. Subsequently, the stock has recovered 10% in quick time, but it is still nicely in value.

In retrospect, it is now observable that the price drop occurred because two major TGA shareholders had either decided or were forced to sell down their substantial holdings. Indeed, the selling intensified as the price fell, as a price was reached where large lines of stock were demanded.

Right now, I question whether a similar situation is developing with OrotonGroup Limited (ASX: ORL), which is in my growth portfolio. In recent weeks, it has suffered a 15% price decline for no apparent reason. In recent days, the volume of ORL shares traded has increased significantly and there has been no announcement from the company.

Is this price move an aberration caused by stock supply exceeding daily demand (i.e. a forced sell-down) or is there a fundamental change occurring that is yet to be announced to the market?

Obviously time will tell, but the price decline has suddenly conjured up rumours that ORL could lose its Ralph Lauren licence in Australia and New Zealand in 2013. Given that ORL is performing well with the licence, this rumour would appear to have little basis in fact. Ralph Lauren may surprise us and be desperate to grab the licence back (or select a new licensee), but this would represent a small opportunity for a company achieving $US6.8 billion of annual turnover. Why would they invest an insignificant amount of capital and take on operational risk in a small market?

Another rumour is that ORL, like many other retailers, will have to downgrade its current year earnings. These are difficult times for retailers and it will be difficult to maintain profit in this environment. However, companies are perpetual entities and short-term profit moves are often excessively focused upon. To achieve long-term gain from the market, an investor needs to look at long-term history and long-term potential. On these scores, ORL ranks very highly.'¨

However, price falls do start rumours and the above rumours may be more palatable than the observation that a major fund manager, which is a significant ORL shareholder, is losing mandates and simply has to sell.

OrotonGroup’s fundamentals and financial performance

The following performance table outlines the excellent performance of ORL in a difficult retail environment in Australia over the last five years. This performance should give an investor some confidence when investing in ORL.

The key take-outs from the table are:

1. ORL has not raised any new equity from shareholders in the last five years. Indeed, all of the increased equity over five years ($10 million) has come from retained earnings less a buyback of capital;
2. ORL has over five years made $109 million of tax-paid earnings and paid $87 million of franked dividends. These returns were generated from an opening equity base of just $26.8 million;
3. The “normalised” average return on equity is 108% over the five-year period. This is an extraordinary return and ranks as one of the highest in the Australian market; and
4. The retained equity over the five years of about $10 million has been converted into about $10 million of increased annual profit.

Figure 1. Financial History and Forecast: OrotonGroup Limited
Source: MyClime

These are exceptional financial performance features and they have been achieved without resorting meaningfully to debt. This means that ORL has a high financial rating in MyClime with a Clime Quality Rating (CQR) of 8.5 stars (out of 10).

That is the past – what about the future? This is the difficult part of investing, but based on market consensus and the lack of any negative statement by the company, I have a valuation for ORL of $9.69 upon achieving its expected final results later this year. At current market prices, the stock is already priced for lower earnings, so if a downgrade did occur it appears to be well factored into the market.

ORL has about 41 million shares, a market capitalisation of $290 million, an equity base of $36 million and little debt. Is the business worth 8 times equity or $260 million of goodwill? I believe so, based on the exceptional historical performance, the growth opportunities presented to ORL (its own brand) in Asia and a strong internet retail offer.

Figure 2. Valuation & Performance: OrotonGroup Limited
Source: MyClime

Figure 3. Price Value Chart: OrotonGroup Limited
Source: MyClime

At current prices, in the low $7 region, ORL is a worthy member of my growth portfolio and I expect a superior return over the next three to five years. Currently, ORL is providing its owners with a fully franked 7% dividend, which is about 10% pre-tax to a pension fund. Thus, even if earnings stall for a while in the current environment, I expect to be compensated by high dividends. Remember that cycles are cycles and they always end. ORL will recommence its growth, which has historically been superior to most other listed companies.
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In any case, I suspect that the current share price is the result of changing circumstances within a major fund manager and so the opportunity is there now for patient investors.

Growth Model Portfolio

-Clime Model Growth Portfolio (prices as at May 31, 2012)
Company	Code	Purchase Price	Market Price	June 2012 Value	Safety Margin	GU Yield	Total Return
BHP Billiton	BHP	35.5	31.97	54.63	70.88%	4.60%	-9.94%
Commonwealth Bank	CBA	50.78	49.40	58.94	19.31%	9.14%	-2.72%
Westpac	WBC	22.02	20.29	27.57	35.88%	10.49%	-7.86%
Blackmores	BKL	27.55	25.91	28.33	9.34%	0.61%	-5.95%
Woolworths	WOW	25.85	26.44	31.53	19.25%	6.54%	2.28%
Iress	IRE	6.75	6.07	7.28	19.93%	8.55%	-10.07%
The Reject Shop	TRS	12.04	10.05	14.51	44.38%	4.41%	-16.53%
Brickworks	BKW	10.45	10.35	12.33	19.13%	5.66%	-0.96%
McMillan Shakespeare	MMS	11.01	11.16	11.42	2.33%	4.74%	1.36%
Mineral Resources	MIN	11.77	10.02	14	39.72%	5.85%	-14.87%
Rio Tinto	RIO	66.6	56.86	84.06	47.84%	2.99%	-14.62%
OrotonGroup	ORL	8.64	7.25	9.48	30.76%	9.85%	-16.09%
* Market prices as at close May 31, 2012

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