OrotonGroup on shaky ground
Until Friday, OrotonGroup—owner of the Oroton brand and licensee of the Ralph Lauren brand in Australia and New Zealand—was the very definition of 'market darling'. Occasionally people were incredulous that Intelligent Investor didn't cover this upmarket retailer. Well-managed, with a strong return on equity and high margins, the implication was that this was the sort of stock we should recommend.
We seek out companies with these characteristics, of course. But price is all-important, and we judged that OrotonGroup's share price was failing to take several major risks into account. The first was that the high margins were already reflected in the price, as we said in A window on small retailers from 3 Aug 11. What if there is an upset, as so often happens in retail?
The second was that the company might one day lose its licence to operate the Ralph Lauren brand in Australia. We briefly referred to this possibility in a reply to an Ask the Experts query about the company back in 2010.
Licence lost
Yesterday OrotonGroup announced the loss of the Ralph Lauren licence from June 2013. While the company will be paid for inventory and store assets, the loss of the licence will reduce net profit by around 35% in 2014.
The stock fell 18% on Friday as a result.
My point is that you need to beware low probability, high impact events. I suspect the market under-weights the probability of 'earthquake risks' like this. These events can hit large companies too—remember when Tatts Group and Tabcorp lost their licences to operate poker machines in Victoria?
Strong-performing companies with high returns on equity are seductive for investors. But there is no shortage of market darlings with 'earthquake risk':
McMillan Shakespeare—a significant chunk of McMillan's salary packaging business depends on a legislative loophole that allows some government workers to use pre-tax dollars to pay for their personal expenses. While there is good reason to think this loophole won't be closed—because otherwise these workers would need to be paid more—some type of crackdown can't be ruled out.
Navitas—many Navitas students arguably use the company's courses and follow-on university degrees as a way to gain permanent residency in Australia. The company is therefore vulnerable to changes to immigration policy.
SAI Global—the company is eight years in to a 15-20 year licence to distribute Australian Standards. As the time to expiry approaches, shareholders should think about what the business might look like without this licence.
There are plenty of other examples. The current crop of income securities that are flooding to market are poor value. In their haste to obtain a higher yield, income security buyers are under-weighting the probability of being wiped out. If you judge the wipeout risk as a one in 100 chance, you should demand one additional percentage point of yield to account for that possibility.
Then there are consumer finance companies like Cash Converters. Charging up to 48% per annum interest rates for short-term loans, they're vulnerable to tougher usury laws.
Companies with high returns on equity and strong margins are certainly attractive candidates for further research. But don't overweight the importance of these factors; indeed, they could be evidence that the company is 'over-earning'. What's more important is what's reflected in the price.
If anything, Friday's 18% fall was probably an under-reaction. OrotonGroup remains priced for success, not failure.
Don't forget what happened to David Jones. Retailing is a difficult business, apt to teach lessons to the over-optimistic. I judge more lessons are coming for OrotonGroup.
What is the bull case for OrotonGroup? Can you think of any other companies with 'earthquake risk'?