Learning Investment Lessons from Restaurants
There are exceptions to any rule and there is an obvious exception to this rule. But, celebrity chef Gordon Ramsey has taught millions of viewers to his television shows that he believes a good restaurant should have a small menu.
He often comments that he prefers a small menu because he finds it nearly impossible for one restaurant to do everything well. This makes sense and could be helpful when looking for a place to have dinner.
Now, there is a well known exception to this rule. The Cheesecake Factory has more than 200 items on their menu, but the chain has developed a system that allows its kitchen to offer such varied fare.
Realizing there will be exceptions, this lesson could be applied by investors. It seems difficult for management of a company to manage many diverse operations.
Steak, a Suit, or a Nice Scarf?
This rule could be one of the reasons the fashion designer Ralph Lauren Corporation (NYSE: RL) is stumbling.
Ralph Lauren describes itself as a company that makes and sells lifestyle products, including apparel, accessories, home furnishings and other licensed product categories. Its products, including men’s and woman’s fashions are found in department stores and specialty stores around the world.
The company also operates its own retail stores, concession based shop within shops at other stores, and e-commerce operations around the world.
Its licensing business consists of royalty-based arrangements, under which the right to operate retail stores and/or to use its various trademarks in connection with the manufacture and sale of designated products, such as certain apparel, eyewear, fragrances and home furnishings.
Many of the businesses have a clear relationship. Fabrics and styles used in clothing lines could be extended by the right designers to home fashions.
But, a recent review of the designer’s restaurants (Ralph’s in Paris, Polo Bar in New York, RL in Chicago) raises some questions about whether or not the fashion icon is spreading his attention too much.
The review explains that Ralph Lauren makes extraordinary steaks. Diners are advised to “choose between the 22-ounce Double RL bone-in rib eye, $70, served with fries, or the full feast of 44 ounces alongside creamed spinach, delicately sliced silver-dollar potatoes and two plump servings of porcini bread pudding, sold for $200 and meant to share.”
These are prices in line with Ralph Lauren’s best fashion items. But, the long term stock chart below raises the question of whether or not the company is focusing on fashion as much as it should be.
The stock is about 50% below its 2014 highs. And, it appeared on the list of the day’s biggest losers on Tuesday. There was no news to explain the decline in the company’s sector. Although retailers were generally lower on the day, the decline in RL was large relative to its industry.
Even after the price drop, the stock is still trading at price to earnings (P/E), price to sales (P/S) and price to book (P/B) ratios that are above its industry average.
Earnings growth is also slow at the company and is expected to remain slow. Analysts expect growth over the next five years to average about 3% a year. At this point, even slow growth is welcome by investors. In the past five years, Ralph Lauren’s earnings per share have declined an average of more than 10% a year.
The stock is now likely to struggle. The weekly chart shows that the stock remains in a downtrend and faces resistance just above the recent prices.
The stock could now struggle while traders wait for news about holiday sales. With short term momentum pointing lower, traders should consider using strategies that benefit from lower prices for at least the next few weeks.
A Trading Strategy to Benefit From Potential Weakness
Because of the fact the stock is overvalued and in a down trend, traders should consider using an options trading strategies known as a bear put spread to benefit from the expected price move.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for Ralph Lauren
The bearish outlook for Ralph Lauren, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the December 15 $96 put can be bought for about $1.70 and the December 15 $94 put can be sold for about $1.00. This trade will cost about $0.70 to enter, or $70 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $70. This loss would be experienced if RL is above $96 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in RL, the maximum gain is $1.30 ($96 – $94 = $2.00; $2.00 – $0.70 = $1.30). This represents $130 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $70 to open this trade.
That is a potential gain of about 85% on the amount risked in the trade. This trade delivers the maximum gain if RL closes below $94 on December 15 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $70 for this trade in RL.