"Likely events sometimes fail to occur, and unlikely events sometimes do." – Howard Marks
The move by Chinese authorities to detain staff of Crown Resorts Ltd (ASX: CWN) for reportedly promoting gambling in the country came clean out of the blue.
The action wasn't unprecedented, but it did represent an unwelcome attack on the Golden Goose which had been laying so richly for Australia's big casinos, including Star Entertainment Group Ltd (ASX: SGR) and SKYCITY Entertainment Group Limited-Ord (ASX: SKC).
Should investors have foreseen such an event impacting the industry? Absolutely.
It was blindingly clear that 'International' or 'VIP' high roller business had been a huge driver of revenue growth for the companies in the last two years, coinciding with the increased scrutiny of high roller gambling in Macau. A disruption to this new found business so reliant on one country was always going to be a risk.
I highlighted this back in April, noting the increasing exposure gaming companies had to high-roller business.
Crown Resorts' percentage of normalised gross gaming revenues coming from VIPs in the half year period had risen from 22% to 28% in two years, Star Entertainment from 21% to 27%, while SkyCity Entertainment had backed up the truck and loaded up with VIPs pushing international business from 7.5% to 17%.
I was concerned with the risk of making large capital expenditure decisions on the assumption that the trend would continue. It reminded me of the boom in LNG years back.
The numbers make sense during boom times, but what happens if demand drops, or supply surges?
What happens if junket business stops like it did in Macau? If local governments start regulating the VIPs, or Macau somehow surges back to life creating competition for the big spenders. The odds of each may be low, but sometimes unlikely events do occur.
Putting so much reliance in the hands of a country known for its aggressive and sudden clampdowns was like having the axe-man's blade hovering overhead.
The simple investing lesson for investors
Successful investing is about generating above average, risk adjusted returns.
This means that when we come across a risk which could disrupt the earnings of a company, we should be willing to pay less for a piece of that company and adjust our valuations accordingly.
A goose with an axe hovering over its head is less valuable to us than a goose happily honking and going about its life.
To account for risk we can use a higher discount rate in our discounted cash-flow valuation, or simply be willing to pay a lower multiple (such as price-to earnings or EV/EBITDA multiple) when comparing to other companies.
It won't prevent the axe from falling, but it will offer some protection if the risk comes to fruition and the company's share price gets a trimming.
