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The Experts

Michael McCarthy
+ About Michael McCarthy
Michael McCarthy is chief market strategist for CMC Markets in Australia. He has over 30 years of experience in financial markets – specialising in equity trading and trader education.

Ausnet flying without a safety net

Tuesday, September 19, 2017

By Michael McCarthy

Utilities are often prized because in an investment sense they are boring. Steady and predictable income streams that (*ahem*) generate regular income streams. However the outlook for Ausnet Services (AST) is getting more exciting by the day. This could be bad news for investors.

Many investors know that Ausnet is an energy infrastructure company. Victorian based, it owns pipes and wires that carry gas and electricity. It is the wholesale provider of high voltage transmission lines and provides ancillary services such as metering to its utility clients. Boring.

The backdrop to this discussion is the potential for interest rates globally and locally to increase over the coming years. This makes the regular dividend streams that many investors treasure less valuable as annuity income becomes more competitive in interest rate markets. The better income on stocks comes at a higher risk. Shares prices can go down as well as up. This is exacerbated where debt is present. At its last report AST had more than $6.6 billion of debt on its balance sheet.

That’s just the backdrop. The politics of this highly regulated sector is turning toxic. The Victorian state government locked up all conventional and unconventional untapped gas supplies just as Australia’s gas export industry ramped up. The electricity network is de-stabilised by a rush to switch off traditional, carbon dioxide intense generators. The Australian Energy Market Operator has publicly warned of potential power black-outs this summer in NSW, Victoria and SA.

While the economics of this rigidly ruled industry are not straightforward these developments are not a positive for AST. Disrupted supplies mean disrupted earnings. Then there is the potential for the Federal and State governments of differing political hues to strongly disagree over energy matters, while both eying substantial budget gaps, with AST caught in between.

In fact analysts are forecasting a drop in profitability for AST over the next two years, another negative. While nobody yet is arguing the state is a tinderbox, AST is also vulnerable to potential bush fire claims. The last payout of $5 million dollars is not significant in light of AST’s current profitability. But catastrophe is by nature unpredictable.

In short, risks are rising substantially for AST, and its investors. The good news is that AST shares are trading nearer all-time highs than most stocks. Shareholders may wish to take advantage.

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Time to take a bite of Retail Food Group?

Tuesday, September 12, 2017

By Michael McCarthy

Here’s an investing riddle. If a company has an earnings profile that displays steady growth, but repeatedly overestimates its futures earnings, is it a buy or a sell?  The answer lies in the share price. Is it near highs or lows?

If you’ve ever eaten a Crust pizza or scoffed a Michele’s pie you’re a Retail Food Group customer. They also franchise Donut King, Brumby’s, Gloria Jeans, The Coffee Guy and Pizza Capers, among others, and supply many of these outlets. Since 2014 RFG grew earnings per share from 27 cents to 44 cents. The problem is it misses more earnings estimates than it hits.

It’s established that the reaction to earnings announcements reflects the performance in relation to forecasts – hence the focus on earnings surprise. RFG’s share price reflects regular punishment for negative earnings surprise.

This relentless sell down has pushed RFG to levels just above long term support around $4.15. The valuation argument is stronger.  A forward PE around 10x and a dividend yield calculated on the last two dividends of 9.5% (including franking) make this one worth a look.

There are risks. In particular RFG is pushing ahead with international expansion. India, the US, Pacific nations. And the stock traded ex-dividend on Monday this week. However the much more defendable levels of the share price and potential for positive surprise could draw investor attention. Further, 12.4% of RFG is short sold. A positive surprise could see its shares rocket higher.

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Don't fall into the dividend trap

Tuesday, September 05, 2017

By Michael McCarthy

Share dividends and estimated dividend yields have a firm grip on the investing public’s imagination. The company reporting season just passed saw some of the sharpest share price sell-downs directed at businesses that cut their dividends. Yet dividend yields are estimates subject to change, and are often a poor predictor of overall returns.

Sustainability is a primary consideration in estimating dividend yields. A bank with higher levels of capital, a lower pay-out ratio and no sign of bad or doubtful debts is not under pressure to cut dividends. A telco with a looming growth challenge currently paying out 100% of profit as dividends is ripe for a dividend cut. There are sustainable dividend yields and there are dividend traps.

This requires re-iteration as this very important difference has largely slipped from the investing consciousness.

Any dispassionate examination of the contributors to share market returns shows that the impact of share price change is orders of magnitude more powerful than estimated dividend yields. Yet some investors are using dividend yields as their primary (and in some cases only) measure to determine a share’s attractiveness. This method will likely end in tears.

That so many investors are doing this at this point speaks to the power of experiential learning in investment. Put simply, a good investment experience biases investors towards that style of investment. This neatly explains the rise of the dividend yield as an investment selection tool. Think back to late 2011. After a rally off the 2009 lows, the Australia ASX/S&P 200 index again slid into the last half of the year. The outlook for shares was clouded at best.

The problem for investors was that interest rates were low and looked like going lower. Staying in cash preserved capital but gave minimal returns. As fears eased investors sought ways to put their money to work. And they were most underweight shares.

What shares do you buy when you believe the worst is over but the short-term outlook is worrying? A share that you can afford to hold through any market wobbles. A share that pays better dividends, meaning investors can receive income while waiting for any share price recovery. Investors who bought bank shares at this time enjoyed large gains as more investors joined the theme. This not only increased the popularity of dividend yields but saw the search spread to other sectors.

Australia’s tax imputation system only enhances the bias. The tax credits shareholders receive reflects the fact that tax is already paid on the dividends by the company. The combination of a generally higher dividend yield for the Australia ASX/S&P 200 index and attached franking credits supported the dividend yield strategy.

Dividend yields are expressed as an interest rate. However, the capital position associated with dividend yields is vastly different to most interest rate products. The capital risk of shares is relatively enormous and can dwarf the holding yield. This risk can be positive or negative – share prices can go up as well as down.

When shares are nearer lows than highs, and look attractive on valuation, selections based on sustainable dividend yields make sense because capital risks are lower. But when markets and valuations are stretched the capital risks make dividend yields a minor factor. The potential for a company to cut its dividends adds to the risk.

This is just one of the investment lessons from Telstra’s recent share price troubles. The decline from a highpoint above $6.50 just two years ago illustrates a number of important market guides.

First, when “market darlings” turn, the damage can be substantial. Telstra is now back at five-year lows. Without a growth plan beyond the NBN it’s hard to imagine the share price improving anytime soon.

Secondly, using dividend yields as a primary stock selector is appropriate only at particular points of the market cycle ie market lows. Employing this methodology at higher points in the market cycle can be dangerous.

Thirdly, even where it is appropriate to apply dividend yields as a selection criterion the dividends must be sustainable. Companies facing significant capital expenditure, increasing bad debts, paying out 100% of earnings or facing an earnings downturn are unlikely to increase or even maintain dividend levels.

Lastly, investment circles are as subject to fashion as any other field of human endeavour. Once an investment approach or style approaches mania it is increasingly unstable and dangerous. Those basing stock selection on dividend yields alone may wish to examine their exposures.

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Domino's looking tasty

Tuesday, August 29, 2017

By Michael McCarthy

The trading action in Domino’s Pizza (DMP) following its result was eye-catching, and potentially mouth-watering.

Here’s the catch up for new DMP watchers. In August 2018 DMP hit an all-time high of $80.69. Sustained selling pressure has weighed on the stock since that peak. DMP is now one of the most short sold stocks on the Australian share market. The issue is valuation. In a low growth environment, high growth stocks like DMP can reach giddy heights. At its peak the PE ratio was more than 60x. A flush was inevitable.

That came with last week’s results. A lift in profit of 25% is good news anywhere. Yet the stock fell more than 20% in reaction, before recovering somewhat. The fall came after investors and analysts whipped themselves into a growth frenzy. A profit uplift of more than 30% was required to maintain momentum.

The good news is that DMP is now in a position where investors can buy growth at a reasonable price. The forward PE ratio is back to around 26x, the lowest level since 2013. The concerns generated by the results announcement revolve around international growth, yet simultaneously DMP told shareholders sales in FY 2018 are already up 6%.

Admittedly some analysts slashed price targets to levels around the current share price. However, plenty of others cut to levels between $55 and $60 a share. The superior growth profile is intact and the franchise story of some months ago is looking like a beat up.  DMP is worth a good look at current share prices.

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Bluescope under the microscope

Tuesday, August 22, 2017

By Michael McCarthy

Share markets regularly throw up head scratchers. Here’s the latest. Bluescope Steel (BSL) reported a 102% increase in profit on Monday. The shares were promptly sold down more than 23%. What gives?

There are a couple of contributing factors. The picture of 2018 painted by management was *ahem* cautious. They may have good reason to spell out potential hurdles. In results commentary that appeared aimed directly at Canberra, BSL’s management warned on energy costs and steel dumping. The result was guidance for a coming circa 18% drop in half-year earnings.

While appeals for government welfare are generally perceived as odious, the company laid bare the consequences of restrictions in gas exports and government interference in electricity markets. A 75% increase in energy costs in two years will cause any investor to pause. The call that 2018 sales are constrained by potential steel dumping is harder to sustain. The reality is that businesses tariff, protected for decades to the cost of the Australian taxpayer, get fairly short thrift when they complain about international competition. 

The company also announced a change of CEO, and the launch of ACCC action relating to alleged cartel behaviour in 2013 and 2014. The overwhelming consideration for BSL over the coming years is the health of the global economy and therefore the steel industry. While both regulation and succession must be taken seriously, neither of these issues looks economically material at this stage.

The chart shows how dramatically BSL was sold off. Importantly, it reached the persistent support around $11, and held. This may mean that the low on Monday as bad as it gets. A quick back of the envelope suggests that BSL is now trading on 13-14x, a discount to the market PE above 16x. I’m not a fan of the steel industry in Australia for long-term investment. However, in my opinion on a one-year view, BSL looks cheap at current prices.

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Stock in the spotlight: oOh!Media on display

Tuesday, August 15, 2017

By Michael McCarthy

Wow. 18% profit growth in the advertising industry. oOh!Media’s (OML) result this week is eye-catching. In perhaps even better news for the shareholders, the Out Of Home (O.O.H – get it?) advertising segment grew at 8.6%, while overall media advertising spend declined by 1.6%. OML’s a better performer in a sector that’s winning market share.

OML offers advertising on billboards, at shopping centres, airports and other locations, and related services. It’s important to note that the digital revolution is occurring in OOH as well. More than half of OML’s revenue now comes from digital formats. 

The $34 million profit unveiled on Monday was around 10% better than the consensus forecast. A key driver of this performance is lower than expected. It’s little wonder that the share price jumped by 8% to $4.36. Naturally, many analysts are now revising their estimates upward, and upgrades to recommendations are coming through. However, even after the post-result surge, the forward PE for OML is around 16x – in line with the average for the top 200 companies. Given the superior growth prospect, some will argue that this is cheap.

Investors concerned they may have missed the boat could also take comfort from the chart above. The jump only brings OML back to the mid-point of the 2017 trading range, and still well shy of the all-time high at $5.88. According to Bloomberg, the average price target is $5.08, with six buy recommendations, one hold and no sells. 

The long-awaited upswing in the advertising cycle remains elusive. Investors underweight growth exposures may see OML as a leader in the industry.

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Key company reports: What to look out for

Tuesday, August 08, 2017

By Michael McCarthy

The semi-annual company reporting season gets into full swing this week. Alert readers are aware that a number of active investors are generating higher returns by taking advantage of sharp share price moves in either direction. With the Australia 200 index stuck in a narrow range, the large moves that can both precede and follow earnings announcements may represent opportunities for investors.

There are two main opportunities in these moves. Shareholders may consider taking profit where a large and sudden jump occurs (as opposed to a slow, sustained grind higher). And investors may maintain a list of stocks they wish to buy at the “right” price, and leap on any sharp weakness. One of the surest predictors of share price moves is earnings revision, and a report that prompts analysts to change their estimates (in either direction) can have a powerful impact in the following days and weeks. If the upgrade or downgrade is part of a larger trend, it may speak to the long term direction for the stock.

A case in point is Bluescope Steel (BSL). The company reports on 21 August and expectations are high. The average analyst’s estimate is a profit increase of 125%. Naturally, the improvements in BSL’s operations over the last two years were well-flagged, and investors voted with their wallets. The share price has more than quintupled from a low at $2.70 in mid-2015.

Over the weekend, one hard working analyst re-cut the BSL numbers and delivered another earnings upgrade for BSL. The impact was a 6%+ leap in trading on Monday:

The jump was likely aided by the 10% slide in the weeks prior, but is an illustration of just how powerful earnings revision can be.

The major report this week is the Commonwealth Bank (Wednesday). Others to watch include Cochlear, AGL, Seven Group and REA. The earnings reports mean participation in trading these stocks is likely higher. This is an opportunity for institutional investors, as the increased liquidity allows them to take positions commensurate to their size. However, this in turn can cause unusually large moves, representing an opportunity for individual investors who are ready to pounce.

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Stock in the Spotlight: Brickworks

Thursday, August 03, 2017

By Michael McCarthy

Sometimes the label on the jar is misleading. Sure, Brickworks (BKW) is exposed to the building industry, and its official sector is construction materials. However, at current prices, the mathematics of investing in BKW is fascinating.

Alongside its bricks, block, tiles and paver manufacturing business, it has a property division and a 42.72% stake in Soul Pattinson (SOL holds a similar chunk of BKW). At current share prices, that stake in SOL is worth around $1.8 billion. After recent falls, the market capitalisation of BKW is around $1.9 billion. If we deduct ALL of the $600 million in liabilities on BKW’s balance sheet ($509 million non-current) we get a market value of the remainder of BKW of $700 million.

The building products division alone is expected to generate $73 million in earnings this financial year. However, most analysts expect this number to fall in 2018, as the long predicted property downturn finally arrives (?!). Nevertheless, ascribing a zero value to the property division (likely a gross underestimate) we get an earnings multiple of less than 10x.

In traders’ parlance, this is a stub trade. A trader could buy BKW, strip out the SOL exposure by selling 4,272 SOL for each 10,000 BKW held, leaving the trader exposed to the stub of the BKW business. In theory, the trader then waits for the market pricing to reflect the relative value of BKW to SOL and trades out at a profit.

Investors can take a much simpler approach. The current value difference in the stocks points to a long trade in BKW. The managers at BKW are regularly typified as conservative. While some investors agitated against the cross-shareholdings between BKW and SOL, one likely effect is that it will keep the same management team in place. The management team with a stronger track record. The same management that have increased dividends every year since 2001.

BKW is not often viewed as a dividend stock. However, the recent share price drop means that the calculation on the two recent dividends shows a yield better than 5% (including franking). And the chart points to support at $12.30, a possible backstop to current levels around $13.00.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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Investor alert: Heightened downside risk

Wednesday, July 26, 2017

By Michael McCarthy

The days ahead are packed with news investors ignore at their own risk. PMIs in China and Europe. Inflation readings in Japan and Australia. Durable goods and other national accounts data in the US. Additionally in the US, there is an FOMC meeting, an interest rate decision and the busiest week of the company reporting season so far.

Many shifts in market thinking are possible this week.

The volatility of many markets is higher, apparently in recognition of these potentially game-changing events. Unfortunately for Australian investors, this increase in market action comes as the share market index trades near the lows of the range.

Those who favour the view that markets are organic in nature are often drawn to the price action. The actual moves of a currency, a share or an index are read as primary evidence – an expression of the collective will of all participants. The current price, relative to its history, contains information about market conditions and possible future moves. That’s why this chart is unsettling.

After peaking in May, the index is down more than 5%. In the last two weeks, it has tested important chart support around 5,660, making a lower low each time. Many chartists interpret this behaviour as a sign of overall market weakness. The bounce yesterday, and positive overnight leads, suggests the market is moving away from the danger zone. However, any sudden shocks could see this important level breached.

Investors chose to buy at the same index level as before, causing a bounce. A move higher from here would suggest a test of at least 5,825, and possibly 6,000.

However, a fall through this support, and a daily and/or weekly close below 5,660, could bring sellers out of the woodwork. The technical picture may deteriorate swiftly considering the events of this week. The good news is that there is a lot of previous action between current market levels and 5,000. A support level at 5,400 coincides nicely with the 61.8% retracement of the rally from November to April, and may prove a turning point if the market does sell down.

At the bottom of the chart is a Relative Strength Index (RSI) indicator. The fall through 50% is also a negative development. Further, the RSI is nowhere near oversold territory (below 20%), suggesting little to slow momentum should the support level break.

The “right” response is dependent on investors’ individual circumstances. Ideally, when the Australia 200 index was closer to 6,000, investors sold stock, bought put options or rotated into more capital stable or undervalued stocks. Investors who acted at that point may now watch and see (ready to pounce on pre-selected stocks), take profits on put options should the market bounce, or ride their reduced exposures to lower levels for such an opportunity.

It’s never too late to act. If the index signals lower levels by closing below 5,660, a quick response is available using what are known in wholesale financial markets as equity swaps. Individual investors know them as CFDs. CFDs (Contracts for Differences) are a “plain vanilla” derivative, as they change in value at a constant rate with the underlying market.

It’s important that any investor considering CFDs understands the power of leverage. While allowing investors to secure significant hedging positions with a small amount of capital, leverage can magnify potential losses, as well as potential gains. Nevertheless, for those willing to make the effort to understand these powerful investment tools, there is an opportunity to quickly and efficiently hedge a market portfolio with a single index CFD transaction.

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Profiting from a holding pattern

Wednesday, July 19, 2017

By Michael McCarthy

Just over a year ago, on 16 June 2016, I wrote an article for Switzer Daily titled Investors need to stick with a strategy. Here's a recap:

  • The global investment outlook remains difficult. The numbers are mildly positive, but there are significant risks.
  • The global outlook is further clouded by the conflicting actions of central banks. While the US Fed tightens, banks such as the European Central Bank (ECB) and the Bank of Japan (BoJ) continue to man the pumps. These cross flows add to market volatility and uncertainty.
  • The outlook for the Australian economy remains modestly positive, despite a number of local distractions such as the Federal election campaign. Sentiment swings are the likely major driver of market moves in this scenario.
  • The share market performance overall could remain sideways, with the Australia 200 index respecting a range between 4800 and 5400.
  • This means “buy and hold” strategies are unlikely to deliver the best returns. Instead, rewards in the current environment may go to active investors – those willing to take advantage of market swings.

Today, I would update the first two points, and change the range for the Australia 200 index to 5,400 to 6,000. And that’s the problem in writing investment strategy. Sometimes conditions evolve over time, meaning that the “right” strategy remains the same. Here’s how the index traded over the past year:

The modest upward bias saw a 9% capital gain for an index portfolio, plus any dividends (around 5% with franking). A 14% return when cash rates are at 1.5% is respectable. However, many investors will report returns lower than the benchmark. Overweight cash positions are one contributor to weaker returns. However, there are a couple of strategy points that could have improved performance for many investors:

  • Sentiment swings are the likely major driver of market moves in this scenario.
  • Rewards in the current environment may go to active investors – those willing to take advantage of market swings.

As the chart shows, the main index has traded sideways for most of 2017. With a couple of breaks, it has largely respected a very narrow range between 5670 and 5825. 

Naturally, these market conditions will not last forever. At some stage, there will be a move away from the current range. The likely trigger is a change in the macro economics. A burst of inflation or wages growth could see shares break upward. A dramatic sell off in bonds is another potential positive driver. On the down side, possible market disruptors include disappointing growth numbers in China or the US, or political dysfunction in Europe or the US.

Barring a macro event, the range trading is likely to persist. This demands a strategic response from investors who have not already adapted.

The recent experience in retail stocks illustrates a source of potential opportunity. The whole sector was marked down on the “Amazon effect”. This was NOT due to any change in current earnings or any evidence at the company level of any negative impact. In other words, the sector was marked down on sentiment alone.

Aware investors may have snapped up JB Hi-Fi at levels close to the $21.20 low just six weeks ago. It’s now trading close to $25.00. Similarly, Harvey Norman traded down to $3.59, and is now closer to $4.00. Gains of 10-20% in just two months can significantly improve overall returns.

The good news is that the market may see more sentiment induced swings as Australian companies head into the full financial year reporting season. The news flow begins in the first week of August. Now is the time to identify good investment AND profit taking opportunities and create a watch-list. Any sentiment-induced swings in the lead up to a company’s earnings announcement could be an opportunity, albeit at higher risk ahead of the event.

Two sectors are high on my list due to recent moves. The real estate investment trust index is down around 12% in a month. This is an unusually large fall for a sector considered capital stable. Despite concerns about higher interest rates hurting valuations, bond markets have rallied back strongly over the last week. And the REIT sector is yet to react.

The other sector on the radar is Healthcare. The fall in the sector index in the last month is around 8%. While not as dramatic as property, this swing largely on fears of change in the US healthcare landscape could be a chance to buy into a sector that in recent history has traded at lofty multiples.

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Fairfax (FXJ) and the damage done

Diversification across sectors is key

Milk bubbles?

JB Low-Fi?

Is the market set for a pullback?

Wild Western Areas

Retail tales: The Amazon effect and JB Hi-Fi

Stock in the spotlight: Adding growth exposures

Stock in the spotlight: Going for Platinum

Climbing the wall of worry: 3 events that could derail the market

A beef with P/E ratios

Going for growth

Stock Spotlight - Healthscope (HSO)

The triple top: Is the market set to slide?

Are shares at risk of a pullback?

Gold for Australia: stocks to watch

Reporting season: the good, the bad and the ugly

Factors affecting portfolio performance

Common behaviours that could hurt your investments

Can the 'Goldilocks' economy keep the bears away?

How to invest in 2017

Who’s afraid of the big bad Fed?

Market volatility demands action

3 market hurdles in the silly season

ASX 200 could reach 5900 by year's end

The chart every investor must see

3 things you missed during the US election circus

Could Trump sink your portfolio?

Healthcare stocks catch a cold. Time to sell?

This week's jobs numbers could make or break the market

Will there be a Santa Claus rally?

Should you buy the banks?

Active investors are cheering, not panicking

Why should Aussies care if the Fed raises rates?

Pay close attention! Market action could heat up

How to energise your portfolio

How to know if your company is a winner

Rate cut or not, stocks could climb

Is the market in the sell zone?

Is the share market ready to surge?

Australian shares and the federal election

Investors need to stick with a strategy

Flight Centre has its wings clipped

What every successful investor needs to know

Sell in May and go away?

Share investors are currency traders

Buying stocks in choppy markets

Any value in Woodside?

Media under the Southern Cross

ANZ: forecasting disaster

Blowing housing bubbles

Australian shares back in the zone

Investment approaches in volatile markets

The not-so-big Australian

Signs of a market bottom

Slaying golden goose myths

Investment strategy and the reporting season

Good news for rational investors

Tightening tales

The upside of low energy prices

Australian shares: looking ahead

Energising your portfolio

The wisdom of copper

How will rising US rates impact your investments?

News versus noise

The investment toolbox

The three-stock portfolio

Digging for gas bargains

How to keep your investment cool

“Dow 30,000 Now” and CSL

Canberra puts a Buy on shares

Market volatility and dividend floors

Dusting off the portfolio

Market routs, corrections and sell offs

Share market falls and CBA – time to buy

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