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The Experts

Michael McCarthy
Expert
+ 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.

Washington H Soul Pattinson - an expert investment

Tuesday, November 21, 2017

By Michael McCarthy

Washington H Soul Pattinson’s (SOL) name is possibly misleading. Many investors associate the name with the chain of chemist shops. This represents its origins, but it is now much more. Essentially SOL is an investment vehicle with an impressive track record.

The Washington H Soul Pattinson portfolio is broad. It contains cash, term deposits, property, shares, energy and related assets, copper and gold holdings. Washington H Soul Pattinson also provides corporate advisory services. One of its share holdings is a controlling interest in Brickworks, and Brickworks holds a similar stake in Washington H Soul Pattinson. This structure has been criticised. However, one effect is that it is very difficult for a hostile bidder to remove the existing management team.

In 1998 Washington H Soul Pattinson shares hit a low at (the equivalent of) $2.22 (there was a share split in 2002). While there are fluctuations over the years, the quarterly chart shows a rise over the intervening years to the all-time high of $19.00 in June this year.

So this is a structurally stable investment group with a strong track record – at least judging by the long term share price rise. The daily chart (pictured) shows a significant pullback from the highs. Some of this share price pressure is due to activist shareholders agitating for a change in the cross-shareholding, and the stock is now ex the November dividend. It’s now trading nearer an important support level at $15.75.

A challenge for many investors is the narrowness of their portfolios. While this often reflects a cautious approach, selecting only higher quality investments one at a time, it ironically means there is higher risk due to the larger exposures to single stocks. Investors looking to draw on long established investment expertise, and wish to diversify to reduce portfolio risk, could have Washington H Soul Pattinson on their radars.

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Orica’s implosion

Tuesday, November 07, 2017

By Michael McCarthy

Buy the rumour, sell the fact. Orica reported on Monday. You can see from the chart the strong rise into the announcement, and that investors certainly “sold the fact”. However this could offer an opportunity for investors not yet on board.

The recovery in metals prices is driving mining stocks higher. By extension, a pick-up in mining activity should see the associated mining services powering ahead. Naturally this includes explosives maker Orica (ORI). The issue here is that miners have not fully responded to the commodity price signals – yet – and therefore Orica’s bottom line didn’t improve. In fact, revenue and profit fell by around 1%.

Investors who see a global upswing in industrial sentiment indicated by strong industrial commodity markets are the likely drivers of the recent Orica rally. Mining services operations offer a diversified exposure to a surge in mining operations.

In some respect stocks like Orica offer an exposure to the theme without the mine specific nature of many choices in the resource sector. This pull back eases valuation concerns. Additionally, the price action is supportive. In Monday’s sell down the stock fell through a support zone between $19.00 and $19.20. However this was enough to spur buyers back into the stock.

By the end of the day the share price rejected the lower levels and respected the support. This is a positive for technical analysts. While Orica holds above $18.80 the risks for the stock are on the upside.

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Time to go shopping

Tuesday, October 31, 2017

By Michael McCarthy

Many investors are attracted to a value based approach to investing. Buy good quality businesses on the cheap, and let the market prove you right. Fortunes are made this way. The catch is that there’s (almost) always a reason a stock is cheap. Deciding whether the current rationale for a low share price is temporary or permanent is a core skill for value investors.

Amazon is coming! The Chicken Littles of the share market are panicking. Many do not seem to know that Amazon commands a princely 3% of US retail sales. Their entry to Australia lifts competition, but it doesn’t lay waste to the retailing landscape. And in my view the associated sell down has brought some quality choices to lower share prices.

This argument is not new. However, the price action in JB Hi-Fi (JBH) suggests a lower risk entry.

Note how the price found consistent support around $22.50. This price behaviour is an indication of “back foot” buying. A buyer or buyers are happy to soak up stock at that level, but are not chasing the stock higher. This is particularly important where a stock is short sold, as this sopping up of sellers reduces the ability of short sellers to buy back. And JB Hi-Fi is the fourth most shorted stock in Australia, with 15% of stock short sold.

Adding to the technical support is a lower PE, around 11x, and a dividend yield with franking of around 5.2%. This coincidence of technical and fundamental support increases the chances of a melt up in JB Hi-Fi's shares.

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Copper and oil ring BHP’s bell

Tuesday, October 24, 2017

By Michael McCarthy

Copper and oil are bellwethers for global industrial sentiment. Copper is used in everything from computers to construction. Other than nuclear fuels, the world’s energy markets are closely linked to the price of crude oil. Global investors take note of the signals coming from these key industrial commodities, and right now there is a bell ringing.

Here’s a longer term copper chart:


Note the price recovery back to levels last seen in 2014. Admittedly, the picture in crude oil is less impressive. However the price has stabilised, and is now trading near the top of the two-year trading range. Importantly both iron ore and coal prices are also trading above many analysts’ long term forecasts. Now take a look at the BHP chart:

More aggressive investors snapped up BHP shares at prices below $20. However purchasing at those lower prices meant a higher risk profile, and was not suitable for all portfolios. Now, the profile is shifting again. I know there’s nothing more mundane than a “buy BHP” call.

But.

In my view all four of BHP’s main commodity markets are pointing higher, and BHP’s share price is lagging this broadly co-ordinated move. If BHP lifts above $28 there could be a scramble, and investors could miss out not on a bargain, but on a key driver of any significant moves higher for the Australian share market.

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Taking a chance on telecommunications

Tuesday, October 17, 2017

By Michael McCarthy

On Monday the S&P/ASX 200 index broke out of its four-month trading range. In good news for investors, it traded up through the ceiling, meaning from a technical point of view, further gains are more likely. However, the challenge for investors is “what to buy?”.

Simplicity is a virtue in investing. The clearer a principle or proposition, the easier it is to determine its worth. This applies to many investing endeavours, from valuation to portfolio construction and beyond. One of the most straightforward approaches to buying stocks is to start by looking at sectors that are lower.

There are eleven official sectors of the Australian share market. Looking at the last four years, only two are nearer lows than highs, Telecommunication and Energy (Consumer Staples stock are around the midpoint).

The telco sector is suffering from NBNitis. This is characterised by delayed roll outs, margin pressure and under delivery. Naturally these are real investor concerns, but not everyone will lose from this nationally important infrastructure build.

The sector incumbent, Telstra (TLS), is also the most widely held stock in Australia. Its apparent lack of a growth strategy beyond the NBN roll out makes it, in my view, the most likely to lose market share, and therefore no bargain at the currently depressed share price. Others in the sector spark more interest.

TPG’s (TPM) ambitious mobile plans have analysts worried about the required capital commitment and its potential impact on cash flows. The construction of the NBN will also hurt its cable network revenues. On the other hand it has scale in its business but is still more agile than the sector gorilla. This combination of characteristics could make it a winner from the changing telco environment.

Importantly the market has trounced TPM’s share price. Taking a chance on the future was hard to justify at $12 a share. Below $5 per share it’s a much more interesting proposition.

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Healthscope under the microscope

Tuesday, October 10, 2017

By Michael McCarthy

When you hear “healthcare sector” what do you think of? Hospitals and aged care? The Australian healthcare sector is all that and a lot more. They were lumped together when investors sought “defensive” earnings. An aging population and government payment of many bills dominated individual company features. As this desire for defensive earnings recedes, the sector may be viewed in a more nuanced way.

It’s easy to underestimate diversity in the sector. There are hearing and anti-snoring device manufacturers, blood product makers, medical suppliers, pathologists and drug companies, as well as the traditional medical services groups. The recent half year earnings reports saw responses at the company level, and share price performance varied enormously.

One to catch the eye is Healthscope (HSO).

HSO traded to all-time lows into its August half-year result announcement. Then a miss on earnings, and forecasts some analysts thought were too optimistic, saw share price targets slashed. The stock fell a further 15%.

Note most analysts’ earnings estimates are below HSO management’s guidance. Even at these lower levels the price to consensus earnings ratio is around 17.5x – close to the broad market and well below the healthcare sector average.

This healthcare provider is not an income play. A key question revolves around the current hospital build – when will the site start earning, and how high will those earnings be? Given the conservative consensus view and the lower share price it’s time investors take a good look at this hospital care provider in development.

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A free hand in a free market

Tuesday, September 26, 2017

By Michael McCarthy

Profound industry change can happen in slow motion. The changes to Australian retail are playing out over decades. There is no end in sight to the evolution in the way we buy goods and services, and we first started talking disruption and disintermediation in 1998. The change in the media space is just as glacial.

Twenty years after the Naked News first went to air, and twelve years after the Huffington Post “published” its first edition, changes in media delivery and content roll on. The Australian government recently abolished the media “two out of three” and “reach” rules, anachronisms from the pre-Internet era. The general view is that “old media” companies now enjoy greater freedom to compete with their newer rivals.

This freeing up of the landscape should accelerate the process of identifying winners and losers among the established media groups.

In my opinion, Fairfax’s (FXJ) demonstrated propensity to sell off any areas of new media they develop (SEEK, Carsales.com etc) continues as they ready real estate business Domain for IPO. It’s as if FXJ management think this whole interweb thing is one giant fad that will end at any time, and they want to sell out while they still can. I put a big “L” on FXJ’s management’s collective forehead.

While the rules of media have changed with the internet world, principles of good business remain. Give an entrepreneur a free hand in a free market and results can be astonishing.

The development of Seven West Media (SWM) is a case in point. It has a foot in both camps. Its old media assets include Channel Seven, Pacific Magazines and WA News. However it has long held a position in new media via its Yahoo! portal. With the ownership gloves off, its proven track record in acquiring and building businesses could be a competitive advantage.


The clear downdraft in Seven West Media’s earnings and subsequent write downs over the last four years are a major driver of the share price decline to all-time lows. At current prices SWM is trading on a PE ratio around 8x – half the market’s 16x. Despite the earnings downturn, Seven West Media has reduced debt since 2014 from over $1.2 billion to below $800 million.

The media landscape is about to change – perhaps radically. Seven West Media is an experienced player with a cleaner balance sheet, and potentially a winner from the shifting media sands.

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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 dividend 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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MORE ARTICLES

Domino's looking tasty

Bluescope under the microscope

Stock in the spotlight: oOh!Media on display

Key company reports: What to look out for

Stock in the Spotlight: Brickworks

Investor alert: Heightened downside risk

Profiting from a holding pattern

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

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“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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