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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.

The News on Isentia

Thursday, April 12, 2018

Value investors can be unbearably smug. Despite an overwhelming body of evidence that no one investment style is best in all markets, value investors delight in their own certainty. The stock is undervalued, the investor is right and eventually the market will agree and the stock price will rise.

Warren Buffet’s long term investment performance is often cited as an example of the power of the value style. There’s no disputing the strategy has many successes. However, there are at least two problems with this approach. The first is that the wait for a stock to “come good” can be interminable, tying up capital for years. This is an investment opportunity cost. The second issue is that value investors rarely use the discipline of a stop loss order. In other words if a value stock is falling, there is no share price at which many value investors will admit defeat.

This brings us to Isentia Group (ISD).

Isentia is a long term darling of the value investment community. Initially listed in mid-2014, the stock more than doubled in price from $2.40 to $4.95. Those buying ISD on a value argument were well rewarded. However, since the high in late 2015, the stock has slid dramatically and is now closer to $0.80 per share. The problem is the downward revisions of ISD’s market value have lagged the share price drop, trapping investors.

 
Many valuations are based on the present value of future earnings. This does not account for market failure. It’s hard to dispute that the failure of ISD’s content marketing business is the primary cause of the share price slide, and the trapping of value investors.

Now that ISD has shed content marketing and its CEO, my view is the stock has become interesting. The remaining media monitoring business is well established and profitable. I estimate the current PE ratio around ten times - cheap if there is future growth. The long term outlook for the media monitoring industry is not clear. Right now it is delivering. Some investors may wait for the share price to break the downtrend with a move up through $1.00.  But at eighty cents I’m happy to take a 12-month speculative view that this share price will recover significantly.

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Is now the time for traders to start panicking?

Thursday, March 29, 2018

Professional traders know fear and greed. Panic is the active manifestation of fear, and affects markets as much as every other field of human endeavour.  The saying above reflects the human nature of markets. Panicking early means preserving capital as markets fall, ready to grab bargains. Panicking late can mean selling at the bottom of the market. One of the keys to trading and investing success is panicking early, not often.

Pressure on share prices is growing. Fears of trade disruption and the negative impact of higher interest rates are fraying investor nerves. Share market indices near multi-year and all-time highs are adding to the worries, as are stretched stock values. Is it time to bail out?

One of the reasons for investor optimism is a positive outlook for local and global economies. However the market is not the economy, and the economy is not the market. While they are clearly connected, the economy is happening now whereas markets price the future. This means a market sell down can occur even when the underpinning commercial activity is rudely robust.

How do professionals decide when to panic? One school of thought relies on prices themselves as indicators of market thinking. The chart based analysis of trends, and price support and resistance, are attempts to discover the collective behaviour of the participants in a given market. The beauty of this approach is the market “tells” traders when to act. And the charts are pointing to a very important price point:

 

This weekly chart is the big picture. Relative to the past seven years share prices are elevated. There is a longer term uptrend (yellow line), and a defined trading range between 5,650 and 6,150. With the market sitting close to 5,800 the chart is mildly positive. There are a number of scenarios, including the possibility that the Australia 200 index will find a footing and rise to test the resistance at 6,000 and then 6,150 (orange lines).

However a market drop of just 3% would paint a negative picture. Not only would it breach the longer term support at 5,650, it would break the uptrend line. This sort of price action opens the door for an index pull back to levels closer to 5,000.

 

This demands attention from investors. A clear breach of 5,650 could be a read as a signal to panic, or at least reduce market exposures. And if the breach occurs its unlikely sellers at that level will be the last to panic.

 

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IAG – time to jilt your market sweetheart?

Thursday, March 15, 2018

On St Valentine’s Day, Insurance Australia Group (IAG) delivered shareholder love with the announcement of a 24% lift in first half profit. Management also re-iterated their estimate of the annual operating margin in the 15.5% to 17.5% range. The market took off to make all-time highs for IAG above $8 per share.

IAG has grabbed a lead on its industry peers. Suncorp’s net profit fell 16%, and QBE reported a net loss after significant write downs and increased insurance losses. IAG’s engagement with Warren Buffet and the subsequent pivot to globally re-insuring risk could be a key driver, given that written premiums and revenues increased much more modestly.

IAG is now facing the same problem faced by many market darlings. One misstep and the share price could crater – and missteps are almost guaranteed in the insurance industry (declaration of personal bias – the author does not invest in insurance shares). Around $8 a share the PE ratio is close to 18x next year’s earnings and a dividend yield (last 2 dividends) of 4.5%. This makes IAG look expensive against its peers, financial stocks and the broader market.

The weekly chart illustrates the steepness of the IAG share price rise. The recent stand out earnings result deserves accolades, but the sharp rise puts shareholders in danger territory. It’s harder to identify support as this is a completely new level for IAG shares. From a technical point of view the first downside support is between $7.00 and $7.37. And a pull back to a zone between $6.40 and $6.60 cannot be ruled out.

“Don’t fall in love with your position” is a well-known saying among traders. The principle could apply here. Investors in love with IAG should consider a break up – at least temporarily.

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As the Dominos fall

Friday, March 09, 2018

Picking stocks is an exercise in predicting the future. No matter how intelligent or hard-working, no-one knows the future with certainty. In both strategic and tactical terms as investors we make our best estimates based on the available information. It is inevitable that at times our choices will lead to poor investments.

Putting stocks in “the bottom draw” is a classic investment mistake. Sitting on losing positions until they “come good” not only drags on a portfolio’s value, it ties up capital that is better deployed elsewhere. There are techniques available to help avoid this error. The most popular is the use of stop loss orders.

Stop loss orders recognise the limitations of forecasting. Essentially they ask investors “at what stock price will I say this a poor choice?” The best time to make this decision is before the investment is made. Ideally a sell stop loss order is placed with the buy order.

However like any risk management techniques the use of stop loss orders has its own risks. This brings us to Domino’s Pizza (DMP).

When Domino’s fell below $40 in August last year and then stabilised around $43 it came onto my radar. Earnings growth slowed – from near 30% to around current guidance of 17%-20%. The PE to Growth ratio was around 1.5x – attractive in my view. The risk management aspect also worked. The clear low at $39.50 gave a line in the sand. Buying at $43.30 with a stop loss sell order at $39.30 fits my investment strategy.

Alert readers can see what’s coming. The results delivered on February 13 were largely in line with consensus, or potentially a small miss. However the share price reaction was extraordinary. The shares were smashed over the next few weeks, from close to $50 to a low at $38.11. Naturally this triggered many stop loss orders.

DMP is consistently ranked as one of Australia’s most shorted stocks. The current short position is around 16% of the issued capital, or 12 million shares. With the event risk of the results announcement out of the way it’s possible the selling was related to existing shorts. In my view the current share price represents an opportunity to gain exposure to a higher growth stock. However, maintaining portfolio discipline is even more important to long term investing success than stock picking. Under my rules I can’t buy DMP until a clear uptrend is described. At the moment that means a move over $50. What do your rules say?

 

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Two stocks to hold on to for 5 years

Thursday, March 01, 2018

One of the most frequent questions from investors is, what stocks should they buy for the long-term? The reason being that finding long-term holdings is no easy feat. So, here are two that I'd recommend holding onto for at least five years.

AUSTAL

One criterion in looking for shares for the long term is higher barriers to entry. A company with a clear lead in product, technology or process that is difficult to replicate, may enjoy many years of higher margins. Ship builder Austal (ASB) fits the category.

ASB manufactures combat and transport ships for the US Navy and the Royal Navy of Oman. It makes patrol vessels for the Australian Border Force. It also makes an assortment of auxiliary vessels. It has ship building operations in the USA, Western Australia and the Philippines, and enjoys a strong reputation for high quality delivery.

The company also supplies and installs weapons and other systems, and provides training and other support services. In short it is involved at every stage of vessel supply from design to post delivery. This vertical integration and close relationships with customers means ASB is not often threatened or pressured by competition. Combined with the long term nature of its contracts, this may give investors assurance about the future for ASB.

At its recent half year result announcement ASB released an improved bottom line and a guidance towards a steady earnings this year. Additionally ASB is one of the few stocks likely to benefit if geo-politics heats up. Long term earnings, high barriers to entry and a beneficiary of increased military activity makes ASB a stock worth considering for defensive earnings.

 

This long term chart shows Austal is trading at historically lower levels and is bubbling up towards a potential break through $2.00 per share.

WOODSIDE PETROLEUM (WPL)

Balancing ASB’s long term defensive profile is the growth exposed Woodside Petroleum (WPL). Currently suffering some indigestion after a placement the shares are well down on recent peaks close to $35.

However the longer term prospects are strong in my view. World class fields and reserves, proven building and operating expertise and demonstrated investment discipline are three key reasons to hold WPL for the long term.

Despite the hopes of environmentalists for a switch from fossil fuels straight into renewables, none of the new technologies are economical without government support. The need for a transition fuel that is big enough to scale up but has lower carbon dioxide content is more pressing than ever, and LNG is in the frame. As reality dawns on environmentalists and investors there is potential for a long term re-rating of the stock.

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Woodside shares plummet despite equity raise

Tuesday, February 20, 2018

At the resumption of trading this week, Woodside Petroleum shares plummeted. The successful completion of the institutional leg of a capital raising seemed to leave the market unimpressed, or at least with some indigestion.

Analysts are re-cutting their numbers, and projected target prices are moving up AND down. The offering to individual investors opens on Wednesday. How will they decide whether or not to take up their 1 for 9 entitlement at $27?

At the heart of the analysts’ stoush is the question of strategy. Is this a prudent re-focusing of development priorities or a timid response to a joint venture split? Is Woodside buying Exxon’s Scarborough stake a sign of frustration at difficult joint venture negotiations or simply the result of a disciplined and carefully considered investment process?

Perhaps more importantly; are those who are now suggesting Scarborough is a low quality growth option the same critics who for the last two years criticised Woodside’s lack of growth options?

It can be difficult for investors to decide when the “experts” disagree. Each investor must make up their own mind. Nobody knows the future and the answer to these questions will not be clear for three to five years.

Stepping back from the argument, it’s worth remembering the development of oil and gas fields is a high risk, potentially high reward activity. Woodside have demonstrated their ability to bring vast projects online successfully, and the foresight in building the Pluto processing plant with capacity to handle production from fields as yet undeveloped is an example of their longer term, strategic thinking.

Investors who agree that in a carbon dioxide constrained universe, gas is the answer, may see the current Woodside share price weakness as an opportunity:

As an investor I’d be delighted at the opportunity to buy Woodside shares at $27. And as a trader I see a buying opportunity developing. There is important support near $28, and that’s where I’m setting my price alert.

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Myer stock replacement strategy

Tuesday, February 13, 2018

Some stories are comforting because they are familiar. Others seem like a recurring nightmare. Myer shareholders may be forgiven if they place last week’s half year profit results in the latter category.

First half sales fell by 3.6%. There is an impairment charge coming and management did not give a number. The six month profit of $37-$41 million doesn’t leave much room to move. 

Perhaps worst of all, CEO Richard Umbers said “Myer…remains resolutely focussed on foot traffic and sales across all channels….” With respect to Mr Umbers, this is the greatest “der” moment of reporting season. The problem is, it looks like there is still no “how” to go with this “what”.

The market response was predictable. Share trading volumes surged. Myer shares found a new all-time low. And on Monday, six major brokers downgraded the stock. Earnings downgrades are the recurring part of the Myer shareholder nightmare.

Yet many investors are holding on. The psychological aspects of investing can make it hard to act on the poor investment choices we all sometimes make. Shareholders who think that Myer’s prospects look very dim but are unable to push the sell button may consider a stock replacement strategy.

This involves selling the stock and redeploying most of the proceeds. A small amount is spent on Myer call options. With the stock trading at 54 cents the right without obligation to buy Myer shares at 65 cents at any time up until June (Myer June 65 call) was offered at 2.5 cents. 

Holders of a call option do not receive dividends. If Myer edges higher to 60 cents the holder of the call option will receive little benefit. However if Mr Solomon Lew, a vulture fund or anyone else makes a takeover bid, the call option holder participates in all the gains above 65 cents. In the meantime most of the capital (say 54 cents less 2.5 cents equals 51.5 cents per share) is safely in the bank or invested in another stock.

The stock replacement strategy is the “no regrets” way to sell an underperforming stock.

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How low can the US go?

Tuesday, February 06, 2018

The action in US markets over the last two trading sessions (Friday and Monday night) is pointing to a rout. The confidence and exuberance that took US indices around 10% higher in January has melted along with bond markets. Two important questions confront local investors – how low can it go, and how will it affect Australian shares?

Some investors are scratching their heads and wondering what has changed. The short answer is very little.

The trigger for the sell-off was stronger than forecast wages data on Friday night, indicating wages are growing in the US at an accelerated 2.9%. This raised inflation expectations, and with it the forecast number and size of interest rate rises this year. This in turn took US ten year bonds to their highest yield in four years, and close to a technical bear market. Investors shifted focus from the strengthening US economy that is driving rates higher to the impact of higher rates on company bottom lines and share valuations, and the selling began.

It looks like a good, old-fashioned market panic is on. At the moment the downward momentum in US markets is strong. Valuing a market is fraught, but an examination of Pes in light of prevailing interest rates can help. Over the period 2014-2017 the average ten year bond yield in the US was close to 2.20% and the average forward PE for the S&P500 was 16.2x. As at this morning, the PE stood at 16.7x and the ten year bond yield 2.76%.

One way to read this is that the S&P500 has further to fall to reach a PE that reflects the changed interest rate environment. If that PE is around, say 15.5%, there is a further 8% or so for the index to fall.

This co-incides quite nicely with the big picture technical outlook:

On the weekly chart the accelerating up trend produces multiple trend lines at increasingly steeper angles. The sell down has breached the higher of these trends. Investors may note the support level close to 2,400 intersects the lower, longer term up trend. This technical support zone is also roughly 8% lower.

This analysis points to a rocky ride for equity investors over the coming weeks.

However Australian investors may fare relatively better. The PE comparison for the Australia 200 index is currently 15.7x versus a four year average at 15.2x. However the interest rate environment is very different. The average ten year bond yield for the comparison period is 3.1%, versus the current level close to 2.9%.

This points to a much gentler local downdraft. The technical picture shows multiple major supports between 5,950 and 5,650. Predicting the turning point is always difficult. Nevertheless, the positive economic outlook means there is a potential buying opportunity coming for investors well placed to buy a corrective dip.

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AWE Limited – game on

Tuesday, January 30, 2018

The energy sector is in focus after a third bidder for AWE threw their hat into the ring. A rising oil price and the potential for an all-out bidding war have investors wondering how high the AWE share price can go – and who’s next?

This is a vast improvement from the low point for the sector a year ago. The oil price that plumbed prices below US $30 a barrel is now trading at more than double that price. AWE shareholders are doing even better. After touching lows at 31 cents last year it traded at $1 after the latest bid from Mitsui.

Mitsui are long standing players in Australian energy markets with a presence established in the 1950’s. While the all-cash bid is non-binding until there are 50.1% acceptances, it is a far cleaner bid than many of the highly conditional takeover proposals of recent years. Given the previous best bid, from locally listed Mineral Resources (MRE), was both lower and composed of scrip and cash, shareholders may consider Mitsui’s bid superior.

The trading of up to $1 after Mitsui’s 95 cents per share bid indicates there are some willing to risk their funds on a higher bid. This is not a forlorn hope. All three bidders are trade groups with potential synergy benefits, not private equity groups whose only concern is buying cheaply. Given the third player is state related China Energy, there is no concern about the depth of pockets.

However it plays out there is no doubting the benefit to AWE shareholders of a competitive bidding environment (above). The energy sector is ripe for further moves, particularly on small players with higher quality assets. Investors looking to M&A activity as a portfolio kicker in 2018 could also consider mining services and media as sectors with potential for consolidation.

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Seven West in the SWiM

Tuesday, January 23, 2018

How the mighty can fall. A stock that traded above $15 pre GFC and close to $8 in 2010 is now trading at just above 60 cents. It’s grabbed the number one spot in its industry and has a management team with a strong operating track record. There is a clear value argument, despite the fact the consensus forecast is for a further edging down in revenues in the next three years.

Why is this stock trading cheaply? 

Seven West Media (SWM) is perceived as an “old” media stock. Certainly, Seven Television, Pacific Magazines, various radio stations and WA News (papers) are part of the conglomerate. However, it has online exposure as well, most notably through Yahoo and its digital television channels. 

This straddling of the old and new means SWM does not have the high-growth profile of a purely new media start up. On the other hand, there is an argument that it well placed to roll with the evolution of the industry. The hard reality of online media is that profitable business models are difficult to identify. And having legacy income streams can support media groups as they continue the search.

After sustained pressure, earnings have dropped by more than 50% from 2014. Now, the consensus forecast suggests analysts believe the group is close to base earnings. The drop in share price to record lows puts SWM on a more attractive earnings multiple. At current prices the P/E ratio is 6-7 times both next year’s earnings and the average of the next three years. Despite the pressure on the business this compares well to a market multiple around 18 times earnings.

Further, the shares paid 4 cents in fully-franked dividends last year. If it does the same this year, that’s a dividend yield (including franking) north of 8.5%. Consolidation in the sector may also mean potential takeovers or mergers. 

The outlook for media revenues remains clouded, with further disruption of traditional models likely. In my view SWM’s share price is at a level that makes it a potentially higher risk, and a potentially higher reward investment. Please consider.

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