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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.

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, 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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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

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

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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