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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.

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.


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.


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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Telstra - out with the old

Tuesday, January 16, 2018

A new year, a new beginning. Time to revisit the investment strategy and reset the portfolio. For many investors, this will mean further moves towards growth exposures (materials, consumer discretionary, IT) and away from defensive themes. In my opinion there is one stock that should be on everyone’s sell list – Telstra (TLS).

Telstra has served many investors and the broader Australian share market very well. It introduced a generation to direct share investment, and it remains the most popular Australian stock with more than a million shareholders. Investors who bought into the first or third issue of shares (T1 and T3) have received above average dividend streams for many years and bought their shares at less than the current stock price. T2 investors may be less impressed:

However, history and sentimentality have little useful role in portfolio construction.  Share markets price the future and unfortunately for Telstra the future positives are harder to see. Questions about growth beyond the NBN roll out in an increasingly competitive environment mean analysts are unlikely to lift their earnings outlook anytime soon. A lack of positive catalysts usually means share prices languish at best.

Poor recent share price action adds to this negative outlook – at least in the short term:

Note well the two gaps on the chart – the fall from $4.40 when the stock went ex-dividend in mid-August and the plummet in late August after TLS told the market it couldn’t monetise the NBN income as previously announced. 

These gaps are highly significant to chartists.

They act as important support and resistance levels. A closing of the gap is considered a strong signal for further moves in that direction. Unfortunately for TLS shareholders a failure at a gap is also highly significant.

That’s what occurred last week. TLS shares traded up into the gap. A closing price at or above $3.83 would have closed the gap and likely sparked trader buying. However, when the share price peaked at $3.78, then dropped below $3.75, the signal became decidedly negative.

Despite investors natural affection the combination of fundamental and technical negatives could see TLS tests the low at $3.34. A breach of that level brings long term targets below $3.00 into play. Committed long investors may consider selling now to buy back at their leisure.

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US tax cuts – sell the fact

Tuesday, December 19, 2017

By Michael McCarthy

Despite a lack of legislative success, many US investors are pinning their hopes on the White House. A promise to slash corporate tax rates alongside other tax reforms has investors piling into US shares, creating new all-time highs. Naturally, this strength is spreading around the globe. Local shares that could benefit have received particular support.

However, the promise of tax cuts has been around for a long term. Corporate earnings momentum is positive, supporting higher share prices, but the US S&P 500 index is up more than 30% since the election. There is a similar effect with stocks exposed to US growth, such as Boral, Computershare, Cochlear and James Hardie. There is a real possibility that tax cuts are already factored, and that the delivery of the tax cuts could spark a “sell the fact” move. 

If the markets do adjust downward as the legislation is delivered, in my view, James Hardie (JHX) is particularly vulnerable. 

JHX benefitted from both the potential for tax cuts and the promise of a large and stimulatory infrastructure spend. The difficulty in gaining the approval of both houses of the US parliament for ANY legislation is apparent. Yet JHX’s share price is once again approaching all-time highs around $23.00.

It’s not just a “sell the fact” move that is potentially troublesome for JHX shareholders. Should the tax reform or infrastructure bills become unpassable the market judgement could be severe. On the other hand the best case scenario – both bills passed by both houses - may not add much to the current share price given the roughly 30% rally this year.

In valuation terms JHX looks more expensive at around 30 times earnings. The dividend yield is a relatively low 2%. Given a limited upside potential and a number of possible damaging scenarios, JHX shareholders may want to lock in gains before the fate of the tax legislation is known.

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