Everybody loves a bargain. In share market investing the thrill of plucking a beaten down stock from the bottom and watching the share price eventually begin to rise is hard to match. Unfortunately the thrill may never materialize as the seemingly ridiculously low share price keeps getting lower. How then does an ordinary retail investor spot a true bargain stock?
While some would question the belief that price movements in share markets are inherently “rational”, there is no question that behind any upward or downward swing lies a rationale of one form or another. Longer term swings indicate investors are of the belief the stock is in trouble or poised for continued good fortune.
Companies faced with staggering falls in the price of their shares typically react in one of two ways. The first is to point to external factors. Customer demand is weakening; price competition is approaching cutthroat proportions; costs of raw materials are increasing; and on and on.
Then there are those companies who cast their diagnostic eye internally. In the belief the company can control its own fate; a common first step is to announce a “strategic review” followed at some point by the announcement of a bold and daring long term “turnaround” plan based on the findings of the review.
The problem for retail investors attempting to evaluate the plan is two-fold. First, the technical details of the turnaround plan can be difficult to analyse. Second, given the length of time needed for a real recovery, how does the investor select an appropriate entry point? Progress in the near-term can drive up the stock price but the increases can quickly dissipate in the face of setbacks.
Ideally one would want to get in at the lowest point but there is the risk the turnaround has yet to take hold. An alternative is to forego the profit to be had from an early rise and get in once the stock price appears to be steadily moving upward. As a case in point, we can look at a turnaround story in progress – Metcash Limited (MTS). To begin let’s look at a five year price movement chart for Metcash.
The Metcash descent to the bottom began in late August of 2013 with the share price dipping below $3.00, falling below $2.00 by the close of the 2014 trading year. At that time the company was operating as a wholesaler supplying independent retailers in groceries, liquors, hardware, and automotive parts. In March of 2010 the company expanded into hardware with the acquisition of a controlling interest in the 400 independently owned Mitre 10 Hardware stores. In 2012 the company expanded again; this time into the automotive business with the acquisition of a controlling interest in Automotive Brands Group. Metcash shed the automotive group in 2015 as part of the turnaround plan in order to focus primarily on the grocery operations.
The acquisitions came at a time when the “supermarket wars” were in full swing as the Australian grocery “duopoly” of Woolworths Limited (WOW) and Wesfarmers Limited (WES) responded to the growing threat from discount rival Aldi’s. Taken together Woolworths and Wesfarmers controlled 80% of the Australian grocery market. If they were threatened by Aldi’s how could Metcash with its higher costs survive in the face of lower prices at the grocery cash registers?
To respond to its deteriorating operating conditions, Metcash announced a strategic review of its operations in June of 2013. At the same time Metcash downgraded earnings per share (EPS) guidance for FY 2014, anticipating a drop of 13% to 15%.
The turnaround plan was rolled out in March of 2014, with a key focus on driving the grocery business called Project Diamond. Here are the targeted improvements contained in the plan:
Transforming Metcash Food & Grocery (MFG), known as Project Diamond;
Driving consolidation and sustainable network growth;
Further enhancing its world class supply chain; and
Enabling Successful Independents.
These are generic goals with little “meat on the bones” to convince investors. More specific details in the plan included:
Expanding its independent retailers in grocery, liquors, hardware, and automotive parts grocer base;
Providing retailers with more support, including training and data analysis;
Omni-channel marketing; and
Investments in infrastructure improvements.
To fund the expected $640 million in improvement costs the company cut its dividend payout ratio to 60%. The share price did not budge and analysts were moderately skeptical.
By 21 September of 2015 the share price had fallen to $0.98. The first Full Year Results (2015) announced since the commencement of the turnaround plan came on 15 June. The company posted a loss of $384 million, down from a profit of $169 million in FY 2014.
The stock price has been rising since hitting that low on 21 September. FY 2016 results released in June of this year showed Metcash returning to profitability with a slight decline in revenue. Profit rose to $216 million while revenues dropped from approximately $1.37 billion to $1.36 billion. Year over year the MTS share price is up 100%.The price performance may seem surprising to some, given the fact Metcash is number three on the Top Ten Short List, with 13.75% short interest. Short interest is the total number of shares investors have sold short but not yet covered, expressed as a percentage of the total shares outstanding.
Short interest is considered an indicator of market sentiment regarding a given stock. Investors who believe the stock of a given company is due for a downward trend borrow shares at a given price, with the shares to be bought at a later date to “cover” the borrowing once the short investor’s profit appetites are satisfied. Shorting a stock at $10 and then covering at $5 yields a healthy profit.
Retail investors are told to avoid short-selling as the potential risk is literally infinite. If you buy a stock at $10 and the company goes bankrupt, your loss is capped at $10 per share. If you short that same stock and the price rises to $20 and beyond the loss incurred when covering the stock continues to mount. As a result, a reduction in short interest could be an indicator a stock’s price is recovering and likely to rise.
There are no sure things in share market investing. Some investors rely on technical analysis signals to make buy decisions while others rely on improving company fundamentals. Because of the risks involved short sellers are generally considered to be smarter than the average retail investor due to the rigorous analysis often needed to spot potential trouble. For that reason, tracking short interest would seem to be a helpful tool in determining a buy point for a bargain stock in the midst of a turnaround effort.
Retail investors can track short interest by visiting the ASIC (Australian Securities and Investments Commission) website. Metcash has been on the Top Ten List since 2013. On 2 September 2010 the short interest for MTS was 2.41%, which went up to 3.87% on 2 September 2011 and 5.13% in 2013.
By 2 September of 2013 the 9% short interest was enough to make the list. At that point it would be safe to say the short sellers were of the opinion the Metcash turnaround plan would fail. One year later short interest was up to 12.68%, climbing to 21.22% on 2 September of 2015, about one year ago. Since then the short interest has dropped to 13.75%, as of 2 September. That is still high, but the decline would seem to indicate some of the shorts are wary of continued improvements from the Metcash turnaround plan.
In what some would consider a strange turn of events, the latest good news for Metcash investors is the acquisition of Woolworths Home Timber and Hardware Group (HTHG). The group will add 1,200 stores and is considered to be a good complement to the existing Mitre 10 outlets. Woolworths acquired Home and Timber in 2009, following that with a 2011 joint venture with US based home improvement retailer Lowe’s Companies Inc. (NYSE:LOW) to establish Masters Home Improvement Stores in an attempt to do battle with Bunnings, the dominant player owned by Wesfarmers.
The Masters move proved to be disastrous. Woolworths had plans to sell off its Masters outlets but now faces opposition from Lowe’s. Despite its iconic status here in Australia, Woolies is losing the supermarket wars to rival Coles, owned by Wesfarmers and now both are facing the prospect of increased completion with new Aldi’s stores set to open in South Australia and Western Australia.
The once left for dead Metcash has outperformed the two giants over the year. Here are the price movement charts, first for Metcash versus Woolworths and then for Metcash versus Wesfarmers.
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