Breaking new ground - the trend is your friend?

Friday, 10th June 2016 14:43 - by David Harbage

Many of the best short term traders base their decision making on price charts, taking action when they see a stock (or commodity, or currency) move out of its normal trading band – be it to the up or downside – and break into new territory. Such study of historic price movements, termed technical analysis, can be complex (many text books have been written on the subject) and the active trader requires a technology-rich platform which provides live prices, information and news flow (such as that provided by LSE.co.uk’s premium service).

Depending on your perspective, the premise that a chart-following trader would take action after seeing a share price move into a new range or level may seem logical or an ‘after the horse has bolted’ response. A focus on fundamental analysis might prompt action at more opportune moments (deciding to buy at the bottom or sell closer to the peak), but a chartist prefers to ignore any news flow-driven prompt (in the belief that such news might turn out to be irrelevant or wrong) until the share price moves sufficiently decisively in a new direction.  Typically, when investor’ opinion changes - in response to new or unexpected developments - the subsequent weight of money will impact the share price.

The writer is not a particular fan of technical analysis, per se, but will maintain price targets (of considered fair value – based on an assessment of traditional metrics, against peer businesses – together with a range indicating temporal or acceptable under or over valuation). Essentially ensuring that any positive or adverse changes concerning the business itself (notably trading results, acquisitions or asset disposals) broker views, or stakeholder positions are reflected in those prospective valuations.

Amongst assets moving into new territory, the price of Brent crude oil is a standout feature: steadily rising from a year-low of US$27.4 in mid-December to nearly double and reach $53 today. This bounce-back merits further examination as, looking beyond the contributing factors that influence the price (supply-demand, political uncertainty etc.), this essential core commodity has experienced a dramatic roller coaster ride over the past two years ago when the price was $115. The supply side of the equation has been the major driver of the volatility, with the United States increasing its output (notably via fracking) from 2012, offset in the past six months by supply restraints amongst OPEC constituents Libya, Nigeria & Venezuela and, most recently, the wildfires in Canada have inhibited output. Consumption over the past two years, by contrast, has been steady and inelastic – despite the marked fall in the price - with global GDP advancing by 3% per annum.

It would appear that the price of crude is moving in an upward direction and equity investors may be looking for a means of benefitting from this expectation. Upstream (explorers & producers, rather than refiners & marketers/retailers) businesses like Cairn Energy and Tullow Oil look expensive based on projected profits in the current year and next; in reality most are likely to report losses this year and few appear capable of producing positive earnings before 2018. Investing in areas of geography which have lower inherent political risk appeals (the North Sea, rather than certain parts of Africa, for instance) and accordingly Ithaca Energy – which is set to double output (to 20-25,000 barrels of oil equivalent per day, abbreviated as boepd) and reduce extraction costs (to $20 boe) from September, when its Greater Stella field begins production out - might represent an interesting, if higher risk-reward (accentuated by its high financial gearing) play on the oil price. However, although the technicals might look favourable, there are real concerns that the recent constraints on supply are likely to prove temporal as indicated by current consensus forecasts for Brent of $44 in 2016 and $53 in 2017. Perhaps the oil price has recovered more quickly than expected, or it may be that analysts have been slow to revise their targets. On balance, global economic growth appears set to surprise on the downside and stock inventories remain high enough for this observer to believe the oil price is more likely to stabilise – than advance further – over the coming important driving (US summer holiday) season. So, while not tempted to buy at present a fully integrated oil & gas company, like Royal Dutch Shell with its wider source of earnings than simply its exploration arm, might have greater defensive appeal to those who believe the chart is promising further upside. It would seem that this Anglo-Dutch mega-cap will maintain its high dividend in the immediate term, in the expectation that earnings in calendar 2017 will recover (at a similar pace to the oil price) and cover the forecast 128p pay-out.

Another strong move in price has been evident in Private & Commercial (PCF) equity: from 19p on the 1 March to its current 32p level. The shares of this AIM listed, provider of finance for specialist motor vehicles, company have been a ‘ten bagger’ over the past four years: advancing from just 2.75p. However, technical analysis works best when markets are liquid and traders are able to buy and sell with ease – in pursuit of their strategies. A company stock such as PCF, which was highlighted in this blog a couple of years ago, has a market capitalisation (total worth of all its equity) of just £50m and the typical maximum deal size is in 10,000 shares. As such, while private individuals can purchase a holding of say £3,000 in value, big fund managers will have to ignore such investment opportunities simply because they cannot amass a meaningful stake. (For example a £10m investment within a £1bn fund would represent a barely significant 1% exposure, but £10m would equate to owning 20% of businesses of the size of PCF). Incidentally, the board of directors own 3.5% of this web-friendly company and three institutions have stakes totalling 15%.

Earlier this week, PCF announced its interim results showing a business growing strongly and being on cusp of a step change next year (if the company is granted a banking licence by the end of 2016, which would enable deposits to be raised from the retail market, at much lower cost). The numbers were impressive, with its loan portfolio growing 12% to £112m, impairments falling to just 1.1%, earnings per share rising 38% and return on equity up 36% to 13.9% in the half year to 31 March 2016. A maiden dividend, in respect of the current year, will be announced in due course. However, in the belief that ‘travelling can often be better than arriving’ in stock market terms and considering that the shares now command a premium rating, by reference to profits forecast next year (albeit based on minimal outdated broker opinion), PCF appear fairly valued at its current valuation.

Bottom line, in terms of adopting the chartist’s mantra of “the trend is your friend”, this fundamental valuation-based commentator would prefer not to buy into the strength of oil and not chase Private & Commercial higher. However, there is another stock whose shares have fallen 30% over the past nine months but now appear oversold, capable of reversing the trend and breaking into new higher territory. This FTSE250 index constituent is trading well and is supported by valuation – the company will be identified in next week’s article.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.