Our McKesson (NYSE:MCK) position has been a laggard in our portfolio for quite some time now. Despite managing to rally aggressively out of its December low last year, shares came right back down towards the $110 mark before printing what we hope will end up being a final bottom here. The problem though with depressed stocks is that they can take their time to return to rallying mode. McKesson at present trades with a book multiple of 2.5 and a cash flow multiple of 7.5. These numbers are significantly below the industry and McKesson’s five-year averages.
We believe at present there is a strong possibility of an inverse head-and-shoulders pattern playing out on the technical chart. Sometimes in technical analysis, traders can make the error of seeing what they want to see instead of observing the cold harsh truth of the price action on the chart.
Therefore, from that note, let’s take a look at the chart to see if McKesson really is undergoing an inverse head-and-shoulders pattern at present.
A head-and-shoulders pattern (either normal or inverse) consists of two shoulders (red arrows) and a head (blue arrow). The black trend line drawn above is called the neckline. This trend line needs to be closed above in order for the multi-month pattern to be completed.
Although that rising trend line can be taken as a sign of market strength, it still is roughly $20 a share from the current share price. That is a long time to wait for a buy signal. What we need from McKesson over the near term is for last week’s low to hold. This is imperative as it is crucial to the reversal pattern potential playing out.
Volume also needs to up the ante in McKesson. In reversal head-and-shoulders patterns, volumes should gradually increase from the head. The head as we can see in the chart above took place on the 24th of December last year. Buying volume is definitely up since that point, but we need more of it to be confident that this particular pattern is being played out.
With the S&P having confirmed its daily cycle low last Friday, now is the time for McKesson buyers to start stepping in. For existing investors who are underwater on their positions, we would recommend patience. So often, we see investors selling their shares way too soon once the share price comes back to more or less the original price paid. It seems to be that the longer the downturn (position in negative territory), the more likely the investor sells quickly once the share price rallies back somewhat. What may add to this bias is McKesson’s below-average dividend of $1.56 per year or 1.31%.
However, the dividend is not the only way shareholders are getting paid by this company at present. The amount of shares outstanding has come down by almost 90 million shares over the past decade. This is something shareholders many times overlook when evaluating a position in their portfolios. It isn’t a surprise therefore to see earnings expectations slowly drift upwards as the float comes down. Over time, we believe these growing earnings will definitely move the needle with respect to the share price.
Furthermore, sustained strong buybacks and strong growth in the dividend look likely due to how management is allocating its capital. Over the past five years, free cash flow never came in below $2.5 billion in a fiscal year. In the company’s latest fiscal year (which ended in March 2018), the firm bought back $1.7 billion of its own stock and paid out $262 million of dividends. This total of $1.97 billion came out of free cash flow kitty of $3.76 billion. No problems here, with these financing activities being covered by free cash flow.
Therefore, to sum up, we would urge long-term holders to wait at least until $137 is closed above. Why? Because that is the level on the neckline which would bring in a lot of technical buyers. We would expect a strong trending move to take place if that key resistance level can be closed above. Patience is not simply the ability to wait – it’s how we behave while we’re waiting. Don’t cut yourself short here by selling too soon.
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Disclosure: I am/we are long MCK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.