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Why free cashflow is King? Invast.com.au explains the importance of cashflow in this 'Insights' report. It is a common question when buying a company. Many analysts, when talking about stocks, often quote price to earnings ratio's or analysis of revenue and investment returns. We explained why we liked this method so much.
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Invast Insights
Week Commencing November 18, 2013
www.invast.com.au | 1800 468 278
This week we look at the following topics:
1.0 Why Free Cashflow is king
2.0 Oil price revisited – where to from here
3.0 Is the carry-trade alive and kicking?
4.0 Is Keep an eye on this small cap stock
5.0 Recap of our 2013 covered topics
6.0 Weekly economic calendar
www.invast.com.au | 1800 468 278
www.invast.com.au | 1800 468 278
1.0 Why Free Cashflow is king
What is it worth? This is the most common question when buying a company. The question can also be applied to any other asset, like asking what a certain property, currency income annuity or commodity is worth. If you don’t trade stocks this section might not seem important to you, but it’s worth noting that companies are the basis for all index and stock market measurements. Companies often dictate where central banks pitch their monetary policy, in return driving currencies. For this reason, we hope this analysis is of use to you regardless of what asset class you trade.
When chatting about stocks, many analysts often quote the price to earnings ratio or go into detailed analysis on revenue, margins and investment returns. In most circumstances most of these numbers are useless and over the years we have grown to prefer one specific measure above all the rest – Free Cashflow per share. We explain why we like this method so much below. But firstly, we need to put this discussion into context. The process of valuation is at best, a guess. There are no perfect methods or magic measurements.
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www.invast.com.au | 1800 468 278
When we launched this weekly publication back in late August, we explained that the process of valuation is guesswork right from the beginning. We made clear that our role here is to help improve your investment and trading returns. At times we get some of our thoughts right and we also get some wrong. But we don’t take our estimates and numbers too emotionally, they are just a guide to help build our thoughts and ideas. Many other analysts fall into the habit of using a particular method as it becomes common practice. They get hooked, obsessed and talk about margins, ratios, earnings drivers and so on without really thinking about what the importance of cash in a business.
We decided to write this section after reading a newspaper headline, explaining Australian electronics retailer Dick Smith’s plans to list on the Australian stock market. We were surprised at the range of numbers being mentioned. The newspaper said Dick Smith was valued by a certain investment bank at between 11.5 to 14.5 times its earnings. This measure is called a price to earnings ratio. The actual numbers mentioned aren’t the problem but the valuation method is. We don’t think it is appropriate for a business like Dick Smith.
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Dick Smith is an Australian electronics retailer, previously under the
ownership of Woolworths. After many years of stress with Dick Smith,
Woolworths recently made the decision to sell and move on. Woolworths by
the way is the largest retailer in Australia. You would have probably realised
that by now. If the largest retailer in Australia cannot make money from a
concept, we think others will also struggle. Retailing is very difficult but there
can be opportunities to turnaround interesting businesses. We don’t doubt
this, but we just don’t have confidence in Dick Smith as a concept. We think a
price to earnings ratio as inappropriate since earnings as a measurement are
not the best indicator of what Dick Smith owners will make. Measuring
earnings alone is too simple. For example, costs could fall and revenue rise in
a certain period of time, which will lift earnings. This was the same case with
Myer prior to its sale in a few years ago at $4.10, before it fell below $2 two
years later.
Retailers like Dick Smith and Myer require ongoing spending in their stores to
make sure customers keep coming back. If you survive without spending
money, competitors will eventually copy and take away your profits. Barriers
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to entry are low. To maintain power and discourage competition, retailers
need to keep spending money. As a measurement, earnings do not always
capture this investment requirement. The more stores you open, the largest
the annual commitment becomes to refurbish and maintain your stores.
Myer’s previous owners spent around half a billion dollars getting the
business back to a respectable competitive level before selling shares to the
market. The investment cycle for retailers is at most ten years. The best
retailers like Woolworths pour billions of dollars each year to improve
products and expand their stores, ensuring they don’t lose the fight with arch
rivals.
Retailers can do well at certain points, mainly due to external factors. In a
particular period of time, earnings might be growing because new stores and
improved consumer sentiment is driving sales but that means nothing if in a
few years time, stores need to be completely refurbished and new money
spent on products, layout etc. when customers tune out. Myer is starting to
realise this. Using a price to earnings ratio on a good earnings base is very
misleading and the smart money doesn’t buy the rational. It is a measure
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at one point in time which can be manipulated by lowering costs or
unsustainable revenue.
So how do we measure this timing more appropriately? Fortunately a few
days before reading the Dick Smith press report, we were reminded that Free
Cashflow per share is an important measure of business performance by the
very smart folks over at The Motley Fool. They run an independent research
service. Free Cashflow per share measures cash generated by a business
though its operations in one year. It then subtracts money put aside for
capital spending, money used to fund working capital and the payment of
taxes. Free Cashflow is essentially what is left over in the cash piggy bank
after all commitments are made. This differs very much from earnings because
the money set aside to invest is not capture on the profit and loss statement.
The Motley Fool wrote their note in the Sydney Morning Herald; you can click
here to read it. We think it is a great conversation around why the chief
executive and founder of Amazon.com focuses only on Free Cashflow per
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share as the key method of benchmark performance for his business.
Amazon.com doesn’t really care if it earns a low margin on its sales. What
really matters to the business is increasing sales and cash on an absolute
basis. Amazon.com would rather earn 1% return on large sales than 5%
returns on average sales. Absolute returns are what matters. What matters is
the amount of cash flowing through to its bank account and this cash
ultimately helps Amazon.com decide on how it grows and how to reward its
shareholders. Profit margins are a relative measure, cash is absolute.
Amazon.com CEO Jeff Bezos knows a thing or two – he started Amazon.com
in the mid 1990s from humble beginnings after many years in the finance
industry, his last role in a quantitative hedge fund. His sole focus on Free
Cashflow per share has seen his operation grow to become one of the largest
global retailers and the leanest in the industry, employing best of practice
technology. We all know the story.
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In Australia, Telstra shows why Free Cashflow is more important than actually
earnings. Telstra spent large amounts of cash in technology under its previous
boss, Sol Trujillo. This ensured service was superior to rivals. Cashflows started
to improve after the investment was made. Because of the large investment,
Telstra needs to book depreciation onto its numbers and so the earnings
number understates the amount of cash the business actually generates. The
infrastructure is built so as of the time of writing Telstra is investing very
limited amounts of money to generate cash from its mobile operations. We all
know how good the network is. Free Cashflow per share is a better measure
of the ability to pay out dividends or make acquisitions than does the
earnings base. Telstra generated $5bn of Free Cashflow in 2013 compared to
earnings of $3.9bn – a huge difference of $1.1b.
Retailer JB Hi-Fi will be used as the perfect comparison against Dick Smith,
even though their businesses are miles apart. The investment banks and IPO
marketers will be using the solid rise in JB Hi-Fi’s shares to justify an earnings
multiple for Dick Smith. Which one do we prefer? We wouldn’t be buying any
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any of them at the moment based on the Free Cashflow generation of the
whole sector. Let’s take JB Hi-Fi’s numbers as an example. On our estimates
the business generated Free Cashflow of around $125m last year. As it rolls
out more stores and as many of its existing stores hit their maturity profile, it
will need to spend more money and so the Free Cashflow growth profile is
probably not as good as what many expect.
JB Hi-Fi is a leader in its segment, but that doesn’t always make it a good
investment. It is already admitting that it’s currently business model is
struggling and has announced plans this year to roll out a new Home concept
– broadening its product offering. This probably won’t be the golden goose it
needs. The only option will be to continue spending – either by rolling out
more stores or by investing in new technology. Meanwhile as the base of
stores grows, so too will be the annual commitment to maintain and refurbish
the stores which are already bare bone in terms of fit out. Therefore we are
fairly confident in saying that any earnings growth that JB Hi-Fi makes over
the next three years – assuming all goes well with the Australian economy –
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it will probably have to reinvest into its survival. So the $125m Free Cashflow
booked last year is very limited in its absolute growth.
JB Hi-Fi’s Free Cashflow return is roughly 5.6%, when comparing $125m
against the $2.2bn valuation. We measure the business by taking total
number of shares and multiplying them by recent prices. We form the
conclusion that on a cash basis, taking into consideration the need for
investment and change, JB Hi-Fi’s annualised return of 5.6% is poor compared
to Australian 10 year bond yields of 4.69% as of the time of writing – hardly a
1% margin of excess to compensate for all the things that could go wrong. We
wouldn’t touch it for that reason.
Some will argue that JB Hi-Fi is a good business. They will say it can grow
earnings, is well placed to benefit from the Australian economy turnaround.
These are true but all these points fail to asses on merit the cash flow position
of JB Hi-Fi. It might be a good business, but with returns less than 1% above
bond yields, we don’t think it’s a good investment. For this reason we would
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be inclined to stay away from the Dick Smith sale or any other Initial Public
Offering (IPO) which lacks the ability to generate superior Free Cashflow
growth into the future. Online businesses have become the darlings of the
investment community for very good reason – they generate huge amounts
of cash and once built into a market leadership position, their position is very
difficult to diminish. These stocks remain our key focus.
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2.0 Oil price revisited – where to from here
In our Invast Insights report published on 23 September 2013 we published
our technical analysis on the Brent crude price in light of the Syrian situation
moving from a military possibility to a negotiated settlement. At that time our
technical analysis showed Brent crude trading within a target band range of
US$107-117 per barrel which it did until briefly falling below the bottom end
early this month. Based on that, we thought it prudent to revisit the charts
and update our view.
Our technical analysis indicates a potential end to the early November falls.
The close on 8 November 2013 confirms a bullish engulfing candlestick
pattern and a bounce off US$103.00 key levels which has acted as a support
for the pair in Q2 this year. A Fibonacci extension of the recent drop from (A)-
(B) suggests a potential gain to US$112.00 where the 127.2% Fibonacci
extension is aligned with resistance level on the 10th October 2013. Vito
Henjoto published these views in more detail in one of our daily technical
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analysis videos which is worthwhile revisiting again – calling the bounce of
the bottom perfectly. Watch the video here:
https://www.youtube.com/watch?v=H2GVBrAyG-4
Image: Brent crude analysis 13 November 2013 via Invast Website
www.invast.com.au | 1800 468 278
3.0 Is the carry-trade alive and kicking?
One of the more popular currency trading strategies is the Carry Trade. So
popular that traders with minimum understanding of carry trade will have
taken part in it. In fact, currency traders that have ever held a buy position in
USD/JPY overnight are carry traders.
The primary objective behind a carry trade is to carry a return by borrowing
from a low yielding currency and invest in high yielding currency or asset. For
example, if a trader held a buy position on the AUD/JPY overnight. He/she
would receive an overnight swap from holding that position, because
Australia’s interest rate is higher than Japan’s.
The secondary objective is to profit from movements in the forex market.
Should AUD/JPY appreciate, carry traders stand to gain from the overnight
swap and currency gains by holding AUD/JPY overnight. A depreciation on
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on the other hand, will result in the trader losing more than the overnight
swap he/she earns.
So even though carry trade is simple, the knowledge and timing of the
currency market is important in a successful carry trade strategy. The ideal
condition for a successful carry trade is an appreciation in the invested
currency. Therefore, carry trade is associated with global risk sentiment,
expanding when risk appetite is high and unwinding when risk is off the
table.
Carry Trade History
Majority of currency carry traders are from Japan and the strategy itself
gained popularity during Japan's lost decade starting in 1991. Japan’s lost
decade occurs when the asset-price bubble burst and the country saw little to
no growth despite the near zero interest rate policy. Due to the low interest
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rate, Japanese turns to overseas investment for a better return. Since the
mid-1990s, Japan is the only major economy with a near zero interest rate. The
Japanese Yen essentially acts as the gatekeeper to access the carry trade and
soon the term currency carry trade is better known as "Yen Carry Trade".
Early 2000s saw a boom in global markets, with the CBOE Volatility Index (VIX)
at a low level. There is a sense of stability in the market, leading to an increase
in risk appetite. This entices hedge funds, investors and traders alike to
borrow Japanese Yen at a low interest rate and invest it in riskier assets. Assets
such as higher yielding currencies like AUD, EURO, GBP, US subprime
mortgages, commodities, global indices and even emerging market debts.
Due to the way carry trade work, the borrowed currency usually depreciates
against the higher yielding investment. To maximise this, majority of carry
traders leveraged their trade to increase the potential gains, often neglecting
that the risk associated increases as well.
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By the end of 2006, investments through Yen carry trade alone was estimated
to be around USD$1 Trillion. Carry trades works as long as Yen continues to
depreciate, and the investment provides significant return, all while the
interest rate in Japan remains near zero. While carry trades work wonders
under the right condition, the risk associated with it through leverage are
often not hedged. Traders and Investors alike were so bullish between 2003 -
2007 they pay little attention to changes and the slowdown in the US market
which eventually turn into the subprime mortgage crisis.
Carry Trade and the Global Financial Crisis
Another key important aspect of the Carry Trade is time. Carry trades are
designed for gradual changes in global economy, allowing carry traders time
to decide and manage their trades and ideally scaling out of their trades.
When the subprime mortgage went out of control and confidence in the
market was waning, traders scurry out of their carry trades.
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As mentioned previously, yen carry trades amounts to USD$1 trillion just
before the subprime mortgage crisis. The unwinding that took place when
market spirals down, only adds to the momentum. High yielding assets and
currencies rapidly loses their value as traders pull out their investment and
the Japanese Yen surges to an all-time high against these currencies and the
US dollar in particular. Not to forget that most of these carry traders leverages
their position resulting in massive losses from the carry trade unwinding and
crippling most hedge funds and financial institutions.
While not widely reported in the media, there is no denying that carry trade
unwinding has a huge impact in the global economic collapse. Japan's lost
decade becomes bi-decade as the surge in Japanese yen rolled back what the
Japanese government has set out to do to take the nation out of deflation. To
stimulate growth in the economy during the global financial crisis most
central banks adopts an aggressive monetary policy such as lowering interest
rates, introducing quantitative easing and other stimulus packages.
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At the peak of the global financial crisis, major economies such as United
States, Eurozone and the United Kingdom have adopted “near zero interest
rate policy”. Leaving carry traders with risky investments with no significant
return. Currency market becames volatile as the VIX went to all time highs,
there is no other way except to unwind their carry trade positions as soon as
possible.
Is carry trade alive and kicking? If so what has changed?
5 years following the global financial crisis, carry trade is now back in
discussion. As major economies recovers thanks to their respective
quantitative easing and stimulus packages. Wall Street at all-time high and
increasing risk appetite in the market reminds us of 2003. In fact VIX is exactly
around the same level before carry trades lift off in 2003.
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Figure 1, CBOE Volatility index, 2013 = 2003 right before the boom source: tradingview.com
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So is this a right time to get in and ride the carry trade? A hard question to
answer but in 2009 as global economy is cleaning up the mess, carry trades
are already up running although in a much smaller scale. Australian dollar was
one of better performing currencies during the global financial crisis, thanks
to Australia’s relatively high interest rate. Australia’s high interest rate attracts
investors from US, Europe, UK and Japan. Not to mention that New Zealand's
interest rate also remains high. Australia and New Zealand with their higher
interest rates attracts old and new carry traders, most of which has done so
without realising it. Both the AUD/JPY and NZD/JPY are now considered the
benchmark in gauging carry trade appetite.
Statistics gathered from the trading volume of exchange traded FX in Japan
provided courtesy of our Japanese headquarters reflect an increasing net
long position while net short position remains constant. Proof that carry
trades are indeed alive and kicking.
www.invast.com.au | 1800 468 278
Figure 2 AUD/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
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Figure 3 NZD/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
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Figure 4 GBP/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
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Figure 5 CHF/JPY Trading Volume in Japan 2009 - 2013. Source: Invast Research
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The only hiccup and sudden unwinding of the carry trades are noted during
the Tohoku earthquake and tsunami. Repatriation of the Japanese yen occurs
not only from Japanese carry traders but also the global humanitarian aids
adding to the rapid appreciation of the Japanese yen in early 2011.
Debt crisis in the Eurozone and the US also seems like a small bump in the
carry trade progress. While carry trade is still actively conducted, traders are
now smart enough not to unload everything in one go. Looking at the chart
patterns in currency movement and the stock market, technical trading is a
huge part of modern day carry trading.
Following most rallies in the market, there is consolidation or correction in the
market. Ranging from 38.2% to 61.8% Fibonacci retracements per
consolidation. Suggesting the current carry trades are done in a much more
cool headed way to prevent sudden and massive unwinding in the market, as
traders exit out of their currency carry trades regularly.
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In the past three years, we noticed more traders and investors abandoning
their search for holy grail in the market, instead they pursue a method to
reign in their emotion and better manage their trades. Majority of traders are
now realising the importance of banking their profits or limiting their losses
instead of hoping for the best in the market.
This changes the whole landscape of currency trading and in particular the
carry trade strategies. The game is now played seasonally in stages, allowing a
rally to consolidate properly without stressing key resistances to its limit. So if
patterns are to repeat, the current condition is similar yet not the same as it
was in 2003. With major nations adopting “near zero interest rate”, there are
more currencies available to borrow with a low interest rate. Reducing the risk
of a major unwinding of a single currency like the Yen did a few years back.
Previous carry trades are similar to investing, where traders hold on to longer
term position. The carry trades occurring in the market post global financial
crisis are quick and shorter in time. We call it a "mini carry trade", most of
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which lasts no longer than 3 months before it corrects itself. The United States
and Japan, two nations previously associated with Yen carry trade have a low
leverage limit, following strict government regulation to protect traders and
investors from losing more than they have.
www.invast.com.au | 1800 468 278
4.0 Keep an eye on this small cap stock
In our Invast Insights reported published on 16 September 2013, we wrote
about a business called Vision Eye Institute (VEI) as a long term holding to
benefit from increased demand for eye surgeries – otherwise known as
ophthalmic procedures. The more time we spend looking at mobile devices
and electronic display screens, the worse our eyes will become over a longer
period of time. We don’t have the exact medical study to confirm this view but
as noted above, it is something we have written about previously. VEI shares
haven’t done much since then, but we made clear the fact that our view was
fairly long term so we aren’t breaking a sweat just yet.
One of the stocks we also mentioned in our very first report under the 15
hidden gems section was Ellex Medical Lasers (ELX). The business specialises
in lasers to the ophthalmic care industry – eye doctors – like those operating
Vision Eye Institute centres. We aren’t sure if Vision actually use the
technology but on a recent visit to the optometrist, your author undertook
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a very quick and non evasive eye retina scan on what he believed to be an
Ellex machine, confirmed upon later due diligence when returning to the
office. We don’t completely understand the technology or the product
features but we like what we see in Ellex – a market leading product coming
out of Australia and attracting global customers in a huge market
opportunity.
We must declare an interest here – the author did buy a modest parcel of
shares but we believe in backing our own recommendations and so this
should not come as a surprise. Ellex is a business which is expected to
generate around $50m in global sales this financial year with a total market
capitalisation of around $30m as of the time of writing. They recently raised
equity through an oversubscribed share issue worth just over $3m which we
think will be enough to see them through their plans in the medium term.
Profitability has disappointed but there are expectations for Ellex to return to
the black this year as sales in key markets like the United States improve. The
fall in the A$ also makes life much easier.
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In terms of growth markets, Ellex has only recently started to penetrate into
Asia and the US market for its existing products. It has plans to undertake
new studies for new lines of equipment which could be game changers for
not only the stock but also the whole industry. The snapshot below shows the
geographical diversity in sources of revenue with very obvious hurdles in 2013
but signs of improvement. The most important part below is the turnaround
in the second half of 2013 and last week’s report that the 2014 financial year
has so far commenced with very strong volumes.
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Tables: Ellex Investor presentation reported to ASX on 12 September 2013
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Our bottom line is that we like Ellex and think the turnaround strategy is
progressing to plan. The market will start to pay attention when earnings
grow and we think this will become more evident early in the new year. We
want to get in before that and think at around 30 cents per share and a
market capitlisation of $30m, the risk reward ratio is more than attractive to
justify a holding in a well diversified portfolio. Liquidity is thin with the top 20
shareholders holding around 45% of the stock and directors’ holding 24% -
but this also creates opportunities when the market decides it’s time to buy
the stock. We plan to speak to CEO Tom Spurling sometime in the next few
weeks if we can get a hold of time – he’ll no doubt be busy showing off his
company’s products at the 2013 Annual Meeting of the American Academy of
Ophthalmology in New Orleans on 16-19 November.
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6.0 Weekly economic calendar
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Visit our blog to get additional trading insights.
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7.0 Disclaimer
Please note that you are receiving this report complimentary from Invast Financial Services Pty Ltd (AFSL 438 283). Invast staff members may from time to time purchase securities which are included in this or future reports. The authors of this report may or may not be holding a position in the securities mentioned. Please note that the information contained in this report and Invast's website is of a general nature only, and does not take into account your personal circumstances, financial situation or needs. You are strongly recommended to seek professional advice before opening an account with us.
General Disclaimer: This newsletter contains confidential information and is intended only for the person who downloaded it. You should not disseminate, distribute or copy this newsletter. Invast does not accept liability for any errors or omissions in the contents of this newsletter which arise as a result of downloading this newsletter. This newsletter is provided for informational purposes and should not be construed as a solicitation or offer to buy or sell any financial product. Invast Financial Services Pty Ltd is regulated by ASIC (AFSL 438 283 | ABN 48 162 400 035).
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Risk Warning: It's important for you to read and consider the relevant Product
Disclosure Statement, and any other relevant Invast Financial Services Pty Ltd
documents before you decide whether or not to acquire any financial
products listed in this email. Our Financial Services Guide contains details of
our fees and charges. All these documents are available here on our website,
or you can call us on +612 8036 7555. CFDs and Foreign Exchange are
leveraged products and carry a high level of risk and you can lose more than
your initial deposit so you should ensure CFD and Foreign Exchange trading
meets your personal circumstances.
General Advice Warning: Being general advice, this newsletter does not take
account of your objectives, financial situation or needs. Before acting on this
general advice you should therefore consider the appropriateness of the
advice having regard to your situation. We recommend you obtain financial,
legal and taxation advice before making any financial investment decision.
*Distributed with the permission of Invast.com.au