Our Outlook for Business and Financial Services Stocks
Companies with moats and strong balance sheets should outperform.
2008 was unkind, and 2009 doesn't look to be any nicer. Our near-term outlook for the business and financial services industries we cover is negative in any kind of absolute sense, but we think this kind of environment demonstrates the power of economic moats. We also believe that financial leverage is poison during a downturn. Our opinion is that companies with strong competitive advantages and balance sheets will outperform and reward the patient investor. Looking at a range of seemingly disconnected industries demonstrates the point.
Take the staffing industry, for instance. The employment market has reached a depressed state not seen since the early 1980s. The unemployment rate has increased to 8.1% and the U.S. has lost 4.3 million jobs. The temporary employment segment, a leading indicator of the overall employment market, has seen job losses accelerate month after month, with February 2009 being the worst yet. We don't expect this trend to reverse anytime soon, meaning there's more stress ahead for the staffing industry. But not all employment-related firms are as sensitive to the overall employment market, and our picks have substantial competitive advantages that insulate them from the down cycle. We believe Paychex (PAYX) and Automatic Data Processing (ADP) are attractively priced given their strong competitive position. Scale, high customer switching costs, and a respected brand image constitute a triumvirate of advantages and the companies' debt-free balance sheets mute near-term risk.
Waste management is an industry we like better than staffing, but it also faces a tough near term. In November, recycling commodity prices fell through the floor as China--the largest buyer of plastics and old corrugated cardboard--halted demand. As demand for commodities plummeted, commodity prices of recycled goods dropped from $130 per ton to $20 per ton, on average. In addition, waste volumes continued to decline due to slowing demand for construction and demolition. We believe the industry will continue to offset lower waste volumes with rational price hikes, which should minimize the operating margin impact. But given the capital intensity of this industry and the resulting financial leverage, there's not a lot of room for error. With ongoing uncertainty surrounding the economy and ultimately waste volumes, we think that investors are best advised to look to the companies that have the strongest competitive advantages and use leverage only moderately. In our opinion, Waste Management (WMI) and Waste Connections (WCN) are most worthy of keeping on your radar.
Turning to the financials side, insurance companies continue to struggle due to their exposure to capital market conditions, and they are doubly cursed due to their balance sheet leverage to the large investment portfolios they carry. With equity markets cliff-diving and credit spreads blowing out, almost all asset classes are taking a hit. While stocks in the insurance industry have taken a pounding, we are maintaining our cautious stance. In this environment, we think the proportion of book equity to the investment portfolio is a key statistic, and, for the most part, we are limiting our recommendations to insurance companies that are positive outliers in terms of capital strength, such as Mercury (MCY).
The asset managers are also exposed to capital market declines, and their operating results in 2009 will show a dramatic decline from 2008 levels, barring a miraculous market recovery. Although their near-term fortunes will wax and wane with the direction of the market (something we are loath to predict), we think the players with a diversified lineup of investment offerings and customer bases, intact reputations, and the cleanest balance sheets will not only outperform over time, but will also seize upon this period of stress to further expand their presence. From this point of view, we think BlackRock (BLK) is the best positioned.
Valuations by Industry
In the table below, it can be seen that, while our price/fair value estimate ratios don't vary wildly by industry, our uncertainty about those fair value estimates do differ quite a bit.
|Business and Financial Services Industry Valuations|
|Star Rating|| Price/Fair |
| P/FV Three |
|Change (%)|| |
|Insurance (Property & Casualty)||4.13||0.60||0.79||-24%||82%|
|Data as of 03-13-09. *Market-Weighted Harmonic Mean |
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.
Data processors carry one of our highest average star ratings and there's a lot to like about this type of business in the current environment. Their asset-light business models create very limited (or no) financing needs, which tends to lead to little debt on the balance sheet. Additionally, in general, their businesses tend not to be very cyclical and produce stable free cash flow, a valuable characteristic in tough times.
We think insurance companies are generally undervalued, but we also think that a high margin of safety is required, due to the industry's exposure to volatile credit markets. As a result, we don't have a lot of recommendations in this space. On a relative basis, we like reinsurance and property & casualty insurance better than life insurance, as these companies have larger equity cushions to absorb investment losses.
Although we believe that asset management is an extremely attractive business from a long-term perspective, the market plunge has hit these companies hard and much of that is being reflected in their valuations. The emphasis for investors here is that market declines have a very real impact on these businesses, and these stocks will continue to be volatile as long as the markets are unsteady.
Our Top Business and Financial Services Picks
|Top Business and Financial Services Sector Picks|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
|Automatic Data Processing||$58||Wide||Medium||15.9|
|Data as of 03-18-09.|
Automatic Data Processing (ADP)
We think ADP can withstand the strongest of labor market head winds. Even if the employment market takes a dramatic turn further downward, businesses still need to pay their existing employees. The high customer switching costs and business model scalability for ADP should help the firm preserve revenue and profits. The minimal amount of capital required for its operations adds greatly to the attractiveness of this firm. Stable and robust cash flow has enabled ADP to keep its debt balance at zero and the substantial strength of its balance sheet is reflected by a AAA credit rating. ADP has consistently produced strong operating margins and great returns on invested capital over an extended period of time and we believe this trend will continue.
Mercury General (MCY)
Like most insurers in 2008, Mercury fell victim to higher yield spreads in its investment portfolio, but unlike most insurers, Mercury has the benefit of a relatively strong capital position. Its debt/equity ratio of 10.5% is low--and its conservative strategy of allocating most of its investments to tax-exempt government bonds reduces risk. More importantly, Mercury has a fat equity cushion to absorb investment losses, as book equity covers 50% of its portfolio holdings, a considerable amount of downside protection. Mercury also has a winning sales strategy of focusing on low-cost auto insurance, which is nicely attuned to today's economy, and Mercury's solid distribution channels and wide sales reach position it to grow market share. Judging by its disciplined underwriting, which has allowed Mercury to earn superior profit margins averaging 6% over 15 years, we think the company's prospects are good.
Jack Henry (JKHY)
Jack Henry is one of the top core processing providers for domestic financial institutions, and it also offers related services and products like risk management and online banking software. Because a bank's operations depend on core processing (which control day-to-day operations), the cost of switching providers is prohibitive, allowing the industry to avoid profit-killing competition. The high switching costs for its customers lead to multiyear contracts and 99% renewal rates, excluding acquisitions of customers, providing a base of recurring revenues for Jack Henry, even in the face of a struggling financial services industry. While discretionary purchases by its customers will likely fall as banks conserve capital, the steady core processing revenues will help insulate Jack Henry from the effects of the banking crisis. With no long-term debt, solid cash flows, and little need for reinvestment, Jack Henry's financial position is as solid as they come.
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Brett Horn does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.