8 Business Services Stocks Bought with Conviction

By Todd Young | Senior Stock Analyst

When we did a preliminary run-though of the holdings of several of our Ultimate Stock-Pickers back in August, our inspection uncovered more than a few high-conviction purchases, such as  Accenture (ACN),  McGraw-Hill (MHP), and  Paychex (PAYX), in addition to the health-care names that these managers were buying. While purchases in the health-care sector seemed to be the predominant theme during the most recent period, we were impressed by the number of business services stocks (like Accenture and Paychex) that were also purchased with conviction by our Ultimate Stock-Pickers.

The business services sector, which is a distinct Morningstar sector designation, includes everything from railroads, such as  Burlington Northern , and logistics firms, like  FedEx (FDX) and  United Parcel Service (UPS), to education providers, such as  Apollo Group , and credit card payment processors like  Visa (V) and  MasterCard (MA). While this sector's representation remains relatively small, at less than 7% of the aggregate holdings of the 26 managers on our Investment Manager Roster, it is much larger than what is found in the benchmark S&P 500 Index (SPX), where the Morningstar business services sector makes up less than 4% of the index.

Top 10 Business Services Holdings of Our Ultimate Stock-Pickers

Stock price and Morningstar Rating data as of 10-08-09.

The top 10 holdings of our Ultimate Stock-Pickers in the business services sector include two railroads, Burlington Northern and  Union Pacific (UNP); one airline,  Southwest Airlines (LUV); three logistics firms, FedEx, UPS, and  CH Robinson (CHRW); a document storage company,  Iron Mountain (IRM); a credit card payment processor, Visa; a tax preparation firm,  H&R Block (HRB); and a consultant,  Accenture (ACN). Of these, four were being purchased with conviction by our top managers during the most recent period, with Accenture being the one name that really stood out. The global consulting, technology services, and outsourcing firm also made the list of top 10 purchases by our Ultimate Stock-Pickers during the latest period.

8 Business Services Stocks Our Top Managers Have Been Buying

Stock price and Morningstar Rating data as of 10-08-09.

The biggest buyer during the quarter was  Parnassus Equity Income (PRBLX), where manager Todd Ahlsten made Accenture a top five holding during April of this year after being convinced of the merits of the firm's value by one of the portfolio managers at a sister fund, Parnassus Mid-Cap (PARMX). While not currently in 5-star territory, our analyst Swami Shanmugasundaram believes that few firms can even come close to matching Accenture's scope of services and thinks the stock is worth considering at prices below $32 per share.

Taking Advantage of Market Volatility
Another top purchase during the period was  Apollo Group , whose stock actually bounced around a few weeks back after a government report sent the entire sector's stock prices up in one day, only to have an announcement from Congressional leaders the following day cause stock prices in the sector to give up most of their gains. Given its recent new money purchase of Apollo, we wouldn't be surprised if the managers at  Oak Value  stepped up again last month to take advantage of the market volatility. The managers added Apollo to the fund's portfolio for the third time in the last three years during the second quarter, noting in their quarterly review that "investments in Apollo have been among its most rewarding as we have taken advantage of Mr. Market's manic depressive tendencies" over the years.

As we mentioned above, these tendencies erupted again last month as investor fears about increased regulation for the industry were eased and then quickly reinflated over the course of just two days. On Sept. 21 the Government Accountability Office (GAO) released a report that suggested only limited recommendations for additional regulation of the for-profit education industry. Many investors had been cautious up until the release of the report, expecting increased and detrimental regulation. However, the muted tone of the GAO's findings sent stock prices higher--especially as the "findings [did] not represent nor imply widespread problems at all proprietary schools."

Apollo saw its share price increase from $69 to almost $75, an increase of 8% in that one day alone. The very next day, though, Congress' House Education Committee said it planned to take a deeper look at the industry as it was troubled by some of the findings in the GAO report. With this news, the industry sold off and Apollo's stock dropped to $71. At current prices, Apollo is still close to our Consider Buying price of $70, and given the volatility in the for-profit education industry due to regulatory and other concerns, we expect that long-term investors could find Apollo's stock trading at an attractive entry point again in the near future.

Not All For-Profit Education Firms Are Bad Apples
While we expect there will always be a few bad apples in the education space due to the vast number of institutions, we think it is important to remember that a few questionable players do not represent an entire industry. According to the National Center for Education Statistics, there are over 6,500 postsecondary institutions. Nearly 2,700 of these are categorized as for-profit institutions. Roughly two thirds of those for-profit institutions are non-degree-granting, offering only certificates or diplomas as opposed to associate through doctoral degrees. That said, it is important to keep in mind that most of Apollo's students are enrolled in degree-based programs.

The fact that for-profit (or proprietary) schools have higher student loan cohort default rates was one of the major focuses of the GAO report. Default rates can be thought of as a measure of a school's quality. If students are graduating and finding jobs (and, thus, benefiting from their education), they are less likely to default on their loans. While the GAO report used older data, the most recent data (for 2007, which just came out in September 2009) showed that the average default rate for all institutions was 6.7%. Also, institutions with four-year degree programs had a lower default rate than institutions with shorter programs as more advanced degrees typically confer a lower likelihood of default. Not surprisingly, while public institutions had a default rate of 5.9%, and private institutions were at 3.7%, proprietary schools had a significantly higher default rate of 11.0%.

Two Key Takeaways from the GAO Report
There were two comments that really stood out to us after reading the GAO report. The first one hinted at the notion that individual results at each school, as opposed to sectorwide outcomes, are far more indicative of a school's quality: "Even though the proprietary sector generally has higher cohort default rates than the public and private non-profit sectors, many individual proprietary schools have lower rates than the sector as a whole."

An example of this would be  Capella Education Company , which focuses on more advanced degree programs. It had a default rate of only 2.5% in 2007, well below not only the overall benchmark of 6.7%, but below the average result for both public and private institutions. Putting Apollo into perspective, its flagship school, the University of Phoenix, had a 9.3% default rate for 2007. While this is above the default rate for all institutions, it is below the 11.0% rate for proprietary schools. Given that the GAO acknowledged the fact that there are lower rates at some schools, we're less concerned that there will be any overarching regulatory changes that could materially impact the proprietary sector as a whole.

The other comment we noted demonstrates that the GAO realizes that demographic trends, not just school-specific issues, could be a main driver for default rates: "Variations in default rates across school sectors may reflect the characteristics of the students who attend the schools, according to academic research studies." The GAO found that higher default rates were linked to students coming from "low family incomes" and "parents who lack a higher education degree." With for-profit schools serving many lower-income students, who are often the first in their family to earn a college degree, higher default rates for these institutions should be expected. This suggests that default rates may not just be an indication of the quality of a degree, but a reflection of the type of student served.

With President Obama's focus on continuing education, we don't think there will be an emphasis on new regulation that hinders high-quality for-profit schools, especially given their tendency to serve a segment of the market that is in drastic need of postsecondary education. The GAO report does, however, note that it would like to see increased scrutiny over entry tests that determine if a student is prepared to handle college and therefore the loans associated with additional schooling. In our view, only schools behaving in an unethical manner should fear this potential increase in regulatory oversight.

Apollo Remains Our Top Choice in For-Profit Education
With many people looking at the for-profit education industry as nothing more than a degree-mill, there is always going to be the fear of increased regulation hanging over these stocks. While there certainly are unethical players in the field, we don't believe that the publicly traded education firms we cover fall into that category. Congress may be looking further into this sector given the GAO report, but many of the management teams at for-profit education firms welcome the increased oversight as they feel they have nothing to worry about and it will only help expose the industry's bad apples. With "Mr. Market's manic depressive tendencies" likely to present investors with another potential buying opportunity, we recommend that investors keep a close eye on Apollo, a high-quality for-profit education company trading close to our Consider Buying price.

Disclosure: Todd Young does not own shares in any of the companies mentioned above.