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'Hire' Performance by Our Top Employment Services Pick

We think these higher-quality names will outperform the rest.

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For the vast majority of local newspapers, the help wanted section has shrunk to a tiny fraction of what it was just two years ago. During this "Great Recession," the employment market has reached a weakened state not seen since the early years of the Reagan administration. Monthly job loses have averaged in the hundreds of thousands, and the unemployment rate is poised to break the psychologically important 10% mark. Also, the majority of economists do not expect job loses to cease until early to mid-2010. Even with the plethora of negative news, we believe there may be a slight glimmer of hope. We have seen a marked improvement in the pace of month-to-month sequential employment losses for almost all major economic sectors. Other data series and anecdotal evidence we watch closely also point to the beginnings of a recovery for the employment market. However, caution should be taken when viewing these positive signs as the situation remains very precarious, and we do not expect any significant job growth until the middle of 2010.

Given the many moving parts to this story, how does an investor make sense of the disorderly information and pick the best-performing employment-related stocks? In this article we plan to discuss some of the trends we are currently seeing and what stocks we strongly believe will provide investors with outsized returns over the long term.

How Have Our Expectations Played Out?
When we wrote our last article back in February, the unemployment rate was at 7.6%. At that point we were gravely concerned that the current recession would be harsher than most and the effect it would have upon the employment market would be very negative. We looked at the trends and believed there was a very good chance that the unemployment rate could reach and/or surpass 10%. So far, the path of the unemployment rate has been on par with our expectations. However, this does not mean that we feel the environment will get materially worse for the employment firms we cover. Believe it or not, the current underlying trends bode well for the stronger employment-services players.

What Are Our Expectations Moving Forward?
Even though the unemployment rate will likely continue to rise at least over the near term, we are seeing some encouraging signs on several fronts. A key data point we keep a keen eye on is the usage of temporary labor by businesses. The monthly sequential movement for this number can give an indication as to how businesses view their staffing needs. Businesses use temporary labor mainly as a cushion. When prospects turn negative, they tend to divest temporary resources and when prospects turn positive, they start to acquire temporary resources. As the chart below shows the sequential movement of this number has ticked very close to 0; meaning businesses have turned neutral from deeply negative about their staffing needs.

Additionally, all major economic sectors have shown good improvement in terms of monthly sequential loses as the steep drop in the aggregate level of employment has slowed significantly during the last five months. Losses are still occurring, and this is still troubling. But the torrid pace has subsided. Even some of the most notoriously cyclical firms we cover, the temporary staffing firms, have been more and more positive in their tone for future prospects.

Even with these positive trends, we still see a few troubling points. The U-6 unemployment rate, or what we like to call "the shadow unemployment rate," has stayed at an elevated level. The U-6 encompasses not only the unemployed, but also workers who would like to work full-time but are only able to garner part-time work. The chart below shows how this rate has behaved in relation to the headline unemployment rate.

As one can see, the differential between the U-6 and headline unemployment rate has risen to an elevated level and this likely means that the lackluster labor situation is worse than what the headlines may indicate. During this economic downturn, businesses have been a bit more active in terms of cutting hours or putting parts of their staff on furlough. Fewer work hours lead to less disposable income and ultimately less economic activity. One key externality of this dynamic pertains to the impaired level of seasonal holiday hiring for the retail sector. Seasonal hiring last year hit a 20-year low as the chart below shows and this obviously is a negative factor.

Every year hundreds of thousands of jobs are pushed into the economy because of seasonal hiring. Depressed seasonal hiring last year hurt the overall economy; however, this year's trend looks a little better as job losses for the sector were about half of what they were year-over-year for the month of August.

This all leads to a set mixed set of results. The main point in our opinion, however, is that the employment market is improving, albeit at a lethargic pace. The deep loses associated with the last year have ended, and we feel the debate should now surround the pace of a recovery. Given the weakened and deleveraging consumer, the shock of the credit crisis, the significant increase in worker productivity, the deep secular troubles of certain sectors (such as auto manufacturing and construction), and the delayed disbursement of the federal stimulus funds, the pace may be more gradual than what some stock market participants would like to see.


Put Your Money to Work with Our Top Employment Services Pick
Even though employment firms are notorious for their extreme cyclicality, we do believe the higher-quality names will outperform the rest over the long term. Temporary staffing is a harsh business, and this industry enjoys a boom-and-bust cycle that can rival any economic bubble. Picking a firm that can somewhat limit its downside risk while still being able to reap the rewards of an upswing can be tough. However, we believe the quality staffing firms with solid competitive advantages such as  Manpower (MAN),  Robert Half (RHI), and  AMN Healthcare (AHS) will outperform the rest of their peers.

Although the temporary staffers can offer the investor a wild ride, we prefer steady and robust returns when we invest in the market. This is a hard task given the cyclical nature of most employment services firms. However, there are two employment services firms we believe that can consistently produce great profitability,  Automatic Data Processing (ADP) and  Paychex (PAYX). These firms compete within the payroll processing industry which is driven mainly by the total level of the employment market, which is a much more stable demand base. Returns on invested capital have been substantial for both firms, and we believe each possesses formidable competitive advantages. Although both will thrive long term in our opinion, only Paychex is currently priced at a deep discount to our fair value estimate. Even though ADP is a stalwart performer, its stock has risen significantly since we recommended it earlier this year, and it is no longer priced at a deep enough discount to our fair value estimate. In the case of Paychex, we believe the market has unduly penalized it. Paychex currently trades at a trailing price/earnings ratio of 20 while the stock has averaged a 29 for this metric during the last five years. Given the deep loses within the employment market, the firm was still able to increase revenue and produce close to 40% operating margins during fiscal 2009. Even firms in less cyclical industries would like to have produced these results in this harsh economic environment. However, this kind of performance has been the norm for Paychex.

Vishnu Lekraj does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.