The Ec lect ica Fund 30 June 2015

Use of the Henry Ford option gathering steam

Our enthusiasm for a shift to a global policy promoting higher

wages has proven contentious. Nevertheless, the UK has

become the latest advocate of such a demand boosting

initiative with the newly re-elected government announcing

plans to raise what it terms the “national living wage”. By

2020 British businesses will be mandated to pay at least $14

per hour for employees aged over 25, a rise of almost 40%

which affects at least 20% of the distribution of wages in the

country. Despite prominent businesses such as Ikea, the

large Swedish retailer with 9,000 UK employees, announcing

its intention to adopt the plan, the initiative set off the usual

chorus of alarm bells that such policies run the risk of

destroying jobs and investment in the UK.

Phrases such as “economically useless and intellectually

empty…” tend to be the customary riposte to a controversial

vision of the future and yet they say nothing to counter the

Henry Ford notion that if workers have more money,

businesses have more customers. And it conveniently

sidesteps the evidence from America where the highest rate

of job growth by small businesses is occurring in those states

and cities with the highest public mandated minimum wages.

As I write New York seems set to become the latest US city

to enact a $15 per hour minimum wage for fast-food workers

versus the current rate of $8.75. Henry’s insight, it seems, is

spreading like a rash.

The recent experience of the UK economy is also insightful;

the country has never employed more people than it does

today with jobless claims at the same low level as they were

pre-crisis in early 2008 and the unemployment rate is now

only 0.8% higher than in 2005, when it was probably close to

full employment. And yet despite such achievements,

economists tend to fret over what is perceived as an

enduringly low level of productivity and the menace that, with

the tightening of the jobs market, the central bank will be

forced to hike interest rates.

This perpetual phantom, the speculation that central banks

will have to hike rates and produce a rout in stock prices (in

Japan the fear stretches as far back as 25 years) reminds

me of the sad case of Steve Feltham who gave up his job,

house and girlfriend 24 years ago to live in a van and devote

his life full-time to looking for the Loch Ness Monster. Reality

dawned last week when he gave up his whimsical pursuit

concluding that he had probably been duped all along by the

rather more prosaic theory that the images most likely

captured large catfish first introduced to the area by the

Victorians for sport fishing.

Figure 1: Loch Ness Monster?

The great mystery of the UK’s curse of low productivity, its

likely debilitating effect on domestic corporate profitability

and the perceived need for British rate hikes are all like the

mystery of “Nessie” probably made obsolete by recourse to

more humdrum explanations. To us, the path to British

recovery owes much to the early initiative of the previous

government to boost wages for low income groups by

increasing the tax-free allowance by 54% from £6,475 to

£10,000. This dramatically increased the supply of labour –

both from those previously willing to abscond and accept

generous welfare payments as well as non UK residents

lured by this effective take home after tax pay rise of

c.11%. The blossoming British recovery therefore probably

owes much to this boost in wages which also explains the

spectacle of an economic recovery that has been dismissed

as job “rich”/productivity “poor”.

What nonsense. Britain’s “productivity problem” seems to

owe its existence more to the semantics of economists

insisting that it be measured on a per hour worked basis,

than the evident reality that having people sit idle receiving

state benefits is perhaps the ultimate drain on total

productivity. Thankfully, with British public policy initiatives

having widened the reach of the labour market to better

capture this lower paid and inevitably less productive

workforce it seems inevitable to us that we should have

recorded a stagnation in the productivity growth of the

average British worker. Who really cares? This de-facto

wage boost has increased the total production of the British

economy, generated fewer transfer payments and allowed a

younger generation to enter the workforce, something which

is sadly lacking in other parts of the European economy. And

by enriching consumers, corporate profits are rising and the

economy is expanding without threatening an uptick in

inflation.

The Ec lect ica Fund 30 June 2015

This helps explain our current enthusiasm for the recruitment

sector where share prices are breaking out of a long fifteen

year bear market relative to the broader stock market. Such

businesses are an excellent play on improving and tightening

labour markets globally as they are only just starting to recover

from a savage downturn. Consider that in 2014 the staffing

market in France was 32% below its 2007 high, the UK/Ireland

30% and Japan 42%. Source: Adecco Investor Presentation

The stocks remind me of our positive experience back in 2004

investing in the oil services sector when share prices were just

breaking out from a long bear market. The better companies

had managed their downturn well and as a result traded at

valuation levels which seemed to exclude the prospect for

large price upside; instead one had to believe that the oil price

was going to triple – something that no analyst would ever

dare to publish in their valuation model.

With the global jobs markets recovering we believe the

dynamics of the recruitment industry are set to change

positively in a manner yet to be captured by DCF models.

These companies double dip – they get paid their fees as a

share of higher wages, and then if the job market strengthens

sufficiently, staff turnover goes up as workers become willing

to forgo job security, tenure and safety from the tyranny of ‘last

in first out” style job cuts in order to chase more lucrative

salaries elsewhere. This is the golden period when the

recruitment agencies get to have their cake and eat it. The real

gearing therefore comes in the companies exposed to the

permanent hiring end of the industry; in Europe, that is

PageGroup, Hays and Robert Walters.

And it is this latent additional kicker that is typically excluded

from investment banks’ research. Say it quietly, but if things

really improve, in the manner that we can envision, and clients

want to turn more temps into permanent staff, the staffer

receives a fee which provides an incremental income stream

which is very high gross margin and comes with minimal

additional cost.

The UK names are perceived as low growth cyclicals where

margins seem to have fallen structurally since the mid-2000s.

It is exactly the same argument I heard time and again ten

years ago as British pension funds shunned the commodity

mining sector; plus ça change! Hays used to make 10% profit

margins but are forecast to make just 5% and the stock sells

for 0.6x sales whilst PageGroup, which made 18% margins at

the peak but now reports just 8-9%, trades on an EV/Sales of

1.4x. Source: Company Annual Reports

As I said in my introduction, it seems the market has been

reasonably efficient at pricing these businesses. But from

experience I am willing to bet that as the tide turns the

extreme profit gearing to economic cyclicality will make a

mockery of analysts’ modest expectations and with the stocks

enjoying very strong balance sheets and 2-3% dividend yields

the sector seems ripe for lift off.

Figure 2: Michael Page Price Chart (2001-Present)

Source: Bloomberg/EAM

Hugh Hendry

Tom Roderick

George Lee