Today, active portfolio management is extremely important as a consequence of high divergences between sector returns. Volatility creates strong opportunities when you know where to hunt for alpha in the market.
At the end of this summer, I started acting on the extreme outperformance in growth stocks compared to value stocks, bringing their valuation gap to the highest level in 20 years. I wrote several articles (July 27, August 8 and September 19) discussing why the tech outperformance would end, causing a sector rotation to value stocks. Over the past months, we hunted for winning high-quality value stocks at Insider Opportunities.
On November 9, the positive Pfizer (PFE) and BioNTech (BNTX) vaccine announcement served as catalyst for this sector rotation, which continued the weeks after. This rotation to value is clearly visible in the significant outperformance of the value-weighted Russel 2000 (IWM) index compared to the tech-weighted S&P 500 (SPY) index.
I believe that there are still significant opportunities to generate alpha with turnaround stocks today. However, I expect that this outperformance will be concentrated in stocks with specific characteristics, which will be explained in this article.
There is one very attractive turnaround sub-sector which I believe provides the crown jewels of turnaround stocks today: Human Resources & Employment Services. I will share my reasoning behind this and provide my favourite stock in this sector.
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(Source: Insider Opportunities with Tradingview)
Turnaround value plays: which ones will keep generating alpha?
I am a big believer that, in stock market investing, following basic principles (even the simple ones) can improve returns drastically.
Let’s start with the definition of a value stock, according to Investopedia:
A value stock is a stock that trades at a lower price relative to its fundamentals (agree) such as dividends, earnings, or sales. (don’t agree)
Unfortunately, I only agree with the first part of this definition. It is not the current dividends, earnings, or sales which determine the value of a company, making the current dividend yield, P/E ratio, and EV/sales ratio irrelevant as standalone metrics.
In contrast, I believe a value stock should be defined as follows:
A value stock is a stock that trades at a lower price relative to its fundamentals based on all future cash flows discounted to today (which can be analysed with a DCF model)
The cash flow, which can differ significantly from earnings, is the cash the company generates which can be distributed to shareholders. For me, value investing does not mean picking stocks with a low P/E ratio, it means picking stocks which can generate higher cash flows in the future compared to what the market is currently pricing in. Such buying opportunities are oftentimes caused by market sentiment.
And to be clear, tech can also be picked as value stock during rare circumstances. For example, I believe that Apple (AAPL), Facebook (FB) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) have provided value opportunities several times in the past.
So, let’s analyse the recent surge of turnaround stocks in this context of value investing. While many investors are currently buying great value stocks based on ratios such as P/E, they are not great based on the cash flow definition of value investing ( = a value stock is a stock trading lower than all future cash flows discounted to today) as a consequence of several factors:
1. Capital intensity
Many of these so-called turnaround stocks are operating in sectors which require high capital intensity. This means that they need to invest most of their operating cash flows into capital expenditures to be able to keep operating in the future, leaving few cash to distribute to shareholders.
Let’s use some examples to explain this better. Exxon Mobil (XOM) and Carnival (CCL) look to be amazing turnaround picks as they are down, respectively, 48% and 66%, year to date and look very cheap based on pre-COVID-19 P/E ratios (current price/EPS of 2019) of 11x and 4x, respectively.
However, Exxon Mobil needs to invest cash into new oil drilling projects and refineries to be able to keep supplying barrels of oil. Carnival needs to invest in new cruise ships to be able to keep shipping people.
As these capital requirements outpace those of the past, free cash flow is almost always inferior to net profits, which is shown by the low cash conversion metric (free cash flow/net profits).
The lack of generating free cash flows is very important to understand as this is the cash which is available to distribute to shareholders. Over the coming years, Exxon and Carnival will need to keep investing in CAPEX to keep their business alive, which impacts their cash flow generation, impacting their value.
(Source: Insider Opportunities research based on SeekingAlpha data)
Look for companies with low capital intensity, which can be tracked by looking for conversion rate higher than 100%.
2. Increasing debt
The second factor is somewhat related to the first one in the sense that businesses with high capital requirements oftentimes need to raise debt to be able to keep financing their projects.
Many of the turnaround stocks already had a troubled balance sheet before the pandemic. To be able to survive, they needed to either raise debt or equity during the COVID-19 pandemic, which impacts their value on the stock market.
Future cash flows will be impacted by high interest rates on this debt and will be used directly to pay off this debt, impacting the fair value of the stock significantly.
Let’s discuss some examples who look great turnaround stocks at first sight, but might generate disappointing returns due to their debt increases. Movie theatre company AMC Entertainment (AMC) looks attractive being down 50% YTD and being valued at a P/E of 4x based on 2018’s EPS. Airplane manufacturer Boeing (BA) looks attractive being down 37% YTD and trading at a P/E ratio of 11.5x based on 2018’s EPS. Cruise line company Royal Caribbean Group (RCL) is down 43% YTD and is trading at a P/E of 8.5x based on 2019.
But they are less attractive if you take into account their huge debt increases in 2020 which will impact free cash flow available to shareholders in the future. AMC Entertainment raised $1.1 bln at 2.58-10.5% interest rates, while it only generated $37 mln in cash flows over the past decade. Boeing raised $37.3 bln at 4.5%-5.9% interest rates, which is more than its free cash flow generation over the past five years. Royal Caribbean Group raised $9.2 bln in debt at 1.48%-11.50% which outpaces its free cash flow generated over the past decade by 200%.
Look for companies who didn’t raise excessive amounts of debt in 2020, as this can impact future shareholder value significantly.
The third factor is oftentimes overlooked, but may be the strongest power impacting turnaround value stocks’ returns: competition.
Companies which have a very weak economic moat are prone to competitive pressure and could face strong cash flow declines in the future, impacting the value of that stock significantly.
The ” economic moat”, popularized by Berkshire Hathaway’s CEO and legendary investor Warren Buffett is defined as follows:
The economic moat is a distinct advantage a company has over its competitors which allows it to protect its market share and profitability.
As CEO of Ark Investment and legendary investor (can we say this already?) Cathie Wood says, crises lead to an acceleration of disruption. It is during tough economic periods (like 2020) that businesses and consumers change their habits significantly. Let me explain this, again, with some examples.
A very obvious winner of COVID-19 is e-commerce. Many consumers have started experiencing the convenience of online shopping, which will impact several brick-and-mortar companies which don’t provide a unique advantage.
Department stores like Macy’s (M) and Kohl’s (KSS) look very interesting with P/E ratios (based on 2019’s EPS) of 5.8x and 7x, respectively, as these stocks declined 36% and 37% year-to-date. Unfortunately, these companies don’t have any economic moat which will protect their cash flows from e-commerce giants like Amazon (AMZN) and Shopify (SHOP) over the coming years. As profits and cash flows are very likely to evaporate in the future, ratios based on the past are irrelevant.
Look for companies with an economic moat, i.e. distinctive advantage which protects its future cash flows from competition
If you look for value stocks which are likely to generate alpha in the mid-to-long term, look for companies which face short-term troubles due to COVID-19 but are able to convert profits into cash flows, have clean balance sheets and have decent economic moats.
That’s not easy to find, given the fact that most of these companies already reached all-term highs over the past weeks and are trading at high multiples.
Fortunately, at Insider Opportunities, we find great stocks and sectors based on our insider tracking with in-house algorithms.
I have found one very interesting, overlooked sector which might provide you the perfect combination of both value and strong fundamentals.
Our favourite sector today: HR & Employment Services
Unfortunately, there are no ETFs which track this sub-sector, so I will use the basket of 7 small-cap HR & Employment Services stocks that YCharts provides:
- ASGN Incorporated (ASGN) (market cap: $4.3 bln): A staffing/consulting company primarily focused on technology and governmental workforce.
- Heidrick & Struggles International (HSII) (market cap: $492 mln): An executive research and consulting services company.
- Kelly Services (KELYA): (market cap: $807 mln): A staffing company primarily for administrative functions.
- Korn Ferry (KFY) (market cap: $2.1 bln): An executive research and consulting services company, focused on digital capabilities.
- ManpowerGroup (MAN) (market cap: $5 bln): A recruitment services company which provides services like training and career management.
- Insperity (NSP) (market cap: $3.35 bln): A services company which provides a platform to SMEs for several HR-related practices such as payroll and training.
- TrueBlue (TBI) (market cap: $601 mln): A staffing company for blue-collar workforce.
Over the past decade, this industry has performed exceptionally well as a consequence of a big secular tailwind: the increasing importance of workforce for business success.
Industries, in general, have become much more dependent on know-how to succeed. Moreover, industry environments are more volatile and prone to disruption than they have ever been, increasing the demand of HR consultants to find the workforce to compete successfully.
This was visible in this sector’s returns, which in fact outperformed the popular tech-focused Nasdaq index (QQQ) during the period 2013-2018:
However, this strong performance faded away since 2018, caused by two factors.
First of all, as a consequence of record-low unemployment rates, there was a lack of workforce supply, which impacted the growth of staffing agencies significantly.
Second, markets were pricing in a higher probability of an economic downturn in the following years as the economic cycle was nearing its end. HR services have proven to be very cyclical in the past.
The COVID-19 pandemic led to a halt of workforce recruitment at many business and consequently impacted the HR sector significantly. In fact, a recent analysis showed that the US Staffing industry is expected to decline by 17% in 2020.
(Source: BG Staffing investor presentation)
Despite the recent positive vaccine news, the above-mentioned basket of stocks is still down 14% year-to-date and 29% from its 2018 top. I believe that this industry provides some great value opportunities today.
First of all, this is a capital-light industry which consists of companies that provide consulting services and thus has the ability to generate very strong cash flows. In fact, the average cash conversion of the above-mentioned stocks (excluding HSII with an extremely high cash conversion of >600%) was 124% over the past decade, meaning that they generated cash flows which came in 1.24x higher than their earnings.
Second, as these companies’ operations are based primarily on intellectual property rights (“IPR”), technology and human resources, they need very low capital investments and have a very healthy balance sheet. In fact, 6 out of 7 stocks had a net cash position, which decreases risks significantly.
One can discuss extensively about the competitive factor in this sector: do these companies have a moat which will protect their future cash flows or not? First of all, it is important to mention that customers tend to be very sticky with their HR consultancy company (i.e. they have a high retention rate). This is caused by high customer switching costs: many businesses operate in complex environments, and as such, it can take many months for an HR consultancy company to align their services (training, recruiting, consulting, career management) with the specific needs of their customer. As such, companies tend to choose one HR services company to cooperate with for many years.
However, it is important to note that there are significant divergences in the industry based on this factor. The higher the complexity of the clients and the more value an HR business adds to their customer, the higher the moat. For example, we don’t like TrueBlue as it can be seen as a middleman to provide unskilled workforce. TrueBlue will rather compete based on prices of their services, rather than the quality of their services.
Based on the high quality of this sector fueled by long-term tailwinds, the recent underperformance which resulted in low valuations and the expected economic rebound in 2021, we believe the sector could double over the coming years (which would be a 42% increase from the 2018 top).
(Source: Open Domain)
Our favourite HR pick: BG Staffing (BGSF) – 83% upside
At Insider Opportunities, our in-house algorithms have picked HR companies Korn Ferry and Insperity in July and September. Unfortunately, they are up both 30% since our buying recommendation and their current upside is limited.
Another great stock definitely worth looking into for the long term is industry leader ASGN which grew its revenue by 17.9% annually over the past three years and has one of the widest moats in the industry. The stock is up 15% YTD, but still trading significantly below its top in 2018.
But our ultimate favourite pick with significant upside for investors today is BG Staffing. This small cap staffing company is picked for Insider Opportunities members two weeks ago after director Richard Baum purchased $50,000 worth of shares at $10/share. Unfortunately, due to the market volatility, the stock keeps gaining as I am writing this article. However, we do believe it keeps being a strong buy below $14.
Insiders, who have superior information about the company compared to Mr Market, have also purchased shares in May. The stock is still down 45% YTD and 58% from its 2018 top, which we believe is unjustified.
(Source: Insider Opportunities research with Tradingview)
BG Staffing is a young staffing company founded in 2007 and publicly-listed since 2014. It is a provider of workforce solutions for ~6,800 clients in the United States.
Bg Staffing splits his business in three segments: Real Estate (24.5% of revenue), Professional (51.4% of revenue), and Light Industrial (24.1% of revenue).
Light Industrial, the smallest and least exciting segment of BGSF (5-year revenue CAGR of -1.86%), provides lower-end workforce primarily in the logistics & warehouse sector. This division has a weak moat and primarily competes with companies like TrueBlue based on pricing.
Professional provides staffing services to customers who search for highly-skilled personnel that enables their business to achieve organisational change and digital transformation. This segment is operating in industries like IT, finance & accounting and marketing. It has been growing revenues significantly at a CAGR of 16.87% since 2015, primarily contributed by acquisitions. Professional is a great segment, but it is not easy to compete with big staffing agencies in this field like Robert Half (RHI) and Kforce (KFRC).
The crown jewel of BGSF is its Real Estate segment, which provides workforce for the Real Estate industry like leasing agents, property managers and a maintenance crew. BG Staffing is the only publicly listed Real Estate staffing company and has a leadership position in this niche.
It grew its revenue by an astonishing CAGR of 22.93% over the past five years, all organically. And more importantly, it has been able to grow its operating margins to 16.99% in 2019, which is a significant gap with the industry range of 2-10%. I expect this segment to keep performing well post-COVID-19 as the company is still expanding its business to several new states with strong Real Estate demand such as California.
(Source: Insider Opportunities research based on Sec Filings; numbers in $mln)
The astonishing Real Estate growth and strong execution of acquisitions led to an 852% increase of free cash flow generation since its IPO, which more than doubled the second-best company in its industry, ASGN:
Still, the stock significantly underperformed its sector, which can be caused by two reasons.
First, its Real Estate business is significantly hit by the pandemic. COVID-19 led to moratoriums on evictions (less people moving to new places) and rent abatements, which hurts property management companies significantly, and thus, they are decreasing their investments in new workforce. This segment’s revenue fell by 51.72% and 35%, respectively, in Q2 and Q3 of 2020, ending the strong streak of revenue growth.
Second, BG Staffing is a really small company ($124 mln market cap) which is underfollowed by the market. With a very thin amount of shares traded (~70,000 daily on average), the stock can be very volatile. Due to fear for the ongoing pandemic, the stock did not get rediscovered by the market yet, but this could change drastically soon.
I believe that BG Staffing’s financials will recover from this crisis at the end of 2021, creating strong buying opportunities at today’s depressed prices. BG Staffing is currently trading at a very cheap TTM free cash flow yield of 15.8% and forward P/E ratio of ~10x for 2021.
Our price target of $22 provides 83% upside from today and is based on a very conservative combination of a DCF and multiple analysis. Our full analysis of the stock is exclusive for Insider Opportunities members.
I believe that, in the long term, BGSF might be the next ASGN (~1,500% return since 2010). This investment case might work out if ASGN can keep growing its high-margin Real Estate business which will both increase cash flows as the multiple Mr Market wants to pay for this stock.
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Disclosure: I am/we are long BGSF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.