Recruitment companies are volatile stocks with zero future earnings visibility and trade at heady valuations - a punchy cocktail for even the most risk-tolerant investors. Operating earnings across the sector’s major UK-listed stocks collapsed by 80% the year after the financial crisis before tripling again the year after. Stock prices fared similarly.

Over time, it has been demonstrated that volatile and cyclical stocks - known as high beta securities - underperform relative to stodgy low beta defensives, like utilities, for example. Volatility in earnings of the magnitude seen in recent history would imply sector-wide earnings - or at least those of the larger UK recruiters - go to zero in the long run.

Extrapolating past performance into the future is not always wise. If the madness of 2008 was an aberration not to be repeated again for many years, future generations would look back at today and conclude everyone was far too cautious.

For this reason, we’re bullish on the sector - our favoured picks are among the UK’s leading recruitment firms: Michael Page (MPI), Hays (HAS) and Robert Walters (RWA).

Conviction call

This is a fairly controversial call in light of recent economic wobbles across the world. Among the first to outline the potential for the sector to surprise investors and analysts was hedge fund manager Hugh Hendry at Eclectica Asset Management.

Risk-adjusted returns on bonds have exceeded those on equities for decades, Hendry shows, a situation he considers neither good for capitalism nor helpful to the credibility of governments and central banks.

‘If April’s price gyrations prove more than just a fleeting phenomenon, then European bond yields now seem most likely to track inflation expectations,’ wrote Hendry in an April market commentary. ‘This probably means prices settle around here and then slowly sell off as inflation expectations likely rise whilst equities should continue their recovery.

‘This is what I think of as I survey the cross asset charts for Europe. And I can’t help but think that central bankers want this trade to succeed; that they want their stock markets to outperform their bond markets; that they want you to make money.’

Rising stock prices, Hendry argues, would help increase the type of risk-taking necessary to drive the global economy back towards higher growth rates. It would also increase wages in the real economy. ‘Our enthusiasm for a shift to a global policy promoting higher wages has proven contentious,’ he adds in a June note.

‘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 (£9) 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 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 view of the future and yet they say nothing to counter the Henry Ford notion that if workers have more money, businesses have more customers.’

Trend beneficiaries

To play this reflationary theme, Hendry has highlighted a number of opportunities in the recruitment sector, UK housebuilders and German real estate. ‘This helps explain our current enthusiasm for the UK recruitment sector where share prices are breaking out of a long fifteen year bear market relative to the broader stock market,’ Hendry writes.

‘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%.’

Hendry highlights the big three UK-listed permanent recruiters Hays, Michael Page and Robert Walters as beneficiaries of this theme.

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Hays, which we covered last week as a key pick to play a shift in consumer spending and work patterns (see Shares, Cover Story, 1 Oct) , is the largest of the UK recruiters with a market capitalisation of £2.2 billion.

Diversified across 33 countries and 20 sectors, Hays has a roughly two-thirds to one-third split between mature and growth markets. Around a third of its business is in the UK and Ireland with the remainder in Europe and the Asia-Pacific region.

Cash machine

Hays has outlined a plan, subject to market conditions, of returning excess capital to shareholders towards the end of 2016 and says it is on track to achieve a five-year target of doubling operating profit to £250 million by 2018. Analysts at Investec have a ‘buy’ rating on the stock with a price target of 195p.

‘Management remains confident of hitting its 2018 profit targets following a solid set of full year 2015 numbers,’ wrote analyst John Mullane the day after results were published on 27 August. ‘Operating profit climbed 25% year-on-year to £164 million, leaving its conversion ratio (a key measure of performance) at 21.5% back above 20% since the first time since 2009.

‘With the group offering a sector-leading conversion ratio, underlying momentum in its core and end-markets robust and capital returns on the agenda for 2016, we reiterate our “buy” rating.’

Top quality

Michael Page, a running Play of the Week (3 Sep), was picked based on Hendry’s idea that permanent recruiters are in for a strong run as unemployment falls to record lows and churn within the workforce starts to pick up. We are also impressed with Page’s longer term track record, balance sheet position and willingness and ability to return excess capital to shareholders.

Valued by the market at £1.5 billion, Page has a 78% to 22% profit split between permanent and temporary recruitment, and is present in 35 countries around the world. ‘Special dividends, better gross margins and strong outlook - what’s not to like?’ remarked analysts at HSBC after half year results to 30 June.

Page ended the period with £100 million of net cash, a conservative policy preferred by investors in permanent recruiters because of their cyclical tendencies. Temporary recruiters tend to have higher earnings visibility so can run higher debt levels.

‘At this juncture, a macro-economic shock could undermine candidate and company confidence and cause growth to fall, say analysts at Stifel who have a 650p price target on the stock which presents trades at 480p.

Eponymous leader

Another high quality permanent recruitment play is Robert Walters valued at £327 million. It operates in 24 countries in professional services like accounting and finance, banking, engineering and administrative positions.

Run by founder Robert Walters, its strategy is differentiated by a commitment to invest through downturns and not to take knee-jerk reactions by shutting offices when conditions temporarily deteriorate.

This helped drive earnings per share 78% higher in the last six months as Walters stuck with investments in countries like Spain where the market is now picking up dramatically. The CEO explains that as loss-making units move back into profitability, they deliver dramatic improvements in group-wide profitability like those seen recently.

Walters, who studied as an accountant before moving into recruitment, is also critical of management teams using exceptional items or other measures to mask poor financial results and has a policy of charging all costs as they are incurred.

At interim results to 30 June, an impressive cash haul helped the business move into a net cash position of £14.6 million, paving the way for potential shareholder capital returns in coming months. Third quarter results are due out as Shares goes to press. There are five buy ratings from the five analysts that cover Walters with an average price target of 552p.

Permanent bias

Technology recruitment specialist SThree (STHR) is another stock with a heavy weighting towards permanent recruitment, with a ratio of around two-thirds perm to one-third temp.

Valued at £462 million, the stock has been hit by some concern around its exposure to recruitment in the energy sector. Net fee income was up 13% in the three months to 31 August but would have been 20% higher without the drag of its energy-facing businesses.

‘We like SThree from a valuation and growth perspective,’ writes analyst David Greenall at RBC Capital Markets. ‘It is currently delivering one of the highest net fee growth rates of the quoted staffers despite the energy drag. We see momentum continuing and see significant upside.’

Greenall also believes the business is potentially an acquisition target. A key risk specific to the business is insider share selling: the former chief operating officer left SThree last year but continues to own 5% of its equity, down from 9% previously. Other present and former management own an additional 13%, including chief executive Gary Elden’s holding of 3%.

In the past year, share overhangs have proved short-term impediments to a number of stock prices including those at Entertainment One (ETO), Brooks Macdonald (BRK:AIM), Empresaria (EMR:AIM) and Regus (RGU).

Industry explanation

Staffline (STAF:AIM) provides a good summary of the difference between the financial profile of permanent and temporary staffing on its website. ‘Permanent placement is very much a “cash cow”, whereas growing a portfolio of contractors tends to be cash consumptive, given the lag between paying contractors and receiving cash from clients,’ it explains.

‘However, in strong market conditions, the cash generated by the permanent business more than compensates for this factor. In very poor conditions, contractor numbers reduce, releasing “trapped” cash.’

Investors looking for a more cautious way to play the recruitment space could take a look at those with a higher weighting in temporary recruitment. Acquisition-led welfare-to-work specialist Staffline is probably now the UK-listed market-leader of this group. Others include Matchtech (MTEC:AIM), Empresaria and Harvey Nash (HVN).

‘It seems the market has been reasonably efficient at pricing these businesses,’ Hendry says in summary to his commentary on recruiters. ‘I am willing to bet that as the tide turns the extreme profit gearing to economic cyclicality will make of 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.’

It’s worth pointing out Hendry’s view is based on an idiosyncratic view of the global economy. Any decline in economic activity and particularly the jobs market is likely to have a negative impact on recruitment profits and share prices, as we highlighted at the start of this article.

SHARES’ TOP PICKS

Michael Page (MPI) 480p

Market value: £1.6 billion

Prospective PE June 2016: 23.7

Prospective PE June 2017: 19.3

Hays (HAS) 155p

Market value: £2.2 billion

Prospective PE June 2016: 17.9

Prospective PE June 2017: 14.9

Robert Walters (RWA:AIM) 424p

Market value: £327 million

Prospective PE Dec 2015: 22.7

Prospective PE Dec 2016: 19.3

(Click on charts to enlarge)