The Eclectica 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. Henrys 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 UKs 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. Britains 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 Eclectica 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.

Hugh Hendry
Tom Roderick
George Lee

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 a 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