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The U.S. labor picture may not be clear, but investors can profit by acquiring shares of Paychex Inc. (Nasdaq: PAYX) to take advantage of the new employment paradigm.
As the former head of credit and analysis for ADP Capital Management, the investment arm of Automatic Data Processing (Nasdaq: ADP), I know the outsourced payroll industry from the inside out. ADP – a company in which I have kept the stock I received – is the leader in the payroll sector. It focuses on the larger and more stable companies in the United States.
Today, taking into account the latest employment dynamics, and the massive change in the structural characteristics of the U.S. economy, we are going to focus on an ADP competitor – Paychex Inc.
After the U.S. employment number last Friday we saw Pimco's extremely successful and savvy Co-Chief Executive Officer Bill Gross talk about the new paradigm in employment. I was happy to see that it was congruent with my own views.
The U.S. economy is de-leveraging and regulating, he pointed out. The implication is that the recovery will be much more drawn out. Unlike past crises, the U.S. government is making a concerted effort to change the entire structure of the banking and non-banking financial system. And a crucial structural change that has already occurred is the reduced level of leverage in the U.S. economy and the limitations on new leverage and on excessive risk-taking being implemented.
These latter changes will limit the size of the economic "bounce" effect from the financing re-leveraging that we've seen after prior crises. In this case, the financial "crutches" are in the hands of the fiscal stimuli and of the U.S. Federal Reserve, with temporary quantitative easing supplanting the traditional private sector financing.
At the same time, the low Federal Funds rate provides a large spread for banks that allows them to recapitalize. This mammoth financial intermediation spread will eventually outweigh the lingering problems on the banks' balance sheets and put the sector back on its feet, able to lend again. But that will take time.
There are still many uncertainties and very large pending structural problems – such as healthcare and social security reform, and the problems in residential and commercial real estate. For those reasons many large companies are reluctant to hire back the workers that they had to let go when the economy hit the wall in October of 2008.
But what corporations are doing is cutting costs and increasing efficiency by outsourcing and hiring temporary workers and consultants.
That can be seen in the in the discrepancies of last Friday's employment numbers. While the payroll numbers showed a decline of 20,000 jobs, the household survey showed an implied increase in employmentwith the overall jobless rate falling to 9.7%.
You see, in order for unemployment to decrease, you have to have growth in payrolls. So, economic experts were befuddled after the numbers came out. But what I strongly believe is happening here is that many people are being hired back as external consultants and temporary workers.
This is confirmed by the rally in companies that profit from that traffic, like Robert Half International Inc. (NYSE: RHI) and Manpower, Inc. (NYSE: MAN). These companies are the early cyclical winners among employment companies, and they are typically followed first by Paychex and then ADP.
But this cycle will be drawn out. Now, the market, encouraged (you could also say fooled) by the economic indicators that have shown an increase in activity, jumped the gun with respect to employment companies and bought them aggressively. But the employment numbers did not show up. And now these stocks are in a profit-taking mode, reversing prior enthusiasm.
Paychex moves faster to both the upside and to the downside than ADP, which has much larger clients. Paychex also focuses more on payrolls than does ADP, making it slightly more volatile.
Eventually, though, jobs will start materializing in this economy. Bank recapitalization will do its trick over time, the recovery will become more self-sustained in the longer term, and temporary and consulting employment will be replaced with permanent jobs.
At that point, Paychex will take off to the upside ahead of ADP once more.
And do not fear price wars between them, because the two very distinct customer focuses of each of those companies have kept them from targeting each other's customers. This has allowed for better pricing in the industry and larger margins. Also, the cost of switching allegiances is high, and that encourages companies to stick with their initial payroll provider.
This latter factor benefits Paychex, since most jobs are being created by small businesses.
Lastly, but very importantly, U.S. President Barack Obama in his State of the Union address emphasized precisely this issue and intends to deploy financial help to the banks that lend to small business and tax incentives for small corporations to hire workers.
So we are going to buy Paychex, but take care to limit the current high volatility effect.
Recommendation: Buy Paychex Inc. (Nasdaq: PAYX) into daily weakness, dollar-cost averaging over the next six weeks, in order to limit the current market volatility(**).
(**) Special Note of Disclosure: Horacio Marquez holds no interest in Paychex Inc.
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