In this bizarre feast or famine covid economy, I bypass many of the more obvious winners and instead add a covid casualty to the portfolio, hoping that a reopening of the economy will fuel a recovery in this company’s fortunes.
The Uncession
I’ve had the dubious pleasure now of investing through three official recessions and a handful of milder economic slowdowns, with a sprinkling of sector-specific booms and busts thrown in along the way for good measure. The playbook for these sorts of events is reasonably straight forward: Look for companies that have been beaten down but that also look like they will be able to weather the storm and emerge relatively unscathed on the other side. If you’re willing to look past the near-term storm clouds, you can snap up some good bargains this way.
But this recession is different. I’ve taken to calling it the uncession. Last spring it looked like we were headed for a severe downturn, as the world went into lockdown mode. But then the paradigm shifted, and things went off in an astonishing new direction. Certainly, there have been some companies and sectors that have been hit hard by this pandemic and for those, the usual recessionary playbook still applies, but at the same time there are many other companies out there that are profiting enormously from the distortions brought on by covid.
The combination of generous government stimulus payments with the enforced savings imposed by the economic shutdown meant that consumers were left with unexpectedly healthy bank accounts. With whole sectors of the economy shut down, and isolation, stress and boredom to contend with, people went on a bit of a spending spree. Not only were they spending freely, but they were spending on different things and in different areas than they had been before. Capacity constraints + unusually high demand = windfall profits for any company able to tap into this wellspring.
Outdoor leisure and recreation companies (sporting goods retailers, RV manufacturers, boat dealerships) have been raking in the cash. Any company tied to house building or home renovations has been enjoying record profits. Direct marketing companies have been signing up legions of new sales associates as people look for something productive they can do from home. Exercise equipment makers have been cashing in on the home fitness boom. Defense contractors that were able to get their hands on a lucrative PPE contract from the government or pharmaceutical distributors that snagged a vaccine distribution deal have been beneficiaries. So too have many commodity-based companies like lumber producers and copper or iron ore miners. People have been spending time in their garages tinkering with their cars and have driven a boom in the sales of aftermarket auto parts. Grocery stores were early beneficiaries of the restaurant sector shutdown. Technology companies are benefitting hugely from the work from home phenomenon. Packaging companies, shipping companies, trucking companies. Everywhere you look, profit margins are exploding higher. Sales and earnings are setting all-time records. Retailers are finding that they don’t have to do any advertising or promotion. Goods are flying off the shelves at any price.
I don’t like any of this. I’m the grumpy looking lump sitting by himself at a party, complaining that the music is too loud. I don’t believe these “good times” are going to last. As the government stimulus programs wind down and we emerge from our hide-outs and get back to real life, a lot of these distortions will correct themselves. Those record-high profit margins will come back down to earth. We may even have a nasty hangover to contend with following the sugar rush of the last 12 months.
Value Traps Everywhere You Look
The term “value trap” typically refers to seemingly cheap companies that are not the bargains they appear to be at first blush because the underlying businesses have major structural problems or a weak and deteriorating outlook. I’ve been caught out by these before. I managed to get tangled up in Blackberry for part of its fall from grace. A low p:e ratio is not always your friend.
Covid has given us a value trap of a different sort. Here, there is nothing inherently wrong with the underlying companies, but the distortions caused by covid have dramatically skewed earnings up in the short term (instead of down) and therefore are making these companies look cheaper on a p:e basis than they really are. I’m assuming, of course, that the covid-fueled windfall profits end up being somewhat transitory. In which case, the ATV manufacturer or lumber sawmill that you bought with fantastic year over year earnings growth and a single digit p:e ratio may suddenly look a little less attractive when earnings come back down to earth and the low p:e ratio disappears.
Sometimes the covid booster effect is dramatic and obvious and the effect is clearly temporary. The risks of buying into a hand sanitizer company right now should be fairly apparent. But in many cases, the effect is more subtle. Unless you’re looking for it, you might miss it. The combination of a low p:e, strong year over year growth and fantastic near term results is a beguiling cocktail that can be difficult to resist. With a traditional value trap there are usually signs that trouble is brewing. With these covid value traps, though, the businesses are doing great. There is a strong temptation to give them the benefit of the doubt. After all, some of the changes we’re witnessing in the business landscape will be permanent. The whole work at home / stay at home / play at home phenomenon probably does have legs. More people will likely be working from home in the future and this will create a new set of winners and losers in the market.
It becomes a difficult balancing act: for the winners, trying to determine how much of the recent surge in sales and profits are sustainable in the long term and for the losers, trying to determine how much of their recent distress is temporary and how much lost ground they will regain as the economy reopens.
In my recent quarterly review, I looked at well over 1000 companies. I was constantly being faced with this dilemma. How to normalise earnings after a very abnormal year. As my starting point, I would often go back and use pre covid earnings to calculate a meaningful p:e ratio. If the p:e came in on the low side using this more conservative number, then I’d dig in a little further and see if I could fine-tune my earnings estimates. A confounding variable here was that 2019 was actually a slow year for the economy. Not a full-blown recession, but a slowdown similar in magnitude to what we saw in 2012 and 2015. Many companies saw their earnings and profit margins slump in 2019, so using that year’s results could give an overly pessimistic reading in the same way that using 2020 results might give an overly optimistic one. In some cases, going back and using 2017 or 2018 results seemed more appropriate. But when you start going back that far, the numbers begin to get less relevant. A lot can change in 3 years. Acquisitions are made, new shares are issued, debt is taken on, markets shift, divisions are shut down, restructuring is done. And of course, a global pandemic turns everything on its head and makes results from 3 years ago even less reliable. The world is not going back to the way it was in 2018. Nor is it going to stay in the bizarre twilight zone conditions we experienced in 2020. (I hope!) The truth is somewhere in between. And honestly, any earnings estimate you come up with is going to have to be based on an uncomfortably large amount of guesswork at this point.
Which is exactly why I favour value investing as an investment approach. When you buy low, you’re building in a margin of safety that can make up for an earnings estimate that ultimately ends up being well shy of the mark. That margin of safety has saved my bacon on more than one occasion when my rosy projections turned out to be overly optimistic.
While I looked at quite a few covid high-flyers, in the end it was a more traditional, beaten down turnaround story that caught my eye. Here at least, I was on more familiar ground. And the company does have a covid recovery angle to it, to keep me feeling hip and topical.
BGSF Inc. (BGSF.NYSE – $12.50)
BG Staffing, or BGSF Inc. as they would now prefer to be known, is a small company (market cap $130 million) involved in providing workforce solutions. In other words, a temp agency. Their workers fill in for regular employees that are off sick or on vacation or maternity leave. They also provide staffing for one-off projects or to help fill seasonal demand. Or they may supply workers in cases where the work is periodic or where there is not quite enough work to justify hiring a full-time employee.
They have three main divisions: real estate, professional and industrial. The industrial division provides temporary workers to companies in the warehousing, distribution and manufacturing sectors. This division actually did reasonably well during covid as the rush to online commerce meant lots of extra warehouse workers were needed. Their professional division mainly deals in IT (information technology) services and this too held its own during covid as some of their major customers completed big IT projects.
But it’s the real estate division that is their biggest money maker and this is where they got hammered. They provide a variety of property management services, mostly to apartment building landlords. They’ll do regular day to day maintenance, they’ll fix up an apartment during a change of tenants to get it ready for the next set of renters and they’ll help to show the apartment off to new prospective tenants. Demand for all these services was hit hard by covid. Because of covid, people weren’t moving apartments, they were staying put. As well, the eviction moratorium meant that landlords couldn’t kick out tenants that weren’t paying their rent. Landlords have been struggling financially and have cut back sharply on all expenses, including all non-emergency repairs. The end result has been that profits are down significantly at BGSF. The company is still making money thanks to its industrial and professional divisions, but the real estate division has really been dragging things down.
Looking back a year or two, things look more promising. Pre-covid, the company was earning $1.32 per share. At the current share price of $12.50, that gives the stock a p:e of 9.5. Earnings have dropped in half since then, but if they were to recover, that would look like a reasonably attractive valuation. Debt is a little higher than I’d like at around 3 times pre-covid earnings and the company has no tangible book value to provide a safety net, but then nothing’s perfect, is it?
Eviction moratoriums are due to lift at the end of this month and the company says they expect to see some pent-up demand materialize for their services when this happens. As the economy reopens, people will start to move again. Surging home prices may help support the rental market as well. I’ve been reading reports of big investment companies like Blackrock buying up entire new housing subdivisions as investments to rent out. Seems to me, they’ll be looking to companies like BGSF to help them manage all those new properties.
To sweeten the pot further, the company made two sizable acquisitions in the months immediately preceding the onset of covid, both in the technology services space. In their pro forma results, the company said EPS would have been closer to $1.46 in 2019 if the earnings from these two acquisitions had been included in their results for the full year. The full benefit of these acquisitions have largely been hidden from view so far as the covid downturn followed right on the heels of these new additions, but as we emerge from this crisis, they could provide a nice boost to profits. If you use that pro forma earnings figure of $1.46 for your normalized earnings estimate, then the p:e ratio at the current share price drops to an even more appealing 8.6.
For those of you into collecting dividends, this company did pay quite a substantial dividend pre-covid. The dividend has been cut now to conserve cash but if it were to get reinstated at previous levels of $1.20 per share that would provide a juicy yield of around 10%.
While I think there is a lot to like at this company, I do have a few misgivings. Staffing companies are notoriously cyclical. They do well when the economy is booming and businesses are hiring and they do poorly when the economy is in a funk. BGSF is a relatively new company. They have grown rapidly over the last 10 years through a series of acquisitions. They went public after the last recession in 2008 so there is no historical financial data to shed light on just how they might perform during the next major recession (as opposed to the current bizarre uncession). Looking at two of their larger, publicly traded competitors, Kelly Services and Manpower Group, the picture is not reassuring. Both of these companies struggled mightily during the last business cycle and the long, slow recovery from the great financial crisis of 2008. 10 years later and profits at these two staffing companies were barely above the levels they reached at their peak in 2007. If we saw the same dynamic play out over the next 10 years, that would not bode well for BGSF. However, BGSF is much smaller than these two competitors and is more narrowly focused on a few profitable niches. It’s profit margins are consistently higher and while I’m just guessing here, it seems to me that apartment rentals could be a relatively stable and less cyclically sensitive sector.
My other concern is their rapid growth through acquisition. Since 2011, they’ve grown their revenue by a factor of 5 through a series of multiple acquisitions. (This has been funded largely through equity so per share growth has not been nearly as impressive.) This kind of rapid growth through acquisition can create headaches down the road if these acquisitions aren’t properly integrated. Problems can get papered over and the Frankenstein conglomeration of different bolted-together businesses can become ungainly and cumbersome. On the flip side, the temporary staffing sector is a very large, fragmented sector and many companies have pursued a roll-up strategy in these types of fragmented sectors to great effect. They took a modest write-down of some of their acquired goodwill last year but otherwise do not have a track record of making recurrent write downs the way some companies do. I’ll be watching future write-down activity to get a sense of whether they are amortising all their acquired goodwill and intangibles appropriately.
Right now, they say they are seeing heavy demand for some of their services but are being constrained by a lack of available workers as covid unemployment benefits keep some workers at home who would otherwise be keen to get out there and earn some money. This seems like a good news / bad news story to me and I’ll just have to wait and see how this develops.
On the whole, and despite a few lingering concerns, I like this story. The p:e, using pre-covid earnings, is low compared to the overall market. The balance sheet is not too over-extended. There seems to be an obvious short-term catalyst to provide a lift to the company’s fortunes as eviction moratoriums come to an end and the economy reopens, and the acquisitions done immediately before the downturn could provide an unexpected boost to earnings as we emerge from the other side of this pandemic.
Unwilling to part ways just yet with any of my other portfolio holdings, I played a game of musical chairs and sold off dribs and drabs of some of these other positions to make room for this new entrant in the portfolio.
Full disclosure: I own shares in BGSF Inc.