NSP bought

My portfolio continues to wade slowly through the rather treacly summer markets. Some of my larger holdings, notably Burford, seem to be going from strength to strength, while others, like Bioventix, are showing some (hopefully temporary) weakness. Still, slow progress is better than no progress and right now I’m feeling optimistic that the second half of the year should be a good one.

Part of the reason I’m optimistic is that there seems to be quite a bit of unnecessary pessimism out there right now. There has been some hullabaloo in the press this week about how the current bull market may or may not now be the longest in history (it depends on exactly how you define a correction). Regardless of whether this is the case, it seems that many people believe that a correction is overdue simply because the current bull market is ‘long in the tooth’. I think it’s quite natural to have this worry and for a while I have had it myself. However, on reflection it seems pretty irrational.

Stocks are still reasonably valued relative to historical averages (so actually very cheap in my opinion). It is true that the spread of valuation multiples between growth and value stocks has expanded in recent years and is well above historical averages, but I don’t think this is major cause for concern in itself. The world economy, especially the US, is in rude health with no obvious major concerns on the horizon as far as I can tell. Interest rates, while starting to rise, are still near the lowest they’ve ever been in history. The growth prospects of the technology businesses increasingly dominating the global economy still look great and they still look reasonably valued. Given all this, I’d say the current degree of pessimism seems unnecessarily high.

Another one of the reasons I’m feeling optimistic is that many of my holdings have issued positive results recently and I think the market has yet to fully respond. For example, NMC Health and Moncler have recently put out very good results with rosy outlooks, yet have been rewarded by falling rather than rising share prices. I expect this weakness to prove temporary. Churchill China and Somero have also recently issued bullish trading updates, yet have experienced bouts of share price weakness for no apparent reason. Both issue results in the next month.

I made one trade last week, selling out of AB Dynamics for a 17% profit as it started to show signs of weakness and buying a new position in Insperity.

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Insperity

Insperity is a US company that provides outsourced HR services to SMEs. Its business model is to act as a Professional Employer Organisation (PEO), whereby it jointly (with the SME) employs the workers of many SMEs and offers the complete package of HR services to them e.g. payroll, healthcare, government compliance, performance management and recruitment. This arrangement allows for greater economies of scale in providing HR functions and in accessing healthcare and related benefits at more competitive rates.

I would say that Insperity is probably not as high a quality business as many of the others on my watchlist. While it has some attractive qualities, it also has some weaknesses. However, the medium term growth opportunity looks very attractive and the current business momentum is very strong.

Quality

  • Business economics: Insperity has a capital light business model and is highly profitable. Returns on capital are fairly consistently above 30%. Returns on equity are in the triple digits. It has extremely healthy cash flows. One significant weakness is that it has a low operating margin (currently 4%) making it somewhat vulnerable to a deterioration in trading. The flip side of this is that if further growth allows for greater economies of scale as it should, this should have a very material impact in expanding margins. This has started to occur over the last few years and means that the business should benefit substantially from operational gearing, where its profits grow proportionately much faster than revenues.
  • Track record: over the longer term, Insperity has an impressive track record of growing revenues and profits. It was hit by the Financial Crisis but then more significantly suffered another lull in performance in 2013 and 2014. Since then, partly through the involvement of an activist investor (Starboard Value) Insperity has made a number of operational improvements that have substantially improved the effectiveness of its sales and marketing strategy, improved customer retention and reduced operating costs. Given Insperity’s excellent performance since 2015, I’m satisfied that the 2013 lull in performance does not indicate a major concern in the quality of the underlying business.
  • Competitive advantage: Insperity is likely to benefit from switching costs to some extent, as switching HR provider would be disruptive for many customers. Switching costs are not insurmountable and some switching does occur, though Insperity manages to achieve decent customer retention rates approaching 90%. The market for PEOs is still in its relatively early stages, in that most new business comes from customers using a PEO for the first time, rather than those switching from competitors. Nevertheless, Insperity does face competition from a number of other large players, including ADP, Paychex and Trinet. Insperity has positioned itself with a high quality, full service proposition. This is attractive to many customers, though it is potentially vulnerable to lower cost more unbundled alternatives in the future. For now, while the market is still growing rapidly Insperity’s competitive position seems pretty stable. In the longer term I do have some doubts about the sustainability of Insperity’s competitive advantage, but not sufficiently to put me off.
  • Growth prospects: the growth prospects are the main draw here. There are huge numbers of SMEs that could benefit from this service in the US and penetration of the overall addressable market looks to still be pretty low. There look likely to be several years of decent revenue growth ahead. With the benefit of decent operational gearing, profits should compound at an even higher rate. Insperity has recently expanded its offering to also target somewhat larger customers (so they no longer switch away when their business grows too big) and customers who prefer a more stripped-back lower cost offer. This should broaden its addressable market further.

Price

Momentum is excellent. Insperity has recently upgraded its expectations for this year with a very bullish outlook. The share price has steadily rocketed up over the past year and is currently making new highs. The valuation seems reasonable given the growth prospects.

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