Pick carefully on the support services

Feb 11 2009 by Iain Laing, The Journal

WITH good economic news still in very short supply, the hunt is on to identify ‘defensive’ sectors best positioned to survive a downturn.

Support services (security, staffing, distribution etc) are traditionally seen as being, at least in part, such a sector. This is partly due to an assumption that Government contracts (important for many firms in the sector, but not all) will be maintained, even in a relatively severe recession. Other perceived support services strengths include a belief that demand for some of the sector’s output (eg security) will not be reduced by economic woes, and an expectation that in difficult times more and more firms across the economy as a whole will attempt to cut costs through outsourcing.

Because of this belief in the support services sector’s ‘defensive’ strength, the sector traditionally trades at a premium to the market. Recent events have added support to this belief. Strong performances in outsourcing and security sub-sectors helped the support services sector as a whole to significantly outperform the market in 2008. As a result, the share price premium to the market has risen yet further.

But it remains important to realise that all support services firms are not the same – this is a sector that covers a range of different industries. Some of these industries will be better placed to ride out a downturn than others. And different firms within these sub-sectors have varying prospects, too.

One interesting option is the UK firm, Serco. This is a highly diversified business, providing (amongst many other things) prison management, school services, business process outsourcing, military communications, railway operations and air traffic management. But the key unifying factor is that the core business is in the public sector, offering long-term contract-based, critical services. In fact, some 90% of the company’s revenues are derived from the public sector, and the average duration of the company’s contracts is 10 years – reducing the potential for short-term upset. Higher public spending should, as for many other support service companies, also help matters.

G4S (formerly known as Group 4 Securicor) offers a rather narrower range of services, but is another company where recent acquisitions should help bolster future growth.

However, many of the more cyclical companies in the sector may not yet make good investments – despite their apparently attractive valuations. For many of the staffing and hygiene companies, future dividends may be at risk. And, while the support services sector as a whole is characterised by relatively low operational gearing and debt levels, this is not the case for several sub-sectors (notably component distributors and hygiene companies.) So, in summary, support services may well appear attractive investments at present – but pick carefully.

Andrew Miller is regional head of Barclays Wealth