A Return of Service?
By Sam Stovall
S&P believes recent economic data suggest the domestic economy is growing, with hints of an improving job market and higher corporate spending. The impact on the nation's economy by Hurricane Katrina is likely to be limited, in S&P's view. The subindustry's momentum looks favorable, but the fundamentals don't support an aggressive stance in the coming year.
Standard & Poor's hasn't changed too much in the past few weeks. So I went in search of a possible turnaround candidate that may join its ranks in the coming months.
First, I looked for those industries that showed an improvement in their rolling 12-month relative-strength ranking in the past four weeks. Four sectors made the cut: agricultural products, biotechnology, diversified commercial and professional services, electric utilities, and semiconductors.
The next step: Find a group that posted a numerical increase in ranking and had a chart formation that looked promising. The top candidate turned out to be diversified commercial and professional services.
SURGE IN DEMAND.
What's more, this group may have some allure from a fundamental standpoint, because it may benefit from an increase in service demand as the recovery effort from Hurricane Katrina continues.
The rolling 12-month relative strength price chart (pictured ) displays a favorable pattern for the subindex. As a reminder, the jagged blue line represents the subindex's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500.
Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the subindustry index's 14-year mean relative strength.
This subindustry index consists of 20 large-, mid-, and small-cap companies that provide a variety of services to commercial customers. During 2004, this subindex underperformed the broader market, rising 5.9%, while the S&P 1500 advanced 10.0%.
Year to date through Sept. 9, this subindustry index has fallen 1.0%, while the overall market has gained 3.2%. After the group's lagging performance, I wondered if there was the potential for a lift in share prices for its companies. So I checked with S&P equity analyst Richard O'Reilly, CFA, who indicated that S&P's fundamental outlook for the group is neutral.
In general, O'Reilly says, more economically dependent commercial services outfits, including those in uniforms rental, travel, and hospitality services, performed better over the past few years after being laggards in the early part of the decade.
These companies had struggled as clients cut workforces and limited their budgets for certain services, while worries about terrorism greatly reduced domestic travel, in S&P's view.
Yet, O'Reilly says S&P believes service companies cut costs and automated operations during the economic slowdown, so when the economy finally started to rebound over the past three years, their profits rose in conjunction. S&P thinks that these operating trends will continue, although it believes that the upside potential in the stocks will be more limited.
Overall, according to O'Reilly, S&P believes recent economic data suggest the domestic economy is growing, with hints of an improving job market and higher corporate spending. The impact on the nation's economy by Hurricane Katrina is likely to be limited, in S&P's view.
O'Reilly notes that S&P sees domestic real GDP growth at 3.5% in 2005 and 3.1% in 2006, respectively, slower than the 4.2% rate of 2004. S&P expects the national nonfarm employment levels to continue increasing through 2006.
The national unemployment rate fell to 4.9% in August, the lowest in four years. S&P expects consumer spending to grow 3.6% in 2005 before slowing to a 3.0% rate in 2006.
Also, says O'Reilly, S&P expects the residential housing market to remain healthy for the rest of 2005 as mortgage interest rates are relatively low.
CASE BY CASE.
Overall, S&P sees the expected economic expansion supporting revenue growth as, for example, consumer spending, headcounts, and hotel occupancy rates rise. Based on this growth, coupled with better cost structures, S&P expects the diversified services industry conditions to improve.
O'Reilly notes that S&P thinks there are some attractive investment opportunities in this industry. One example: Uniform supplier Cintas (CTAS ), which carries an S&P investment ranking of 4 STARS (buy). That said, because of the diverse nature of the group, S&P believes each company and its respective peer group should be evaluated on its own merits.
So there you have it. In S&P's view, the subindustry's momentum looks favorable, but the fundamentals don't support an aggressive stance in the coming year.
Source: Standard & Poor's
Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of September 9, 2005.
|Construction & Engineering|
|Diversified Metals & Mining|
|Fertilizers & Agricultural Chemicals|
|Health Care Services|
|Managed Health Care|
|Oil & Gas Drilling|
|Oil & Gas Equipment & Services|
|Oil & Gas Exploration & Production|
|Oil & Gas Refining & Marketing|
S&P STARS: Since January 1, 1987, Standard & Poor's Equity Research Services has ranked a universe of common stocks based on a given stock's potential for future performance. Under proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to their individual forecast of a stock's future capital appreciation potential versus the expected performance of a relevant benchmark (e.g., a regional index (S&P Asia 50 Index, S&P Europe 350 Index or S&P 500 Index), based on a 12-month time horizon. STARS was designed to meet the needs of investors looking to put their investment decisions in perspective.
S&P Earnings & Dividend Rank (also known as S&P Quality Rank): Growth and stability of earnings and dividends are deemed key elements in establishing S&P's earnings and dividend rankings for common stocks, which are designed to capsulize the nature of this record in a single symbol. It should be noted, however, that the process also takes into consideration certain adjustments and modifications deemed desirable in establishing such rankings. The final score for each stock is measured against a scoring matrix determined by analysis of the scores of a large and representative sample of stocks. The range of scores in the array of this sample has been aligned with the following ladder of rankings:
|A-||Above Average||D||In Reorganization|
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S&P Core Earnings: Standard & Poor's Core Earnings is a uniform methodology for calculating operating earnings, and focuses on a company's after-tax earnings generated from its principal businesses. Included in the Standard & Poor's definition are employee stock option grant expenses, pension costs, restructuring charges from ongoing operations, write-downs of depreciable or amortizable operating assets, purchased research and development, M&A related expenses and unrealized gains/losses from hedging activities. Excluded from the definition are pension gains, impairment of goodwill charges, gains or losses from asset sales, reversal of prior-year charges and provision from litigation or insurance settlements.
S&P 12 Month Target Price: The S&P equity analyst's projection of the market price a given security will command 12 months hence, based on a combination of intrinsic, relative, and private market valuation metrics.
Standard & Poor's Equity Research Services: Standard & Poor's Equity Research Services U.S. includes Standard & Poor's Investment Advisory Services LLC; Standard & Poor's Equity Research Services Europe includes Standard & Poor's LLC- London and Standard & Poor's AB (Sweden); Standard & Poor's Equity Research Services Asia includes Standard & Poor's LLC's offices in Hong Kong, Singapore and Tokyo.
In the U.S.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.
As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.
5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.
4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.
3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.
2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.
1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.
Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.
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Stovall is chief investment strategist for Standard & Poor's http://www.businessweek.com/investor/pi_images/stovall.jpg