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Magic Formula Business Sector #1: Business Services

Coming in at #1 in our Magic Formula Business Sector Rankings is the Business Services sector. This sector accounted for 778 stock days dividend amongst 33 different stocks - far and away the most of any sector. The industry breakdown looks like this:

Morningstar IndustryStock DaysUnique Stocks
Business/Online Services1978
Employment1567
Consultants1476
Engineering & Construction693
Printing562
Advertising351
Business Support352
Transportation - Misc281
Security Services281
Data Processing251
Waste Management21

The top 3 industries clearly dominate this sector's presence in the Magic Formula, so this article will focus on them, and then provide some quick insights on the remaining industries. One common thread between all of these industries is that their customers are businesses instead of consumers. This is advantageous to the investor for 2 reasons. First, businesses tend to be less price sensitive, and will pay more (often much more) for services than consumers will. Second, business services are "stickier" than consumer services. For example, canceling that Netflix (NFLX) subscription or changing your lawn service doesn't really alter your life that much. However, once a business has committed to a particular payroll processor, changing it is more difficult because the time and effort in initiating the change and then fixing inevitable problems forces the new payroll provider to offer very significant cost savings or other benefits.

Business/Online Services

Companies in the Business/Online Services industry were primarily enterprise software providers whose products focused primarily on internet based interaction. Examples are Microstrategy, a business intelligence software provider; Computer Programs and Systems (CPSI), a provider of medical record software for hospitals; and Travelzoo (TZOO), providing travel oriented services booked online.

The business models for these providers differ greatly. Some actually install entire systems (hardware and software), train employees, run maintenance contracts, etc., while others are simply a stand alone service that businesses can use on a one time or repeating basis. As you may have guessed, the former is a MUCH more attractive business. Besides the recurring revenue earned from maintenance and support, the customer has likely spent significant time and resources to evaluate competitors, learn the system, incorporate their data into the system, etc. This creates tremendous lock-in benefits that provide the vendor with a significant moat. These make nice investments if you can find them, and I'm always on the lookout for these situations to recommend to members as Top Buys.

Employment

This industry is pretty self-explanatory. Companies in the Employment area provide temporary or contract labor, usually specializing in certain competencies. Magic Formula examples include Resources Global Professionals (RECN), providing highly trained accountants, and Kforce (KFRC), who specializes in technical labor such as programmers and networking specialists.

Clearly, the Employment industry has been sold off by the market due to recession fears reducing the demand for temporary hiring. The Magic Formula loves employment providers as the nature of this business is very low capital, relying more on human resources than capital resources. However, this is not a field with many natural moats. There is no lock-in effect here as there is in some other business services - a client can just as easily switch to a competitor for contractors. The only true competitive advantage to be gained here is reputation, which famously "takes a lifetime to build and a moment to destroy". Still, cheap is cheap, and many employment providers trade with the job market, making them decent cyclical plays.

Consultants

Ah, Consultants. This has to be one of the best industries to evolve from the technology boom of the late 1990's. Consultants are companies that learn how industry leaders do things, and then sell that knowledge to the laggards, in effect. Sometimes they will even help implement the solution, for a fee of course. This is another business model that is tailor made to fit the Magic Formula parameters. Consultants' primary assets are their knowledge base, people, and reputation - all non-capital assets that don't really show up on a balance sheet. While most of these firms are technology based (such as MFI pick Diamond Technology - DTPI), many others advise companies on how to find and hire executives or implement businesses processes like accounting or human resources.

Moat building for Consultants is somewhat similar to employment firms, in that reputation is an important factor. However, it was mentioned above that reputation is just one of the primary assets. Knowledge base is an important asset, and consulting firms with a wide breadth or depth of knowledge certainly have a leg up on the competition. For example, MFI stock Accenture (ACN) has consultants in a wide variety of fields, from IT to accounting to human resources. Large, global firms are more likely to use a single consultant for these problems than to divvy up the work among 3 different ones.

The Rest...

Some of the other industries in the table at top do have attractive moat characteristics, but are not well suited for the Magic Formula unless they get *really* cheap, due to fairly high capital requirements. Waste Management, for example, is a very attractive business from a moat standpoint. Landfills are rare and governments are unlikely to authorize new ones (due to the "not in my back yard", or "NIMBY", effect), so waste companies that own the existing ones can charge large dumping fees to competitors that don't. Data Processing and Business Support firms enjoy many of the lock in characteristics native to the generic business services companies.

The least attractive industry in this group is clearly Transportation. This is one of the most capital intensive industries in the entire market. Buying and maintaining aircraft, tractor trailers, rail lines, or ships is a hugely expensive and never ending concern. These high fixed costs also hurt in a recession, as the company is unable to cut costs to compensate for reduced revenues. Airlines are famously one of the worst industries in history for investment. On the bright side, the Magic Formula keeps you away from these poor businesses.

Business Services - Conclusion

We've seen in this article why businesses make better customers than consumers, at least from an investor's point of view. It's also clear that service providers that weave their way into the fabric of their customer's operations enjoy wider moats than those services that businesses can cut or just choose not to use. Clearly the different industries of the Business Services sector have starkly different capital requirements and moat potential, but in general this is a very ripe field for good investment opportunities.

Magic Formula Business Sector Countdown

#9 - Energy

#8 - Software

#7 - Media

#6 - Consumer Services

#5 - Hardware

#4 - Industrial Materials

#3 - Consumer Goods

#2 - Healthcare

#1 - Business Services

MFI Business Sector Project

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Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

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