This week, the British Chambers of Commerce warned that UK GDP growth is set to drop from 2.8% in 2006 to 2.5% this year, and then 2.0% in 2008. The main culprit? Four interest-rate rises since August 2006, along with the imminent prospect of another 0.25% hike to 5.75%. So it's no surprise that traditional cyclical stocks, such as house builders, trade on p/e ratios for 2007 of around 10-12 times. But what is puzzling are lofty valuations in the notoriously feast or famine' recruitment sector. Sure, agencies keep churning out solid updates, but if you consider the past two downturns, this cannot go on forever.
Turkey of the week: sThree (STHR), tipped as a BUY by UBS
Take sThree, a specialist staffing business with offices in the UK and Europe. It makes more than 80% of gross profits in the information, communications and technology (ICT) sector. But it is also building up other units, including banking and engineering. It runs 12 brands, the top four being Computer Futures, Progressive, Huxley Associates and Pathway. In February it released a strong set of results, buoyed by a solid jobs market and expansion into new territories. Operating profits before exceptional items leapt 39% to £41m, on turnover up 25% to £393m, with underlying earnings per share also rising 45% to 22.4p. So can things get better?
Well yes, but only in the short term at some point the hay-making has to end.
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I believe this will happen late this year or early next, particularly if the British Chambers of Commerce is correct. sThree is especially vulnerable to a UK slowdown, as it makes more than 70% of gross profits here. Its exposure to ICT could also be a major issue, as this segment suffered far more than the general staffing market last time round although this may have been due to one-offs such as the dotcom boom. Moreover, much of the IT industry is off-shoring more and more back-office jobs to places such as India and Pakistan, which in the long term could hit earnings. Finally, as a red flag to investors, there have been substantial director share sales (at Michael Page, for example) across the industry in the past six months, suggesting this is a good time to bail out.
At 505.5p the shares trade on a very full 2007 p/e ratio of more than 18.5. I would rate sThree on a p/e of 14, giving a fair value of 370p about 35% below current levels. In these fickle markets it is crucial to stay disciplined, bank profits when valuations become stretched and realise gains without becoming too greedy and now's the time to do so.
Recommendation: TAKE PROFITS at 505.5p
Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments
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