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Consulting Services Outlook: Long-Term Prospects Encouraging

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The consulting services industry is benefiting from overall strength in manufacturing and non-manufacturing activities backed by all-around strength in the economy.

Economic activity in the manufacturing sector expanded in May as Purchasing Managers' Index (PMI) measured by Institute of Supply Management (ISM) touched 58.7%. This shows strong growth in manufacturing for the 21st consecutive month, driven by continued increase in new orders, production activity and employment.

The ISM non-manufacturing index (NMI) was 58.6% in May, recording the 100th consecutive month of expansion. The expansion was driven by continued increase in business activity, new orders, employment, inventories, prices and supplier deliveries.

Out of the 18 non-manufacturing industries, 14 reported growth. The Non-Manufacturing Business Activity Index registered growth of 61.3% in May, up 2.2% from the April reading of 59.1%, growing for the 106th consecutive month.

However, higher talent costs due to a competitive talent market coupled and Trump’s stringent policies on immigration are hurting consulting services stocks. The industry is labor intensive and heavily dependent on foreign talent. Moreover, while advancement in automation and AI offer massive opportunity to the industry, these technologies enable clients to comprehend and integrate new methods to improve performance, thereby creating uncertainty for consulting services firms.

Industry Outpaces Sector and S&P 500’s Yield

Looking at shareholder returns over the past year, it appears that the border economic recovery is enhancing investors’ confidence in the industry.

The Zacks Consulting Services Industry, which is a stock group within the broader ZacksBusiness Services Sector, has outpaced the S&P 500 and its own sector in the past year.

While the stocks in this industry have collectively gained 24.5%, the Zacks S&P 500 Composite and Zacks Businss Services Sector have rallied 12% and 19.1%, respectively (the blue line in the chart below represents the industry).

One-Year Price Performance

Consulting Services Stocks Look Expensive

The share price rally in the past year has, however, led to a relatively rich valuation.

Comparing the industry to the S&P 500 on the basis of price to forward 12 months’ earnings, we see that the industry’s 22.2X is ahead of the S&P 500’s 16.7X. It is ahead of the sector’s 22.3X.

Price to Forward 12 Months

Comparing the industry to the S&P 500 on the basis of price to forward earnings growth, we see that the industry’s 2.1X is again ahead of the S&P 500’s 1.8X. It is also ahead of the sector’s 2X.

Price to Forward Earnings Growth

Price to EBITDA

Comparing the industry to the S&P 500 on the basis of price to EBITDA, we see that the industry’s 12.34X is again ahead of the S&P 500’s 12.33X. It is also ahead of the sector’s 11.7X.

So any way you cut it, the industry is overvalued.

Improving Economy Confirms Near to Mid-Term Outperformance

The macroeconomic drivers such as improving economy, reduced tax rates, robust manufacturing and non-manufacturing activity, and higher government spending are likely to offset operating challenges encountered by the industry.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. The earlier valuation discussion shows that market participants are willing to pay up for these stocks already, potentially limiting further upside from current levels.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is its earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for the industry and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.

 Price and Consensus: Zacks Consulting Services Industry