The business services industry is in good shape as it is firmly tied to the health of the broader economy, which is currently quite favorable. U.S. GDP growth in the second quarter almost doubled from the first quarter. Higher wage growth, a tightening labor market and a low unemployment rate indicate a bullish economy.
Further, following the tax reform, U.S. companies are pouring tax savings into growth initiatives. This is aiding both manufacturing and non-manufacturing activities, thereby spurring demand for business services.
While new business growth, job growth and increasing corporate involvement have been benefiting the industry, heightened trade war tensions are a concern. Moreover, higher talent costs due to a competitive talent market and Trump’s stringent policies on immigration are hurting certain business services stocks. Further, owing to operations across the globe, service providers face regulatory hurdles and compliance-related issues.
Industry Outpaces Sector and S&P 500’s Yield
Looking at shareholder returns over the past year, it appears that the broader economic recovery is enhancing investors’ confidence in the industry.
The Zacks Business - Services Industry, which is a stock group within the broader Zacks Business 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 22.5%, the Zacks S&P 500 Composite and Zacks Business Services Sector have rallied 17.9% and 22.2%, respectively (the blue line in the chart below represents the industry).
One-Year Price Performance
Business Services Stocks Look Expensive
The strong run in share prices over the past year have, 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 23.12X is ahead of the S&P 500’s 17.32X. It is also ahead of the sector’s 22.99X.
Comparing the industry to the S&P 500 on the basis of price to forward earnings growth, we see that the industry’s 2.06X is again ahead of the S&P 500’s 1.88X. It is also ahead of the sector’s 2.05X. So any way you cut it, the industry is overvalued.
Outperformance May Not Continue
While growth in both manufacturing and non-manufacturing activities has been aiding the industry, heightened trade war tensions remain an overhang. Increasing U.S. protectionism is hurting growth prospects of this industry.
So, 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 have been willing to pay up for these stocks already, potentially limiting further upside from the current levels.
One reliable measure that can help investors understand the industry’s prospects for a solid price performance going forward is the industry's 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: Business - Services Industry
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Please note that the $2.83 EPS estimate for the industry for 2018 is not the actual bottom-up EPS estimate for every company in the Zacks Business – Services industry, but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the earnings of $2.83 per share of the industry for 2018, but how this number has evolved recently.
Current Fiscal Year EPS Estimate Revisions
As you can see here, the $2.83 EPS estimate for 2018 is down from $3.03 at the end of March and $3.07 at the end of August 2017. In other words, the sell-side analysts covering the companies in the Zacks Business - Services Industry have been steadily decreasing their estimates.
Zacks Industry Rank Indicates Gloomy Prospects
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.
The Zacks Business Services industry currently carries a Zacks Industry Rank #190, which places it at the bottom 26% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
Our proprietary Heat Map shows that the industry’s rank has been volatile over the past six weeks and has remained among the bottom 50% all through.
Industry Promises Long-Term Growth
While the near-term prospects do not look welcoming for investors, the long-term (3-5 years) EPS growth estimate for the Zacks Business – Services industry appears promising. The group’s mean estimate of long-term EPS growth rate is at the current level of 12.25%, same as that of the Zacks S&P 500 composite.
Mean Estimate of Long-Term EPS Growth Rate
In fact, the basis of this long-terms EPS growth could be the recovery in the top line that Zacks Business - Services Industry has been showing since the beginning of 2003.
A strong U.S. economy, reduced tax rates, robust manufacturing and non-manufacturing activities and higher government spending should support growth of the industry in the long run. However, shortage of skilled labor, higher talent costs and Trump’s strict rules on immigration will act as hurdles in the short run.
Since the near-term prospects of the industry do not appear encouraging, it will be prudent to stay away from some weak stocks that are likely to underperform.
Xerox Corporation (XRX - Free Report) : The Zacks Rank #4 (Sell) stock has lost 13.8% over the past year. The Zacks Consensus Estimate for current-year EPS has declined 5.4% in the past 60 days.
One-Year Price Performance: XRX
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
DCC plc (DCCPF - Free Report) : The Zacks Rank #4 stock has lost 0.6% over the past year. The Zacks Consensus Estimate for current-year EPS has declined 4.6% in the past 60 days.
One-Year Price Performance: DCCPF
Sodexo S.A. (SDXAY - Free Report) : The Zacks Rank #4 stock has lost 8.5% over the past year.
One-Year Price Performance: SDXAY
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