John Lynch Chief Investment Strategist, LPL Financial
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S&P GICS sectors to undergo a significant makeover later this month. Effective September 28, S&P Dow Jones Indices will make significant changes to its Global Industrial Classification Standard—referred to as GICS. Index provider MSCI will follow with its own updated indices in early December. Reclassifying companies into different sectors may not sound like a big deal, but this one will be quite meaningful—even more so than the addition two years ago this week of real estate as an S&P GICS sector. Here we discuss the implications of creating the new communication services sector and changes to the consumer discretionary and technology sectors.
WHAT’S HAPPENING
About three weeks from now, the telecommunication services sector will be greatly expanded and renamed “communication services.” The stocks that will be added to the expanded sector are mostly media and internet companies within the consumer discretionary and technology sectors, with a focus on digital advertising and social media. In fact, after the changes, three of the original four “FANG” stocks (Facebook, Amazon, Netflix, and Google) will be part of the new communication services sector.
The information technology sector, which will be impacted most, will see about 5 percentage points trimmed from its current 26% weight in the S&P 500 Index. The haircut for consumer discretionary will be smaller at just under 3 points (from 12.8% to 10.1%), and is tempered by eBay’s move from technology to consumer discretionary. The end result is that the S&P 500 Index weighting for the telecom services sector—rebranded as communication services—will increase from 2.0% to 10.1% [Figure 1]. Given that more than 8% of the S&P 500 is being reclassified, these changes will have the biggest impact on the sector landscape in the history of the GICS.
WHY DOES THIS MATTER?
For some, this may not be such a big deal. For those investing solely with active mutual funds in the traditional asset classes (small caps, large caps, growth/value, and international), this change may not affect you at all. But for those of you who invest by sector, including using sector exchangetraded funds (ETFs), we think this change may be significant for several reasons:
We lose a defensive sector. Historically, telecom has been considered a defensive sector, meaning its prospects were less dependent on economic growth than the more cyclical, or economically sensitive, sectors. In a weakening economy, consumers tend to forego more discretionary purchases before they give up their cell phones. As a result, telecom stocks—along with consumer staples, real estate, and utilities—have tended to be less volatile than the broader market during sell-offs. The sector’s makeover will significantly increase its volatility because more stocks that are sensitive to the fluctuations in the economy and stock market are being added and overwhelming the more defensive dividend-paying stocks that made up most of the legacy telecommunication services sector. The sector will enjoy stronger growth prospects—the average consensus long-term earnings growth forecast is 13% for stocks (FactSet data) that will make up the communication services sector, well above the 3% growth rate for the legacy sector. Investors will have to pay up for that significantly enhanced growth outlook, however, as the sector’s next 12 month price-to-earnings ratio (PE) will increase from 10 to approximately 24 (FactSet data, as of August 29).
Technology may be lower octane. Some of the digital advertising and social media stocks that are leaving the technology sector are high-fliers. Losing these historically faster growing technology leaders may dampen the growth prospects for the technology sector, but it also slightly reduces valuations. The five technology companies leaving the sector have an average consensus longterm growth rate of 17%, compared with 14% for the sector overall. But those stocks carry an average PE of 29, compared with 19 for the sector (FactSet data). Also keep in mind the smaller technology sector will be more concentrated in its largest holding: Apple.