Telecom’s usual value play will become more growth-oriented come September, as the S&P® Dow Jones® Indices and MSCI Inc. implement changes to the Global Industry Classification Standard (GICS®) structure. Under the changes, certain companies from Consumer Discretionary and Information Technology sectors will be combined with the existing Telecommunication Services companies to form the new Communication Services sector. With more than 8% of the S&P 500 Index Market Cap being re-classified, the changes will have the biggest impact on the sector structure in GICS history.1 This will create a new landscape of growth-oriented exposures and the need for investors to reconsider their sector investing due diligence approach.
To explore the potential impact of these shifts on the new sector growth, valuation, quality and macro sensitivity, we conducted analysis based on the announced list of large-cap companies expected to be impacted by the upcoming changes. We reallocated these companies to their new sectors and weighted them by market cap. Then, we took a bottom-up approach, capturing historical information at the stock level and aggregating it at the sector level. This allowed us to avoid back testing—our analysis represents historical information repackaged under a different label.
The New Communication Services Sector
The new Communication Services sector upgrades the Telecommunication Services sector to better reflect modern communication activities. The new sector will include companies that facilitate communication and offer related content and information through various types of media, such as Comcast, News Corp, Netflix, Google and Facebook. The new sector will be comprised of approximately 31% Consumer Discretionary, 50% Technology and 18% Telecommunication stocks based on their current GICS sector classification.
The changes will also boost the presence of Communication Services and reduce the weight of the Technology sector in the S&P 500 Index, as shown in figure 2.
More Growth Options for Sector Investors
The Telecommunication Services sector was historically viewed under a “value” lens due to its number of bond-proxy, high dividend paying stocks. However, when it becomes Communication Services, it will hold a majority of growth stocks from Consumer Discretionary and Information Technology. (See Figure 3) Based on bottom-up sector fundamentals, as shown in Figure 4, the new Communication Services sector have also exhibited higher historical and projected growth.
Growth at What Cost?
To answer this question, we compared valuation multiples of the current and new sectors, as well as the bottom-up Price-to-Earnings (P/E) ratio of new sectors versus the same group of stocks historical average.
As shown in Figure 5, the new Communication Services and the Consumer Discretionary sectors are trading at higher multiples than the old sector while tech valuations remain largely the same. However, a value opportunity exists in the new Communication Services, as the new sector is trading below its 15-year average P/E and at a greater discount to the S&P 500 than its historical average.
Impact on Sector Quality
The ROE of Telecommunication Services has historically been volatile. Part of the reason is the sector’s high financial leverage. As shown in Figure 6, the new sector will have far less leverage, measured by the long-term debt-to-capital ratio. As its ROE comes down from an abnormally high number, relying less on leverage makes it potentially less volatile. Meanwhile, the operating margin for the new sector will be higher, indicating greater profitability from ongoing business.
Changes Nix Communication Services as a Bond Proxy
The new set of Communication Services stocks will not be the typical bond proxies like the current Telecommunication Services. Note that the Communication Services sector will be more sensitive to the broader equity market and less sensitivity to the US 10-year Treasury yield. This is no surprise, given that the dividend yield of the new sector is less than 2%, compared to more than 5% for the current Telecommunication Services sector.3
Time to Upgrade Your Sector Due Diligence
These upcoming GICS changes mean sector growth opportunities will become more widespread. The new Communications Services sector also will be more cyclical than Telecommunication Services.
Unfortunately, this sector revamp also means performing a bottom-up fundamental analysis or a top-down macro analysis will become more difficult. Investors can no longer simply run a screen based on historical values because the Informational Technology sector from the last ten years will look different for the next ten. Momentum-based sector rotation strategies will also need to course-correct given that the new Communication Services sector will have 11 constituents that rank in the top 50% of performers in the S&P 500—while the former Telecommunication Services sector had none.4
1 Bloomberg Finance L.P., as of 02/28/2018.
2 FactSet, as of 02/28/2018. The broad market is represented by the S&P 500 Index.
3 FactSet, as of 02/28/2018.
4 FactSet, as of 02/28/2018.
Beta: Measures the volatility of a security or portfolio in relation to the market, usually as measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
Global Industry Classification Standard (GICS): A financial-industry guide for classifying industries that is used by investors around the world. The GICS structure consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries, and Standard & Poor’s (S&P) has categorized all major public companies into the GICS framework.
Price to Book (P/B): A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities.
Price to Cash Flow (P/CF): A valuation metric that compares a company’s cash flow per share against its current share price.
Price to Earnings (P/E): A valuation metric that uses the ratio of the company’s current stock price versus its earnings per share.
Return on Equity (ROE): The amount of net income returned as a percentage of shareholders equity.
S&P 500 Index: The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.
Sector Rotation: Sector rotation is a strategy based on moving investments across business sectors to take advantage of cyclical trends in the overall economy whereby a portfolio may overweight positions in strong sectors and underweight positions in weaker sectors.
Yield Curve: Graphs the yields available for bonds of equal credit quality and different maturity dates.
The views expressed in this material are the views of Matthew J. Bartolini and Anqi Dong through the period ended February 28, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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