Making sense of the sector dimes
There are two major takeaways from this analysis:
1. Low foreign revenue, stick with the sector: Sectors with low foreign revenue—Utilities, Real Estate, and Financials—have negative spreads between domestic and foreign medians. The level of foreign earnings is just too small to create intra-sector dispersion based on the level of single-stock foreign revenue exposure. While the sector, overall, benefits from a low foreign revenue exposure, picking single stocks based on this theme does not add any noticeable benefit based on this analysis.
Key takeaway: In this case, there are limited opportunities down the sector spectrum for the areas noted above. Investors are likely better off staying at the sector level to position for the current environment of a stronger dollar and heightened trade tensions for these sectors.
2. High foreign revenue, focus on domestically oriented areas within the sector: For some sectors, focusing on more domestic firms vastly improves the earnings sentiment within that sector. This is apparent in two sectors: Communication Services and Technology.
Take Communication Services, for instance. While roughly half its market cap has ≥50% of revenue from overseas, there are still opportunities from firms with more domestic revenue. The spread between growth rates for both Q1 and Q2 between these domestically versus foreign-oriented revenue firms is the highest out of any sector at 50.45% and 35.73%, respectively. Not only is growth high but sentiment is also strong, with the earnings per share (EPS) growth change differential between Communication Services sector firms that have ≤50% of foreign revenue relative to those with ≥50% of foreign revenue at a staggering 23%. This is not a result of significantly improved Q2 expectations for the more domestic firms (as their isolated change rate was a -2.4%), but rather sidestepping the brutal negative 30% change in expectations from firms with ≥50% revenue overseas.
Key takeaway: The Communication Services sector is dominated by some bellwether names, like Google, Facebook, and Netflix. Two out of those three names (Google and Facebook) have revenue of ≥50% from overseas. But there are more domesticated names further down the cap spectrum, largely residing in the media and entertainment industry (similar to Netflix). Therefore, look for this sector to experience outsized volatility during this earnings season as headline sentiment from the big names collides with potential strength from the smaller domestically oriented firms. Given both active long-only managers and hedge funds are overweight to this sector relative to the S&P 500,1 it will definitely be an area to watch if stock pickers were able to derive alpha through stock selection within the sector.
Technology is another sector with this profile. But where do these firms reside? Using a similar analysis, we examined the median metric for sub-industries in tech. We found that sub-industries with high foreign revenues (e.g., semiconductors) have vastly negative performance and earnings trends. Meanwhile, more domestic areas, like the services and software industries, have had much better performance and earnings sentiment.