It looks like the proverbial apple cart is going to be upended for sector investors in 2018.

Come September, S&P® Dow Jones® Indices and MSCI Inc. are changing the Global Industry Classification Standard (GICS®) structure and reclassifying selected companies. When these changes become effective, they will create a new landscape of growth-oriented exposures and the need for sector investors to alter their due diligence.

While there will still be 11 GICS sectors, the Telecommunication Services sector will be renamed Communication Services. Along with its new name, its profile will be expanded to include companies from Consumer Discretionary and Information Technology, which will add growth to a sector that has traditionally been seen as a value play.1

To explore the potential impact of these shifts on sector investing, we performed an analysis of new sectors based on the currently known list of large-cap companies expected to be impacted by the upcoming changes. To create the new sectors, we reallocated these companies to their new sectors and then weighted them by market cap. Next, 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 resulting five charts illustrate how these changes will likely impact GICS sectors and sector investing going forward.

Telecommunication Services gets a makeover

The new Communication Services sector will include companies that facilitate communication and offer related content and information through various types of media. This is an upgrade of the Telecommunication Services sector, allowing it to reflect modern communication activities.

The revamped sector will include existing telecommunication companies, such as AT&T, as well as former media-related Consumer Discretionary stocks, such as Netflix, and consumer internet-oriented Information Technology stocks, like Facebook.

This means FAANG (Facebook, Apple, Amazon, Netflix and Google) will be redistributed across three sectors as opposed to two. The Communication Services sector will represent around 10% of the S&P 500® Index market cap, compared with the 2% weight of the current Telecommunication Services sector.

Source: FactSet, as of 1/11/2018. Characteristics are as of the date given and should not be relied upon as current thereafter.

More growth options for sector investors

Historically, the Telecommunication Services sector was viewed under a “value” lens due to its number of bond-proxy, high dividend paying stocks. However, certain high-flying FAANG stocks will be removed from Consumer Discretionary and Information Technology to join Communication Services.

This means Communication Services may be viewed under the “growth” lens based on a style exposure analysis we conducted using Morningstar Style Box classifications. As shown below, Telecommunication Services is currently classified 100% as a value sector. When it becomes Communication Services, it will hold a majority—57%—of growth stocks, as shown in the chart below.

But these changes do not completely strip growth from Consumer Discretionary and Information Technology. They will have a 58% and a 49% allocation to growth stocks, respectively—figures that are higher than the broader market.

Source: Morningstar, FactSet, as of 1/11/2018. Characteristics are as of the date given and should not be relied upon as current thereafter.

The Fundamentals of Change: Higher growth, lower leverage at attractive relative valuations

Communication Services’ growth tilt is reinforced when examining the historical growth rates of its underlying companies and their consensus analyst estimates for the next three to five years.

Shown below, the new sector will result in a portfolio of stocks that have produced—and are expected to produce—a high level of earnings and sales growth. These growth rates are projected to be above that of the broader market.

The new sector will also have far less leverage, as measured by the long-term debt-to-capital (LTC) percentage. Its LTC will be 28% vs. its current rate of 62%. But the leverage profile of the other two sectors only shifts slightly, with Consumer Discretionary rising from 51.4% to 52.7% and Information Technology increasing from 30.3% to 37.4%.2

Source: FactSet, as of 1/11/2018. Characteristics are as of the date given and should not be relied upon as current thereafter. Estimated growth rates based on Consensus Analyst Estimates compiled by FactSet.

Growth at what cost?

This raises the question: What is the price associated with these new growth dynamics? To answer this we chose four fundamental metrics, while also comparing the current aggregated sector level Price-to-Earnings (P/E) ratio versus the same group of stocks historical average P/E ratio over the past ten years. The latter point may provide insight into whether the new sector will be more expensive, fundamentally speaking, versus what history would indicate.

As shown below, the Communication Services sector trades at higher multiples than the old sector while the other two sectors’ fundamentals remain largely the same. Compared to the 10-year average, all new versions of the sectors are trading above their historical average. However, when each sector is viewed relative to the market, a relative value opportunity exists, as each sector is trading at a lower premium to the S&P 500 than their historical average over the last 10 years.

Source: FactSet, as of 1/11/2018. Characteristics are as of the date given and should not be relied upon as current thereafter.

Macro sensitivity

Sectors are also closely aligned to specific economic variables. The table below shows the beta of the new and current sectors based on sector constituents’ beta. The Communication Services sector will be more sensitive to the broad market, less negatively sensitive to the US dollar while more positively sensitive to the US 10-year Treasury yield. While the latter move is small, it illustrates that this new set of communication stocks will not be the typical bond proxies of the current telecommunication sector.

The Communication Service’s shift in beta sensitivity to the US dollar is representative of its increased tech-like global footprint. The previous sector had only 2.9% of foreign sales. The new one will have 32%.3

Source: FactSet, as of 1/11/2018. Characteristics are as of the date given and should not be relied upon as current thereafter.

Sector due diligence will need an upgrade

These upcoming GICS changes mean sector growth opportunities will become more widespread. They also mean the Communications Services sector will be more cyclical than Telecommunication Services, which was more defensive.

Unfortunately, this sector revamp also means performing a bottom-up fundamental analysis or a top-down macro analysis will become harder. 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. Trend following rotation strategies will also have to course-correct given that the new Communication Services sector will have 13 constituents that rank in the top 50% of performers in the S&P 500 over the past year4—while the old Telecommunication Services sector had none.

Stay tuned to SPDR® Blog and our Sector Dashboard as we continue to track the implications of these GICS changes on sector investing as their September implementation nears.

1“S&P Dow Jones Indices and MSCI Announce Revisions to the Global Industry Classification Standard (GICS) Structure in 2018,” msci.com, as of 11/15/2017 
2FactSet, as of 1/11/2018
3FactSet, as of 1/1/2018
4FactSet, as of 1/11/2018

Definitions

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.

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.