Written by Rick Welch
A sector is an industry classification or grouping of companies sharing common characteristics. The most common structure of industry sectors, the Global Industry Classification Standard or GICS, divides the equity universe into eleven major sectors: Communication Services, Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate and Utilities. A focus on industry sectors can provide the investor with a clearer understanding of where stock price returns are generated. A sector rotation strategy provides an efficient means to adjust equity weightings within a portfolio based on an understanding of where we are in the current business cycle. As the economy moves through a cycle, sectors will often perform differently causing them to move out of sync with each other. Sectors provide many benefits, including their typically static composition, clear patterns of volatility and low correlation to each other. Since the development of GICS in 1999, there has been just one change to the number of sectors, that being in August of 2016 when Real Estate (a member category within Financials) was removed and became the eleventh sector. More recently some major changes were made to GICS which saw the expansion of the Telecommunication Services sector to include companies from the Consumer Discretionary and Information Technology sectors and then its renaming as Communication Services. The impact of this change was the largest in the history of GICS as it required the reclassification of more than 10% of the S&P 500 Index (by market cap) and involved 26 S&P 500 stocks of which 16 were Consumer Discretionary, 7 were Technology and 3 were Telecommunication. For equity portfolios which focus on industry sectors, rebalancing will be required in order to minimize tracking error and properly account for stock-specific and industry-specific risk of the individual companies and sectors involved in this reclassification.
In explaining the reason for the recent change to GICS, Brad Sorensen of the Schwab Center for Financial Research offered this, “technology has advanced to the point that a line should be drawn between those who use technology and those who produce technology. This change should be a positive one for investors as constituent relationships within sectors become more accurate.” With the reclassification, the new Communication Services sector will include existing Telecommunication sector companies (like AT&T and Verizon), selected companies from the Consumer Discretionary sector (including Charter Communications, Comcast, Netflix, Time Warner and Disney) and selected companies from the Information Technology sector (including Alphabet and Facebook). Coincident with these changes will be the reclassification of eBay from Information Technology to Consumer Discretionary. Tech heavyweights Apple (Information Technology) and Amazon (Consumer Discretionary) were not affected by the GICS reclassification. After the changes, the Communication Services sector will see its weighting within the S&P 500 Index grow from 3% (for old Telecommunication Services) to about 10%. Previously many investors considered the old Telecommunication sector as a bond proxy due to a rich dividend yield (about 5%) and low beta (0.55) to the S&P 500 Index. No longer. The new Communication Services sector will be more sensitive to the equity market (beta of 0.98) and less sensitive to changes in the benchmark US 10-year Treasury yield. The new sector will provide investors with a more growth-oriented exposure that will trade at a higher P/E ratio (16.7) compared to that of the old Telecommunication sector (7.1). An examination of historical growth rates together with consensus forward-looking projections suggest that the new Communication Services sector has been constructed of a portfolio of stocks that have produced, and will continue to produce, above trend earnings and revenue growth for years to come.