On Monday, the most widely followed U.S. equity index, the S&P 500, will re-arrange its sector classification system. Currently, there are 11 sectors across consumer, energy, financial, healthcare, manufacturing, technology and utility industry groups. Through numerous acquisitions, innovations and changes in business strategy, the lines between traditional cellular service, cable and wireless have become increasingly blurred with internet software, advertising and media. As such, the S&P 500’s Global Industry Classification Standard will eliminate the Telecommunication sector and create a brand-new sector: Communication Services.
The Communication Services sector will absorb the traditional Telecom names such as AT&T and Verizon. In addition, all companies deemed “Media” within the Consumer Discretionary sector will be transferred. These companies include streaming platforms and content originators such as Netflix, cable providers like Comcast along with studios and broadcasters such as Disney and CBS. Within Media, advertising agencies Omnicom and Interpublic have also been reclassified. However, the largest companies in this new sector, Google and Facebook, come from the Software and Services group within the Technology sector. Lastly, videogame companies Electronic Arts and Activision, currently Technology companies, will join the fold. Although this new sector includes just 20 companies, it will carry a significant 10 percent weight in the S&P 500 as Google, Facebook, AT&T and Verizon are some of the largest companies in the world.
From a business perspective, the rationale makes sense: CBS generates advertising revenue from the same customers as Google and Facebook. With AT&T’s recent acquisition of Time Warner, the telecom giant now competes with Disney in the box office. At the same time, Comcast competes with AT&T for broadband customers. Moreover, Google’s YouTube TV is challenging Netflix to win subscribers for streaming shows and movies over the internet.
While many of these companies have overlapping offerings and are battling to become “Kings of Content” to win subscribers and advertising dollars, their financial profiles differ materially. For example, AT&T and Verizon’s core business remains wireless and cellular services. These services are “mature” businesses, with growth rates at or below GDP. Because most of their profits are generated in low-growth businesses, the telecom giants are inexpensive stocks, trading around 10x earnings. Another characteristic of the Telecom companies is that they pay high dividends and are less sensitive to the macroeconomic cycle. As such, they are described as “defensive” stocks that tend to outperform during economic slowdowns and recessions.
Conversely, the Technology and Consumer Discretionary sectors are broadly understood as cyclical sectors, where their growth is tied to the economic cycle. These sectors tend to underperform when the economy is under pressure. These “growth” stocks, such as Google and Netflix, do not pay dividends and trade at earnings multiples of 30x and 136x, respectively. While this reclassification makes sense from a strategic or business perspective, company profiles from a financial perspective are very diverse; ranging from high-yield, low growth, with cheap valuation to no-yield, high-growth and expensive valuation. This profile makes the sector one with both “growth” and “value” characteristics and, at this point, its status as “defensive” or “cyclical” is still up for debate.
Week in Review and Our Takeaways
The S&P 500 hit another all-time high despite continued saber-rattling on trade issues between the U.S. and China
Interest rates have risen slightly in the past couple of weeks, with the 10-year U.S. Treasury closing above 3.05 percent on Friday
Media, Internet and Telecommunication are merging into an all new sector called Communication Services