GICS Rebooted: A New Sector for Modern Communication

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1 GICS Rebooted: A New Sector for Modern Communication September 2018 By Rebecca Chesworth, Senior Equity ETF Strategist, SPDR EMEA Technological advancements have revolutionised content creation, access and delivery. Many companies now provide integrated media and communication, making the previous distinction between telecommunication services, media and internet less relevant. In response, GICS has updated its sector classification system and introduced Communication Services to reflect how we now communicate. Overview The sector-level changes are significant, accounting for 10% of the S&P 500 index and 8% of MSCI World. 1 The GICS changes will affect three existing sectors: Telecommunication Services, Information Technology and Consumer Discretionary. The new Communication Services sector replaces the Telecommunications Services sector and provides a more effective tool for implementing economic and sector views. The official reclassification of the GICS structure takes place on 28 September, while S&P will rebalance indices after the close on 21 September. MSCI will follow after the close on 30 November. We believe the changes will result in a more efficient and relevant sector classification. Evolving Communications have Created the Need for Sector Change Technology has changed the way people communicate. Mobile phones, and the internet now dominate our communication channels, having long since replaced telegraphs and rotary telephones. One result of these changes is the decline in the quoted telecom sector. Fixed line and mobile providers have left the sector, some due to corporate takeover, whereas companies in other sectors (e.g. media, currently in the Consumer Discretionary sector) have packaged telephone services in their wider offering to consumers. In addition, the provision of traditional telecom firms has become significantly less profitable because of price competition and the need for heavy investment in infrastructure, particularly spectrum and fibre. In the US equity market, the telecom sector made up 9% of the S&P 500 in 1999, a sizeable part of the TMT (technology/media/telecommunications) complex, which dominated investor attention at the time. 2 Over the subsequent years, the sector underperformed the broader equity market, and now represents just 2% of the S&P 500. The telecom sector contains only three stocks (AT&T, Verizon, and CenturyLink). 3 These fixed line and mobile carriers have failed to attract interest as an investment strategy, despite their appealing yield and defensive characteristics (which emerge from the nature of the service). The concentration of the US telecom sector meant that it was impossible to manage a UCITS-compliant telecom sector ETF, leaving investors without an easy Europeandomiciled investment option. The case is not as extreme in the European or global equity markets, but the nature of the decline in telecom has been similar. Although, the relatively larger size of the telecom sector in both of these regions meant that sector ETFs still functioned as effective exposures. GICS Rebooted The largest and best known classification of equity sectors is the Global Industry Classification Standard (GICS). Developed in 1999 by S&P Dow Jones Indices and MSCI, the GICS structure consists of 11 sectors, 24 industry groups, 68 industries and 158 sub-industries (see Figure 1). 4 GICS is used by thousands of market participants across all parts of the investment process: asset managers, brokers (institutional and retail), custodians, consultants, research teams and stock exchanges. The GICS system provides a consistent definition that allows for comparative analysis, reporting of exposures, and capturing of trends.

2 Each company is assigned a single GICS classification at the sub-industry level according to its principal business activity, which filters through the corresponding industry, industry group and sector. Revenue sources are a key factor in determining a firm s principal business activity. MSCI and S&P conduct annual reviews to ensure that the structure remains fully representative of the equity market. The GICS revision that will be implemented after the close on Friday 28 September 2018 marks the largest change following a review. This revision will significantly alter the composition of three sectors: Telecommunication Services, Information Technology (IT) and Consumer Discretionary. The Telecommunication Services sector will be recreated as the new, expanded Communication Services sector. This new sector will include telecom companies like Verizon and AT&T; technology companies like Facebook and Alphabet (Google s parent); and media and entertainment companies like Comcast and Netflix.* These GICS changes aim to make the three impacted sectors more representative of how consumers behave and businesses generate revenues, thus increasing the sectors relevance to investors. The new classification is also more efficient because the rebalancing results in three more equally sized sectors. The classification system comprises more than 50,000 traded securities across 125 countries. In this paper, we explore how the changes being implemented in September will impact several of the major S&P and MSCI indices, namely the S&P 500 (the bastion of US large cap companies) and MSCI World and MSCI Europe (leading benchmarks for investors across the globe). Figure 1: Global Industry Classification Standard (GICS) 11 GICS SECTORS Communication Services 24 Industry Groups Media & Entertainment 68 Industries Entertainment 158 Sub-Industries Interactive Home Entertainment Source: State Street Global Advisors, S&P Dow jones Indices, as of 31 y The above diagram reflects the September 2018 changes to the GICS structure. * This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. State Street Global Advisors 2

3 How the Sector Changes will be Reflected Across S&P 500 and MSCI Indices The reboot of the GICS is an acknowledgement of the convergence in communications. Amongst other activities, the companies being reclassified create interactive entertainment content and aggregate information that is delivered through multiple platforms such as cable, internet, fixed and mobile telephones. As index providers, S&P Dow Jones and MSCI will make changes to their indices to reflect the new classifications. S&P indices will implement the changes as part of their quarterly rebalance at close on 21 September, becoming fully operational on 24 September. MSCI plans to implement the changes later this year as part of their Semi-Annual Index Review on 31 November, effective on 3 December. Given the timing and relative impact in terms of market capitalisation, we focus primarily on the S&P 500. Changes to S&P Select Sectors The reclassification affects approximately 10% of the S&P 500 index, and the three sectors implicated account for approximately 40% of the S&P 500 index. To put this into perspective, only 5% of companies have changed sectors during the past 21 years. 5 We have shown the changes at an index level for the S&P Select sectors, which have the same constituents as S&P 500 but a stock cap of 24%. 6 This is important as two of the three sectors will breach the capping requirements. Figure 2: New Communication Services Index Representation of Index Market Cap by Current GICS Sector Market Capitalisation ($ Trillions) New Index Communication Services Industry Group by Weight 87.5% 11.5% Media & Entertainment The new Communication Services Select sector consists of two industry groups: The three stocks from the previous telecom sector will form the Telecommunication Services industry group, which will constitute approximately 11.5% of the sector going forward. 7 These are diversified providers of local and long-distance phone service, wireless and data communications. The much larger part of the sector will be Media & Entertainment. It contains the seven stocks moving from IT and 16 stocks reclassified from Consumer Discretionary. The industries in this grouping are: Interactive Media & Services companies engaged in content creation or distribution through proprietary platforms. The best known names are Alphabet (whose separate trading classes count as two stocks) and Facebook, which together will account for 40.1% of the new sector.* Entertainment includes companies producing movies and programming, e.g. Netflix, Walt Disney and 20th Century Fox, and electronic games, e.g. Activision Blizzard. Media a grouping of advertising companies, broadcasters and cable operators, including CBS and Charter. * Both of these stocks will be liable for capping so weights will vary between the Select and S&P index. Information Technology Industry Group by Weight Telecommunication Services 2 0 Information Technology Remains in the Existing Sector Consumer Discretionary Telecommunication Services Communication Services Moves to New Communication Services Sector Source: Bloomberg Finance L.P., as of 31 y Sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector shown. It is not known whether the sectors shown will be profitable in the future. 51.1% 29.2% 19.7% Software & Services Semiconductors Technology Hardware & Equipment Information Technology loses some of its large constituents and internet-related names. The ongoing sector will also consist of three industry groups: Half of the market weight of the sector will be in Software & Services, where Microsoft dominates alongside other software providers, such as Oracle, and payment system providers, such as Visa. State Street Global Advisors 3

4 Technology Hardware & Equipment includes Apple and companies offering data centres, cloud networking, storage infrastructure, and web hosting services. Semiconductor companies, the largest of which is Intel, make up the third group, accounting for just less than 20% of the rebalanced sector. Consumer Discretionary Industry Group by Weight 61.3% 18.0% 13.1% 6.2% Retailing Consumer Services Consumer Durables & Apparel Automobiles & Components Consumer Discretionary will also be smaller after the reclassification. It loses media and entertainment providers but actually gains a stock: internet retailer ebay. The five industry groups will be: Retailing will include online retailers alongside store groups with physical locations. By far the largest is Amazon*, accounting for 24.4% of the rebalanced Select Sector, making this the largest industry group. 8 Consumer Services, with a weight of 16.2%, consists of hotels, leisure and restaurant companies, including McDonalds and Starbucks. 9 Consumer Durables & Apparel is predominantly suppliers of apparel and luxury goods, with Nike the largest constituent. Automobiles & Components is the smallest component, and includes some of the oldest quoted stocks in the US, such as General Motors and Ford Motor Company. * Amazon is liable for capping under select sector index rules (the weight in the S&P sector going forward is approximately 31%). Implications of Changes to S&P 500 Sectors Telecommunication Services Becomes Communication Services: Much Larger and More Compelling Apart from the premium yield of its members and defensive characteristics (which helped relative performance in bear markets) telecoms lacked attractions for investors. The nature of the sector in its place, Communications Services, is markedly different. At a high level, we expect the new sector to behave like IT, performing better in rising rate and inflationary environments. The importance of advertising revenue to the sector will give it a cyclical bias. In aggregate, the stocks moving into Communication Services will have higher pre-tax margins, lower leverage, better cash positions, and higher interest coverage ratios; these traits tend to indicate quality. These characteristics should also make the new sector less volatile than the old one. Earnings growth will also likely improve, moving the sector to the growth category (whereas telecom was known for its value tilt). With an estimated beta of 1.1, the sector could fare better in rising equity markets. 10 Given the weight of approximately 10% of the S&P 500 index, we expect Communication Services to garner investor attention. The new sector has two of the five largest global brands in the sector (Google and Facebook, according to Brand Finance), and three of the FAANG names (Google, Facebook and Netflix), which have been popular with investors in recent years.** These three stocks in particular would have helped Communication Services be one of the best sector performers over the last 10 years. The chart below shows strong outperformance against the broad equity market. ** This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. Figure 3: Selected Sector Index Performance Cumulative Total Return Performance (%) S&P Communication Services Select Sector Daily Capped 25/20 Index NTR S&P 500 Information Technology Sector Net Total Return Index S&P 500 Capped 35/20 Consumer Discretionary Index NTR Information Technology Focuses on Real Tech ; Slimmed Down but Still Largest Sector The size of IT falls from 26.2% to 22.4% as the Interactive Media & Services companies move to Communications Services. Nevertheless, IT remains the largest sector Source: Bloomberg Finance L.P., as at 31 y S&P Communication Services Select Sector Daily Capped 25/20 Index NTR was incepted on 23 y 2018, S&P 500 Information Technology was incepted on 28 June 1996, S&P 500 Capped 35/20 Consumer Discretionary Index was incepted on 6 y Results prior to this date were calculated by using available data at the time in accordance with the Index s current methodology. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. The more focused IT sector could attract investment from those seeking more exposure to core hardware and software producers, along with tech innovation. The sector is likely to see less dispersion between its stocks, which would make it a more effective sector tool for investors, as there would be less reason to select individual stocks. State Street Global Advisors 4

5 Consumer Discretionary Gains Exposure to Retail; Stock Concentration Unattractive Consumer Discretionary has generated strong investment returns in recent years, thanks mainly to Amazon. Whilst Amazon remains in Consumer Discretionary, the company actually becomes the main concern for the rebalanced sector, accounting for 31.5% of the S&P sector or 24% of the Select Sector (which is used for SPDR funds). 12 Either way, Amazon will provide a significant amount of idiosyncratic stock risk. In addition to the high stock concentration, the sector has been a challenging investment tool because of the low correlation of its stocks to each other. Even after the removal of one industry group (media) this is unlikely to change dramatically. Sector Changes for MSCI World and MSCI Europe MSCI proposes to implement the changes to the GICS structure in their equity indices as part of the November 2018 Semi-Annual Index Review. The amount of rebalancing is not as significant as for the S&P 500 but will still lead to large differences in three sectors. Here we focus on the changes to sectors in MSCI World and MSCI Europe. Telecommunication Services Becomes Communication Services: Less Concentration, More Attractions Whilst the MSCI World Telecommunications Services and European Telecommunications Services sectors are not as small as their US counterpart, they are concentrated. More than 50% of the current MSCI World telecoms sits in just four names: AT&T, Verizon, Vodafone and Softbank Group. The same holds true for MSCI Europe, which holds Vodafone, Deutsche Telekom, Telefonica and Orange.* In the new Communication Services sector, the number of stocks will increase dramatically and, therefore, the indices in World and Europe will become less concentrated. From December onwards, the two industry groups will be: Telecommunication Services, which will constitute almost a third of MSCI World and MSCI Europe Communications Services. The names mentioned above will be the largest members. The larger part of the sector will be Media & Entertainment. For MSCI World Communication Services, there will be a bias towards the former IT stocks. Going forward, the biggest names will be Facebook, Alphabet Inc Class A and Alphabet Inc Class C (making up approximately 30% of market weight alone). There will be a sizeable exposure (over 70%) to US-listed businesses. * This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. MSCI Europe Communication Services will have 37 stocks in total and a higher weight to ex-consumer Discretionary stocks. The top names will look different from MSCI World, as technology has never been such a large sector in Europe. Instead, the largest stocks will be Vivendi, WPP and SKY, companies earning their revenue from advertising and broadcasting. Information Technology Focuses on Real Tech : Slimmed Down but still Interesting for World IT loses some of its biggest and best known US names post the GICS changes, which has a significant impact on MSCI World Information Technology but not so sizeable for the European equivalent sector. However, even after the reclassification, there will be around 150 stocks in the former. Starting in December, the three industry groups will be Software & Services, Technology Hardware & Equipment, and Semiconductors. Half of the market weight of the sector will be in Software & Services, where Microsoft dominates. For MSCI Europe Information Technology, the major holdings are software providers, such as SAP and ASML. Technology Hardware & Equipment in MSCI World Information Technology includes Apple and companies offering data centres, cloud networking, storage infrastructure, and web hosting services. For MSCI Europe Information Technology, the holdings of note are handset manufacturers, including Nokia and Ericsson. Semiconductors is a small industry group. In MSCI World the largest listing in this category is the US-listed Intel. MSCI Europe Information Technology includes the Dutch NXP Semiconductors and French STMicroelectronics. Consumer Discretionary Loses the Media Element: Stock Concentration Unattractive for World, More Diversity for Europe MSCI World Consumer Discretionary loses 18% of its constituents to Communication Services. Half of that loss comes from three names: Comcast, Walt Disney and Netflix. This results in MSCI World Consumer Discretionary becoming a more concentrated index, with relatively greater diversity in the European Consumer Discretionary sector. Retailing will include all online retailers alongside store groups with physical locations. Again the largest weight is Amazon, accounting for 17.6% of the rebalanced MSCI World sector. Online seller ebay also makes a new appearance in this industry group, as does an online trading site operating in Latin America, Mercadolibre (both transferring from Information Technology). MSCI Europe Consumer Discretionary has retail chains Inditex and H&M in this industry group. State Street Global Advisors 5

6 Consumer Durables & Apparel is predominantly suppliers of apparel and luxury goods, with Nike the largest constituent, but closely matched by European brand owners LVMH, Richemont and Adidas. MSCI Europe Consumer Discretionary also holds LVMH, Richemont and Adidas. Consumer Services includes hotels, leisure and restaurant companies such as McDonalds and Starbucks. MSCI Europe Consumer Discretionary has caterers Compass. Automobiles & Components has Toyata as its largest stock in this industry group for MSCI World. MSCI Europe Consumer Discretionary contains Daimler, amongst other car manufacturers. 1 Source: Bloomberg Finance L.P., as of 31 y Source: S&P Dow Jones Indices, as of 30 June Source: Bloomberg Finance L.P., as of 31 y Source: Bloomberg Finance L.P., as of 31 y Source: S&P Global Application of S&P 500 Sectors, March Source: State Street Global Advisors, Bloomberg Finance L.P., as of 3 y Figure 4: New S&P Communication Services Select Sector Index Holdings Current Sector Stock Weight (%) Information Technology Facebook Inc A Alphabet Inc Class C Alphabet Inc Class A Activision Blizzard Inc 4.56 Electronic Arts Inc 4.23 Twitter Inc 2.23 Take-Two Interactive Software 1.38 Consumer Discretionary Comcast Corp Class A 5.05 Walt Disney Co 4.98 Charter Communications Inc A 4.69 Netflix Inc 3.94 Twenty-First Century Fox A 2.98 CBS Corp Class B Non Voting 1.92 Omnicom Group 1.67 Twenty-First Century Fox B 1.22 Viacom Inc Class B 1.10 Interpublic Group of Cos Inc 0.93 Discovery Inc C 0.90 Dish Network Corp A 0.77 TripAdvisor Inc 0.66 News Corp Class A 0.62 Discovery Inc A 0.44 News Corp Class B 0.20 Telecommunication Services Verizon Communications Inc 4.77 AT&T Inc 4.60 Centurylink Inc 1.97 Source: Bloomberg Finance L.P., as of 31 y Weights and sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. State Street Global Advisors 6

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