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Will the GICS reclassification shift investor perception of the FAANG and BAT stocks?

Ben Paul
Ben Paul11/5/2018 08:00 AM GMT+08  • 7 min read
Will the GICS reclassification shift investor perception of the FAANG and BAT stocks?
SINGAPORE (Nov 5): Many years ago, when The Edge Singapore was still in its infancy, I had the good fortune of being seated next to Mark Mobius during a luncheon event. As we ate, I asked the renowned proponent of investing in emerging markets to explain
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SINGAPORE (Nov 5): Many years ago, when The Edge Singapore was still in its infancy, I had the good fortune of being seated next to Mark Mobius during a luncheon event. As we ate, I asked the renowned proponent of investing in emerging markets to explain the trailing performance of some his funds.

Without missing a beat, Mobius pointed out that some benchmark emerging market indices were dominated by certain large stocks, but that his funds were not allowed to be more than 10% exposed to a single stock in order to mitigate risk. Many of these large companies grew relatively quickly, and developed justifiably high market valuations. As his funds were not allowed to match the weighting of these stocks in the benchmark indices, they ended up underperforming.

Today, one could similarly argue that maintaining a broadly diversified portfolio of technology stocks would have resulted in investors failing to fully benefit from the huge upside in the so-called FAANG stocks — the acronym denoting Facebook, Amazon.com, Apple, Netflix and Google owner Alphabet. For one thing, under the so-called Global Industry Classification Standard (GICS), neither Amazon nor Netflix was ever part of the Information Technology sector. They were actually both grouped under the Consumer Discretionary sector.

Moreover, the Information Technology sector as defined under GICS included industries like semiconductor equipment and technology hardware, storage and peripherals, which are generally capital-intensive and cyclical. By contrast, Apple, Alphabet and Facebook, which were part of the Information Technology sector, displayed strong secular growth for several years, and became among the largest stocks in that broad category.

Now, S&P Dow Jones Indices and MSCI are implementing changes to the GICS structure, in a move that will see most of the FAANG stocks as well as thousands of others recategorised under different sectors. S&P made adjustments to its indices in September, while MSCI is expected to adjust its indices this month.

Specifically, a new sector called Communications Services has been created in place of Telecommunications Services. Besides the traditional telecoms companies such as AT&T, Verizon Communications and Vodafone Group, the new Communications Services sector will also include companies that provide platforms for communication and companies that operate various media businesses.

These would include companies that were under the Information Technology sector, like Facebook, Alphabet, Twitter, Activision Blizzard and Electronic Arts. It would also include many companies from the Consumer Discretionary sector, including Netflix and TripAdvisor as well as a whole gamut of media companies like Walt Disney Co, Twenty-First Century Fox and News Corp.

With these reclassifications, the Standard & Poor’s 500 Index will see its exposure to the Information Technology sector fall to just over 20% from more than 25%, according to a recent report by State Street Global Advisors. Its exposure to Consumer Discretionary will slip to 10%, from nearly 13%. The new Communications Services sector would have an exposure of over 10%. The Telecommunications sector that it replaces had an exposure of almost 2%.

Global stock indices would see a similar shift. The MSCI ACWI Investable Market Index, which has some 8,870 components across 23 developed markets and 24 emerging markets, would have a more than 8% exposure to the Communications Services sector, versus a 2.5% exposure previously to the old Telecommunications sector, according to a report last month from MSCI. The weighting of the Consumer Discretionary sector in the MSCI ACWI would slip to less than 11% from more than 12%, and the Information Technology sector would fall from almost 19% to just under 15%.

Same stocks, different categories

Of course, reclassifying a stock does not make its fundamentals any better or worse. Yet, with the growth of passive index-oriented investing, the GICS reclassification could change the way some stocks are perceived. For instance, telecommunications stocks were traditionally viewed as “value” stocks that pay relatively large dividends and carry significant gearing. Now, in the Communications Services category, they are part of a basket containing a high proportion of “growth” stocks that trade at higher price-to-earnings multiples. That could result in more support from sector-oriented exchange-traded funds.

“Communications Services will hold a majority — 61% — of growth stocks, whereas the current Telecommunications Services consists of 100% value stocks,” says State Street in its report. It adds that the Consumer Discretionary and Information Technology sectors will still retain a growth flavour. “These sectors will have a 64% and a 47% allocation to growth stocks, respectively — numbers that are higher than the broader market.”

The GICS reclassification could also help investors see the FAANG stocks for what they really are. These companies are supposed leaders within the technology sector that are transforming the way we live. Consequently, many investors felt compelled to own their stocks. However, their businesses actually have little in common with one another. If the likes of Facebook or Netflix initiate a merger and acquisition deal, it is more likely to be with another component of the new Communications Services sector than the Information Technology sector under wathich they were once categorised.

The only FAANG stock that will be left in the Information Technology sector is Apple. It is currently in the Communications Equipment industry within the sector, which makes sense considering that sales of the iPhone are now its main earnings driver. Its weight within the Information Technology segment of the S&P500 will rise to about 20% from 16%.

Technology fuelling broad growth?

Since my conversation over lunch with Mobius, advancing technology has dramatically transformed the complexion of emerging markets. Over the past decade, the weightage of Information Technology stocks within the MSCI Emerging Markets Index has almost tripled to nearly 28% (before the GICS reclassification). This was partly the result of a slump in stocks in the Energy and Materials sectors. It was also partly driven by the rise of the so-called BAT stocks — which refer to Baidu, Alibaba Group Holding and Tencent Holdings — China’s answer to the FAANG stocks in the US.

All three of the BAT stocks were previously part of the Information Techno-logy sector. With the GICS reclassification, Baidu and Tencent will be moved to the new Communications Services sector, while Alibaba has been reclassified under the Consumer Discretionary sector. Hence, there will be no BAT stocks in the Information Technology sector.

With these and other stock reclassifications, the weighting of the Information Technology sector within the MSCI Emerging Markets Index will almost halve to 15%. The weightage of the Communications Services will more than triple to nearly 16%, while the Consumer Discretionary sector will edge up to over 11% from almost 10%. Interestingly, with these shifts, the largest weighting in the MSCI Emerging Markets Index after the GICS reclassification will be the Financials sector, at more than 24%. This comes just as rising interest rates are expected to boost net interest margins at the banks, and drive a big improvement in profitability.

Could the Financials sector be the next leading sector for emerging markets? Or, will a recovery in the Energy and Materials sectors after a long slump be more important? Or, is it just a matter of time before a handful of companies leverage emerging techno-logies like artificial intelligence, leading to another big expansion in the weightage of the Information Technology sector?

Without knowing the answer, I am just accumulating a broad portfolio of fundamentally sound and reasonably priced stocks in the face of the current selloff. Years ago, I thought Mobius was just making an excuse when he blamed the underperformance of his funds on their inability to take too concentrated a position on some stocks. After all, professional fund managers have to be judged on the basis of some benchmark. Yet, as a small-time private investor, I have developed an appreciation for owning a portfolio of stocks that offer a reasonable return for an acceptable amount of risk, even if they do not ultimately beat some benchmark index.

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