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How the Stock Market Sector Shake-Up Will (and Won't) Affect Investors

Nick Sciple, The Motley Fool

The internet changed everything, and our old classification schemes just aren't cutting it anymore. In the last few decades, the "tech" sector came to encompass wildly different companies, from hardware manufacturers to social media platforms. It's a huge, sprawling category that dominates most major market indexes it's in...but that's about to change. In the next few months, the S&P and MSCI are overhauling their Global Industry Classification System (GICS), changing how the largest market funds classify some of the biggest companies and industries.

In this episode of Industry Focus: Tech, analysts Dylan Lewis and Nick Sciple explain what it'll mean -- for the market, the companies, individual investors, and fund managers. Want to know how this could affect you? Tune in to find out.

A full transcript follows the video.

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This video was recorded on Sept. 14, 2018.

Dylan Lewis: Welcome Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, September 14th, and we're talking about a shake up in the tech space. I'm your host, Dylan Lewis, and I'm joined in studio by fool.com's, Nick Sciple. Nick, what's going on? 

Nick Sciple: I'm just getting ready for the weekend, looking forward to another week of college football and having a good time.

Lewis: This is your time of the year as an Alabama fan.

Sciple: This is! This is the time you watch your team do well. They are playing Arkansas state this week. Hopefully seeing some backup. See how the team is shaken up for the future, so I'm looking forward to it. 

Lewis: You're basically going to watch next year's Alabama's team in the second half, right?

Sciple: It's a scouting report. You gotta get ready. You gotta know all the names. 

Lewis: That's awesome! You are the newest addition to fool.com. I know that in the episodes that you've done with Vince before, you've done a little bit the intro. I'm happy to have you on to talk and get used to the podcast circuit a little bit. 

Sciple: Yeah, I'm looking forward to it. Longtime listener, starting to get in that host seat a little bit. Looking forward to it!

Lewis: Today, we're going to be doing a wonky show. We're going to be breaking down some changes that are going to be going into effect over the next couple of months. It's going to impact how the stock market groups stocks. Nick, do you want to give us the breakdown?

Sciple: Sure. The S&P and MSCI are overhauling their Global Industry Classification System, also known as the GICS. What that is, it basically divides the industry into sectors, groups, industries, and sub-industries. When you talk about the tech sector or the energy sector of the market, that's really what we're talking about here. Coming up at the end of this month, on September 28th the S&P is going to reshape their GICS classification. The MSCI is going to do it December 3rd after close later this year. It's really going to shake out where different stocks are placed in their industries and how the comps work out between those industries. 

Lewis: The reason we're talking about it on today's Tech show is, a lot of the departures are from tech. Tech is one of the largest industries by market cap. We're going to see that still hold, but some of the major names in this space are going to be going to either other industries that currently exist, or these carve-outs that they're creating now. 

Sciple: That's right. There's a new industry that's going to be created called the communication sector. That's going to take a few companies out of tech. That includes AlphabetFacebook, the big video game makers, Activision, Take-Two, EA. Twitter is going to move into that space. Like you said, the tech sector is currently the largest sector. It's going to remain the largest sector, but it's going to move from about 26% of the S&P 500 to about 23%. It's going to be a big shake up in the industry classifications.

Lewis: What I think we're really seeing with this is a focus more on the tech space becoming about hardware manufacturing components, chip makers, and software, and a little bit less about the media side of tech. 

Sciple: That's right. These internet companies you think about -- Netflix is another one that's going to be moving -- these internet companies are going to be in this new communication sector, whereas these hardcore hardware players -- of course, the biggest one everybody talks about all the time is Apple, with these folks moving out of tech. Apple is going to become a larger share of tech. It's 15% right now. It's going to move up to about 20%. It's going to change the profile of the industry from an earnings perspective. It's going to be a little bit less high growth, but a little bit more robust, mature businesses over the long-term. 

Lewis: Tech is not the only sector that is being robbed of some of its constituents. The consumer discretionary space is going to change a little bit, too. The story is kind of the same. It's more of the platform companies that are moving away from it.

Sciple: That's right. I mentioned Netflix, the consumer discretionary sector, they're in that currently. They're going to move to this new communication sector. Other big media companies, Disney, 21st Century Fox, Comcast, eBay is going to come into the consumer discretionary sector. That sector is really moving more toward a core retail focus, while the internet and platform companies, like you said, are moving to the communication sector.

Lewis: What's the ideology with this? Communication services is a hodgepodge, this new sector that they're creating. They have all of these IT infrastructure and networking companies, the people that basically set up the networks that allow us to access all this stuff, and these really high-growth internet companies. It seems like kind of an odd combination. 

Sciple: That's right. I think the big thing, when you look at the market, is the telecom sector had really fallen by the wayside. It was about 2% of the overall S&P 500. This shake up is going to give something for those companies to do. Also, like we talked about earlier, tech had grown to such a large proportion of the market, so it's going to bring tech back to heel a little bit. And, it's going to make those telecom companies -- which has been, like I said, by the wayside, that's the AT&Ts and Verizons -- they'll be a more significant part of the market. 

Lewis: The best way to think about the communication services segment is basically, how people access the internet and what people spend most of their time doing on the internet. 

Sciple: That's right. Like we said, about half of this new sector is going to be made up of Facebook and Alphabet, which, of course, are the huge technology platforms, the most visited websites on the internet today. And as well, it's going to be, like we talked about, those old legacy telecom players -- AT&T, Comcast. Those are the ways you get onto the internet. Those are those internet service providers that really allow you to get access to these big online websites. 

Lewis: As a before and after, you mentioned before, IT is somewhere in the neighborhood of about 27% of the S&P 500. Now, the next closest is about 14.5%. IT is basically double second, third, and everything else down the list. 

I see this as something that evens out the sectors a little bit. It makes IT not quite as big compared to some of the others. It's still the largest, but as a basis for comparison, the new communication services is somewhere in the low teens as a percentage. That is immediately the fourth largest. I think it's shaping the stock market to be a little bit more balanced across all of its sectors. 

Sciple: That's right. It's going to be the fourth largest tied with consumer discretionary, which also, we just mentioned, is going to get a little bit of a shake up there, as well. 

Lewis: We're going to talk about why this matters for investors. Nick, there are probably a lot of people that are listening to this discussion and saying, "OK, they're shuffling around the companies. It's more of a cosmetic thing, it seems." But the reality is, there is an impact here for fund managers and for the average investor with the shakeup.

Sciple: That's right. I think the primary impact is going to be on professional money managers. A lot of professional money managers might employ what's known as sector rotation strategies, which is exactly what it sounds like. It tries to rotate between the sectors based on market conditions and those sorts of things to drive profits. Professional money managers that are using those sorts of systems typically use a back test to see how that system would work over the long-term. But if you're back testing to a sector that didn't exist before, those back tests really don't work anymore. 

I think for individual investors, the most significant way that's going to impact them is, if you're an investor in a sector-based ETF or index, that's really going to affect you, because there's going to have to be some rebalancing among those indexes. If you're invested in a telecom ETF at this point in time that might have held ten companies, and may have had to buy companies outside of that sector just to meet their diversification requirements, now you're going to be owning, instead of these old, AT&T, Verizon players, half of that ETF is going to be Facebook and Alphabet. That's going to be a significant change.

Of course, some of these ETFs have already rebalanced. I know Vanguard has already done those sorts of things. Some are doing it later in the year. I know that the (unclear 10:09) SPDR ETFs are very popular. They're doing those later in the year. 

An important thing to note is, probably the most popular sector-based ETF is the QQQ. That's the that's the NASDAQ-based ETF. That's not going to be affected. That only tracks the 100 largest NASDAQ stocks. If you're in a sector-based ETF outside of that, you might see some friction as these foresales go on. But, it's not going to affect you in a significant way if you're not invested in these sector ETFs.

Lewis: I've seen some news coverage that's talked a little bit about how, with this large-scale selling and buying, there might be some kind of odd price pressure on some of the companies that are affected with the reorganization. I think that that's possible. The reality, though, is there's nothing thesis-changing about any of these moves for these stocks. It is more, if you are in the ETF or fund-based world, and you're looking at specific sector ETFs and funds, the constituents of those might change a little bit, particularly if you have been invested in something in the telecom space. Make sure that you check and see what's going on. If you're expecting that to continue to be something that is relatively low-growth, kicks you a dividend, the profile of the companies in there are going to change pretty dramatically.

Sciple: That's exactly right. You're moving from these companies that are based on a robust infrastructure that's been built over the long-term, to really dynamic companies like Facebook and Alphabet that are changing the world today. You're definitely going to see a change in the growth profile. You're going to see a change in the expectations of what you get out of the sector. Investors need to take that into account when they're making their investment decisions. 

Lewis: I think one other thing to keep in mind with these changes is, I know, we've done some screener-based shows in the past where people want ways to find stock ideas, and they want to be able to compare stocks to their industry averages. I think that that's a great thing to do as a baseline. That is, maybe, where research starts. The reason for that is, in this case, all of the industry averages, particularly for the telecoms, are going to go out the window if you're looking at communication services. Keep that in mind. Look at the growth profiles, the dividends, that some of these funds, ETFs, and sectors are going to be paying. With the additions and subtractions, it's going to change a little bit. 

Sciple: That's right. Like we were saying earlier, it's hard to compare a Facebook to an AT&T. Don't try to do it as an investor. 

Another thing to take into account, the actual businesses are not going to be affected. If we're investing based on fundamentals and where this business is going to be over the long-term, what sector it's in should not matter to you, if you're buying individual stocks. Again, if you're a fund investor, this is something you need to pay attention to. There may be a little bit of foreselling. You may see, in some of your holdings, a little bit of weird price movements that don't make a lot of sense. If you see that toward the end of this month, or in December, when the MSCI rebalances their sectors, that's probably why. Just keep that in mind and stay the course.

Lewis: Yeah, exactly. Long-term, not a huge thing, but could create a little bit of short-term weirdness. Nick, thanks for hopping on the show!

Sciple: Thanks so much! I enjoyed it!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, you can shoot us an email at industryfocus@fool.com, or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Nick Sciple, I'm Dylan Lewis. Thanks for listening and Fool on!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of GOOGL, AAPL, FB, and DIS. Nick Sciple owns shares of AAPL and FB. The Motley Fool owns shares of and recommends ATVI, GOOGL, GOOG, AAPL, FB, NFLX, TTWO, TWTR, and DIS. The Motley Fool has the following options: long January 2020 $150 calls on AAPL and short January 2020 $155 calls on AAPL. The Motley Fool recommends CMCSA, EBAY, EA, and VZ. The Motley Fool has a disclosure policy.