Can The Communication Services Sector Continue Rallying?

by: Sankalp Soni

The Communication Services sector has rallied by about 14.40% since the start of the year.

The sector has gone through some composition changes lately, which investors need to take into consideration when deciding to invest in the sector.

Amid a lofty valuation and a deteriorating earnings outlook, this rally may be unsustainable going forward.

The Communication Services sector has so far delivered a YTD return of 14.40%, outperforming the S&P 500’s 11.36% YTD return (at time of writing). This sector has recently witnessed changes in its composition, whereby more stocks have been added to the sector, which has resulted in a heavier weighting in the S&P 500 at 10.20%. Due to the latest changes in composition, this sector requires more careful consideration and scrutinizing from investors, as past performance and trends may not be as reliable when assessing it as an investment choice, and requires additional factors to be considered.

Source: Fidelity

What is the Communication Services sector?

The Communications Services sector is a collection of 5 industries including Diversified Telecommunication Services, Entertainment, Interactive Media & Services, Media and Wireless Telecommunication Services. The sector has broadened recently due to changes made at the end of September 2018, whereby a notable list of stocks from the Consumer Discretionary sector and Technology sector were moved to the newly classified Communication Services sector.

This has resulted in 3 FAANG stocks, including Facebook (FB), Netflix (NFLX) and Google (NASDAQ:GOOG) (GOOGL), being placed in this sector, which have played a major role in the sector’s outperformance this year. In fact, the 3 FAANG stocks collectively have a 46.96% (nearly half) weighting in the Communication Services Select SPDR ETF (XLC).

How does the sector perform during different stages of the business cycle?

The chart below from Fidelity research exhibits how the sector is expected to perform during the different stages of the business cycle.

Source: Fidelity

The chart reflects the Communication Services sector as being a rather defensive sector, which performs poorly during the early stages of the business cycle, but tends to outperform during recessions. This would suggest that investors should increase exposure to the sector amid the onset of a recession. However, I am skeptical of this investment strategy, especially following the recent changes in the composition of the sector.

The model above is based on historical performance, and given that the changes in composition happened very recently (just over six months ago), it is unlikely to accurately reflect the sector’s true risk/performance profile during the different stages of the business cycle.

Formerly, this sector was mainly composed of the telecommunication industry, and hence was considered a rather defensive sector. This is because the demand for cellular phone services is likely to remain rather stable during the different stages, as consumers are unlikely to cut back on such services during a recession.

However, following the changes in composition last year, whereby former Consumer Discretionary and Technology stocks have now become part of the Communication Services sector, it has shifted towards a more cyclical nature. It now contains ad revenue-driven stocks like Facebook and Google, which are likely to suffer during recessions as corporations cut back on advertisement spending and prioritize financial health/ stability instead.

Therefore, investors should tread cautiously when considering gaining exposure to the Communications Services sector, as they should not expect it to strongly outperform during recessions given its increased cyclical nature. Nevertheless, it has been one of the strongest-performing sectors so far this year, and there are several factors behind this rally.

Why Has The Sector Been Outperforming?

One of the main reasons this sector has been outperforming is because after the recent composition change, it now consists of 3 FAANG stocks, which are considered market-leading high-growth stocks. The YTD returns of Facebook, Netflix and Google are 32.22%, 35.19% and 15.32%, respectively. Hence these stocks have certainly helped drive the sector higher given their individual strong performances.

Furthermore, the fundamentals of the sector are also quite strong. The chart below demonstrates how the Communication Services sector has one of the highest Free Cash Flow (FCF) margins.

Source: Fidelity

As I had explained in a recent article of mine:

FCF is an important fundamental measure as it is used as an alternative profitability measure, and is a good indicator for how well the company is able to service its debts, maintain/grow dividend distributions to shareholders, and engage in R&D and large-scale expenditures to drive future growth and remain competitive. Moreover, amid a weakening economy (and a potential upcoming recession), sufficient FCF is even more essential in order to ensure it is able to repay debt effectively and maintain financially healthy.

Therefore, given that the Communication Services sector has the second-highest FCF margin out of all sectors, it provides a compelling case to hold exposure to the sector.

Moreover, the sector also offers one of the highest Earnings Per Share (EPS) growth rates, as indicated by the chart below.

Source: Fidelity

Higher EPS reflects higher profitability for each individual stock owned. Note that this metric is also used to calculate the Price to Earnings ratio (a valuation measure). Hence strong growth in EPS is bullish as it justifies surging stock performance. Therefore, these strong fundamentals have certainly played a role in inducing a rally in the Communication Services sector.

Furthermore, the sector has also been delivering good earnings and revenue growth relative to other sectors in the latest earnings season. For Q4 2018, the sector has declared the second highest earnings growth rate at 22.2%, and the highest revenue growth rate at 20.4%, as shown in the chart below.

Source: FactSet

This strong earnings performance has also helped drive the rally in the Communication Services sector so far this year. However, it is also worth noting that the earnings guidance provided by the sector's corporations have not been positive on an aggregate level, as earnings are expected to contract by 3.2% in Q1 2019. Keep in mind that prior to the start of the latest earnings season, the earnings growth estimate for this sector was 0.6% for Q1 2019.

Therefore, given that the sector continued to rally amid a deteriorating earnings outlook suggests that this rally may have gone too far. In fact, the forward PE ratio for the sector is 19.97, which is quite elevated in comparison to the S&P 500’s 16.65 level. Therefore, based on an expensive forward multiple and deteriorating earnings outlook, this rally in the Communication Services sector may not be sustainable.

Which industry has contributed the most to the sector rally? Is it sustainable?

The best performing industry that has helped drive the sector higher is Interactive Media & Services, which has rallied by 19.92% since the start of the year, outperforming the 11.36% rally in the S&P 500. Note that this industry also includes 2 FAANG stocks, Facebook and Google, which have rallied 32.22% and 15.32%, respectively, since the start of the year (at time of writing). Hence these stocks have certainly played a notable role in driving the industry higher.

Out of all industries within the sector, this industry also anticipates the highest revenue growth for Q1 2019, at 21%. Hence this offers a bullish reason for investors to pile into the industry. However, the industry has also become very expensive, with a forward P/E ratio of 22.88. Moreover, keep in mind that this particular industry is highly dependent on ad revenue, which makes it more sensitive and vulnerable to economic downturns/ recessions. Given that we are already in the late stages of this business cycle, and market participants are anticipating a recession soon, investors should not count on this industry continuing to strongly drive the sector higher going forward.

Bottom Line

The Communication Services sector has gone through some significant composition changes lately, including 3 high-growth FAANG stocks being added to the sector. The sector has outperformed the S&P 500 so far this year. However, these changes in composition have also made the sector more cyclical in nature, performance of which could suffer going forward, given that we are already in the late stages of the business cycle, and we could witness a recession soon. While revenue growth remains strong relative to other sectors, it is also anticipated to witness an earnings contraction this quarter. Therefore, given its lofty valuation amid a deteriorating earnings outlook, I do not recommend investors to buy into this rally.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.