There’s a major upheaval coming to the information technology sector, and while it may be dreaded by the investors who embrace the industry because of its high levels of growth, the changes may ultimately result in a group of stocks that’s both less risky and more attractively valued.
Changes to MSCI’s and S&P Dow Jones’s Global Industry Classification Standard means that September will see the launch of a new communications sector, built largely out of stocks that currently occupy the telecom, technology and consumer discretionary sectors.
Among the technology stocks that will be switching sector classification are Facebook FB and Google-parent Alphabet GOOGL , both of which stand as some of the biggest and best-performing stocks in the whole market over the past few years. The pair have a combined market capitalization of nearly $1.2 trillion, even after a recent spate of weakness related to how Facebook has handled its user data, a scandal that has raised concerns about new regulations being instituted over the companies.
“With two of the largest and fastest-growing companies transitioning out of Information Technology, the sector will lose some of its appeal to growth investors,” Goldman Sachs wrote in a note to clients.
The new sectors will look very different. Currently, tech amounts to nearly 25% of the total sector weight of the S&P 500 SPX. That will drop to 20% after the switch, Goldman said.
While many of the tech sector’s largest components will be staying put — including Apple AAPL, Microsoft MSFT, and Intel INTC — losing Facebook and Alphabet will change how the overall industry trades in terms of its valuation and expected growth levels.
Tech is expected to report sales growth of 15% this year and 7% growth next year, compared with 6% and 5% for the overall market (excluding the energy sector, where growth has been atypically high given a rebound in crude-oil prices). After the switch, “future ’legacy Tech’ sector has expected 2018 and 2019 sales growth of 9% and 5%,” Goldman wrote.
That lower growth will come with lower valuations, which some investors may embrace at a time when valuations are seen as stretched. Currently, tech trades at a enterprise-value-to-sales ratio of 4, and a price-to-earnings ratio of 18.4. That will drop to 3.9 and 17.5 after the switch, bringing it lower to the rest of the S&P 500, which has an EV/sales ratio of 1.8 and a P/E of 16.4.
The biggest components of the revamped tech sector will have “lower earnings growth but lower valuations, a higher shareholder yield, and less regulatory risk than the departing firms,” Goldman wrote.
The change to sector classifications will only really have an impact on the investors who use passive funds to hold specific areas of the market. Such products simply track the performance of an industry like tech, holding the same components as the underlying index, and in the same proportion. An investor who currently owns the Technology Select Sector SPDR ETF XLK will see the components of that fund change, although those who invest in broader markets will not see any impact.