2023-09-13 15:37:33 ET
Summary
- This year, communication services have benefitted from not just capital appreciation (the best-performing sector in the markets), but additional fund flows as well, pointing to a more abiding sentiment shift.
- We see how XLC stacks up against its next largest peer-VOX.
- We close with a few themes that could weigh on XLC's performance going forward.
Introduction
The Communication Services Select Sector SPDR ETF ( XLC ) offers investors exposure to US-based large-cap stocks engaged in the fields of interactive media & services, telecommunications, and media & entertainment. Put another way, this is a product that offers pureplay focus towards the communications services’ stocks from the S&P 500 Index alone.
It wouldn’t be an exaggeration to state that XLC has had a ball this year, and has been one of the rare shining lights, in what has been a rather subdued year. By using the Global Industry Classification Standards (GICS) as guideposts, State Side Global Advisors currently runs 11 different sector-focused ETFs, one of which is XLC. Amongst these 11 different sector ETFs, XLC is currently the best-performing product on a YTD basis, and one amongst just three names to deliver double-digit returns, well ahead of the rest of the pack (tech and consumer discretionary have been the other two stars this year)
What’s also particularly poignant to note is that the euphoria this year isn’t linked to just capital appreciation alone; XLC has also benefitted from a significant spike in fresh fund flows, with its AUM surging by 2x the pace of its total returns, well ahead of any of the other sector-specific ETFs.
This implies that much of the buoyancy isn’t linked to the short-term speculation of price conditions, but a more fundamentally-driven sentiment shift towards the sector.
Is XLC An Adequate Enough Vehicle To Gain Exposure To Communication Services Stocks?
Clearly, XLC is on a roll, but could you be getting more benefits by latching onto another well-rounded vehicle from this sector? Well, for this comparative study, we'll bring the second-largest communication services ETF into consideration.
The Vanguard Communications Services ETF ( VOX ) is in fact significantly older than XLC (it was set up in September 2004, whereas XLC got listed 14 years later), and it also offers you exposure to a wider pool of names (121 stocks versus just 24 stocks for XLC). However, as we’ll cover later on in this section, spreading your tentacles across a wider portfolio of stocks does nothing from a risk angle, and from a risk-adjusted return perspective, the results are even less striking.
It's interesting to note that despite being around for much longer, being less top heavy (top 10 share of 67% vs 80% for XLC), and offering greater coverage to mid-and-small-cap communication service options (the mid-and-small-cap stake variance between the two ETF is around 1500bps in favor of VOX), which in theory, would offer better earnings growth potential, VOX’s ETF total AUM ($3.37bn) lags XLC’s by over 4x!
Note that even from a cost efficiency perspective, there’s no edge in latching onto either XLC or VOX, as both have identical expense ratios. From a stability angle as well, both ETFs aren’t susceptible to an often lot of churn, but VOX’s turnover ratio is still 500bps lower than XLC’s. Ironically, VOX even offers a better dividend yield figure, and its current variance with its long-term yield average is a lot lower compared to XLC’s.
Where XLC trumps VOX, is the generosity with which it has grown its dividends, with the 3-year CAGR of 1.5% coming in at almost 3x the pace of VOX’s corresponding dividend growth. It also appears that XLC would not only just appeal to long-term holders, but short-term speculators as well (the daily dollar volumes seen in the XLC counter are over 15x greater than what’s seen in VOX’s counter), as its average spreads works out to just 0.01% (whereas for VOX it is at 0.04%).
Crucially, note that despite having very similar risk profiles (XLC’s annualized standard deviation of monthly returns is just 40bps lower than VOX’s), XLC’s quality of stock picking and portfolio management is just better. This is evident with the respective Sharpe ratio readings, where XLC’s figure is almost 2x as much as VOX’s. Also when it comes to downside deviations, XLC does a better job of protecting the portfolio, as exemplified by the superior Sortino ratio, relative to VOX. The takeaway here is that in the communications services sector, exposure towards a narrower, mega-cap-oriented fund could be a more optimal way to get bang for buck.
Seeking Alpha, YCharts, Morningstar, ETF.com
Closing Thoughts - Is XLC A Good Buy Now?
XLC has enjoyed its time in the sun, but we remain conflicted over its ability to maintain its relentless streak of alpha. Here are some good and bad factors to consider.
Firstly, we like XLC’s overwhelming exposure to large interactive media and digital ad stocks (which account for 50% of the portfolio) where the outlook looks resilient. At the start of this year, many were expecting digital ad revenues to be in the doldrums for much longer, but based on the latest Q2 results, it appears that advertisers are showing a preference to established players such as Meta, and Alphabet, who are also doing a solid job of leveraging AI across their monetization tools. It looks like a bottom has now been formed in ad revenue growth with both Meta and Alphabet seeing positive growth, even as a smaller player- Snap continued to flounder.
It looks like sell-side analysts are now fast revising their forecasts for interactive media stocks with upward revisions taking place at a much greater pace in recent weeks.
This year these stocks are expected to deliver robust growth of 33%; normally after such a strong base year, you would expect a slowdown to the earnings growth rate, but do consider that even next year, earnings growth is expected to be quite resilient at 20%.
Given 20% earnings growth, XLC’s overall P/E valuation of 17.5x still looks rather reasonable, particularly as it represents a 13% discount to the corresponding multiple of the S&P 500. Given that XLC is a top-heavy portfolio (the top 10 accounts for 80% of the portfolio), one may even be more nuanced and focus on the valuations of the top 10 stocks relative to their historical averages. Well even here, note that on a forward P/E basis, all the top 10 stocks currently trade at a discount to their long-term averages (on a weighted average basis, the discount works out to -19%).
Whilst all this is very well, here are some other sub-plots that make us wary. The chart below highlights how a market-cap weighted portfolio of large-cap communication services stocks is positioned relative to an equal-weighted portfolio of the same stocks. Clearly, the force is with the biggies, but at some point, one has to wonder if things have gotten a bit overextended. Well, based on the chart below, the ratio is now at record highs, and 16% above the mid-point of its long-term range. This could prompt some mean-reversion.
Also note that after weeks of positive weekly inflows, XLC over the last three weeks has witnessed significant outflows; in effect, over the last two months, the net fund flows stand at -143m. When there are signs of buyer fatigue, it would be wise not to be too ebullient about XLC.
For further details see:
XLC ETF: Yes And No