The Communication Services Select Sector SPDR Fund (NYSEARCA:XLC) provides targeted exposure to the leading companies of the sector within the S&P 500 Index (SPY). In many ways, “communications” is a broad term that includes media and entertainment companies, internet leaders, along with more traditional telecom names. It’s a relatively diverse group that shares in common a long-term growth outlook, leveraging next-generation technology to connect consumers and businesses globally.
Despite several secular tailwinds, XLC has been under pressure this year amid the market-wide selloff and macro volatility. Looking at the fund, we’ll note that its portfolio composition is concentrated among a few top holdings, but we like the overall exposure considering a bullish outlook in the underlying names. Taking a more optimistic view of economic conditions, our take is that XLC offers compelling value at the current level and is well-positioned to outperform going forward.
What is the XLC ETF?
With a portfolio of 26 holdings, what stands out in XLC is that the two largest companies, Alphabet Inc. (GOOGL)(GOOG) and Meta Platforms, Inc. (META), together represent 41.2% of the fund. This is a level that almost defeats the purpose of an ETF for diversification but is based on the fund’s market capitalization-based weighting methodology. Naturally, the question that arises is, why not just buy GOOGL and META directly?
In our view, XLC has some key advantages. The first point to highlight is that the other 22 companies still capture different operating and industry trends as a good balance that can help balance volatility and potentially deliver excess risk adjusted returns over the long run. Other types of companies like the telecom names Verizon Communications Inc. (VZ), T-Mobile US, Inc. (TMUS), and AT&T Inc. (T), which together represent 13% of the fund, also play an important role in XLC as they are not necessarily correlated to the mega-cap internet giants.
Going through the list, we can also group other media names as operating with distinct business models. Netflix, Inc. (NFLX), Paramount Global (PARA), Warner Bros. Discovery, Inc. (WBD), along with The Walt Disney Co. (DIS) all have competing video streaming services among other broadcasting businesses. Electronic Arts Inc. (EA), and Take-Two Interactive Software, Inc. (TTWO) deal with video games. Events promoter Live Nation Entertainment (LYV) and even online data platform Match Group, Inc. (MTCH) are also included. The point here is to say that while XLC is tilted by META and GOOGL, investors get a good range of high-quality stocks that capture themes across technology and consumer spending.
The other important dynamic is the fact that XLC distributes a quarterly dividend, which currently yields about 1.1%. In this regard, the fund is a good option to get invested in non-dividend paying stocks like META, GOOGL, NFLX, and DIS with a quarterly distribution. Notably, XLC’s yield is above other sector-specific ETFs like the Technology Select Sector SPDR (XLK) with a 0.9% yield and the Consumer Discretionary Select Sector SPDR ETF (XLY) at 0.7%. The spread here is marginal but highlights the allure of XLC.
We mentioned XLC has been under pressure, evidenced by a 36% selloff over the past year, lagging the S&P 500 which is down 12% over the period. The story here goes back to the changing economic cycle. Many of the underlying names in the fund saw a record year in 2021 benefiting from the early pandemic boom, and low-interest rate environment. Fast-forward, this year has been defined as the sharp correction in technology and high-growth type names against macro headwinds like record inflation hitting consumer spending, climbing interest rates, and a softer growth outlook.
Still, XLC has fared better than many of the individual holdings of the fund, including META which is off by a nearly catastrophic 59% over the period. On the upside, TMUS has been the standout with a 6% return over the past year. Again, the attraction here still comes down to relative diversification even if it’s not perfect.
XLC Analysis and Forward-Outlook
A bullish call on XLC from the current level sort of requires the macro environment and broader stock market momentum to cooperate. It’s fair to say that the fate of the communications services sector and the broader market are intertwined. At the same time, there are a couple of reasons to believe XLC should outperform the upside given its portfolio of higher-beta growth stocks. The silver lining to the deep selloff in the stock market this year is that valuations have come down to what we see as attractive levels.
Focusing just on Alphabet and Meta Platforms, for all the challenges facing these companies, the reality is that both are still profitable and trading at the cheapest levels in their recent history. GOOGL with a current forward P/E multiple of 21x and even 23x free cash flow is at a nearly 30% discount to its 5-year average for both multiples. The spread is closer to 60% for META. While some of the discounts are likely justified given their slower growth outlook and broader uncertainties, there is also a case to be made that the selloff has already been priced in some of the worst-case scenarios.
Our example can be applied to almost every other stock in the portfolio, including Netflix and Disney. While the headlines are dominated by concerns of a US recession, data like the resilient labor market and indications inflation is trending lower are more positive, suggesting communications sector leaders can reclaim their long-term growth trajectory sooner rather than later.
With a bullish outlook, the strategy here is to buy low today for a chance to sell higher in the future. In our opinion, the reward-to-risk setup is tilted to the upside for the XLC fund assuming economic conditions can evolve better than expected.
Whether market sentiment turns around more positively next week or into 2023, the current level in XLC is not a bad spot to start a position. The fund trading at around $55.00 is a level going back to before the pandemic in Q1 2020. The bullish case for the sector is that the underlying companies will continue to consolidate market share while outperforming expectations with a long-term outlook that is better than ever .
In terms of risks, a deeper deterioration of the US economic outlook could open the door for another leg lower in the fund. Indicators including inflation trends and labor market conditions are the key monitoring points to gauge the health of the economy.