Telecom's Not the Problem

By James Brumley | September 01, 2009 AAA

I'll admit it - my insatiable desire to find opportunities that nobody else is considering has led me down some obscure paths. I'm ok with that though, since there's a little more money to be made by leading the crowd rather than following it. My latest round of digging has led me to the telecom sector. Done laughing yet? (I laughed too at first, but hear me out.)

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But Doesn't Telecom Stink?
Yes, telecom in general has been the market's biggest loser since the March low. The Telecom HOLDRs Fund (NYSE:TTH) is only up about 21% since then, which isn't bad, but pales in comparison to the S&P 500 Index Spyder's (SPY) return of 50% for the same period. Past performance isn't necessarily indicative of future performance but let's face it, that kind of lag would force any investor to think twice about telecom.

Unfortunately, this is a case where investors may jump to an errant conclusion about a sector based on an ETF's (or cap-weighted sector's results), without realizing the ETF doesn't even come close to representing all the sector's opportunities.

See, TTH's make-up is stunningly lopsided. Nearly 55% of its value comes from AT&T Inc, (NYSE:T), and 29% is held in the form of Verizon Comm. (NYSE:VZ) shares. It's difficult to call any ETF a "basket of related stocks" when two stocks alone make up nearly 84% of the fund, even if it's a fair representation of those companies' market caps.

Let's look past the large caps dragging down the sector/ETF results, and instead highlight the small and mid cap stocks - or even just the "less big" stocks - in the sector that (1) look undervalued, and (2) are doing much better than their large cap brethren. The table below tells the eye-opening tale, but a couple of highlights deserve a special mention.

Company Div. Yield % * Net Margin % * P/E * Return since March low
AT&T (NYSE:T) 6.3% 9.8% 12.9 20.3%
Verizon (NYSE:VZ) 5.8% 7.5% 14.8 20.0%
Centurytel (NYSE:CTL) 8.8% 12.5% 9.9 35.0%
Qwest Comm. (NYSE:Q) 8.6% 5.9% 8.3 29.0%
Windstream (NYSE:WIN) 11.6% 12.1% 10.0 36.7%
Frontier Comm. (NYSE:FTR) 14.2% 6.7% 15.1 30.2%
Cincinnati Bell (NYSE:CBB) - 8.8% 7.3 118.8%
Iowa Telecom. (NYSE:IWA) 13.6% 7.3% 20.8 17.5%
*data from Reuters as of August 25

Picks of the Litter
When's the last time you saw a stock yielding 11.6% in dividends, boasting margins of 12%, and only trading at about 10 times earnings? Think of it as the other triple-play combination currently offered by Windstream (NYSE:WIN). Dividends not your thing? How about a telecom play that doesn't pay them at all, and instead just grows? That would be Cincinnati Bell (NYSE:CBB). Despite its 114% rally since March, it's still trading at a price/earnings multiple of 7.

That's not to say that being small is the secret of telecom success. Centurytel (NYSE:CTL), for instance, is the third biggest telecom name in terms of market cap, yet has a mix of dividends, and margins that's stronger than AT&T's or Verizon's. So, size isn't necessarily a burden here.

How Do They Do It?
What are the other telecom companies doing that Verizon and AT&T aren't? It's more a question of what they're not doing.

Verizon and AT&T have both been expanding their reach. Great, but how long will they need to spend two dollars to make one dollar? Both have bigger top lines but smaller bottom lines in recent quarters. (See Dial Up Choice Telecom Stocks to learn more about metrics that matter when analyzing telecoms.)

Conversely, the smaller players haven't let their eyes get bigger than their wallets, and instead have focused on getting lean. It's not sexy, but their resulting dividend yields may well be a turn-on for income investors.

The Bottom Line
Telecom stocks have had some bad press as of late, but make sure you get the whole story before giving up on this sector. Several telecoms are worth a second look if you want a diamond in the rough other speculators are overlooking.

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