Telecom: The Picks Of The Litter Are The Runts

By James Brumley | June 28, 2010 AAA

If you follow the major sector indices for cues about new - or waning - trends, then you're probably missing the boat. And if you currently own the Telecom HOLDRs (AMEX:TTH), then you're definitely missing out.

How's that? The telecom sector has just been mediocre of late, but you might want to be careful of what you consider 'the sector'. The big boys, Verizon (NYSE:VZ) and AT&T (NYSE:T), are making the group - and your portfolio - look bad. The Telecom HOLDRs fund is up only 0.9% for the last week and a half, and down 1.9% since the end of March.

No big deal, as sectors come and go (and stall) all the time, right? Nine times out of 10, I'd agree - this is the one out of ten times though. The sector indices and sector funds may be tepid, but the sector hardly reflects (in an equitable way anyway) the majority of the opportunities from the group.

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Size Matters
As for where the opportunities really are here, compare TTH's weak performance for the last week and a half to a 5.4% gain, and then compare the fund's 1.9% dip since March to a 4.4% gain. For that matter, compare Wednesday's weak 0.46% rise from the telecom ETF to a 3.36% pop.

Those gains that easily outperformed TTH's numbers? They weren't hypothetical - they were really achieved by the S&P Small Cap Integrated Telecom Services Index.

Not a One-Trick Pony... Really
The bulk of the recent gains in the small cap telecom services group can be attributed to one name - Vonage (NYSE:VG). The VOIP service provider rallied 11.4% on Wednesday, pushing it to a 26.5% gain for the last week and a half.

Some might make the notation and end the story there, assuming one stock can't carry the group forever. Normally I'd be inclined to agree. You may want to take a closer look at the other small stocks in the sector though. There are some other surprisingly strong stocks of companies with surprisingly strong results. In fact, I'd venture to say the small caps in the group are the safe plays, while VZ and T are the liabilities.

Not All the Runts are Picks
To be clear, this isn't a case where any small cap telecom is as good as another; there are some problem children in the group.

Alaska Communications Group (Nasdaq:ALSK) is one of them. Nobody's more impressed than I am by the 12% run we've seen from ALSK over the last four weeks. Unfortunately, a couple of bad misses on the quarterly earnings front recently makes that forward-looking (2011) P/E of 27.7 more of a pipedream and less of a probability - and it's still an expensive pipedream at that.

No, if I had to pick a poster child for small cap telecom, it would be Cincinnati Bell (NYSW:CBB).

Sexy? No, and it's been modestly hit-and-miss with its quarterly earnings estimates over the last year or so. But, with a single-digit P/E ratio and a reliable 10-12 cents worth of earnings per share each and every quarter now, I'll take it over less reliable competition.

Shenandoah Telecommunications (Nasdaq:SHEN) is another diamond in the rough, topping estimates in three of its last four quarters, and posting margins in the mid-teens - the kind that make the big boys sick.

And where does Vonage stand?

I'll say this much - though I've not been a big fan of the company to date, the fact that we've seen four straight earnings 'beats' is undeniable evidence that whatever they're doing is indeed working. Moreover, those four beats makes 2011's EPS estimate of 9 cents (the company earned 13 cents per share over the last 12 months alone) look well short of the actual potential here. Just don't get trapped (or distracted) by the noise and step in at a short-term high.

The Bottom Line
While the message here was the suggestion of small cap telecom as your next stop in the search for winning stocks, it's not the only point to be made.

At 55% and 28% of TTH's holdings, AT&T and Verizon pretty much are the fund. That's not a complaint - that's just the way cap-weighted index funds work (which is most funds). In this particular case though, that setup is blinding a lot of investors to a few really solid stocks. (To learn more about different types of indices, see: Market Cap, Equal Weight And Fundamental Indexing.)

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