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Broad­band HOLDRS (BDH) is our top pick for tele­com sec­tor ETFs. We also rate the invest­ment merit of the top three tele­com sec­tor ETFs.

Per our first-quarter-2011 review of U.S. Equity Sec­tor ETFs, the tele­com sec­tor is one of five sec­tors that gets our “neu­tral” rat­ing. Fig­ure 2 shows how the tele­com sector’s stocks and the mar­ket value attrib­uted to them stack up under the micro­scope of our stock rat­ing sys­tem. The tele­com sec­tor has only nine stocks that we rate attractive or better, and the sec­tor only has 30 stocks that we rank dangerous or worse. Some good stocks in the tele­com sec­tor to buy indi­vid­u­ally or as part of an ETF are Von­age (VG) and Ver­i­zon (VZ). Some stocks to avoid, sell or short in the telel­com sec­tor are Fron­tier Com­mu­ni­ca­tions Corp (FTR) and MetroPCS Com­mu­ni­ca­tions (PCS).

[Click all to enlarge]

Fig­ure 1: Tele­com Sec­tor – Cap­i­tal Allo­ca­tion & Hold­ings by Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

The tele­com sec­tor has 24% of its value in dangerous-or-worse-rated stocks com­pared to 29% of its value in attractive-or-better-rated stocks. Nearly half of the sector’s stocks get our “neu­tral” rat­ing, which causes the tele­com sec­tor to earn our neu­tral over­all risk/reward rating.

The key take­away here is that the tele­com sec­tor offers both good and poor invest­ment oppor­tu­ni­ties. The invest­ment value of each ETF is derived from its con­stituents, so ETFs that over­weight attractive-or-better-rated stocks, like BDH, are great invest­ment oppor­tu­ni­ties while ETFs that over­weight neutral-or-worse-rated stocks should be avoided.

When ana­lyz­ing the tele­com sec­tor ETFs, we started by iden­ti­fy­ing those ETFs with accept­able struc­tural integrity as mea­sured by XTF, an ETF research firm. We chose the six ETFs whose XTF rat­ing was above the sec­tor aver­age XTF rating.

Fig­ure 2: Tele­com ETFs With Accept­able Struc­tural Integrity

Sources: New Con­structs, LLC; XTF and com­pany filings

Fig­ure 2 shows clearly that not all tele­com ETFs are made the same. Dif­fer­ent ETFs have mean­ing­fully dif­fer­ent num­bers of hold­ings and, there­fore, dif­fer­ent allo­ca­tions to hold­ings. Given the dif­fer­ences in hold­ings and allo­ca­tions, these ETFs will likely per­form quite differently.

After deter­min­ing the struc­tural integrity, we ana­lyzed the invest­ment merit of each ETF based on how it allocated value to each stock it held. Fig­ure 3 shows how the six tele­com sec­tor ETFs stack up ver­sus each other and the over­all sec­tor based on their over­all risk/reward rat­ings and the allo­ca­tion of their hold­ings by rating.

Fig­ure 3: Invest­ment Merit Based on Hold­ings and Allocations

Sources: New Con­structs, LLC; XTF and com­pany filings

Attrac­tive ETFs:

BDH earns an Attrac­tive Over­all Risk/Reward rat­ing and, there­fore, is the only tele­com ETF we recommend.

Neu­tral ETFs:

TTH and VOX allo­cate the value of their fund in a way that earns them a Neu­tral Over­all Risk/Reward rat­ing. We rec­om­mend investors buy the Very Attrac­tive and Attrac­tive stocks in this sec­tor before buy­ing any of the tele­com ETFs except BDH. Fig­ure 3 con­trasts the dif­fer­ences in invest­ment merit between BDH, VOX, and the over­all sector.

Dan­ger­ous ETFs:

This report does not include any Dangerous-or-worse-rated ETFs.

Bench­mark Comparisons Sec­tor Benchmark

BDH out­per­forms the over­all tele­com sec­tor in quality-of-earnings rat­ings. BDH earns a Very Attrac­tive Eco­nomic vs. Reported Earn­ings rat­ing because its Eco­nomic Earn­ings are pos­i­tive and ris­ing. BDH has an ROIC of 16.9%, earn­ing it a Very Attrac­tive rat­ing, com­pared to the sector’s Dangerous-rated ROIC of 5%.

The tele­com sec­tor out­per­forms BDH in val­u­a­tion rat­ings. The sec­tor has a FCF Yield of 8.1%, earn­ing it an Attrac­tive rat­ing, and a GAP of 20 years com­pared to BDH’s FCF Yield of 4.5% and GAP of 27 years.

Fig­ure 4: BDH – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 5: Tele­com Sec­tor – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

BDH more effec­tively allo­cates cap­i­tal than the over­all tele­com sec­tor. Per Fig­ure 3 above, BDH allo­cates 12% of its value to Very Attractive-rated stocks while the sec­tor only allo­cates 0.3%. BDH also only allo­cates 0.5% of its value toward Very Dangerous-rated stocks com­pared to the sector’s Very Dan­ger­ous weight­ing of 2.2%.

Mar­ket Benchmark

BDH and the S&P 500 have com­pa­ra­ble quality-of-earnings rat­ing. BDH and the S&P 500 both earn Very Attrac­tive rat­ings for Eco­nomic vs. Reported Earn­ings and ROIC.

BDH and the S&P 500 also have com­pa­ra­ble val­u­a­tion rat­ings. BDH and the S&P have the same Price-to-EBV and GAP rat­ing but BDH’s FCF Yield of 4.5% earns it an Attrac­tive rat­ing com­pared to the S&P 500’s Neutral-rated FCF Yield of 2.4%.

Fig­ure 6: BDH – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

Fig­ure 7: S&P 500 – Risk/Reward Rating

Sources: New Con­structs, LLC and com­pany filings

BDH more effec­tively allo­cates cap­i­tal than the S&P 500. Per Fig­ure 3 above, it may appear that the S&P does a bet­ter job of allo­cat­ing cap­i­tal since it allo­cates 42.3% of its value to Attractive-or-better-rated stocks com­pared to BDH’s 12% weight­ing. How­ever, BDH’s 12% is allo­cated to com­pa­nies with sub­stan­tially more attrac­tive invest­ment oppor­tu­ni­ties. BDH also only allo­cates 14.5% of its value to Dangerous-or-worse-rated stocks while the S&P 500 allo­cates 23.7%.

Method­ol­ogy

This report offers rec­om­men­da­tions on tele­com sec­tor ETFs and bench­marks for (1) investors con­sid­er­ing buy­ing tele­com sec­tor ETFs and for (2) com­par­ing indi­vid­ual ETFs to the tele­com sec­tor and the S&P 500. Our analy­sis is based on aggre­gat­ing results from our mod­els on each of the com­pa­nies included in every ETF and the over­all sec­tor (43 com­pa­nies) based on data as of April 20. We aggre­gate results for the ETFs in the same way the ETFs are designed. Our goal is to empower investors to ana­lyze ETFs in the same way they ana­lyze indi­vid­ual stocks.

To make an informed ETF invest­ment, investors must consider:

1) The struc­tural integrity of the ETF and its abil­ity to ful­fill its stated objec­tive. We use XTF to find the top three ETFs with the best struc­tural integrity rating.

2) The qual­ity of the ETF’s hold­ings. We deter­mine and ETF’s qual­ity using our over­all risk/reward rat­ing system.

Given the suc­cess of our rat­ing sys­tem for indi­vid­ual stocks, we believe its appli­ca­tion to groups of stocks (i.e. ETFs and funds) helps investors make more informed ETF and mutual fund buy­ing deci­sions. Barron’s reg­u­larly fea­tures our unique ETF research.

Source: Some Good in Telecom Sector ETFs