PRFQ: It All Depends on Its Blue Chips' Performance

by: Don Dion

When we last profiled PowerShares FTSE RAFI Telecommunications and Technology (PRFQ), back in late June, the fund had jumped from 36 to 18 on the Sector Momentum Table in the previous seven weeks and appeared poised to make a leap to the top of the list. PRFQ did inch upward a few spots, but for the most part it has shuffled between numbers 13 and 16 since early July. So while 2007 has been a good year for the telecom and technology sectors, it hasn’t been good enough to send PRFQ past many of the energy and materials funds that have dominated the top of the table.

If PRFQ is going to move north of last week’s position at number 13, it will need the giant firms in which it invests the bulk of its assets to finish the fourth quarter with a bang. Several of PRFQ’s top holdings seem positioned to do just that, but with the broader market enduring a period of increased instability, it’s not clear how these two highly volatile sectors will respond.

PRFQ held up fairly well during the last few months, even as the S&P 500 and many telecom and tech funds suffered losses. In the three months ending November 12, the fund managed only a 0.59% market return, but that’s 1.1 points ahead of the broad-market index and better than 62% of funds in Morningstar’s communications category. Moreover, PRFQ was one of just five funds listed on the Sector Momentum Table last week to show a positive return for the month ending November 8. The fund has held up well largely because its portfolio includes a host of blue chips and other firms with hefty cash flow, which investors typically prize during times of instability.

Mirroring its FTSE RAFI index, PRFQ selects stocks from the telecom and tech sectors based on book value and five-year averages of income, sales and dividends. The formula does not factor in market capitalization, making the fund more likely to avoid overvalued stocks than a market-cap-weighted portfolio would be. The fund’s portfolio recently included 101 holdings, most of which are very large companies: about 63% were labeled giant-cap by Morningstar. The firms represented in PRFQ’s portfolio cover all the industries in the tech and telecom sectors, including services, software, hardware, wireless and networking.

PRFQ usually invests more than 60% of its assets in its top ten holdings and loads the bulk of that in the top three or four holdings. Recently more than 37% of fund assets were invested in top holdings Microsoft (NASDAQ:MSFT), Verizon (NYSE:VZ) and AT&T (NYSE:T), tying PRFQ’s performance closely to the fate of those three firms. Each of these stocks has fared well in 2007, with Microsoft and AT&T each gaining about 13% for the year by November 9 and Verizon showing about a 20% return for the period. Verizon and AT&T are both enjoying major growth in their wireless units, and AT&T benefited in recent months from its association with the much-ballyhooed iPhone (which operates only on AT&T’s network).

There were few surprises among the third-quarter earnings reports from the major U.S. telecom firms released last month, but stronger-than-expected earnings from technology companies caught Wall Street off guard. The tech sector as a whole averaged 15% earnings growth in the third quarter, while the average stock in the S&P 500 actually saw earnings decrease by 1%.

Leading the tech pack was PRFQ number one holding Microsoft, which is in the midst of what’s turning out to be a stellar product cycle. This year, 2007, has been a big one for the software giant, which has released three crucial products: Windows Vista, Office 2007 and Halo 3. All have sold very well. Microsoft’s Windows and Office franchises are almost universally accepted as software norms, so the firm can count on seeing a share of the profits from just about every PC sold worldwide. The market for the Xbox video game Halo 3 is slightly more limited, but the firm still managed $300 million in sales during the week after the product hit retail shelves, not bad inlight of the $40 million the firm spent on producing the game. Shares in Microsoft responded to strong product sales, with six-year highs during the first week of November. The release of Microsoft Server 2008 next year, if successful, may help keep the stock going strong.

PRFQ, which had its inception on September 20 of last year, has only about 14 months of history behind it, but its performance so far stacks up well against similar funds. The most relevant comparison may be with its PowerShares telecom cousin, Dynamic Telecommunications and Wireless (PTE). PTE fared slightly better than PRFQ in late 2006 and early 2007— holding the number one spot on the Sector Momentum Table for four months—but it recently slipped back as some of the smaller telecom firms it invests in plummeted this fall. While PTE’s market value gained only 0.70% for the year through November 12, PRFQ’s shares returned just under 8%.

The main difference between PRFQ and PTE is market capitalization: PRFQ’s average market cap of $65.4 billion seems gargantuan next to PTE’s $7.7 billion average. During times when tech and telecom stocks are rallying, PTE is likely to come out on top, simply because investors will be more willing to take on the greater risk associated with smaller companies in search of the greater growth potential they offer. But if the economy as a whole continues to suffer from credit market turmoil, a weakening dollar and steep energy prices, PRFQ’s grounding in such blue-chip firms as Microsoft, Verizon and AT&T, which have market dominance and financial heft, might make it a safer bet.