After looking at different industries and comparing average return on equity to average price-to-book multiples, telecom stocks appear overvalued in aggregate. As a whole, these stocks appear promising for constructing net-short positions because they produce below-trend average ROE for their average price-to-book ratio. Using this top-down approach to choose industries for a net-short position, attractively-priced stocks and overpriced stocks were identified among telecom stocks.
Why create a fully or partially hedged position?
Alpha hunters might consider net short positions in industries trading at indefensible multiples, market neutral positions for fairly valued industries, and net long positions in industries with attractive valuations. If they are willing to hedge their positions, they can find more investment opportunities than they would by just hoping to find the best industries or stocks to buy today. Instead, they can use fully or partially hedged positions to bet on the mean reversion of different stocks in an industry while minimizing or reducing exposure to industry and market volatility.
Plots of these companies reveal how some stocks are much more attractively priced than others:
In each of these graphs a measure of growth is plotted on the y-axis as a function of a measure of cheapness on the x-axis. Historical price-to-earnings multiples, price-to-book multiples, and price-to-sales multiples were used as measures of cheapness. Analyst estimates for earnings growth, historical return on equity, and historical sales growth were plotted as measures of growth. More attractive stocks are found up and to the left while less attractive stocks are found down and to the right.
In the context of history, many of these valuations are simply indefensible. Historically, a price-to-earnings multiple near 15 is considered reasonable, yet there are several telecom stocks that exceed this rule of thumb.
Two above-trend stocks are presented in bold and three below-trend short picks are listed in italics:
Data from finviz.com
BCE and Siemens were found to lie among stocks in the upper left of these plots (higher growth, undervalued stocks) while Chunghwa Teleco, Equinix, and TW Telecom were found to lie at the lower right of these plots (lower growth, overvalued stocks). Based on this work, a net short position for telecom stocks can be constructed by buying BCE and SI shares while hedging with a larger total short position in CHT, EQIX, and TWTC shares.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.