Global Telecom Stocks Lose Luster

Includes: ACWI, ACWV, IOO
by: Russ Koesterich, CFA

Last summer I favored overweighting global telecom stocks within an equity portfolio. The thesis was that these stocks offered a compelling yield, and the added benefit was that the sector’s defensive characteristics meant that it was likely to hold up relatively well during a volatile period for equity markets. Given the recent rally in the sector, I would now advocate a more neutral stance on these stocks.

Since June 2011 the S&P global telecom Index has risen 1.4%, versus a loss of 1.9% for the S&P 1200. Much of the outperformance occurred during the past three months when global telecom rose by over 7%, versus a gain of roughly 2% for the S&P 1200.

My change of view is based primarily on valuation. As discussed in previous posts, while I believe that investors should emphasize dividends in their portfolios, this does not mean paying any price for income. Telecom still provides a rich yield, but the cost of generating that income stream has risen. The sector as represented by the S&P Global Telecommunications Sector Index now trades at approximately 1.8x price-to-book (P/B), a premium to its average valuation over the past five years. The stocks also appear increasingly expensive based on price-to-earnings (P/E), with the sector trading at 15.4x earnings, a hefty premium to its history.

Based on return on assets (ROA), telecom companies are also less profitable relative to their history than other sectors. In other words, while most segments of the market are experiencing above-average profitability, this is no longer true for global telecom companies in aggregate. Mediocre profitability is also evident on a relative basis; comparing the return-on-equity (ROE) of the sector at 11.2% to the global sector average of 21.2% also suggests that telecom stocks now look less compelling as compared to other sector plays.

Overall, I still prefer stocks and countries that offer a competitive yield at a reasonable price, ideally with a quality bias. These themes can still be found in a number of places: Global energy companies, smaller-developed markets, emerging markets in Latin America and Asia, and in U.S. mega-caps. However, given their recent outperformance, telecom no longer appears to be a particularly good manifestation of this theme. Given that, I would suggest taking this opportunity to reposition to take advantage of the opportunities highlighted above.

For investors looking for global exposure, I like the iShares MSCI ACWI Index Fund (NASDAQ:ACWI), the iShares MSCI All Country World Minimum Volatility Index Fund (NYSEARCA:ACWV), or the iShares S&P Global 100 Index Fund (NYSEARCA:IOO).

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