Good Time to Go Bottom-Fishing for Telecoms

Citigroup certainly thinks so. Tobias Levkovich, the firm's chief U.S. equity strategist, recently upgraded the telecom sector to Overweight, based in part on valuations and the fact that analysts seem to be about done with slashing their estimates for the group. True, this was no table-pounding call. Rather, it was a suggestion as to allocation with an eye toward next year. "We remind readers that our views look at relative performance over the next 12 months, not 12 days, so we are incorporating likely changes to trend," Levkovich wrote.

That view is buttressed by past events. Telecoms historically underperform the market when the economy is in a down cycle, and they've certainly lagged the broader market in 2008. But as Soleil Securities Group analyst Gregory Lundberg noted Wednesday, "if we're coming out of a down cycle or are in a period of stability, then telecom is poised for outperformance."

So let's be optimistic and opportunistic and cast an eye toward later this year or early 2009. In addition to looking cheap right now, telecoms generally throw off lots of free cash. And as shares have plummeted, some dividend yields have become tantalizingly high.

Exchange-traded funds such as the Vanguard Telecom Services ETF (VOX) and the iShares Dow Jones US Telecom (IYZ) offer cheap and diversified ways to give domestic telcos more weight in your portfolio. The iShares S&P Global Telecommunications (IXP) adds international telecoms to the mix. They're an easy way to allocate toward telecoms, but they may not be ideal.

Sector ETFs are indiscriminate and pose their own hazards, as Steven Roge, manager of the Roge Partners (ROGEX) and the Roge Select Opportunities (RSOFX) mutual funds, points out. "We don't like recommending sector-specific ETFs for the most part," he says. "In general, it's very tough to pick specific sectors that are going to do well and the volatility of any one sector is pretty great."

But Roge does believe there are opportunities among specific stocks in the telecom space. His favorite pick is SK Telecom (SKM). The South Korean company has more than 50% of its home country's wireless market share and is No. 2 in the fixed line business. SK Telecom also has opportunities in emerging regions where there's still much growth to be tapped. "We believe they could take the majority of market share in Vietnam within a three-year period," Roge says.

Shares in SK Telecom have tumbled 25% year to date, making the stock look compellingly valued with a forward price/earnings multiple of less than 9. That offers roughly a 30% discount to peers. It also doesn't hurt that the company generates about $2 billion in free cash flow a year. "We think it's worth $40 a share," Roge says. The stock is currently fetching $22 and change.

Jeff Markunas, portfolio manager of the RidgeWorth Large Cap Core Equity Fund (CRVAX), isn't particularly enamored of the telecom sector, either, but he does see one decent opportunity. AT&T (T) represents his only holding in the space. "It's a high-quality megacap company with a 4% yield throwing off a ton of cash," he says. "I'm not looking for shocking upside, but their business model relative to others in is pretty good shape."

With the market having little faith in Street estimates, hitting your numbers and not disappointing on guidance is critical these days, and AT&T looks likely to do so, Markunas points out. "A lot of estimates are getting cut but they look like theirs are achievable," he says.

Shares in AT&T have held up comparatively well year to date, having given up 8%. With a forward P/E of 11, the stock's trading at about a 25% discount to its own five-year average and nearly 60% to peers, according to Thomson Financial. Analysts' median price target of $44 implies upside of about 15%. And don't forget that 4.2% yield on the $1.60 a share dividend.

Like AT&T, Verizon (VZ) is a high-quality megacap, and with shares off 18% year to date, the yield on the dividend is up to 4.7%. Citigroup added the name to its recommended list when it upgraded the sector and shares do look undervalued. The forward P/E of 12 offers discounts of about 15% and 50% to its historical average and peers, respectively. Analysts' average price target stands at $45, up 25% from current levels.

It's hard to generate much enthusiasm for telecoms, what with the market and the economy being as it is. But they've fallen very far very fast, and they do indeed look cheap. History suggests they're set to outperform, relatively speaking at least, once the acrid smoke has cleared. If market watchers can bang the drum for financials, maybe they should consider ringing a tiny bell for telcos, too.