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Communications Stocks Look Strong Despite Market Turbulence

Companies / Telecoms Aug 24, 2007 - 08:33 PM GMT

By: Roger_Conrad

Companies

It's tough to keep in mind during times of turbulence, but market moods and trends come and go. The only constant is businesses. And the performance of those in your portfolio is what's ultimately going to determine whether your wealth expands or contracts.

This week, the markets returned to a relative state of calm. The key was the aggressive action by the Federal Reserve and the world's other central banks to pump liquidity into the global system and prevent the ongoing credit crunch from becoming an economic calamity.


There was also more than a little encouraging news on the economy.

Durable goods orders—basically, big ticket items like automobiles, airplanes, steel, etc.—were much stronger than expected for the month of July. And new home sales staged a surprising recovery in the South and West, offset by weakness in the Northeast and Midwest.

There are still some glaring pockets of weakness. This week, several substantial players left the mortgage business entirely, and rising adjustable rates are still pushing up default rates. In addition, several major banks around the world are reporting large losses related to tumbling US collateralized mortgage securities (CMOs).

The ultimate impact on consumers from the mortgage industry's collapse is another big unknown. Mass defaults not only bring major headaches and losses to the financial services industry; they can also be incredibly destructive to the real economy, as consumers stall or even halt discretionary purchases.

In a worst case, that could lead to a lot more layoffs than just mortgage bankers, setting off a vicious cycle of wealth destruction economywide. Whole communities are at risk of being ripped apart.

Everyone should be prepared to see more bad news in the coming weeks, as the real damage caused by the US mortgage industry's boom and bust come to light. That, in turn, could set off another round of extreme volatility in the financial markets, with the most leveraged and financially engaged players as the worst victims.

The silver lining here is the world's central banks—despite their zeal for fighting inflation—are determined not to let an economically destructive credit crunch develop. And they have the weapons at their disposal to do the job, mainly because the cure for any liquidity crisis is injecting liquidity.

As I wrote in Utility & Income a couple weeks ago, when the Federal Reserve and other central banks acted in 1998, the Asian Contagion wasn't cured right away. But their actions were the handwriting on the wall that the worst was behind us. It was time for investors to start looking ahead to what was likely to come.

In the late 1990s, it was a liquidity-spurred boom in the economy and markets, followed by renewed tightening by central banks to control inflation. That tightening eventually triggered the bust, which saw the Nasdaq Composite give up its unprecedented double of

1999 and a lot more.

Before that, however, income investors got another nasty surprise.

Yield-paying stocks had already been weak earlier in 1998, as the Federal Reserve tightened credit.

They got a reprieve as the financial crisis kicked in, and investors sought their relative safety. But from the end of 1998—when the so-called “growth stocks” began their surge—big dividend stocks started a long slide.

By the time they bottomed in late 1999, the Philadelphia Utility Index traded down more than 20 percent from mid-1998 levels. Even high-quality real estate investment trusts sold for barely asset value and yielded upward of 7 percent. And hundreds of solidly rated bonds and preferred stocks yielded 8 percent and up.

In my view, once this liquidity/credit crunch is deemed under control, the world's central banks are likely to resume the task they set for themselves a couple years ago: Try to keep inflation under control at a time when the global economy has been booming as never before. And the more they have to loosen now to stanch trouble in the mortgage market and elsewhere, the more they'll have to tighten later.

Since the subprime troubles began to surface this summer, the benchmark 10-year Treasury note yield has plunged from a high of more than 5.3 percent to less than 4.6 percent. This week, we got a taste of just how ephemeral that decline may prove to be if the economic ground should suddenly shift and inflation, rather than recession, become the primary concern of market players—as a better-than-expected employment number sent the T-note yield back toward 4.65 percent.

There's at least one major difference between now and the late '90s that should work to income investors' advantage when we cycle out of this decade's credit crunch. The late '90s were a growth-driven market, where promise almost always counted more than real profits.

Income investments were widely derided by advisors and in the popular financial press.

One popular strategy touted by more than a few analysts was for income investors to dump their dividend-paying stocks to buy growth funds. The idea was that growth funds would throw off much higher returns and that investors could sell shares as needed to pay their bills. That was easily one of the most disastrous strategies recommended in memory.

The good news is we're about 180 degrees away from that market mood here in mid-2007, which is very income-centric. As a result, we're unlikely to see a repeat of the 1999 market.

Nonetheless, we're going to be far better off with high yields backed by good businesses, with the ability to boost cash flows and dividends. That's always the case for long-term investors. But the distinction is likely to be more important than ever for performance in the next year or so.

QUALITY FIRST

One such business is communications. Sector stocks languished in a virtual depression beginning with the technology stock crash of 2000 up until the past year or so. Every earnings report was met with extreme gloom, as analysts focused on the loss of basic phone line connections as evidence of an industry in long-term decline.

Missing from the analysis was the definite good news that relatively new services—particularly the use of wireless phone and broadband connections—were more than picking up the slack. Moreover, the larger these operations became, the greater the impact their growth had on communications companies' overall profits and the less the impact of declining basic connections.

In the past year or so, the improving numbers have become increasingly difficult to ignore. Earnings at large communications providers such as AT&T CORP, COMCAST CORP and VERIZON COMMUNICATIONS have begun to routinely expand at double-digit rates as revenue per customer has exploded.

Cable and telecom companies alike are still losing basic connections. But that's no longer the story. Rather, it's all about upselling to a provider's best customers. That's what's powering the growth, and it's what will continue to in the future, as connectivity improves and product lines proliferate in everything from business data to music.

As I commented in a recent U&I review of Comcast's earnings, media coverage of communications company earnings is still tightly focused on the basic connections issue. Comcast's 30 percent jump in second quarter cash flow and revenue, for example, was basically ignored.

Instead, the headline was the supposed “disappointment” of some analysts that it lost more than the expected number of basic cable customers, not including the thousands it had acquired.

Some investors have begun to focus on the industry's growth story.

That's why shares of AT&T and Verizon, at least, have turned up from decade lows in the past year. The pessimism persists in some quarters, however, and continues to hold back their shares.

Therein lies the buying opportunity. Basically, the big three of AT&T, Comcast and Verizon are becoming more powerful and more profitable every day. But market recognition of their strengths is growing at a much smaller rate of speed.

That's left these stocks perpetually undervalued. As we saw this summer, that limits downside in bad markets.

All three stocks slipped a bit on the worst days. But Verizon has swiftly recovered the lost ground, and AT&T isn't far behind. Even Comcast has shown some signs of life, though it remains the cheapest of the three. Equally important, those good numbers will be particularly helpful as the credit cycle turns up in the coming weeks.

Of course, communications is no longer a regulated monopoly business, as it was in the hey day of Ma Bell, before its 1984 breakup. As anyone who has set foot in a cellular phone store lately knows, it's a more profitable business than ever. Despite the plunging cost of traditional local and long distance telephone calls, revenue per customer has been on an upward tear, as new services proliferate and become ever more essential.

Who would have thought even five years ago, for example, that people would be carrying devices like Blackberrys and iPhones in growing numbers. Wireless phone penetration in some countries like Israel is more than 100 percent--in other words, more than one wireless device per citizen.

The best news about the US Big Three is they dominate a market with a penetration rate that's still relatively low. As a result, they can count on continued strong growth in basic wireless customers, as well as new services.

Ditto wireline broadband service, which continues to burgeon.

Verizon's FiOS build-out continues to exceed expectations for acceptance and profitability.

The most important strength of the Big Three is they brook no rivals. At the same time communications industry revenue has exploded, market power has increasingly consolidated. That's in stark contrast to most industries, where rising profitability invariably leads to greater competitive threats.

What sets communications service apart from other sectors is the importance of size and scale. Only the biggest companies have the financial power to build out networks and provide services consumers demand.

The new challenge of integrating wireless and wireline infrastructure into a coherent whole will only magnify the essentiality of increasing scale. The little guys just can't keep up.

Ironically, I've rarely heard Wall Street analysts comment on the importance of being big in telecom. The root of that may have been the basic unpopularity of NYNEX, which was the Baby Bell spinoff serving New York City.

Whatever the reason, the Street has frequently been a cheerleader for the rivals of Big Telecom and Big Cable. In the late '90s, for example, Wall Street houses threw hundreds of billions of dollars at the competitive local exchange carriers (CLECs) in the vain hope they'd prove to be real market rivals to the giants. That money went up in smoke shortly thereafter because CLECs were unable to keep up with their larger rivals.

More recently, voice over Internet protocol service provider VONAGE captured the imagination of many gullible analysts with its claim to capture millions of telephone customers from the giants. And those who bought into its initial public offering at the extremely inflated price have lived to regret it, though are hopefully wiser for the experience.

Small wireless companies have fared slightly better than the wireline upstarts. However, that's mainly because the giants have been keen on acquiring spectrum for growing their networks. That's given them the exit strategy of being taken over. AT&T and Verizon have both made major buys this summer, and the remaining independents also remain prime candidates.

Today, there's excitement in some circles about a possible bid by Google and other Internet content giants to build a rival wireless and data network to the big boys. The content giants have convinced the Federal Communications Commission (FCC) to reserve a portion of spectrum in the upcoming auction—the last to involve major swaths—for the construction of an “open network” that would supposedly help break the market power of the giants.

Google is certainly a large, powerful company, and it's not hard to see why it's captured the imagination of some. Building a network, however, requires more than just a successful bid on spectrum, as the market has learned time and again with small communications providers. For starters, Google and its prospective partners have little expertise in running networks.

Rather, this seems more a move to ensure Google, YAHOO, AMAZON.COM and others will be able to conduct commerce in an untrammeled way in future years. That's certain to be a priority of every future FCC.

However, it's far more likely to be achieved by regulation rather than the construction of yet another wireless network.

Even SPRINT NEXTEL CORP'S buildout of Wimax—a wireless/wireline hybrid network—is showing signs of becoming a boondoggle, as costs escalate. This summer, the company announced it was throttling back plans. Even for a company in the business, it seems, it's expensive to make big moves. That's also reflected in the scaling back of a proposed venture between Sprint and the cable giants in wireless.

Ironically, even as the press has focused on their rivals, the nation's two biggest wireless companies—Verizon and AT&T—have emerged as most likely the biggest beneficiaries of the spectrum auction. That's because the FCC has a goal of maximizing revenue from bidding, and the best way to do that is to let the big boys bid. As a result, the auction rules will allow both companies to buy huge swaths of spectrum, filling out their networks and boosting their ability to offer new and better data services.

Communications stocks aren't risk free. If I'm wrong and the credit crunch takes a turn for the worse, even essential service businesses will slow a bit. But it's tough to beat cheap stocks of companies that have very strong balance sheets and dominate recession-resistant markets with wired-in growth from one of the world's surest trends: growing connectivity.

That's exactly what AT&T, Comcast and Verizon present today to investors. And come what may in the markets in the next few months, they'll be among the best places to be.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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