Stocks & Markets December 3, 2009, 8:58PM EST

Stocks: The Trouble with Telecom

Telecom may be the only S&P 500 sector to finish 2009 with a negative return. Can this unloved group repair its image with investors?

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After a traumatic beginning, the year 2009 has turned out to be a great year for U.S. stocks generally. But one sector of the market, telecom, wasn't allowed into the party.

In a year when many stocks have doubled on hopes of an economic recovery, telecom has been wounded by its reputation for slow, steady growth. While the Standard & Poor's 500-stock index is up 21% this year, the S&P 500 telecommunication service sector was down 1.6% year-to-date as of Nov. 27.

That's the only one of the broad index's sectors in negative territory. The tech sector has gained 50%, while consumer discretionary stocks have risen 35%.

Telecom's troubles are well-known on Wall Street. First, there is uncertainty about the effect of new regulations, particularly from the Obama Administration's Federal Communications Commission, or FCC.

Second, the recession has accelerated the trend away from traditional landline phone service, as more companies and residences cut lines or decide to switch to wireless, Internet, or cable phone service.

Third, competition among telecom players is fierce, both in offering new services—such as wireless smartphones—and in lowering prices.

Defensive Plays

But the biggest strike against telecom may have more to do with trends in the broader stock market, says Ron Altman Sr., portfolio manager of the Aston/M.D. Sass Enhanced Equity Fund (AMBEX). "Part of it has absolutely nothing to do with the fundamental outlook for these companies," he says.

AT&T (T) and Verizon Communications (VZ) dominate the telecom sector. Each firm has a market value greater than the other S&P 500 telecom stocks combined.

Telecom's problem is that both AT&T and Verizon are known as boring, slow-growing, defensive plays. But since March, the stock market has rewarded volatile, risky stocks. AT&T is down 4% this year, while Verizon has dropped 3.7%.

It might seem unfair: Telecom was hit hard by the start of the recession and the financial crisis, but it isn't benefiting from hopes of a recovery. The sector fell 34% in 2008.

"They led the way into the recession," says Collins Stewart analyst Greg Miller. But "these are largely defensive names, so they rarely lead the way out of recessions."

Steady Revenues

Some telecom businesses continue to grow, including wireless, data, and video. That's enough to partly offset the loss of landline customers and tough competitive pressures. For example, Verizon's revenues are up 9% in the past year, while AT&T's sales were basically flat. That's pretty good considering the median S&P 500 firm saw sales drop 6.5% in the last 12 months.

(Both AT&T and Verizon saw earnings-per-share slip about 11% in the past 12 months, as competition for customers narrowed profit margins. Earnings for the full telecom sector dropped 7.1% last quarter, while the profits for the entire S&P 500 fell 13.7%.)

"Their revenues have held up beautifully," says Charlie Smith, chief investment officer at Fort Pitt Capital Group, which has owned AT&T and Verizon shares for seven years.