Analysis: S&P sector reshuffle may do little for telecom stocks

By Sinéad Carew

(Reuters) - The S&P 500's three-company telecommunications services index is about to be folded into a much higher-profile group, but a brighter spotlight may not be enough to boost the stocks as investors continue to favor growth sectors.

The three telecom stocks - Verizon Communications Inc, AT&T Inc and CenturyLink Inc - will be included a newly-minted S&P 500 Communications Services Sector on Monday, along with high-flyers including Netflix Inc, Alphabet Inc and Facebook Inc.

The telecom sector has been the biggest loser among the S&P's 11 major sectors with an 4.4-percent decline so far in 2018, driven by AT&T's 13.3-percent drop. In comparison, many of the other companies joining the group have shown strong gains for the year with Netflix rising 91.5 percent, Twitter rising 21.7 percent and Alphabet rising 10.8 percent.

To be sure, passive investors will end up with telecom exposure by default if they invest in exchange-traded funds (ETFs) that mirror the new communications index.

But many active investors may still ignore telecom stocks, which are typically viewed as defensive investments because of slower, though relatively predictable, growth rates and high dividends.

Instead, they may look to faster-growing internet or media companies for exposure to the growth oriented communications sector.

"Telecoms are likely to fade into the background," according to Patrick Palfrey, equity strategist at Credit Suisse. "Investors aren't going to look to communications for dividend yield. They're going to look to it for businesses that have a tremendous opportunity to grow."

With interest rates rising and an economic expansion still intact, investors are putting more money into growth sectors than dividend stocks, which tend to do better in times of economic weakness. And investors looking to balance their portfolio across different sectors with some defensive bets would be unlikely to seek safety in the communications index.

"If you wanted to own safety or dividend yield you'd go to real estate investment trusts or utilities. Those sectors are uniformly one theme. That's dividend yield," said Palfrey.

Wall Street expects the S&P 500 communications sector to generate 21 percent earnings growth and 11.1 percent revenue growth for 2018, compared with 16.7 percent earnings growth and 7.4 percent revenue growth for the telecom stocks, according to data collected by Thomson Reuters.

Estimates for the next 12 months imply a trading multiple of 18.4 for the communications sector compared with the telecom sector's multiple of 10.6, according to Thomson Reuters data.

State Street Global advisors created the Communication Services Select Sector SPDR Fund ETF to mirror the reclassified sector while Vanguard created the Vanguard Communication Services index fund.

While the new ETFs will give some support to telecom stocks, the decisions of active investors, could have a bigger impact on performance after the reshuffle as passive investments represent a much smaller portion of equity investments. According to a 2017 estimate from BlackRock, less than 18 percent of the global stock market is owned by index-tracking investors.

Growth funds with large-cap investments have been sharply outperforming large-cap value funds with a 16.4-percent increase in value so far in 2018 while value counterparts gained 4.4 percent. In the last five years, growth funds rose 14.9 percent versus 10 percent for value funds, according to Lipper data.

Some stock pickers may take a fresh look at the telephone companies when they join the bigger index, which will make up 10 percent of the S&P 500 compared with the current telecom sector's a 2 percent weighting, according to Todd Rosenbluth, Director of ETF and mutual fund research at CFRA.

And value investors seeking high dividends would still opt for telecom stocks over their faster growing counterparts in the sector because they are cheaper, he said.

But even the strategists who were most hopeful for a boost from the reclassification sounded cautious.

"Telecoms is probably one of those areas where people have been leaning too heavily on the negative side," said Sameer Samana, global equity and technical strategist at Wells Fargo Investment Institute in St. Louis.

"It's not so much that we like it. It may just be a good time to not be as negative on it."

(Additional reporting by Trevor Hunnicutt and Noel Randewich; Editing by Nick Zieminski)