Chapter 4

TELECOM SECTOR DRIVERS

First of all, what is a driver? Drivers are factors that impact—positively or negatively—the performance of stocks, industries, sectors, and the entire market. In this chapter, we’ll look at how drivers impact the performance of Telecom—both the broad category and individual stocks—relative to the benchmark.

There are three broad categories of drivers you can use to examine the forward-looking prospects for any stock market sector:

Drivers—in any of these categories—impact Telecom’s relative performance in a variety of ways: They may affect earnings, profitability, growth, cost of capital, industry regulations, and investors’ appetite for risk, among other things. But investors should primarily be concerned about how drivers ultimately impact investment returns relative to the broader market.

As you learn about drivers in this chapter, it’s important to remember the relative importance of different drivers varies throughout time—this is especially true in Telecom, which has undergone significant structural changes and become much more competitive as deregulation has progressed globally. Often, different drivers point in different directions, and it is up to investors to determine which drivers are most important at any given point.

ECONOMIC DRIVERS

A full book could easily be devoted to economic drivers, but this section will focus on the macroeconomic drivers most applicable to the Telecom sector, which include:

• Economic growth (or lack thereof)
• Interest rates
• Inflation
• Innovation

The easiest way to measure economic drivers is through a slew of macroeconomic indicators that are publicly released regularly. Macroeconomic indicators take the pulse of the economy. Countries’ gross domestic product (GDP) numbers, interest rates, and inflation help paint a picture of the current state of the economy. And they can help you shape expectations about the economy and how it may impact telcos looking forward. Deciphering economic data isn’t easy. Economic reports can be volatile, contradict one another, and are often subject to later revisions. And economic data are usually inherently backward-looking. The data report on what just happened; they don’t necessarily tell you what is going to happen. Markets discount economic news with astounding speed, so investors need to know more than what happened—they must consider what’s next.

So how do you use macroeconomic data to your advantage? By staying abreast of the most important indicators and asking whether present conditions are better or worse than what’s reflected in investor sentiment and market prices. Then, consider where you think the economy is most likely to go in the future based on current trends. You’re looking for predictive value. You’re not as interested in what’s on the cover of the Wall Street Journal today. You’re interested in what’s going to be on the cover next month or next year.

Economic Growth

As a defensive sector with limited sensitivity to the economic cycle (see Chapter 1), Telecom tends to perform best relative to the rest of the stock market when the economic outlook is weakening. This is not because a weak economy is actually beneficial for Telecom fundamentals—after all, employment and housing construction drive demand for fixed lines, and consumer spending affects mobile phone revenue. It’s just that Telecom is less economically sensitive than most other sectors. As such, it’s seen as a relatively safer bet than more economically sensitive sectors (like Energy, Materials, and Consumer Discretionary) when expectations are for weaker growth.

The most frequently used measure of economic growth is gross domestic product—the aggregate output of an economy. But quarterly GDP data are released a month after the quarter ends—they are inherently backward-looking. By the time quarterly GDP is published, economists have already reviewed a plethora of weekly and monthly data releases, and the general economic trend is usually fairly well discounted by the stock market.

And because the stock market tends to lead the economy, Telecom’s relative performance tends to be more closely negatively correlated with some leading indicators of the economy rather than with GDP itself. One indicator that’s historically been useful is the Institute for Supply Management’s Purchasing Manager’s Index—or PMI (www.ism.ws). This index is based on a survey of purchasing managers at manufacturing firms in the United States and gauges the direction of the industrial economy, including trends in new orders, production, shipments, employment, pricing, and other metrics. A rising PMI is a fairly good indicator of increasing economic activity, while a falling PMI is typically indicative of a slowing or shrinking economy.

Figure 4.1 shows the trailing one-year return of the MSCI World Telecom Index relative to the MSCI World (left axis), and the year-over-year-change in the PMI (right axis). Telecom has historically outperformed when the PMI index is falling and underperformed when it is rising. However, one major exception was at the turn of the twenty-first century, when both the PMI and Telecom deflated with the Tech bubble (which we covered in Chapter 2).

Figure 4.1 Telecom Relative Performance and the Purchasing Manager’s Index

Sources: Thomson Reuters, MSCI World Telecommunication Services and MSCI World Index total returns;1 Institute for Supply Management, Purchasing Managers Index, 8/15/96 to 8/15/10.

Interest Rates

Telecom’s performance, relative to the broad market, has historically demonstrated a negative correlation to the 10-year US Treasury yield—a benchmark for the risk-free interest rate. When a bear market hits, investors are scared and often flee to investments deemed safe and defensive. So they buy Telecom stocks because their revenue and earnings are typically more stable than more economically sensitive sectors. Simultaneously, investors tend to favor US Treasuries because they are considered “risk-free.” Such buying drives the prices of bonds up and their yields down. Also, yields fall because the Federal Reserve usually lowers its discount rate during a bear market, which pressures Treasury yields down and provides banks more incentive to lend and help reignite economic growth. The net effect is that when interest rates are going down, it may be a good time to overweight Telecom.

Telecom benefits not just from stock investors seeking shelter in a bear market, but also from fixed-income investors seeking a yield. US Treasury yields get driven so low, investors can be attracted to Telecom’s relatively high dividend yield.

Lastly, Telecom outperforms when interest rates are low because it’s capital intensive and firms are highly dependent on bond markets for long-term financing. When interest rates are high and credit is tight, Telecom firms have to pay much more in interest—which can be a drag on earnings. Not only does it cost more to fund current debt, but without access to more money, spending will likely decrease—which could slow growth in the near term.

Just as Telecom tends to outperform when interest rates are falling, it typically underperforms when rates are rising for the same reasons. Rising interest rates usually coincide with bull markets, when economically sensitive stocks are in favor—that’s typically when Telecom’s dividend yield is relatively unattractive and when firms’ interest expenses are high and tend to weigh on earnings.

If you have a firm conviction on which direction you think interest rates will go, you may want to overweight or underweight Telecom accordingly.

Inflation

Expectations for higher inflation are generally bad for Telecom and a signal to underweight the sector. Why? Interest rates again—inflationary periods usually coincide with high interest rates.

When inflation expectations rise, lenders require higher nominal interest rates on loans in order to maintain their real (i.e., inflation-adjusted) rate of return. And historically, the yield on the 10-year Treasury note tends to track inflation expectations.

Nevertheless, inflation is a good example of how tricky it can be to interpret whether an economic driver is pointing to Telecom outperforming or underperforming the broader market. Some argue inflation is good for Telecom firms because regulatory mechanisms allow them to pass along rising costs more easily than other sectors, which results in their outperformance. And while Telecom tends to underperform more often than not during periods of expected higher inflation, it’s important to remember there will always be exceptions.

Innovation

Innovation of new technologies cannot be overlooked as an important driver of the Telecom sector. Consider the transition from analog to digital transmissions and the cost reductions and deregulation that has accompanied it—innovation has reshaped the Telecom landscape, with significant impacts for investors.

There is no easy way to forecast innovation or to anticipate the speed at which it transforms the sector—for better or worse—but investors who see the promise of new technologies in their earliest stages and can correctly understand how it will impact Telecom may have an advantage over others. This is true on the sector level, but also on the industry and stock level—more innovative players are likely to be better relative bets.

Today, Telecom is facing the rapid development of new technologies and services, but it isn’t always clear what future supply and demand will be and what prices consumers will be willing to pay. Although it is widely known that smartphones increase data consumption, few correctly predicted the wild popularity of Apple’s iPhone—or the stress it would put on AT&T’s network when data usage suddenly spiked. When it’s tough to predict demand, it’s tough to predict supply. For example, during the Tech craze of the late 1990s, wild estimates for Internet growth rates drove telcos to grossly overinvest in bandwidth—then subsequently get slaughtered when the growth projections turned out to be wrong. CEOs may be cautious about repeating a mistake they so recently made.

POLITICAL DRIVERS

Government policies are used around the world to stimulate or slow economic activity (with varying degrees of success), redistribute wealth, promote social goals, or simply generate tax revenue. Although the net societal benefits of any new government policy are usually a matter of perspective, most policy changes do create economic winners and losers.

Government policy affects the Telecom sector in many ways, ranging from expansive changes, like net neutrality (which we’ll discuss in Chapter 6), that could affect a broad array of industries and practically all consumers, to local regulatory proceedings that affect only a regional carrier. Some of the most important political drivers affecting the Telecom sector include:

• Political shifts
• Regulatory changes

Political Shifts

It’s not always easy to predict what regulation will be passed and enforced by a political administration. After all, who could have predicted Janet Jackson’s “wardrobe malfunction” during the halftime show of Super Bowl XXXVIII would kickstart a chain of events leading to President George W. Bush signing a law that stiffened decency penalties from $32,500 to $325,000 per violation?

Under most political administrations, regulators ostensibly seek to protect consumers—but what they’re being protected from can differ. Under the Bush administration, the FCC protected consumers from “wardrobe malfunctions,” while the Obama administration seeks to protect consumers from industry misbehavior through net neutrality.

In most markets, deregulation spurs cheaper prices, innovation, and greater competition and investment, which can benefit consumers, investors, and companies. With this in mind, one might hypothesize Telecom performs better when elections bring Republican governments to power (which tend to favor less government involvement in the sector)—and worse under Democratic governments (which have often advocated for a larger government role). As illustrated in Table 4.1, this does seem to be the case: Telecom has performed better on both a relative and absolute basis under Republican governments. The table shows returns for the Telecom sector and the S&P 500, the Telecom sector’s relative return for each presidential term, and the average returns during both Republican and Democratic terms since 1961.

Table 4.1 Telecom and US Presidential Administrations

Source: Global Financial Data, Inc., total returns for S&P 500 Telecommunication Services and S&P 500 Composite, 1961–2009.

But investors shouldn’t draw too many conclusions about the future based on this historical analysis. The reality is a candidate’s political affiliation and campaign promises tell us little about what his actual policy agenda might look like when he’s in office—and even less about what he’ll actually be able to accomplish. Politicians frequently say one thing and do another.

Moreover, there are many other factors at play that may be much more important than the political party in the White House. A large portion of Telecom’s relative performance advantage during Republican administrations is the result of a weaker overall market—a trend that has been shown to be more attributable to longer-term cyclical trends than any specific public policy agenda.

So while elections—and the parties they bring to power—may provide a place to start political analysis, investors must ask deeper questions. What policies are on the legislative agenda? What do policymakers have to gain or lose from various political outcomes? Are there elections coming up that may have an impact? What do public opinion polls say about relevant issues? Who have policymakers appointed to implement and enforce their policies?

But even when the laws are passed and the rules are made, they don’t always have the effect politicians intend—and sometimes they do almost the opposite. For example, as detailed in Chapter 2, the US government broke up Ma Bell to encourage more entrants and greater competition, but the opposite occurred. Since then, in order to better compete, the US Telecom sector has consolidated—of the original seven Baby Bells, only three remain.

The key to understanding a political agenda’s impact is often determining the likelihood of whether regulation will be tightened or loosened—because it’s surprises that move markets, not information that is already widely known.

Regulatory Changes

Transforming telecommunications from monopolies to competitive markets has required government intervention to ensure the monopolies don’t behead new entrants and competition actually takes hold. As the Telecom sector continues to liberalize, reconciling the interests of governments, customers, new entrants, and incumbents is challenging because they are often at odds. As a result, regulators have to make trade-offs between the objectives and welfare of different interest groups, which are often prioritized depending on the political party in power.

Regulation’s Implementation

Although regulators’ objectives (listed in Chapter 1) are usually widely accepted, their implementation is often controversial. Over the past couple decades, regulation has become more difficult as slow-moving government regulators try to keep pace with technological advancements and changing market dynamics. Whereas regulators previously monitored a voice business over one infrastructure, they now oversee voice, broadband, and video—and all three can be bundled together over various infrastructures. In such an environment, how regulation is implemented poses opportunities and risks to Telecom firms.

Pricing

Because monopolies or service providers with few competitors could charge high rates if unregulated, regulators attempt to emulate the outcomes of competitive markets to determine “fair” prices. There are numerous forms of price regulation in Telecom, but price caps are the most widely used. Price cap regulation uses a predetermined formula to set the price increases a firm can charge—usually for a couple years. Although the caps can be based on anything, they are often based either on inflation or costs. However, the caps can be controversial due to complications in calculating costs and the large impact they can have on both carriers and consumers.

And while price caps seem like a negative for telcos and Telecom investors, they can actually prove somewhat positive if a telco is allowed to keep any benefits from incremental productivity gains. Also, a price cap may encourage a company to seek more innovative services to bolster its business and shareholder value.

Nevertheless, price regulation exemplifies the difficulty of finding an optimal regulatory policy. Price controls may keep prices low for consumers, but they often deter competition and therefore contradict a primary goal for regulators. For example, when a regulator caps the price a telco can charge for a service, it not only hurts the operator who has less incentive to invest in its business, but may also deter new entrants and therefore competition. If prices are too low and new entrants are unable to recoup their high capital investments, they won’t enter the market—so regulators must seek to set prices that ensure affordability for the public while allowing enough profitability for service providers to be motivated to reinvest in their businesses and for competitors to be motivated to enter the market.

Intercarrier Compensation

Interconnection or termination fees are the charges one telecommunications operator charges another for connecting and terminating calls on its network. For example, if you’re an AT&T mobile customer and you call someone on Verizon Wireless, AT&T must pay a fee to Verizon. If you have ever been hit with a nasty mobile phone bill for roaming, interconnection fees were likely the culprit. Such interconnection fees can contribute significantly to a telco’s bottom line and are therefore subject to considerable political risk. Take Turkcell, the largest wireless provider in Turkey. Regulators cut termination rates by 52 percent in 2010, which was great for customers and competitors, but terrible for Turkcell because it terminates disproportionately more calls on its network than on competitors’. As telecom markets have progressively liberalized, interconnection arrangements have become a critical factor for the viability of competition.

Licensing

Licenses are a way regulators can control the number of operators in a region and affect competition. In order to operate in the Telecommunications sector, licenses for new entrants are usually granted by the regulator through a competitive application process. Licenses not only regulate the level of competition in a market, but also provide investors an understanding of the business they are investing in—they specify what a company can and cannot do.

Spectrum

Spectrum is another control governments and regulators have to dictate the level of supply and competition in a market. Governments control the availability and cost of radio frequency spectrum wireless providers operate on.

Taxes

Tax policy is capable of materially impacting any company, and broad changes in the corporate tax rate have a direct effect on all companies’ income. However, many changes aren’t sweeping revisions to the tax code—they are typically smaller provisions that may go relatively unnoticed, but still may be important drivers.

Because the sector tends to return a large portion of its earnings to shareholders through dividends, changes in the dividend tax rate are particularly important to Telecom. In other words, the high dividend yields on Telecom stocks are worth more to investors on an after-tax basis when dividend taxes are lower.

SENTIMENT DRIVERS

Sentiment is the least tangible sector driver. Put simply, sentiment can mean how receptive people are to buying or selling stock—and like any mood, sentiment can change quickly and be hard to measure. It plays a large role in near-term market prices because the stock market is driven by humans making decisions—inclusive of their rational choices and their irrational emotions.

Risk Aversion

Perhaps the most important sentiment driver is risk aversion. Risk aversion can be so low or high, it causes investors to lose sight of economic and political drivers. Because of its defensive nature, Telecom tends to do better when investors are highly risk averse. When investors expect a bear market—rightly or wrongly—they tend to flock to the relative safety of Telecom.

Value Versus Growth

Growth investors tend to favor companies with above-average earnings growth rates, while value investors tend to prefer companies with below-average valuations. There are many benchmarks for these disciplines, including the well-known Russell Value and Growth indexes.

Although proponents of each style would argue their discipline is superior, the risk and return characteristics of both investment styles are similar over the long run. However, they do cycle in and out of favor. At times, growth steadily beats value, and at other times, value steadily beats growth.

Telecom, with its normally low growth rates and below-average valuations, tends to be shunned by growth investors and embraced by value investors. This is well illustrated in Figure 4.2, which shows the year-over-year return of US Telecom relative to the S&P 500 and year-over-year return of the Russell 3000 Value relative to the Russell 3000 Growth. Because there is a fairly strong positive relationship, if you believe value stocks will be in favor and you’re right, it’s likely Telecom will outperform.

Figure 4.2 US Telecom Returns Relative to S&P 500 and Value-Growth Cycles

Source: Thomson Reuters, S&P 500 Composite total returns, Russell 3000 Value total returns, Russell 3000 Growth returns, 1979–2009; Global Financial Data, Inc., S&P 500 Telecommunication Services Index total returns, 1978–2009.

Large Cap Versus Small Cap

Similar to the value-growth cycle, there are periods in which companies with large market capitalizations (large cap) are favored over small capitalization (small cap) stocks and vice versa. Historically, big companies fare better during recessions while small companies bounce big early in the recovery. During periods of volatility and uncertainty, large companies are frequently seen as a relatively safer haven—they’re seen as being stable businesses with healthier balance sheets that can weather an economic storm better than small companies. In turn, coming out of a recession, small cap stocks typically outperform because they usually suffered more during the recession and bounce bigger off the bottom. They are seen as being more nimble and able to make strategic changes more quickly. They can also disproportionately benefit from an increase in mergers and acquisitions—which is common toward the end of a recession. (Though these characterizations of big versus small can certainly be true, perception is what’s most powerful in driving stock returns in the near term.) And because telcos are usually huge, it’s no surprise they typically perform better when large cap is beating small cap, as shown in Figure 4.3.

Figure 4.3 US Telecom Returns Relative to the S&P 500 Index and Large-Small Cap Cycles

Sources: Thomson Reuters, S&P 500 Composite total returns, Russell 1000 Index total returns, Russell 2000 Index total returns, 1979–2009; Global Financial Data, Inc., S&P 500 Telecommunication Services Index total returns, 1979–2009.

Chapter Recap

Like every other sector, Telecom has a set of economic, political, and sentiment drivers. Identifying these drivers can help determine when to overweight and underweight the Telecom sector. The relative importance of different drivers varies over time, and they often point in different directions. It’s therefore up to you, the investor, to determine which drivers are most important at any given point.

• Telecom performs best relative to the rest of the stock market when the economic outlook is weakening. This is not because a weak economy is actually beneficial for Telecom fundamentals; it’s just less detrimental than it is for most other sectors.
• Telecom tends to outperform when interest rates are falling and underperform when interest rates are rising.
• Because Telecom is regulated more than most sectors, the political and regulatory risks can be significant. Therefore, understanding political agendas can help investors predict potential regulatory changes and their impact on the sector.
• Risk aversion is the most important sentiment driver. Telecom tends to perform best when investors are highly risk averse.
• Telecom typically outperforms when value and/or large cap stocks are in favor.