A Primer on the Telecom Sector

By Nicole Seghetti | September 18, 2012

This month at The Motley Fool, we're taking an all-hands-on-deck approach to getting back to basics, culminating on Sept. 25 with Worldwide Invest Better Day. With this in mind, my Foolish colleagues and I are opening the floodgates and unleashing vital information to help you invest better. In a previous article, we reviewed stock diversification, a key fundamental of investing. Today, we'll focus on telecom stocks.

Telecom Sector 101

For many years, the telecom industry was dominated by few players in clearly marked territories. But with the advent of cable, satellite, smartphones, and tablets, the lines of demarcation blur. Traditional telecom companies like AT&T (NYSE - T) now offer services like broadband and video. Meanwhile, cable and satellite companies like Comcast offer phone and wireless services. Even Internet and tech companies offer communication services like Microsoft's acquisition of Skype. The race is on; all want to be the one-stop-shop for your communication and entertainment needs.

According to Bloomberg Businessweek, half of all Americans own a smartphone. And this number is growing by nearly 2% per month. As such, wireless data consumption has experienced incredible growth both in the U.S. and internationally, as we demand more data on our mobile devices. Research by the World Bank finds that "for every 10% increase in the penetration of broadband services, developing countries can see an increase in economic growth of 1.3%." The wireless carriers poised to profit are the ones with rising numbers of subscribers and the ability to tie data consumption to revenue.

Saying hello to dividends

Stable earnings and cash flows have traditionally characterized the relatively defensive telecom sector. Typically, telecom companies pay healthy dividends, a main reason why investors flock to them, especially during periods of low interest rates. But not all dividends are created equal. Just because a company pays a hefty dividend doesn't necessarily mean it's a sustainable one.

Source: The Motley Fool.

Without a doubt, Windstream and Frontier Communications -- which primarily provide landlines to rural areas and small- and medium-sized cities -- both pay mouth-watering dividends. But even though Windstream generates significant cash flow, the company carries a cumbersome amount of debt on its balance sheet and is losing money. Hefty debt loads and falling subscriber rates also challenge Frontier Communications. Both companies' 100%-plus dividend payout ratios signal they pay more in dividends than they make in earnings. Consequently, both companies have cut their respective dividends. And further cuts shouldn't surprise investors. Meanwhile, communications equipment manufacturer Qualcomm pays a punier dividend, but has increased it substantially and has lots of room to grow even more.

A simple way to own the sector

If you're clueless when it comes to telecom stocks, consider exchange-traded funds. Some ETFs mimic the performance of an index, like the S&P 500, while others provide specific exposure to certain sectors. Sector-specific ETFs like SPDR S&P Telecom ETF are helpful when you lack information to make a good investing thesis. Using the MSCI World Sector Weightings as a benchmark, roughly 4% of your overall stock portfolio should be allocated to the telecom sector.

Invest better

If you bet wrong in the stock market, it could cost you. Instead, develop a diversified strategy for adding all sectors to your portfolio. That way, regardless of what happens in the market, you'll sleep well at night knowing a portion of your portfolio will prevail.