If you're looking for low growth but fat yields, telecoms are for you.
Telecoms are the smallest sector by market cap in the S&P 500, making up less than 3% of the index. The sector didn't perform well after stocks bottomed in March 2009, and it isn't doing that well in 2010.
The S&P 500 is still up for the year marginally -- despite the historic one-day intraday drop on May 6 -- while telecoms are down 8.4%. What's dragging down the sector compared with the rest of the market?
The bottom of the barrel?
That telecoms have underperformed recently isn't surprising. This is a traditionally defensive sector, and in a recovering economy, many defensive stocks have lagged behind during the rally. What is surprising, though, is just how badly they're underperforming.
To look for answers, let's start with the two big companies in the sector, AT&T (NYSE: T ) and Verizon (NYSE: VZ ) . Both companies have great dividend yields -- 6.5% and 6.6%, respectively. Both trade at cheaper earnings than the overall market, at least on a forward-looking basis.
The problem is that there isn't much growth in the sector. Verizon's net income has slid steadily over the past five years. AT&T's revenue declined in 2009, and its earnings have stayed relatively stagnant since 2007.
Telecommunications is a business of falling prices, which encourages consolidation and cost-cutting. Ever since the government broke up the old AT&T in 1984, market forces have been trying to mash it back together. SBC, one of the broken-off arms of the old AT&T, swallowed the remains of its former parent and took its name. Similarly, Verizon, the successor to Bell Atlantic, bought MCI soon after it came out of bankruptcy protection in 2004.
The question with both large remaining telecoms is in overcoming the challenges of sliding landline revenues and maturing penetration in wireless services. Aging phone lines are very expensive to install and maintain. Still, both stocks may have all those problems priced in, and dividend yields way above the 10-year Treasury yield may in part reflect steady depreciation in the value of their assets.
High yields aren't unique to the biggest telecoms. The top three dividend yielders in the S&P 500 are telecoms -- Frontier Communications (NYSE: FTR ) at 12.9%, Windstream (NYSE: WIN ) at 9.5%, and CenturyTel (NYSE: CTL ) at 8.6%. The key feature of all three is that they are primarily rural telecoms with little competition. The risk is that all three have dividend payouts that are extremely high compared with their earnings. Frontier and Windstream, in fact, paid out significantly more in dividends than they've earned over the past 12 months. That means dividends could be cut at some point.
The key takeaway, though, is that if you're looking for strong growth, telecoms aren't for you. Investors seeking income, however, may find their cautious interest rewarded.
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Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.