Sell AT&T and Verizon: Follow Warren Buffett's Approach With T-Mobile Instead

Many retirees and income-focused investors gravitate toward stable, dividend-paying stocks. After all, as we age, we look to de-risk our portfolios and seek consistent payouts to supplement Social Security, pensions, and other fixed payments.

In addition to fixed-income investments such as bonds, Verizon (VZ 1.17%) and AT&T (T 1.02%) have long been favorites among dividend investors. These huge companies operate in the telecom space, which is consolidated to just a few giants, making them "seem" safe. Furthermore, the importance of smartphones and the mobile internet makes one's phone subscription the last thing someone would cut, even in a recession.

Sounds easy, right? Well, not so fast. In the age of 5G, Verizon and AT&T's vaunted status isn't assured. In fact, each has fallen behind T-Mobile (TMUS -0.06%) in deploying 5G. While T-Mobile has handily outperformed Verizon and AT&T, even including dividends, T-Mobile doesn't pay a dividend, leaving income-focused investors who may prefer T-Mobile's business in a quandary.

But fear not: One solution to this problem was nicely outlined years ago by none other than Warren Buffett.

Why AT&T and Verizon may be risky for retirees

First on the risks of Verizon and AT&T. While retirees are likely enjoying their 7.5% yield from Verizon and 7.3% yield from AT&T, before you break out the champagne, know that these yields are so high because each stock's share price has come down a lot. In fact, AT&T's dividend is that high despite its cutting its payout in April 2022 in conjunction with its spinoff of Warner Bros. Discovery.

Verizon and AT&T at one time seemed invincible, composing a duopoly that owned the best networks in the country and giving consumers really only two choices for getting decent cell coverage. That left these two in position to make high margins without much worry of competition, enabling generous dividends.

However, back when John Legere took over T-Mobile in 2012, he rebranded the scrappy challenger the "Uncarrier," doing away with customer pain points and charging lower prices, albeit on an inferior network. But because T-Mobile didn't pay dividends, it was able to reinvest its lower margins into improving that network as AT&T and Verizon were making large payouts. T-Mobile therefore attracted cash-strapped customers and gradually brought its network up close to the two incumbents, driving a virtuous circle.

The 5G transition provided T-Mobile an opportunity, and management seized it by purchasing Sprint in 2020. Sprint was a flailing fourth-place carrier at the time but owned valuable mid-band spectrum that could be deployed for 5G. Midband offers a happy medium between speed and coverage, as ultra-fast millimeter-wave -- where Verizon and AT&T initially concentrated -- has trouble traveling far from the tower and through objects.

Since millimeter-wave is really overkill for most applications and difficult to reach, accumulating midband spectrum allowed T-Mobile to leap ahead in 5G. Now, T-Mobile not only has low prices and a more customer-friendly ethos, but it can also legitimately say it has the best network in terms of 5G coverage.

While AT&T and Verizon purchased "C-band" mid-band spectrum in late 2021 for tens of billions of dollars, that was an expensive purchase, and both companies are now about two years behind T-Mobile in midband deployment.

Income investors in the telecom industry should seek an alternative approach. Image source: Getty Images.

Debt and dividends leave AT&T and Verizon vulnerable

Because they have paid out such hefty dividends and made the expensive C-band investments, AT&T and Verizon also have larger debt loads. While AT&T was able to offload some of its debt to Warner Bros. Discovery in the spinoff, it still has high leverage compared with T-Mobile. 

Data source: T-Mobile, AT&T, Verizon recent 10Qs. All dollar figures in billions.

So, AT&T and Verizon are more highly indebted than T-Mobile, and probably aren't going to be able to pay that debt down because of their high dividend payments and investments needed to catch up.

Meanwhile, T-Mobile is outpacing each in terms of growth, with 2.7% services revenue growth and 5.9% postpaid services growth last quarter, with each metric leading the industry. That compares with a 0.2% service revenue decline for Verizon and 2.6% services revenue growth for AT&T.

Given T-Mobile's market share gains and lower debt, it's perhaps not surprising that the stock has outperformed handily in recent years -- even when including dividends.

TMUS Total Return Level data by YCharts

AT&T and Verizon investors should take Warren Buffett's advice

So, what are income-focused telecom investors to do? Back in 2013, famed investor and CEO of Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%) Warren Buffett outlined a potential income strategy for Berkshire shareholders that may apply here.

Buffett mused that he had long been questioned as to whether Berkshire would ever pay a dividend. The Oracle of Omaha refused, basically saying shareholders would be better off with Berkshire's internal growth investments, as long as management could earn a decent return on capital.

Moreover, for income-seeking shareholders, Buffett proposed a better solution. For investors seeking a regular payout, Buffett suggested selling off a bit of one's holdings every quarter or year as a "dividend replacement," rather than having the company pay out part of its earnings as a dividend. Under a scenario in which a company can reinvest profits at a 12% return on capital and a stock price that generally trades at 1.25 times book value, Buffett outlined that selling 3.2% of shares every year, rather than paying one-third of net income as dividends, would actually leave shareholders 4% richer over 10 years.

In addition, the "sell-off" scenario also yields tax advantages. Capital gains are taxed only on gains, whereas dividends are fully taxed on 100% of the payout. So investors will benefit from lower annual taxes with this strategy as well.

Do the "sell-off" technique at T-Mobile?

In light of Verizon and AT&T's challenges and T-Mobile's current lead in 5G, it may behoove investors to switch part or all of their Verizon/AT&T holdings to T-Mobile, then sell off a small portion of their T-Mobile shares periodically as a dividend replacement.

T-Mobile is actually now returning cash to shareholders as well, only in the form of a share repurchases, which are more flexible than dividends and more tax-efficient. Repurchases are only advantaged if they are made at not too high a price. But T-Mobile shares only go for about 12.8 times this year's free cash flow guidance.

That's about an 8% cash flow yield. So, if T-Mobile uses all free cash flow to repurchase 8% of its shares and you sell 8% of your shares every year as a dividend replacement, your ownership of T-Mobile's business won't actually change.

This strategy is, of course, predicated on T-Mobile's maintaining its operational superiority and momentum. That's a view I have, and if you do, too, but own Verizon or AT&T shares, you may wish to consider reinvesting those dollars in T-Mobile and adopting a "sell-down" strategy.

After all, that's what Warren Buffett would suggest!