Sector Focus: Telecom ETFs Look Compellingly Valued

As exchange-traded fund investors survey the battered U.S. equity landscape in search of sectors with solid potential upside, we believe they should take a close look at telecommunications industry ETFs, which right now offer a tantalizing combination of strong dividends, attractive valuations, and large helpings of companies with economic moats.

While there is a moderate amount of uncertainty in the industry (the U.S. Department of Justice currently is suing to block  AT&T's (T) planned acquisition of  Deutsche Telekom's (DTEGY) T-Mobile USA unit, which effectively has placed the entire telecom industry in a holding pattern), for the most part, the telecom sector has developed into a mature industry. Gone are high leverage, weak profitability, and uncertain growth potential. In their places are cash-generating machines such as AT&T and  Verizon (VZ) that long ago rolled up much of their industry and built out much of the basic infrastructure necessary to support services today, along with tower companies and small wireless carriers. As the major carriers' legacy land-line businesses have gone away, the industry has shifted to focusing heavily on the proliferation of wireless devices and Internet usage in society. And growth looks promising for major carriers, with demand for smartphones and mobile broadband still rising at an impressive clip.

The Lay of the Land
The industry landscape right now consists of the two big industry behemoths--AT&T and Verizon. The following are also included:

• Some mid-cap players such as  CenturyLink (CTL),  Windstream , and  Frontier
• A set of smaller wireless carriers such as  MetroPCS (PCS),  Leap Wireless , and  Clearwire
• Tower companies such as  American Tower (AMT),  Crown Castle (CCI), and  SBA Communications (SBAC)
• Special cases such as  Sprint Nextel , and Level 3

However, despite this apparent industry diversity, AT&T and Verizon's market caps so dwarf the rest of the industry that in some respects, today's telecom industry consists of "AT&T and Verizon" and then "everybody else."

In the medium term, Morningstar's equity analysts hold the view that smaller players in the industry, such as Sprint, Leap Wireless, and MetroPCS, need to join forces and gain financial flexibility to invest in next-generation network technology. Such next-generation technology is crucial to be able to add network capacity to keep pace with AT&T and Verizon. And if AT&T's acquisition of T-Mobile ultimately is killed, our analysts expect another operator to pick up T-Mobile.

Most recently, several telecom firms have posted weak earnings, and the sector as a whole has lagged the broader market during 2011. The sector clearly is out of favor, with likely few catalysts imminent until the T-Mobile issue is resolved.

Using an ETF to Invest in a Basket of Telecom Firms
Investors who have seen the market's recent pullback (and, particularly, its recent punishment of telecom firms) but want to avoid single-stock risk, should consider a telecom ETF. Currently, three ETFs focus solely on U.S. telecom firms. All three trade significantly below Morningstar's fair value estimates for the funds, which are calculated by aggregating and weighting our equity analysts' estimates of fair values for the ETFs' underlying constituents.

However, there are important differences among three ETFs that investors should be aware of before investing. Here are the details on the three funds:

 IShares Dow Jones US Telecom (IYZ)
The largest and most liquid telecom sector ETF, IYZ holds 30 telecommunications firms. It tracks a market-cap-weighted index of fixed-line, wireless, and tower companies. This ETF is very top-heavy, with the top 10 holdings making up more than 71% of assets. AT&T alone is 19% of assets, and Verizon is another 14%. IYZ presently trades at 86% of its fair value. This is the most expensive telecom sector ETF as well, charging 0.47%.

 Vanguard Telecom Services ETF (VOX)
VOX tracks a modified market-cap-weighted index of 36 telecom firms, so it should not be surprising that it also invests more than 70% of assets in its top-10 holdings. AT&T and Verizon each make up 23% of this ETF, so investors should know going in that those two holdings together make up nearly half of this fund's assets. We like VOX's lower expense ratio (0.24%). And although VOX is significantly less liquid than IYZ, investors should not encounter trouble amassing a position. Investors also should note that over the last three years, this ETF's performance is 98% correlated with that of IYZ. From a valuation standpoint, VOX--by a small amount--is the least compelling of the three telecom ETFs, trading at 92% of its fair value.

 Focus Morningstar Communications Services ETF
This recently launched FocusShares ETF remains tiny (less than $5 million in assets) and is extremely thinly traded, so investors should watch bid-ask spreads closely.  FCQ charges a bargain-basement 0.19% expense ratio, making it the cheapest telecom ETF available. Unlike the other two funds listed above, FCQ also holds cable companies such as  Time Warner Cable ,  Comcast (CMCSA),  Cablevision Systems , and  DirecTV . The fund holds 30 companies, and its modified cap-weighted scheme means that more than 74% of assets are invested in this ETF's top-10 holdings. AT&T makes up 21% of this ETF's assets, while Verizon makes up another 14%. One particular draw to this ETF is its heavy stake in high-quality companies, as defined by Morningstar's equity analysts. While IYZ and VOX devote 63% and 65% of assets, respectively, to companies with economic moats--which our equity analysts define as sustainable competitive advantages--FCQ invests more than 88% of its assets in firms with narrow- or wide-economic moats. FCQ currently is trading at 90% of fair value.

Alternatives--Both Inside and Outside the ETF Space
Investors seeking ETF exposure to global telecom titans such as  Vodafone (VOD) and  Telefonica (TEF) should take a closer look at  iShares S&P Global Telecommunications (IXP) (0.48% expense ratio), which invests roughly one third of its assets in U.S. telecom firms and the other two thirds in foreign players. There are also  SPDR S&P International Telecom Sector  (0.50% expense ratio), which holds only telecom companies based outside the United States, and the small and very thinly traded iShares MSCI ACWI ex US Telecommunication Services Index  (0.48% expense ratio).

Another option is single-stock investing. Investors could consider making investments in industry behemoths such as AT&T or Verizon. Still another possibility is to venture into the traditional open-end mutual fund space, where several large firms, including Fidelity, Putnam, Rydex, T. Rowe Price, and Wells Fargo, offer higher-priced options.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.