The Evolving Telecom Sector: Opportunity or Land Mine?

Traditionally, the telecom industry hadn't been great fodder for water cooler conversations. It has long been thought of as a boring, dividend-paying sector.

That's changing. Over the last few years, the industry has been undergoing a transformation, with telecom companies foraying into content distribution, upstart wireless firms grabbing market share, increasing digital data usage, and more.

"There are more headlines about telecom today than there were three years ago," says Alex Zhao, an equity analyst with Morningstar.

It's certainly a more exciting--and a more uncertain--sector than it has been for a while. And uncertainty around the sector's prospects have driven down the S&P 500 Telecommunications Services subindex 6.7% since January. Many of the more traditional players in the sector have seen declines: AT&T has fallen 3.5% year-to-date, while Verizon is down nearly 10% since the beginning of the year as of this writing. Other parts of the telecom market have climbed, though. Cable company Charter Communications, for instance, is up 13% year to date.

That divergence in returns among companies is emblematic of the difference between today's telecom sector and the telecom sector of old.

What's Happened with Wireless?

When most investors think of telecom, they likely think of the big-name wireless companies, such as

Years ago, AT&T and Verizon dominated the sector, and while they're still the largest players, their once-large moats have diminished as T-Mobile and Sprint have started taking market share. (Morningstar currently assigns a narrow moat rating to the former two companies and a no moat rating to the latter two.) That has impacted their pricing power, says Zhao. T-Mobile, for example, has introduced an unlimited data package, something the bigger carriers haven't wanted, but are now forced to do.

It's also unclear how the content play that some wireless firms have been engaging in will work out. If AT&T's purchase of

The cellphone market is also fairly saturated. According to research site Statista, the number of U.S. wireless subscribers grew by just 5.4% year-over-year in the fourth quarter of 2016. Increasing competition, weaker pricing and slow growth doesn't say screaming buy, at least not in the near term, says Paul Greene, manager of the Bronze-rated

"The competitive environment in the U.S. wireless industry has gotten worse for the large incumbents," he says, though he does note that he has a sizable portion in T-Mobile, which is growing faster than the others.

Saying all that, buy and hold dividend investors may still be drawn to these companies, says Greene. They offer good payouts--AT&T has a trailing 12-month yield of 4.8%, while Verizon is yielding 4.85%. Like other dividend payers, these stocks may underperform in a rising rate environment--but the dividend is still attractive nonetheless.

Better Prospects in Cable and Towers

For investors who want more growth--and perhaps more upside--managers agree that there are two areas to look at within telecom: broadband cable and cellphone towers. The former, which includes companies such as Charter Communications and

"It's really winning that race consistently," he says.

Broadband is also Netflix-proof. Since the internet is also delivered over broadband, even if someone cuts the cable cord, they'll need a fast and reliable connection to stream movies.

"If you ditch your cable bundle, you still need some way to consume

Both Walker and Greene are also fans of tower companies, which are physical towers that transmit wireless signals to cellphones. They charge carriers a fee for use of their towers, and that fee can increase as consumers consume more data. Companies in this subsector, such as

As people use more data--Americans are expected to increase their data consumption by 535% between now and 2021, according to a 2016 Ericsson Mobility report--tower companies could start seeing double-digit revenue growth, says Walker. Greene thinks the sector will see strong internal rates of return, too.

"We can see compound returns grow at double digit rates with a lot of visibility and without much variation," he says.

Pick Your Spots--and Mind the Uncertainty

Currently, the telecom sector is just slightly undervalued according to Morningstar, trading at 0.96 fair valuation ratio. A few names are trading in 4-star range, suggesting they're undervalued by Morningstar's metrics:

However, investors in this sector should pay close attention to uncertainty ratings, which vary by company. Despite the pressure on the traditional telecoms, AT&T and Verizon both earn medium uncertainty ratings, because they're still large companies that generate plenty of cash, says Zhao. However, CenturyLink, Frontier Communications, and Windstream Holdings all carry high or very high uncertainty ratings due, in part, to increasing competition in the cable sector.

While several Morningstar Medalist funds hold telecom stocks, Greene's T. Rowe Price fund is the only telecommunications fund that earns a medalist rating. Some other telecom-focused mutual funds and ETFs include Fidelity Select Telecommunications FSTCX, iShares US Telecommunications IYZ, S&P Telecom ETF XTL, and Vanguard Telecommunication Services ETF VOX.

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.