Dialing for Dollars

02/18/2010 10:32 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, director of ETF analysis at Morningstar, and analyst John Gabriel say global telecoms have become cash machines, and they like an ETF representing them.

In the current environment, iShares S&P Global Telecommunications’ (NYSEArca: IXP) juicy dividend yield serves as an attractive alternative to fixed income, as bonds currently offer paltry yields amid near-zero interest rates. Unlike bonds, investors here also have potential up side through capital appreciation.

This ETF tracks the S&P Global Telecommunications Sector index. Because the telecom sector contains a handful of behemoths, this market-capitalization-weighted index is extremely top-heavy. In fact, the top ten soak up almost 70% of assets. US companies make up about 32% of the index, with the UK, Spain, Japan, and China next in line.

Outside the US, most phone companies face less intense cable competition, and these businesses continue to hold up fairly well as more customers adopt wireless and high-speed Internet access services. As businesses use networks to move more data around and drive basic business functions, demand for connectivity among offices and workers should continue to grow nicely.

Although we have seen growth suffer recently as customers cut back on wireless usage, most of the telecom carriers our equity analysts follow continue to generate significant free cash flow, which we expect will provide stability through the downturn.

While telecom firms have continued to spend to add capacity, much of the basic infrastructure needed to provide services is already in place, and capital spending as a percentage of sales has declined for many firms. As a result, telecom firms have continued to generate hefty cash flows.

As balance sheets have improved, telecom dividends have become more sustainable and have actually increased in some cases. With juicy dividend yields and improved balance sheets throughout the sector, many telecom firms fit the profile of a traditional bear-market play.

Because of the wide-scale shift from fixed-line toward mobile services as a percentage of these firms’ overall revenues, the telecom industry is probably less recession-resistant than it has been in the past. After all, cash-strapped customers [who] currently subscribe to bundled packages or both fixed and mobile telephone lines could elect to either discontinue their land line or trade down to cheaper cable and Internet services.

All risks considered, we think IXP could offer a compelling investment opportunity. We think global demand for phone, television, and Internet connectivity will continue to expand. The global exposure afforded by the fund is another big positive, as investors can partake in emerging markets’ rapid adoption of telecom services without assuming single-stock or single-country risk.

We think this fund could represent an interesting opportunity for yield-seeking investors. It provides relatively diverse exposure to the global telecom industry; however, a few industry stalwarts do soak up the bulk of assets.

In light of the fund’s narrow focus, we strongly urge would-be investors to think of this ETF as a tactical tool for the satellite portion of their portfolio. The global tilt of this ETF’s portfolio makes it an attractive alternative to domestic-only focused telecom funds.

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