Communications Stocks: Can the Sector Live Up to META’s Gains?

After the wreck of 2022, the Communications sector performed well this year, by far outpacing the broader market, and registering gains second only to the IT sector’s surge. This shouldn’t be surprising, given that the sector’s performance leaders are IT companies “in disguise”; however, other parts of the Communications universe may hold even larger investment potential going forward.  

Is There Life Beyond The “Big Three”?

The Communications sector’s performance trends are very similar to those of its Infotech counterpart, with the lion’s share of the gains concentrated within just a handful of heavyweights, which are basically IT companies, working (or “also working”) in the communications sphere.

Thus, the Communications sector’s ETF, Communication Services Select Sector SPDR Fund (XLC), has surged over 44% year-to-date, more than double the performance of the ETF on the whole of the S&P 500 index, as represented by the SPDR S&P 500 ETF Trust (SPY).

Source: Google Finance

As mentioned above, almost all of XLC’s increase is due to the run-up in the shares of Alphabet Inc. (GOOGL and GOOG), Meta Platforms Inc. (META), and Netflix Inc. (NFLX). These companies’ shares comprise about 53% of the ETF, which mirrors the S&P sector’s composition, so it’s no wonder that their stocks’ movements have an outsized effect on the sector’s overall performance. Meta has seen its shares soaring 157% year-to-date, while Netflix surged almost 60%, and Alphabet climbed by 50%.

The performance of the “big three” sector leaders was spurred by the same factors as that of companies that have led the gains in the Information Technology sector: investors’ enthusiasm towards generative artificial intelligence (AI) technology. Of course, economic and fundamental factors also matter a lot: undoubtfully, the end of the Federal Reserve’s hiking cycle and the budding rebound in digital advertisement spending have significantly supported the sector’s stocks. However, the sizzling rally would probably have been just a gentle rise without the ChatGPT craze.  

The stellar run of the “big three,” whose combined market capitalization approaches $3 trillion, has stolen all the investor attention, leaving all other sector constituents as much as forgotten. However, with these giants trading at rich valuations after their strong rally, investors are doubtful whether they have more room to run. Now, they are turning to other stocks in the sector, wondering if they can find the next Netflix among them.

The Diverse Collection

The Communications sector is the third-smallest S&P sector by market cap: the total capitalization of its constituents is just $5.1 trillion (compared with the IT sector’s $15 trillion, for example). It also holds a considerably smaller number of stocks than other sectors: there are only 22 stocks in this sector, while the other S&P sectors (except for the Energy sector, which is even smaller) comprise at least triple that number.

Nonetheless, within these tight ranks, there are companies as different from one another as if they had arrived from different planets. This diversity within a comparably small sector is the result of the inclusion of the technology companies providing communication services, in what was previously the domain of TV broadcasters and media holdings. Today, in addition to the legacy media firms, the sector also includes wired and wireless telecommunications carriers, telecom resellers, satellite communication providers, fiber optic cable network owners, digital and traditional advertising firms, and more.

In this mixed bag, investors can find tech-entertainment prodigies slated for outsized future returns but currently unprofitable, like Take-Two Interactive Software (TTWO), along with mature, stable but stale blue-chip giants like AT&T (T). The sector combines “digital economy” firms like the online dating site Match Group (MTCH) and the video game leader Electronic Arts (EA), with legacy media companies like Fox Corporation (FOX) and film studios like Paramount Global (PARA). The companies in the sector are as diverse in their fundamental metrics and earnings growth parameters as are their lines of business.

AI Against Boring Returns

Apart from internal diversification, the Communications sector offers many other investment advantages. One of these is the constantly rising global demand for communications of all sorts, underpinned by accelerating connectivity, which is supporting the sector’s growth. Connectivity itself is the realm commanded by the Communications sector so that its companies profit from increasing usage of digital entertainment and engagement, as well as from frameworks that support it through fiber optics or 5G broadbands.

Another advantage is the sector’s high growth potential, which stems from its high rates of investment in new technologies and innovation. While machine learning (ML) and “regular” AI have been used by the sector’s media and internet companies for a decade, underpinning their success in content production and ad targeting, the advance of Generative AI opens an array of new opportunities. These would include hyper-personalized content experiences, detailed and person-specific ad targeting, and more – advantages that fit the Communications sector most beneficially.  

However, as we all know, there can be no opportunities without risks. The competition in most of the sector’s industries is fierce, and disruptive newcomers constantly vie for the existing leaders’ market shares. This competition for the same customer base makes it into a “zero-sum game” whose outcome often depends on the size of the investment in the tech advancement du jour.

Outside of the more tech-savvy corner of the Communications sector, cutting-edge technologies also work their way through the economies of cable networks and filmmakers, but in a much more subdued way, below the customer-facing surface. Companies whose business isn’t expected to be propelled at least tenfold by AI, are perceived as “boring.”   

Earnings Growth Isn’t Boring

Of course, there are many companies within the Communications sector that are outside of the S&P sub-sector definitions, so the choice isn’t constrained to just 22 stocks. In fact, there are 375 companies of all shapes and sizes whose stocks belong to the Communications sector. Even after filtering by size, leaving out the more volatile and riskier small-caps, the investors are left with a choice of 184 stocks. So, there is no need to choose between “unprofitable but exciting” and “stable but boring.”

While not all “boring” companies bring boring returns, the chances that they will match Meta’s rates of growth are quite scarce; their forte is dividends, not share price gains. On the other hand, unprofitable companies, however convincing their case may seem, may not be the wisest choice at a time when their future earnings are discounted by high interest rates, depressing their present value.

Another issue that must be analyzed before making an investment choice in the sector is the debt load. High interest rates make debt servicing and refinancing much more expensive. This is now compounded by the declines in advertising revenues, one of the main sources of income for the sector’s companies, depressing earnings and exacerbating their debt manageability problems.

All in all, the current macro conditions and high uncertainty even in the short term, don’t provide much support for firms with unhinged balance sheets and unconvincing income streams. On the other hand, stability, and even dividends, may not counterweigh the misery of a “solid” stock trading sideways, at best, for years, while investors watch the rally outside.

Communicating Potential Profits

Now that we have established that the Communications sector can provide investors with enormous opportunities, how should they proceed from here, avoiding the trap of both profitless money-burners and outdated non-movers with moth-eaten business models? Should investors go through the balance sheets and income statements of all 375 companies in the sector, performing a SWOT analysis for each one?

Of course not. While thorough analysis of companies’ financial and business metrics, as well as their prospects, is essential in order to find stocks that can match Meta’s or Netflix’s outsized gains, or even outrun them in the future, investors are not alone in this battle for profits. TipRanks provides investors with access to research done by Wall Street’s leading analysts, which can be easily utilized to their benefit. In addition, TipRanks has several handy tools, that employ the vast amounts of data and research stored in its database, helping discerning investors pick the best stocks according to their outlook, risk tolerance, and financial goals.

While using these tools, investors are advised to also pay attention to the companies’ valuations, since overvalued companies are prone to higher volatility on the back of profit taking, while their high price tags generally leave them with lower upside potential versus their more modestly priced peers (when other metrics are more or less equal).

For example, investors can use the TipRanks Top Smart Score Stocks screener, filtering for companies with the highest Smart Score to find the potential winners among the sector’s stocks:

Alternatively, investors can use the general TipRanks Stock Screener tool, slicing and dicing the database of stock analysis according to their preferences:

To conclude, the Communication sector’s stocks may hold a significant outperformance potential going forward, with some of them having high chances to perform as well as, if not better than the IT high-flyers, whose valuations have outpaced even their gains. However, finding decently priced companies with sound business models, innovative growth-fostering approach, and solid fundamentals, requires a high level of due diligence, which can be performed using the help of the TipRanks database and tools.