Seven years into a bull run and stocks are undeniably expensive. FactSet Research finds that every sector but one is trading above its five- and ten-year average price-to-earnings ratio on a forward basis.
There’s good reason for higher P/E ratios, stock prices keep rising even as the companies in the S&P 500 have reported five consecutive quarters of lower earnings.
As investors rush in to send the market to new highs, their share of earnings is getting smaller.
And stocks may be set to get even more expensive throughout the rest of the year. Analysts expect earnings to decline for a sixth straight quarter when reports start coming out in October.
The question is, how much more expensive can stocks get before investor enthusiasm starts to crumble? Is there any value left in the market?
How Much More Expensive Can Stocks Get?
Companies in the S&P 500 are trading at a 20% premium to the average 10-year forward P/E multiple. Nine of the ten sectors in the index trade above their five- and ten-year average multiples with premiums on 10-year multiples ranging from 24.6% (consumer staples) to 7% (information technology).
Investors will need to remain exuberantly optimistic if the market is to keep moving higher. Of the 90 companies in the S&P 500 that have provided Q3 guidance as of early-August, 62 have issued a negative outlook on the quarter. S&P 500 reported earnings were 3.5% lower in Q2 than last year and analysts now expect Q3 earnings to fall by 2% before rebounding 5.5% in the final quarter of the year.
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Telecom is the only sector trading at a discount to its 5-year and 10-year valuation on a forward price-to-earnings basis. The sector is also one of only four reporting year-over-year earnings growth for Q2, and has reported the highest revenue growth of all ten sectors during the quarter.
I’ve removed the energy sector, trading at 65.4 times forward earnings and a premium of 299% on its average multiple, from the chart for scale. The blue-line (right axis) shows sector prices per expected earnings over the next four quarters. The bars (left axis) represent valuation premiums to each sector’s ten-year average forward P/E multiple.
Telecom Is More Than Just A Value Play
Not only does telecom offer relative value, but S&P 500 companies book the highest percentage (97%) of revenue in the United States, compared to just 69% of revenues domestically for companies across the index. That focus on the U.S. market will protect the group from the currency pain reported in other sectors and targets a stronger domestic economy. While consumers may downgrade telecom services during a recession, the industry is relatively non-cyclical as it is a service most customers would not go without.
I screened through leaders in the sector to find best-of-breed names with attractive valuations and strong fundamentals. Let’s take a look at our best picks after the screening…
Centurylink Inc (CTL) represents the old guard of telecom as the third largest phone company in the United States, but the Qwest and Savvis acquisitions have given it a competitive position in the enterprise market. The consumer market is now just 30% of sales and the company is exploring the sale of its data center unit which could produce significant cash for shareholders. Shares trade for just 10.6 times trailing earnings and pays a 7.4% yield.
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SBA Communications Corporation (SBAC) owns and leases wireless communications towers in the United States, Brazil, Puerto Rico, Canada and Central America. Towers in the United States account for 61% of infrastructure but make up 80% of leasing revenue. Surging wireless data demand, especially with the implementation of 5G networks, provides a constant demand for more network infrastructure.
Tower leases are on long-term contracts, making cash flows stable and predictable. Earnings were negative over the last four quarters but are expected to rebound to 90 cents per share over the next year. That could mean the return of shareholder cash return along with a higher share price.
Level 3 Communications, Inc. (LVLT) provides network services in 60 countries, though the United States still accounts for 82% of revenue. Increasing global connectivity is carrying the company higher, with management expecting to grow adjusted EBITDA by up to 12% this year and produce as much as $1.1 billion in free cash flow. Shares trade relatively expensively at 39 times trailing earnings, though just 26 times forward earnings which are expected 48% higher over the next year.
Verizon Communications (VZ) is the largest U.S. wireless carrier with 35% of the domestic market. The acquisition of Yahoo! Inc.’s (YHOO) core internet business is a smart follow-on to the acquisition of AOL last year, and could help it compete in online advertising against Facebook Inc (FB) and Alphabet Inc (GOOGL). Verizon is also testing its upcoming 5G wireless network and could be one of the first carriers to launch in 2017. Shares are trading for just 13.6 times trailing earnings and pay a 4.3% yield.
AT&T Inc. (T) is a close second to Verizon in retail wireless with 32% of the market share — no other carriers can match the companies’ reach and size. The acquisition of DirecTV allows it to bundle services to customers, and recent entries into the Mexican market could spur growth. AT&T requested a license from the FCC to test its own 5G technologies in February. Shares trade for 15.3 times trailing earnings and pay a 4.6% yield.
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Risks To Consider: Even at a discount to historical P/E multiples, shares of telecom companies could weaken in a recession, though potentially not as much as other sectors.
Action To Take: Take advantage of one of the last value plays in the market by positioning in best-of-breed telecom providers.
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