My list of investment pet peeves is long. Near the top is the idea that, to successfully invest in a stock, it must ultimately prove to be mispriced relative to the company's fundamentals. A close cousin to this approach is the "high conviction call": i.e. buy stock XYZ now because it will be worth more in six to twelve months - as if anyone knew with much precision what will happen to stock prices in the foreseeable future.
Were I to think only in terms of mispricing and appreciation opportunity, I would probably not consider AT&T (T) a good stock to own. The company is heavily indebted, growth prospects have fallen short of exciting, and enough of the carrier's businesses have not been thriving.
However, T is a unique stock whose characteristics are valuable inside diversified portfolios, both growth and income-producing alike. In this article, I will explain why I believe T to be grossly underappreciated by looking at the stock from a portfolio strategy perspective.
AT&T For Income Portfolios
T is a staple in most dividend-paying portfolios. The stock yields a whopping 7.3% per year, which is about eight times more than what a safer investment in ten-year treasuries currently offers. AT&T's yield is just about as high as it has ever been, absent a brief moment in 2020 during which the COVID-19 crisis helped to distort asset prices (see purple line on chart below).
A common fear of bears and less confident investors is that the dividend may not be sustainable, should AT&T's fundamentals deteriorate. This is a valid concern, in my view. However, I would also note that:
- the company's net debt position has been consistently improving over the past couple of years, following the pricey acquisition of Time Warner in 2018 (orange line below)
- it would probably take more than modest business headwinds for AT&T to give up its enviable status of second highest-yield dividend aristocrat - may be highest soon, if Exxon Mobil (XOM) cuts its periodic payments to better align with the realities of the oil and gas space
But, more importantly, from a portfolio strategy point of view, keep in mind that the idiosyncratic risk of owning a stock can be largely diversified away. To illustrate the point with a hypothetical example, consider an income portfolio that is invested as follows: 10% T and 90% ten-year treasuries. Also assume, for simplicity, that the government bonds are risk-free, and that their prices will not fluctuate meaningfully going forward.
This sample portfolio could, therefore, be expected to pay roughly 1.5% in income (interest plus dividend) for the next ten years - about as much as a thirty-year US government bond. Sure, this 90/10 portfolio would still be exposed to the risks associated with owning T. But the reward of nearly doubling the yield of the ten-year treasury with a "sprinkle" of T seems well worth the risk, in my view.
On the risk side, assume T suffers a drawdown that matches the stock's worst peak-to-trough decline since the start of the Great Recession: -40%. Should this be the case, the 90/10 portfolio above would lose only 4% of its total market value as a result of the T exposure. For reference, the thirty-year treasury has dipped by as much as 22% during this same period of time.
AT&T For Growth Portfolios
Shares of AT&T may not work only for income-seeking investors. A growth investor myself, I am constantly in search of stocks that can diversify my more aggressive, higher-growth holdings well. To achieve this goal, I pay close attention to stocks whose returns have historically been minimally correlated with those of the broad stock market.
Investors that subscribe to the "high conviction" approach that I described earlier in the article often cite T's inferior historical returns to justify staying clear of this stock. Since the early 1980s when AT&T went public after the telephone monopoly breakup, T has climbed 7.3% per year against the S&P 500's (SPY) 11.1% annualized gains.
But here is the catch: over the past few decades, T has been correlated with SPY at a ratio of only 0.4. The lower this number, the more diversification benefit the stock has offered in the past.
Despite T having been more volatile and suffered more severe drawdowns since its IPO relative to the S&P 500, an 80/20 hypothetical portfolio allocated to the broad market and T would have produced less volatility and less severe drawdowns over the period, maybe counter-intuitively. See chart below.
In Summary
Many investors may find T unappealing due to a combination of low growth prospects, high levels of debt, and relatively low historical returns. I will admit that it is not easy to build a strong "high conviction" case for price appreciation here. But I invite readers to look at T differently.
As a dividend play, I see much more benefit than risk to holding T, assuming risks are spread out across many different assets. And as a growth "assistant", T can conceivably continue to serve as a diversification tool, helping to lower portfolio risk and allowing investors to be a bit more aggressive with the rest of their portfolios' allocations.
