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Stocks  | November 25, 2020

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).

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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:

  1. 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)
  2. 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


Chart

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.


18 MONTHS OR MORE OF UNPRECEDENTED OPPORTUNITY

A revolutionary initiative is helping average Americans find quick and lasting stock market success.

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