EWCO - FCOM: Investors Beware - Red Flags For This Communication Services ETF

Summary

• FCOM holds 100+ Communication Services stocks in all size segments. It has a category-leading 0.08% expense ratio and $515M in assets.
• Performance compared to peers like XLC and VOX is solid, but the sector has historically underperformed the market. FCOM also comes with increased volatility and a poor growth profile.
• FCOM trades at 20x forward earnings, which is still too high. In addition, Alphabet controls 21% of the portfolio, and it has missed analyst estimates for four straight quarters.
• This article compares FCOM's fundamentals alongside five other Communication Services ETFs, and we think XTL is where investors should look for growth. Otherwise, avoid overweighting the sector altogether.

Investment Thesis

This article aims to compare the fundamentals of the Fidelity MSCI Communication Services Index ETF ( FCOM ) with five peers in the category. Though FCOM is more diversified than more popular ETFs like the Communication Services Select Sector SPDR Fund ( XLC ), it's overly influenced by giants like Alphabet ( GOOGL ) and Meta Platforms ( META ) with questionable growth outlooks. Its 20x forward earnings valuation is unattractive, and FCOM's 1.07 five-year beta indicates it's riskier than the market. Given the uncertainty, I recommend readers avoid it, and I look forward to detailing why next.

FCOM Overview

Strategy Discussion and Key Exposures

FCOM tracks the MSCI USA IMI Communication Services 25/50 Index, selecting large, mid, and small-cap Communication Services companies based on Global Industry Classification Standards, or GICS. The Index name refers to IRS diversification rules for regulated investment companies. At the end of each quarter of its tax year, no more than 25% of the value of assets can be invested in a single issuer, and the sum of all weights of issuers with weights over 5% can't exceed 50% of the total assets. Finally, the Index is market-cap-weighted and rebalances quarterly at the end of February, May, August, and November.

FCOM's top ten holdings total 67% of the fund once you combine Alphabet's two share classes. Meta Platforms accounts for 13.03%, followed by Walt Disney ( DIS ), Verizon Communications ( VZ ), and Netflix ( NFLX ). The top 25 holdings total 82%, so it's concentrated due to its market-cap weighting scheme. XLC and the Vanguard Telecom Services ETF ( VOX ) take similar approaches and have nearly identical concentration levels.

In addition to XLC and VOX, readers should consider the Invesco S&P 500 Equal Weight Communication Services ETF ( EWCO ), the iShares U.S. Telecommunications ETF ( IYZ ), and the SPDR S&P Telecom ETF ( XTL ). The six-fund comparison below highlights FCOM's category-leading 0.08% expense ratio. However, its $515 million in assets under management is low compared to XLC and VOX.

Performance Analysis

FCOM launched in October 2013 and performed relatively well recently. The following graph, limited to XLC's June 2018 inception, highlights FCOM's 5.05% annualized return vs. 2.51% and 2.36% for XLC and VOX. One key difference was Meta Platforms. Even after its historic decline last year, the company's exposure is 19.71% in XLC, 6% more than FCOM.

Since FCOM's inception, relative performance has been equally impressive. FCOM gained an annualized 5.61% vs. 2.99% and -0.19% for VOX and IYZ. However, the SPDR S&P Telecom ETF ( XTL ) gained 6.02% with marginally higher volatility. It's a reasonable alternative that includes nearly 50% Technology stocks, mostly smaller in size, that boost the portfolio's growth profile. That's needed because although FCOM's performance looks relatively strong, the SPDR S&P 500 ETF ( SPY ) gained 11.17% over this period.

FCOM Analysis

Key Industries

FCOM holds 108 companies across 10 GICS industries:

1. Interactive Media & Services: 39.08% ( GOOGL , META )
2. Movies & Entertainment: 15.37% ( DIS , NFLX )
3. Integrated Telecommunication Services: 10.68% ( VZ , T )
4. Cable & Satellite: 9.20% ( CMCSA , CHTR )
5. Interactive Home Entertainment: 5.93% ( ATVI , EA )
6. Broadcasting: 5.73% ( WBD , FOXA )
7. Advertising: 4.81% ( OMC , TTD )
8. Wireless Telecommunication Services: 4.05% ( TMUS , TDS )
9. Alternative Carriers: 3.19% ( IRDM , LBTYA )
10. Publishing: 1.76% ( NYT , NWSA )

VOX is nearly identical in composition, but XLC has 3% more exposure to Interactive Media & Services and 5% less to Movies & Entertainment. I mention this in case readers prefer Alphabet, Meta Platforms, Disney, or Netflix. IYZ and XTL are appropriate for those looking to avoid them.

Fundamentals

Those alternatives look attractive because they contribute to a weak growth profile for FCOM. The following table highlights selected fundamental metrics for its top 25 holdings using cash-adjusted weights. Alphabet and Meta Platforms have estimated earnings growth rates of 2.89% and -5.65%. These earnings growth rates are less than their sales growth rates, suggesting analysts expect margins to compress further.

FCOM's earnings growth and valuation ratios aren't optimal. The portfolio has an 8.22% and 4.56% estimated sales and earnings per share growth rate and trades at 20.12x forward earnings. Arguably, VOX is slightly better, is just as well diversified, and has a comparable expense ratio (0.10% vs. 0.08%). I can even make a case for XLC based on valuation (17.74x forward earnings), but large-cap Communication Services stocks aren't growth-oriented anymore. Investors can explore XTL for better growth potential. XTL includes 57% in Technology stocks, 48% in Communication Equipment. GICS, and by extension, FCOM, VOX, XLC, and EWCO, excludes this industry. XTL is how to access high-growth but less profitable companies like the ones below.

These smaller companies also have stronger earnings momentum, as measured by XTL's superior 6.01/10 EPS Revision Score. For example, Arista Networks ( ANET ) beat analyst estimates by 4.82% last quarter. All 22 analysts covering the company raised their EPS targets over the previous 90 days - a rare feat today.

With FCOM, I don't see a reason to overweight Alphabet other than one based on hope. Investors have been unkind to the company because it keeps missing analyst estimates. The most recent -12.33% earnings surprise was the fourth consecutive miss, which followed seven straight beats from June 2020 to December 2021.

Shareholders were rewarded through those earnings beats. Using an estimated two-month reporting lag time, Alphabet outperformed SPY by an annualized 24% from August 2020 to February 2022.

Since the earnings misses began, the stock is off an annualized 33.32% compared to 7.77% for SPY. Other analysts may argue the decline is unjustified, but these earnings surprises indicate otherwise. There might be a small value play here since Alphabet trades at 17.61x forward earnings, slightly lower than its large-cap peers represented by XLC. However, it's nothing significant, and this is a sector where investors should look elsewhere for a better growth and valuation combination.

Investment Recommendation

I don't recommend investors own FCOM because large-cap Communication Services companies have poor estimated growth rates and historically underperformed the market. In particular, Alphabet controls too much of the portfolio, and there are better growth opportunities as you move away from mega-cap stocks. XTL is one way to do this, assuming you view the sector as a growth opportunity. Otherwise, avoid overweighting the sector altogether, as it's not worth the risk. Thank you for reading, and I look forward to discussing FCOM and its alternatives in the comments section below.

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