FCOM - FCOM: U.S. Communication Services Offer High Returns

2023-05-22 03:50:09 ET

Summary

• While earnings expectations are high for FCOM in terms of growth, I think they are fair as they assume a steady return on equity.
• Even in a downside scenario, FCOM offers a margin of safety.
• Should the portfolio maintain its circa 14% forward return on equity, FCOM is likely to outperform.

Introduction

Fidelity MSCI Communication Services Index ETF ( FCOM ) is an exchange-traded fund that provides investors with exposure to U.S. communication services stocks in line with the fund's benchmark, the MSCI USA IMI Communication Services 25/50 Index . The index is comprised of small-, mid- and large-cap stocks.

I last covered FCOM a long time ago in August 2021 . I was bullish, but unfortunately the fund has under-performed substantially since then given the high exposure to Meta Platforms, Inc. ( META ); the company's pivot toward its expensive "Metaverse" project cost shareholders dearly in the short term, although the company has since bounced back significantly. In any event, FCOM has underperformed, but I think it is worth revisiting after so much time, and since I have improved my valuation method (plus my more recent emphasis on nominal returns rather than hypothetical "fair value").

FCOM carries an expense ratio of just 0.08%, while the fund had assets under management of $600.5 million as of April 30, 2023. Over the past year, net fund flows have been negative (as illustrated below) to the tune of -$34.5 million, however most of these negative outflows were front-loaded in the period. Over the past month, net fund flows have turned positive by +$75 million.

On a three-year, monthly basis, I calculate the beta of FCOM vs. the S&P 500 U.S. equity index as being 1.26x; 1.39x on the downside only, and 1.24x on the upside only. The three-year correlation is 0.87x, or 0.94x on the downside only and 0.69x on the upside. In down markets, FCOM has behaved in a similarly risk-off manner, whereas in stronger periods, FCOM has a tendency to potentially lag. However, the past three years is perhaps not the best period to gauge the potential of the fund.

Most recently, the fund's top 10 holdings are presented below:

There is a high degree of concentration, particularly in Meta Platforms, Inc. ( META ) still at 17.22%, although the sum of Alphabet Inc. ( GOOGL ) comes to 24.13%, making it the largest position in the portfolio. The rest of the fund is mixed, including various multimedia, streaming and gaming companies. Generally speaking, FCOM's portfolio of businesses operate in competitive industries. They are also all close to the cutting edge, but the level of competitiveness is reflected in a relatively modest return on equity at the aggregate portfolio level.

We can gauge the return on equity by dividing the price/book ratio into the forward price/earnings ratio; these were 2.45x and 17.03x, respectively, as of May 17, 2023 according to Morningstar . That implies a forward return on equity of 14.39%, which is not especially high. For example, I recently covered EWL , stable portfolio of mature Swiss companies whereas the return on equity was over 18% on a forward basis. In other words, while FCOM's portfolio might be "exciting", and some of the top names might be more productive, the fund follows a capped methodology, so that overall the return on equity is capped at a lower level (brought down by the competitiveness of the space).

Return Profile

Gauging the value of FCOM requires some important financial inputs; the factsheet for the capped version of the index does not provide this information. Nevertheless, we can use the Morningstar data referenced above. We can also reference the consensus average estimate for three- to five-year earnings growth provided by Morningstar of 16.26% (which is very high, but a starting point). I also have an estimate from Yahoo! Finance that reports a trailing price/earnings ratio of 21.19x as of May 19, 2023, which I adjust to align with my May 17 data to 20.99x.

The earnings growth expected may be high, but assuming no buybacks for the moment, and a roughly constant distribution rate for dividends, the underlying portfolio return on equity actually holds at roughly 14-15% over my forecast with a five-year earnings growth rate of 14%. The three- to five-year average (midpoint) in this analysis would be 15.56%, which is slightly under the three- to five-year consensus of 16.26% cited earlier. All considered, the five-year IRR implied is a massive 16.22%.

While the fund's beta is elevated at 1.26x, the implied equity risk premium is so large that the beta-adjusted ERP is 9.96%. This is all at a roughly stable return on equity. Now, if we imagine analysts are too sanguine, and forward growth is hindered by the competitiveness of the media industries, we could think about an alternative investment case where the return on equity is quickly compressed to less than 12% by year five. In this case, the IRR would drop to 11.30%. Yet even in this case, the beta-adjusted ERP would be over 6%, and I think a mature market portfolio should be offering an ERP of no more than 5.5%; anything more suggests under-valuation.

So, on the whole, while FCOM is riskier than average and might under-whelm some analysts, even in a downside scenario I think you have a margin of safety. FCOM seems objectively undervalued. Communication services are also typically viewed as cyclically sensitive, and so FCOM could stand to generate cyclical out-performance should we enter a new business cycle without recessionary fears on the horizon. I would take a bullish stance at this juncture.

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