Communication services: Pockets of opportunity

For 2023, investors in the communication services sector are worried about many of the same things that caused markets to turn volatile in the past year. Interest rates are rising, inflation is high, war continues in Ukraine, and recession risk has risen around the globe.

The big question is whether those fears are enough to finally slow the spending by US consumers that has kept the economy growing over the past 2 years. That matters because consumer spending plays a big role in how well stocks of many companies in the communication services sector might perform.

This sector won't be insulated from these challenges in 2023. But because it contains a broad diversity of companies, whose sensitivity to the economic cycle varies widely, it also may offer a wide variety of opportunities both now, and when stronger economic growth eventually returns.

Coming off a rocky year

At the sector level, in aggregate, communication services did not perform well in the past year. As of late 2022, the sector's year-to-date performance lagged the broader market by about 20 percentage points.

That underperformance was driven in no small part by the sector's heavy exposure to tech-related companies (another sector that faced significant challenges in 2022), and to company-specific challenges faced by some of the sector's largest players.

Yet under the hood, there were also segments and companies within the sector that had a strong year—a fact that isn't that surprising when one considers the wide diversity of segments and business models encompassed by the sector.

A uniquely varied sector

The communication services sector was created in 2018 by taking some of the so-called FANG stocks (namely, Facebook, Alphabet, and Netflix), and mixing them with certain entertainment, telecommunications, and technology companies.

The new sector that was created by this mash-up contains a wide variety of dissimilar companies. Some companies in the sector are more economically sensitive than others. These include high-growth, cyclical stocks of companies that sell digital advertising—a service that companies can easily stop purchasing in a downturn.

But the sector also includes some much less economically sensitive companies that provide utility-like services—including mobile phone and home broadband internet services. These companies have offered slow, steady growth over time. And the sector includes many other companies between those 2 extremes. These include those in the video game, television, and theme-park segments.

Potential opportunities for 2023 and beyond

I invest with a long-term perspective. Looking to 2023 and beyond, I believe the companies in the sector with the best long-term prospects are those that can control costs and maintain solid balance sheets, regardless of their level of economic sensitivity.

For example, sector heavyweights Alphabet () and Meta Platforms () are often thought of as cyclical stocks. Much of their revenue comes from digital advertising, and their absolute levels of growth tend to ebb and flow with advertiser demand—which rises and falls with the economy. However, as long as management at each company can control costs, their business models could remain resilient through the economic cycle—and even see some attractive potential upside in an eventual recovery. Digital advertising has historically bounced back quickly in economic recoveries, and at very high incremental profit margins.

Communication services also contains the entertainment segment, a diverse and variegated group of companies. These include traditional TV broadcasters and cable companies, which are likely to continue their long-term declines. Many of them carry high levels of debt which makes them vulnerable to rising interest rates. Some of these cable companies are raising prices in an effort to offset falling subscriptions, which often makes subscriptions fall further. In contrast, streaming-media platform Netflix () is taking the opposite approach by offering more lower-cost subscription options. A recession may accelerate the shift to lower-cost streaming, which could play to the long-term advantage of streamers like Netflix, who are offering more options to attract and retain subscribers, and thereby earn a better return on existing levels of content investment.

Wireless and broadband providers are among the less economically sensitive companies in the sector. While consumers may cut the cord to their television and cable subscriptions, they are less likely to cancel wireless and broadband subscriptions offered by companies such as T-Mobile (), Comcast (), and Charter Communications (). These services have become more like utilities because consumers see them as “must-haves” even in a recession.

The upside to a diverse sector

One of the benefits of investing with a long-term view is that I can look beyond a potential recession and focus on investing in stocks of companies that may be challenged in the short term but can emerge stronger on the other side of a pullback. The communication services sector can be part of an all-weather portfolio with downside protection in a recession, but enough cyclicality to also do well as economic conditions eventually improve.