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Verizon VZ is Better Than You Think

April 21, 2010 – by Richard Band

I’ve puzzled over this question for a long time. But it’s more apropos than ever, with the Dow hurdling 11,000 recently and fighting to stay up despite trouble at Goldman Sachs (GS). Why do investors keep repeating self-destructive (money-losing) behavior? And why do they keep shunning Verizon (VZ) when a little research shows this stock is better than its current valuation?

As for the bigger syndrome of self-destructive behavior, you can see it at work in the recent explosive rally among the real estate trusts. From February 9 through yesterday, the Morgan Stanley U.S. REIT Index (RMZ), shot up 26%. The same index has skyrocketed 162% from its March 2009 low.

As a result, dividend yields in the sector have collapsed. ATake mall owner Simon Property Group (SPG), the largest REIT by market capitalization, is now priced to deliver a yield of only 3% on cash flow. That’s totally insane for a company in a slow-growing (and highly cyclical) business.

It’s almost as if Mr. Market were saying: “Don’t you remember I just sucker-punched you twice? In 2002 and again in 2008?” And investors reply: “It felt great. Do it again. Harder.”

I don’t know what triggers this investor masochism, but I have a theory. The Internet has opened up a wonderful cornucopia of information, much of it free or nearly free.

Normally, when faced with a deluge of information, people slow down, turn cautious and try to sort out the conflicting points of view before acting. With the advent of the Internet, though, it seems that a certain class of investor (the thrill seeker) feels more empowered than ever.

Overconfidence drives this person to jump on trends and ride them, without much forethought. And so, certain markets and sectors can take on a life of their own, soaring to heights and plunging to depths that no rational person would have imagined possible.

An interesting corollary to this theory is that some markets and sectors with little appeal for the fast-buck, Internet-driven trader can suffer incredible neglect (for a time, anyway). I’m thinking of the utilities right now, and the telecoms in particular.

While the thrill seekers are piling into REITs (and shaggy-dog banks), slurping up every last drop of risk they can find, conservative investors are scared to death of big telecoms like Verizon (VZ). Relative to the S&P 500, VZ closed today at an 18-month low. In the past year alone, the stock has lagged the S&P by a stunning 4800 basis points.

What’s everybody afraid of? That VZ might, just might, have to cut its dividend.

Now, I’m not exactly thrilled myself that Verizon is paying out 81% of its estimated 2010 earnings in the form of dividends. However, I also recognize that the telecom giant generates enough free cash flow (thanks to huge depreciation write-offs) to cover the dividend twice over. Absent a double-dip recession, there’s almost no risk of a dividend cut in 2010; and the likelihood in 2011 is even smaller.

What’s more, if VZ and Vodafone (VOD) can reach a sensible deal to transfer the full ownership of their Verizon Wireless joint venture to Verizon, I would expect the market to assign a significantly higher P/E to Verizon shares. (We’re talking a capital gain of maybe 15%-20% here.)

My advice to you: Buy Verizon.

As of this writing, Richard Band owned shares of Verizon in personal or client portfolios.

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