Communication Services Sector

AI has provided a tailwind, while reasonable valuations point to more runway potential.

Matthew Drukker | Sector Portfolio Manager

Key Takeaways

  • The communication services sector has posted strong results in the past year, thanks to recovering earnings and enthusiasm over the promise of artificial intelligence (AI).
  • Even after the sector's strong performance, valuations generally remain reasonable—pointing to the potential for further runway.
  • New developments in generative AI could drive further efficiencies in digital content and advertising, deepening the relationships between customers and companies that have already been driving results for the past decade in the sector.
  • These trends could also provide a tailwind for the wireless and broadband providers that make increased digital connectivity possible.

Communication services had a breakaway year in 2023.

The sector was in part riding a rebound from the previous year's poor performance, and in part soaring on investors' enthusiasm over artificial intelligence (AI).

Yet even after the year's strong performance, the sector could be heading into 2024 with open runway still ahead of it. As of late 2023, sector valuations were still attractive and earnings estimates had been moving in a positive direction. And even though earnings have been reaching record levels and many stocks have shown momentum, the sector still hasn't returned to prior peak stock prices.

2023: Earnings recovery and a lift from AI enthusiasm

While the sector has seemed to have the wind at its back in recent months, that wasn't the case a year ago. Sector performance was so poor in 2022 that it was dubbed the year of the "tech wreck" (many communication services companies are popularly thought of as tech companies). That year's poor performance was owed to a combination of issues, including falling spending on digital advertising (which is the lifeblood of revenues for many communication services companies), rising expenses, slowing earnings, and a shift in investor preferences.

But in 2023, the winds shifted again. Digital advertising began to rebound, communications companies reined in spending, earnings bottomed out and began to recover, and mega-cap communications stocks came back into favor—partly due to a sense that the Fed's rate-hike cycle was nearing its end, and partly due to investor interest in companies at the forefront of advances in generative AI. As of mid-December, communication services was in second place for performance among all sectors (just behind technology).

Jan.Feb.MarchAprilMayJuneJulyAug.Sept.Oct.Nov.Year-to-date price returnIndexed value+46.5%+19.9%S&P 500COMMUNICATIONSERVICES SECTOR100110120130140150

2024: Potential opportunities in AI—and beyond

Communication services offers a diverse array of companies, ranging from more economically sensitive businesses, such as digital and traditional advertising, to areas that are less so, including wireless and broadband service providers. Across this spectrum, I believe that there are many specific investment opportunities among companies that can benefit from growth in digital services and demand for faster broadband.

Of course, there is no trend that garners as much hype, but also as much promise, as AI. While buzzwords like "generative AI" may have only rocketed into mainstream headlines in the past year, AI had actually already been driving growth in this sector for more than a decade. I believe that several communication services companies could be well positioned to benefit from the continued evolution of generative AI capabilities.

Among the sector's media and internet companies, the success of digital advertising has come from machine learning, a branch of AI that uses data and algorithms to make predictions about human behavior—helping to optimize recommendations for content (and ads) to show. With machine-learning capabilities, firms have been able to offer consumers hyper-personalized experiences based on their search, purchase, and viewing history—fostering greater engagement and better ad targeting. By unlocking this hyper-personalization, AI has already been driving much better efficiency and incredible value in connecting businesses with consumers to drive revenue.

Further advances in AI should increase these efficiencies. For example, the recent developments in generative AI could help advertisers home in on not just who to target with ads, but how to target them—such as by generating text, images, video, or audio that is personalized and designed to encourage users to take action. This could spell benefits for companies that sell digital ad space.

The communication services companies that may be uniquely positioned to harness the power of generative AI may be ones that have access to significant computing power, engineering talent specialized in AI, and massive amounts of data required to customize AI-driven models. Distribution may play an important role in introducing new generative AI experiences at scale, which could lend an advantage to the largest companies—such as ones that have daily interactions with billions of global users.

These tailwinds could be felt beyond just the realm of digital advertising. Communication services also includes telecom, cable, and satellite companies. As digital engagement continues to grow, so does demand for connectivity, which could benefit providers that can most cost-effectively deliver high-quality, fast broadband service through fiber or 5G networks. Companies that have illustrated this investment thesis have profitably grown market share while meeting the needs of customers interested in faster speeds. As AI facilitates the creation of new content, products, and services, these dense networks may remain vital in linking companies to customers looking to shop, learn, work, and relax.

Exciting trends point to a potentially promising outlook

It is difficult to predict any sector's performance over a given time period, either in relative or absolute terms. And it's similarly futile to try to guess what areas of the market investors will favor in a particular year. But in my opinion, positive momentum, reasonable valuations, healthy earnings, and a solid long-term tailwind seem to create a constructive setup for communication services in the year ahead.

Generative AI is a new chapter with the potential to drive incremental engagement and enhance relationships between companies and consumers with increasing efficiency. Ultimately, the success of AI will be measured by its ability to delight and engage consumers and to make businesses more productive. The communication services sector has many companies at the forefront of this trend, as well as the infrastructure to support an increasingly digital economy.

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