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Pro Analysis

Tom Lee: New dividend play to post double-digit gain

Tom Lee
Adam Jeffery | CNBC
Tom Lee

Fundstrat's Tom Lee recommends telecom stocks over utilities for the rest of the year, predicting the group will post a double-digit return as it becomes the new favorite dividend play.

"We see 2016 as ripe for a regime shift and as such, given telecom's 4-years of consecutive underperformance, is the turn for Telcos," Lee wrote in a note to clients Friday. "Between telecom stocks and utilities, as the P/E and dividend differentials have reached extremes...Telecom [is] the most logical convergence trade to utes [utilities] in 2H16."

The strategist cited two major telecom underperformance periods (1946 to 1960 and 1967 to 1975) versus the S&P 500. The outperformance after those periods lasted six to 21 years. He believes the sector is coming out of a 1999-to-2015 underperformance cycle.

Moreover, telecom stocks traditionally had a 2.2 P/E premium versus the utilities sector. Currently, it is trading at a 4.2 P/E discount versus utilities, which is the largest gap in more than 40 years and two standard deviations from the historical average.

Lee found when telecom sector valuation is one to two standard deviations lower versus utilities in the past, the sector outperforms the S&P 500 by 3.8 percentage points the following 12 months.

There is a disparity in dividend yields as well. The telecom sector now has an average dividend of 4.3 percent versus utilities at 3.2 percent. This compares to the 40-year telecom sector average dividend of 1 percentage point lower than utilities.

"One of the more surprising developments in the past year has been the market's willingness to pay a higher multiple for a dividend dollar than a free cash flow dollar," wrote the strategist. The note is his "case for these stocks to generate double-digit gains."

Lee said a good signal for the telecom sector's improving fundamentals is how Wall Street earnings estimates for 2016 and 2017 started increasing since mid-2015.

Here are the telecom stocks Lee recommends to take advantage of this mean reversion trade.