Sure, there might be bargains among telecom stocks, but there are land mines too.

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When the

Nasdaq

bubble popped, telecom shops stopped building networks and making money, leading to bankruptcies, layoffs and stunning investment losses.

Lucent

(LU)

and

Cisco

(CSCO) - Get Report

are both down more than 60% over the past 12 months; the average telecom fund is down some 50% over that stretch. That said, value managers like Bill Miller have been fishing in the sector's choppy water, and the stocks have bounced a bit in recent weeks.

To sort through the sector's risks and opportunities, we're talking to Brian Hayward, who has run the (ISWCX) Invesco Telecommunications fund since 1997. He's taken his lumps over the past year, but he also topped his average peer in each of the previous four years. When will the sector turn around? Will things get worse in the meantime? Where is he investing today? Read on.

1. What caused the downturn in telecom?

The demise of the industry, or many companies in the industry, was prompted by many things. Too many new companies with weak business models were able to obtain funding, and they are now failed or failing. Teligent and Winstar, for example, are both bankrupt, and Intermedia Communications was only saved by WorldCom's (WCOM) bid for them. When those new companies were building their networks and getting all this new funding, pressure was brought to bear on incumbents like the regional Bells, and they began spending more on their networks, partly in response to the new carriers. We had a milestone in March of 2000 in the auction of licenses to allow companies to offer next-generation wireless service in Europe, and many, well, all of the winners of those auctions damaged their balance sheets in the process. Also, the weakening economy is driving everyone's earnings lower.

This is the worst downturn I've ever seen and hope to ever see.

2. What's the case for investing in telecom stocks -- what will turn their earnings around?

There is still growth ahead in this industry. That's the basic case for investing in this space. What will turn it around is continuing growth of traffic, data traffic rather than voice traffic. Throughout all of this, the bubble and the burst of the bubble, traffic has been growing rather steadily. We're seeing much lower rates of growth in data traffic than we were in the late 1990s, but it's still growing probably 100% every 15 months. That eventually will strain the capacity of the network's ability to carry it. We already know that network engineers would like to be spending to improve their capacity now, but in the current economic conditions, those decisions have moved up to the chief financial officer level, where spending has been curtailed or stopped altogether.

The question going back to the engineers has been, "Do you need it today?" Apparently, the engineers have not been able to make that case. Eventually, the purse strings will have to be reopened again. And we see that happening perhaps late 2002 and into 2003.

Talking With: Brian Hayward

Fund: Invesco Telecommunications

Managed Since:
July 1, 1997 (inception), with Barry Gordon

Assets: $753 million

1-Year Return/Ranking:
-63.1%/Trails 92% of Peers

3-Year Return/Ranking:
-1.4%/Beats 65% of Peers

Expense Ratio:
1.10% vs. 1.56% category average

Top Three Holdings: BellSouth
Liberty Media
EchoStar Communications

3. When does that start to play out in the stock market?

Well, the market is pretty adept at anticipating six months ahead of trends, so we're thinking about mid-2002. Actually, we're seeing it today. We've seen a rally in some of these stocks over the last couple of weeks. Granted, they're coming from low bases. Just hints from vendors that they're seeing stabilization has been enough to drive the stocks higher.

Is that what you're hearing from sources in the industry?

The deterioration has decelerated, but it has not stopped. That's what we're hearing.

4. Given that view, where are you investing today, and what's your time horizon in buying stocks?

Well, our horizon is still a year out, at least, and beyond. The trends we're investing in are local service deregulation and local service improvements, next-generation wireless services and infrastructure, and consolidation.

And the local service front, two of our top 10 holdings are the only two competitive local exchange carriers that we think are investable today:

Time Warner Telecom

(TWTC)

and

Allegiance Telecom

(ALGX)

. They have been horrible stocks until about a month ago.

On the wireless service front, we're more focused on the U.S. than in Europe, so companies like

Sprint PCS

(PCS)

,

AT&T Wireless

(AWE)

and

Western Wireless

(WWCA)

are among our holdings. Each one has positives and negatives. We are more interested in the U.S. than Europe, because Europe is close to saturation. The U.S. is much more highly penetrated today than, say, 18 months ago, but still much less so than Europe.

Wireless infrastructure is somewhat in limbo today. Eventually, network infrastructure will be deployed to offer next-generation wireless services, wireless data services. The carriers really don't have a good handle on what will be the "killer application" for data services on wireless networks, but they all need additional voice capacity.

Two wireless stocks in our top 10 are

Qualcomm

(QCOM) - Get Report

and

Nokia

(NOK) - Get Report

.

Next-generation wireless service providers will use some form of code division multiple access technology. Qualcomm holds the patents, is paid license fees, is paid royalty fees, and in some cases for the carriers that use CDMA 2000 technology, Qualcomm sells chipsets for that technology. So the barrier to entry for others being able to offer the CDMA technology is significant.

Nokia is the industry leader in handsets; they have really no holes in their product lineup. They were the first company to really capitalize on the marketing aspect of handsets, the appeal to consumers.

Their Bells Are Ringing
Communications funds' recent woes have even tarnished their long-term records

Source: Morningstar. Returns through Nov. 12.

5. The past year's losses have proven why we should consider the worst-case scenario. What could make things even worse for the telecom sector?

It could be the economy. We've had enough rate cuts in place now to see the bottom, and there are economic stimulus packages being considered. But we still don't know what the consumer will do to help drive the economy back to health. So I would say right now a delay in the recovery of the economy carries as much weight as any industry factors in bringing this group back to health.

6. Are there still many companies on your radar screen that won't be around a year or two from now?

We may see consolidation in the long-distance industry so that the names that we're familiar with today are no longer independent companies, but that won't be as a result of failure. It will be as a result of consolidation.

You think the bankruptcies are washed out at this point?

I think most are. We had some pretty noteworthy bankruptcies, especially thinking about the competitive local exchange carrier space. There are still concerns in the market about Lucent Technologies. I don't have them on a bankruptcy watch list here, but that issue has been raised. They've made some improvements to the balance sheet; there are improvements in their businesses, early signs of improvement. So we're less concerned about Lucent today than we were six months ago.

7. Do you see companies out there that look OK but should be on a bankruptcy watch list?

Not that the market hasn't already determined. You have companies like

Global Crossing

(GX)

, which is on everybody's watch list. That company is among those who were able to get funding with the promise of things to come. Now more money isn't coming and its debt load is a problem. But others in Europe, you know Viatel is bankrupt, Global Tel Systems is bankrupt.

10 Questions Archive

Small-Cap Bargain-Hunter Dan Szemis

Tech-Critic Robert Sanborn

Dividend Disciple John Snyder

Fidelity Expert Jim Lowell

Janus Growth & Income's David Corkins

White Oak Growth Stock's Jim Oelschlager

Firsthand Funds' Kevin Landis

8. Have the past year's losses made you change your investment style or ask different questions about companies before you buy shares?

We are much more prone to seek out the best balance sheets than we had been in the past. But other questions that we might ask the management teams haven't changed. Maybe we ask for more and more clarification on the business model. What are your assumptions for funding whatever debt level, how high do you think the debt level might go and how can you service it? Things like that.

9. If you had to single out two companies you'd have the most confidence in owning for the next five years, which would they be?

Shares where you can sleep at night and come back in five years and they'll still be around?

Yes. They'll still be in business and they'll be worth more than they are today, hopefully.

The two that came to my mind as soon as you said that were Cisco and Nokia. It's not because they're cheap and table-pounding buys today, because they're not. But they will be in business and they will benefit from industry growth trends.

10. Some fund managers are buying telecom companies' debt, figuring that if the company doesn't go out of business, they'll get price appreciation in the long term and a high yield in the near term. Are you doing the same?

I agree with that line of reasoning. We have not participated.

Why not?

The risk in the debt of a company that has a questionable balance sheet is perhaps less than the equity, but it's still a risk that, given the environment we've just come through, we're not willing to take.

Another trend is value managers like Legg Mason's Bill Miller buying shares of companies like Corning (GLW) - Get Report, Tellabs (TLAB) and Lucent. Does that make you think things are turning around?

Yes. It tells me that we are near or at the floor on the valuations.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.