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Second Quarter in Stocks: Buyout Binge Boosts Bulls

But interest rate worries also build.

John Coumarianos, 07/03/2007

Stocks continued their rally from the end of the first quarter into April and May. The markets appear to be sputtering in June, but unlike in late February, another tumble in Chinese stocks at the end of May caused barely a ripple on U.S. exchanges. Moreover, the problems of subprime loans, a continuing housing slowdown, and high energy prices haven't spooked the rest of the economy, which is still solid, though slowing. The Morningstar U.S. Market Index was up 5.2% for the trailing 13 weeks through June 22, and is up 7.6% for the year.

Contributing to the subprime and housing issues were sagging bond prices and higher yields, leading to higher mortgage rates. (Bonds offer a fixed coupon, so their yield--the coupon divided by the price of the bond--rises as bond prices fall.) The Lehman Brothers U.S. Aggregate Bond Index shed 1.62% (nearly all its year-to-date gains) for the quarter through June 21. The bond sell-off pushed the yield on the 10-year U.S. Treasury note to 5.2%, up significantly from the 4.6% range in early March. Investors anticipated that Federal Reserve Chairman Ben Bernanke would hold the line on interest rates as he balances the pressures to lower them in response to a softening economy against the pressures to raise them due to inflation, including higher energy prices. As a side note, Bernanke's still-influential predecessor, Alan Greenspan, moved his employment address from Washington, D.C., to Newport Beach, Calif., taking a consulting post with bond manager PIMCO.

Although bond prices faltered and yields went up, the "cheap money" cited by commentators as the reason for the boom in corporate buyouts (and perhaps an underlying buttress for the strong stock market) appeared as abundant as ever. Interest in real estate investment trusts (REITs) remained high as a consortium led by private entity Tishman Speyer and Lehman Brothers LEH purchased high-end apartment landlord Archstone-Smith ASN for about $22 billion. Other merger and acquisition activity included private equity firm Cerberus buying Chrysler, Microsoft MSFT buying  aQuantive AQNT, and Wachovia WB buying AG Edwards AGE.

Buyout firm Blackstone BX also capitalized on investors' appetite for access to deals--and satisfied its own desire for a permanent, flexible funding source, according to Morningstar analyst Jeff Ptak--by going public, prompting Congress to examine tax regulations governing publicly traded partnerships.

The doings of other notable investors or financiers included Chicago real estate mogul Sam Zell buying Tribune TRB (owner of the Chicago Tribune and other media outlets), News Corp.'s NWS Rupert Murdoch making a high bid for Wall Street Journal publisher Dow Jones DJ, Carl Icahn failing to gain a seat on Motorola's MOT board, and Warren Buffett's Berkshire Hathaway BRK.B buying gold jewelry manufacturers Bel-Oro International and Aurafin. Both Motorola and Berkshire currently trade in 5-star territory.PAGEBREAK

Surveying the Sectors and Industries
Energy led all sectors, surging 18.6% for the trailing 13 weeks through June 22. Coal companies Yanzhou Coal Mining YZC and Fording Canadian Coal Trust FDG rose 60% and 46%, respectively, as global demand for energy continues to increase. Morningstar analysts Michael Tian and Kish Patel think both stocks are trading above their fair values, however. Oil drillers and service providers such as Baker Hughes BHI, Transocean RIG, and Smith International SII also rose 34%, 33%, and 25%, respectively. Baker Hughes and Smith have managed to build narrow moats in a competitive business, but all three trade above our analysts' fair value estimates.

Consumer services was the worst sector, posting a meager 0.35% gain for the trailing 13 weeks through June 22 and a 4% gain for the year. However, this poor performance means that the sector is now offering up some tasty stocks at attractive prices. Food and coffee purveyors Whole Foods WFMI and Starbucks SBUX are in 5-star territory as a result of their 15% and 19% respective declines over the trailing three months. The stocks trade at 27 times and 34 times earnings, respectively, but Morningstar analysts Mitch Corwin and John Owens anticipate strong growth and returns on invested capital for both firms, including significant overseas expansion for Starbucks, and view them as solid long-term holdings at their current prices.

Aluminum and coal were the best industries, with 38% and 26% gains, respectively, for the trailing three months through June 22. Aluminum maker Alcoa AA jumped 17.6% as the market reacted well to its bid for rival Alcan AL. Morningstar analyst Scott Burns thinks the merger makes sense, because aluminum is a commodity business and increased scale can improve a company's cost position. Burns values Alcoa at $40 per share, where it currently trades.

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