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The Year in Stocks: Equities Still Climbing

M&A activity contributes to surge.

John Coumarianos, 01/03/2007

Morningstar's 100 stock analysts cover 1,800 companies. Their full analyst reports are available through Morningstar Principia Stocks Advanced and Morningstar Advisor Workstation Office Edition.

Just as they did in 2005, the markets closed out 2006 with a bang. The Morningstar US Market Index returned 15.7% for the year, with half of that gain coming in the past 13 weeks. This marks the fourth straight year of gains for equities after the brutal bear market of 2000 through 2002.

A flurry of merger and acquisition activity has contributed to the surge, as companies and private equity funds have scrambled to deploy cash, paying premiums to purchase other businesses. Among the more notable acquisitions have been mining company Freeport-McMoRan FCX swallowing Phelps Dodge PD, Bank of New York BK taking over Mellon Financial MEL, a consortium of real estate investors (led by the Blackstone Group) purchasing Equity Office Properties EOP from real estate legend Sam Zell, and Bank of America BAC scooping up asset management unit U.S. Trust from Charles Schwab SCHW.

Other moves of big financiers and investors included Kirk Kerkorian abruptly and sourly eliminating his interest in embattled automaker General Motors GM and Carl Icahn selling his stake in media giant Time Warner TWX. Additionally, Warren Buffett's company Berkshire Hathaway BRK.B got knee-deep in asbestos, continuing to purchase shares in USG USG, which has emerged from asbestos-induced bankruptcy, and taking over insurer Lloyd's asbestos claims. In the latter deal, Buffett put up $7 billion in reinsurance protection against potential claims in exchange for control of nearly $9 billion in reserves. Analyst Justin Fuller has raised his fair value estimate for Berkshire's shares, based on the insurer's long-term earnings power. Fuller thinks fears about legendary CEO Buffett's successor and Berkshire's difficulty putting cash to work are overblown.

If merger and acquisition activity was frenzied, Ben Bernanke and the Federal Reserve were sedate. The Fed left short-term rates alone as neither inflation nor a dramatic slowdown seemed to threaten. Oil prices stabilized in the low $60s, easing the pressure on Bernanke (high oil prices can potentially spur both inflation and a slowdown, rendering a Fed banker hamstrung), and natural-gas prices recovered after a late summer swoon.

The bond market continued betting that Bernanke would lower rates, evinced by investors' seemingly strange willingness to accept lower yield payments on longer-term bonds than on shorter-term bonds. This "inverted" yield curve (the plot of yields based on bonds' maturities) has kept mortgage rates low. Observers debate whether the housing slump has reached its nadir, or is in the early stages. Homebuilding stocks appear to have stabilized from their late summer swoon, though Hovnanian HOV and Ryland RYL remain in 5-star territory.

Surveying the Sectors
The cyclical telecommunications sector led its peers with a 33% gain for the year through Dec. 20. Foreign service providers such as Telekomunikasi Indonesia TLK surged 88%. Analyst Jacqueline Zhang awards the business a narrow moat for its leading position, despite the Indonesian government's efforts to liberalize the industry. The stock's surge has put it a bit above her fair value estimate of $39 per share. BT Group BT also jumped 66%, taking it out of 5-star territory, where it began the year with analyst Allan Nichols' recommendation. An improved regulatory environment has encouraged Nichols to award the business a narrow moat as anticipated returns on investment should be modestly above the firm's cost of capital.

Utilities also did well, continuing their multiyear run with a 32% surge. However, the media sector came alive, posting a 24% gain. Cable TV businesses DirecTV DTV and Comcast CMCSA posted 78% and 65% gains, respectively. DirecTV was in 5-star territory early in the year. Analyst Michael Hodel is fond of the business's cash-flow-generation capability, despite slowing growth. However, the stock has blown past Hodel's fair value estimate at this point.PAGEBREAK

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