The Year in Stocks: Equities Still Climbing

Just as they did in 2005, the markets are closing out 2006 with a bang. The Morningstar US Market Index has returned 16% for the year through Dec. 20, 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 ,  Bank of New York (BK) taking over  Mellon Financial , a consortium of real estate investors (led by the Blackstone Group) purchasing  Equity Office Properties  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 . Additionally, Warren Buffett's company  Berkshire Hathaway (BRK.B) got knee-deep in asbestos, continuing to purchase shares in 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  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  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  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.

Health care brought up the rear with an 8% gain. Biopharmaceutical company  Celgene  rocketed up 82% on the success of Revlimid, its immunomodulatory drug. Analyst Karen Anderson thinks the company has solid growth ahead of it, but the stock is trading well above her fair value estimate.  Merck (MRK) also surged nearly 42%, despite lingering litigation over Vioxx, and the specter of drugs coming off patents in the next five years. However, analyst Heather Brilliant sees a diamond in the rough, with an improving pipeline and recent approval for a new diabetes drug and a vaccine to protect young women from papillomavirus (HPV). For now, the stock trades above her fair value estimate.

The laggards in health care include many medical device makers, and here we find some stocks in 5-star territory.  Boston Scientific (BSX) has dropped 31% through Dec. 20 for a second year, as it struggles with product recalls and to digest acquisitions for which it paid dearly. Nevertheless, analyst Debbie Wang remains upbeat about Boston's longer-term prospects because of its increased product diversification and history of innovation. Boston's competitor  Medtronic (MDT) has also been hit hard by the implantable cardioverter defibrillator (ICD) recall, falling 6% for the year. It has bounced hard off of its lows, however, and Wang sees the market for its products stabilizing and its ability to create new products positioning it well for the future.

Industry Performance
Toys/hobbies and steel/iron led all industries with 80% and 61% returns, respectively, for the year through Dec. 20.  Chaparral Steel  added a whopping 194% but still trades in 4-star territory, a bit below analyst Ben Butwin's $56 fair value estimate. Butwin anticipates robust demand for steel and thinks the niche that Chaparral occupies--structural steel--can protect it from competition. Still, Chaparrel doesn't have a moat, and Butwin requires a very deep discount below his fair value estimate for purchase. Additionally, the newly combined  Arcelor Mittal (MT) is now the world's largest steel producer, and analyst Scott Burns thinks the company is uniquely positioned to respond to market demands. Shares of Mittal jumped 61% for the year, and currently trade near Burns' fair value estimate of $45 per share.

Gambling/hotel casinos also did well, adding 54% for the year through Dec. 20.  Las Vegas Sands (LVS) surged 131%, and  Wynn Resorts (WYNN) rose 80%. Both stocks' runups have taken them into 1-star territory.

Homebuilders finished last, dropping 18% for the year through Dec. 20. Many of them, such as  Centex ,  Pulte (PHM), and  Toll Brothers (TOL), have bounced off of their lows in the late summer when they sat on the 5-star stock list, to approach our analysts' fair value estimates.

Education also stumbled, dropping 14% for the year through Dec. 21.  Apollo Group  shed 36% amid fears of slowing growth, earnings restatements, and an investigation into stock-option backdating. Nevertheless, analyst Kristan Rowland finds a business she likes underneath these problems. She thinks that demographics serve Apollo well, given the number of working adults seeking to improve their careers through higher education. She has awarded Apollo a wide moat designation for its anticipated ability to sustain returns on invested capital that exceed its cost of capital.