Big Mergers and Kiddie Stocks

By MICHAEL SANTOLI | MORE ARTICLES BY AUTHOR

Sizing up takeover speculation and the rise of kid-friendly stocks like McDonald's.

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FOLKS ON WALL STREET WHO SPEND their days staring at news tickers greet big headlines by immediately speculating on their eventual symbolic echoes.

"What does Stanley Druckenmiller's decision to back away from his $12 billion hedge fund say about the business? Can an instinctive macro trader no longer figure out today's market of high-speed robot pinball?"

Or: "If the market bottomed right around the time the government took control of General Motors, what does it mean that GM just filed an IPO?"

(From this desk, the answers to the above lack drama or portent. The first says that 57-year-old billionaires just might not want to worry about quarterly client letters after 30 years of it. The second would perhaps be more ominous if many people in the spring of 2009 were insisting that the government takeover of GM was a clearly bullish signal.)

A lot of this conjectural querying derives from the common failure to anticipate those events that always end up seeming, in retrospect, like the obvious clue of a market turn. As in, "If only I'd gotten short the housing market in '06 as soon as Wachovia and Merrill Lynch bought subprime lenders…"

There's no more science to this than there is in the typical sports-talk radio chatter, but it can be amusing in the late-summer slog, and helps hone one's market views. Here are a few such topical questions about possible symbolic market elements.

• Is this recent surge in corporate acquisition activity outright bullish, or a warning sign of excess, or something else?

First off, it's entirely expected and logical. The bounty of idle cash on the books of big nonfinancial companies is a dog-eared sheet of the market bull's playbook. The bond market is outright pleading with companies to issue cheap debt for deals. Growth today is probably easier to buy than build for many CEOs.

The use of cash, borrowed or not, in such proposed takeouts as BHP's (ticker: BHP) unfriendly $39 billion bid for Potash Corp. of Saskatchewan (POT) and Intel's (INTC) $7.7 billion purchase of McAfee (MFE), spotlights pockets of perceived value in the shares of both the target and acquirer.

Yet, the abundance of takeover rumors of varying levels of plausibility that have been driving speculative options buying the past couple of weeks is the sort of thing that often marks the latter phase of a bullish market phase.

The bottom line is that the M&A theme is a net-positive factor, and will be until it gets more out of hand, but it's surely not the key reason to buy the market here.

• What does the character of the relative handful of large stocks trading near an all-time high tell us about what works in this tape?

For one thing, you might consider having a team of 10-year-olds assemble your portfolio, focusing on brands familiar to them. A screen of Standard & Poor's 500 stocks ranked by how close they are to an all-time high was run by Bespoke Investment Group at Barron's request. Of the 37 stocks as of Thursday's close priced at 90% or more of their all-time peak, at least 10 passed the kid-favorite test.

These include McDonald's (MCD), Yum! Brands (YUM), Dr. Pepper Snapple (DPS), JM Smucker (SJM), General Mills (GIS), Hasbro (HAS), Nike (NKE) and Discovery Communications (DISCA).

While some of these, such as McDonald's and JM Smucker, continue to look attractive based on their valuation, growth prospects and dividends, the lesson of this exercise is really that in a long-lasting sideways market, traditional growth stocks with multi-generational brand equity often attract an outsize proportion of investor dollars. Just go back and look at Coca-Cola's (KO) stock chart from the 1930s.

• What will the popular fury about fiscal funding gaps alight on next, now that outrage about what government employees are paid has become a staple of cable-news screeds?

At the state level, there's been a bear case in the market for a while surrounding the private prison operators, such as Corrections Corp. of America (CXW) and Geo Group (GEO), based on states' budget constraints driving down contract rates and encouraging prison release programs. This hasn't yet materially hurt the companies, but additional straws are blowing around. Fortune magazine, keying off a recent escape of Arizona inmates from a private prison, noted that some research concludes that prison outsourcing might not save much money.

Corrections Corp. remains a well-managed company with stable cash flows and a reasonable valuation. It's owned in size by a pedigreed set of astute institutional investors, and has been a bullish (and profitable) pick of Barron's Daily Stock Alert online subscription service.

Yet if the public anger about government finances builds up a bigger head of steam, the market might focus more on the threats than the promises. 

E-mail: michael.santoli@barrons.com