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Lucky 2007

An equity shortage, a new M&A boom, a weak dollar, and lower interest rates point to another year of big winnings on Wall Street.

Illustration by Marc Boutavant  

Companies don’t need the stock market anymore. Sure, investors love it when the market goes up, and those who own stocks make tons of money, as they did in 2006, a year that defied every skeptic in its march to record highs. But for many corporations and their managements, the stock market is just plain unnecessary, atavistic even. They don’t need the money the market can provide, and they hate the hassle of having a public stock. That’s why, in 2006, we got a record number of takeovers, mergers, and private-equity buyouts. And that’s why I think 2007 will be even bigger than 2006.

After the bountiful year every index had—despite endless Federal Reserve tightenings, a crashing dollar, an auto industry that could be in the crisis of its life, an oil price that wouldn’t quit rising, and a housing market that still can’t find bottom—you would think that 2007 would be a year of chickens coming home to roost. Although many of those problems remain, particularly Detroit’s unraveling, I don’t think they can stop 2007 from being a good year any more than they could stop 2006.

Here are some rosy yet realistic predictions for next year, a year in which the S&P 500 could rise as much as 15 percent if these factors play out this way. That prospective run won’t give you the kind of money that Morgan’s John Mack, Lehman’s Dick Fuld, Bear Stearns’ Jimmy Cayne, or Goldman’s Lloyd Blankfein figure to make in another boom year for deals—but it could create a nice windfall over and above a prosaic paycheck.

First, as I’ve noted in this space before, we’re beginning to have an equity-supply shortage of mammoth proportions. For as long as I can remember, companies came public to tap the equity market, not to avoid it. They were perennially growing and in need of capital for hiring and building. But now the great American businesses are swimming with cash, far more than they need, thanks to record profit levels. That’s why 29 of the 30 Dow Industrials are buying back billions of dollars’ worth of shares instead of floating more equity to take advantage of higher prices. Yet hedge funds, mutual funds, and other institutional investors need stocks to invest in, and the great returns of 2006 are luring individuals back into the market for the first time in a half-decade. That combination, plus management’s newfound love affair with anything that removes them from the market, causes an equity scarcity, so the remaining stocks get bid up in value.

Second, for those managers who hate being public, and those under attack from hedge-fund managers demanding better performance, there’s plenty of money available to pay for going private. We saw, in 2006, the beginning of a new phenomenon: the rise of private-equity funds, pools of capital put together to buy companies, as drivers of higher prices. These funds are taking advantage of a chronic undervaluation of many companies, including ones worth $20 billion or even $30 billion. The undervaluation is a by-product of Wall Street’s love affair with hyperoxygenated growth, the kind that only smaller and midsize companies can provide. Mutual and hedge funds spurn companies with anything less than 10 to 15 percent growth, something that most old-line companies can’t provide. That leaves the stocks of hundreds of corporations, including many steady but unspectacular growers, such as big casino, semiconductor, hospital, and restaurant chains, unloved by the market.

A handful of savvy private-equity buyout firms, like Silver Lake, Bain, Texas Pacific, Kohlberg Kravis Roberts, and Blackstone, have started to capitalize on this phenomenon. They approach managements fed up with their cheap stock price with an elixir: buy out the equity holders with a massive infusion of cash (backed by newly minted corporate bonds that take advantage of record-low interest rates). Then the new owners and management can revel in all the cash these companies generate and no longer have to share it with ungrateful shareholders. I see many candidates for private-equity buyouts in 2007, including Hershey, Barnes & Noble, Applebee’s, and KB Home, none of which get the rewards they deserve in the public markets.

Third, companies are getting a sense that the clock is ticking on many mergers now blessed by a Republican-controlled government. The Democrats’ midterm-elections rout was a reminder to CEOs that they’d better get their deals done now, before the White House changes hands. Right now we have a Justice Department antitrust division that basically serves as an adjunct to the Commerce Department, but that goes out the window if the Democrats—who actually have the audacity to care about things like monopolies and anti-competitive behavior, even if it means lower stock-market prices—take over all three branches of the federal government. Look for the airline companies to team up (United and Continental, as well as US Airways and Delta, have already jump-started that process). And look for giant mergers in telecom, oil, drugs, and health care, all areas the Democrats are likely to scrutinize. I like Qwest, Bristol-Myers Squibb, ConocoPhillips, UnitedHealth, and Humana as companies that could be snapped up by rivals before the Democrats can stop them.