There’s a Reason Wall Street Still Thinks Big Is Beautiful
Quick, what’s the better stock to have owned so far this year: Profitable online titan America Online, or money-losing copper miner Asarco?
Most investors probably know next to nothing about Asarco, but its year-to-date share price gain now stands at 48%--thanks to an unsolicited takeover bid it received Friday from rival mining firm Phelps Dodge.
By contrast, shares of AOL--which arguably represents the U.S. economy’s future as much as Asarco represents its past--are up about 23% year to date.
Buy the future, or buy the past?
Most of the time the answer would seem to be pretty academic: The best place to invest must be the companies and industries that are selling the products and services that have the most growth potential in the years to come.
But this year, some investors are having second thoughts about betting entirely on leading growth companies. As the global merger wave rolls on, concentrating power in key industries in the hands of a relative few corporate players, more Wall Street pros are taking a fresh look at the potential opportunities generated by this record pace of consolidation.
The new watchword is value: Investors are becoming more keen on the idea of hunting for companies where value can be realized--and brought to bear in terms of improving the bottom line.
As my colleague Thomas S. Mulligan points out elsewhere on this page, few analysts believe that the current merger wave will translate into spectacular pricing power for the surviving players any time soon.
But as has been demonstrated at many companies in the 1990s, profit can be boosted without gaining pricing power if a firm can cut operating costs and raise efficiencies significantly--in effect, allowing more of every dollar of sales to drop to the bottom line.
Now, in industries where the market share of the major companies still isn’t overwhelming, such as in paper and lumber, basic metals and energy, investors who are focused on value are finding more reason to be optimistic about the payoff from accelerating merger activity.
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That optimism was apparent last Friday in the market’s treatment of Phelps Dodge’s shares.
The stock soared as high as $62.13 on news of its takeover offers for both Asarco and for Cyprus Amax, which had previously agreed to merge with Asarco.
Phelps Dodge’s share price came down by the end of trading Friday but still finished up 56 cents for the day, at $59.13 on the New York Stock Exchange.
Often, a company that announces a takeover offer sees its own shares initially fall in value as its investors worry about dilution of ownership and other risks.
But Phelps Dodge’s investors sense opportunity. Now the No. 4 U.S. copper producer, Phelps would become No. 1 by acquiring both Asarco and Cyprus Amax.
Copper is hardly a glamour industry. Worse, it’s an industry in which supply has continued to far exceed demand--pushing prices for the metal to 12-year lows last spring.
Without pricing power, Phelps Dodge logically sees the only solution as consolidation that will allow the combined company to slash now-duplicated efforts. The firm said it believes it can generate $200 million in savings by merging the three entities.
Likewise, aluminum titan Alcoa saw its shares rise last week, closing Friday at $67.69, after it succeeded in convincing rival Reynolds Metals to agree to a $4.4-billion hostile takeover offer.
Alcoa’s bid followed news a week earlier of a three-way merger among leading aluminum companies in Canada, France and Switzerland.
Yet combined, Alcoa, Reynolds and the rivals involved in the other major deal will control only about 30% of the world’s aluminum production capacity, analysts say.
That suggests far more consolidation is likely in aluminum, as well as in other heavy-industry sectors that are still suffering from overcapacity worldwide.
No wonder investors are paying attention--and paying up for the stocks involved.
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Indeed, “value” stocks in general now are outpacing “growth” stocks for the year to date.
Vanguard Group’s Value Index mutual fund, which owns those stocks in the Standard & Poor’s 500 that are deemed to be values because of their below-average prices relative to underlying asset value and other measures, has risen 11.3% so far this year.
By contrast, the Vanguard Growth Index fund, which owns the S&P; 500 stocks that sell for above-average prices relative to asset value, etc., is up 8.1% for the year.
The hunt for value is playing out among smaller stocks as well. Vanguard’s Small-Cap Value index fund is up 5.5% for the year, while its Small-Cap Growth index fund is down 1.3%.
There is another factor at work in lifting value stocks this year--at least those that belong to companies in heavy-industry and other so-called cyclical businesses.
Growing signs of economic recovery in Japan and the rest of East Asia, as well as an improving outlook for business in Europe, are driving many investors to bet on a much stronger world economy in 2000.
That wouldn’t be a bad environment for many classic growth companies, but it might be a better environment, relatively speaking, for companies that could see a surge in demand for their products--and, perhaps, higher product prices as well.
Whether the global economy picks up or slows, however, there is little reason to believe that the corporate merger wave will significantly decelerate soon.
And overseas, the wave may just be building. Witness last week’s announcement that three of Japan’s biggest banks--Fuji Bank, Dai-Ichi Kangyo Bank and Industrial Bank of Japan--plan to combine to form the world’s biggest bank.
It probably wasn’t a coincidence that Tokyo’s Nikkei-225 stock index rose 1.2% to 18,098.11 on Friday, and is up 31% year to date.
In Japan, as on Wall Street, investors believe big is beautiful if it means cost savings that can fuel future earnings gains.
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Still, buying the stocks of the industry leaders in even the most concentrated oligopolies isn’t a sure bet--at least not in the short run.
The U.S. railroad industry is already extremely concentrated, with the five major companies controlling 76% of the market.
But railroad stocks have been nothing to gloat about this year.
As analyst James Higgins at DLJ Securities notes, operating problems suffered by some rail companies over the last year “have made many question whether diseconomies of scale have been reached in recent combinations.”
Yet if earnings growth has become even more of a challenge, Higgins sees no alternative but more consolidation in the rail business, which has been plagued by weak revenue growth in part because more companies with goods to ship are increasingly turning to truckers.
“Simply put, railroads benefit too much from increased line haul density, longer hauls, not having to hand off traffic to a partner carrier and overhead cost reductions for us to believe that . . . additional mergers” won’t occur, Higgins said--even though he acknowledges that regulatory barriers appear “nearly insurmountable” to new mergers.
To some investors, it would seem that the best way to cash in on the ongoing consolidation wave in general is to try to pick companies that stand a good chance of getting bought out at hefty premiums to their current stock prices.
But that is always easier said than done. Takeover targets often look obvious only in retrospect.
On Thursday, the market valued Asarco at $18.44 a share. But Phelps Dodge, with its hostile takeover bid on Friday, valued its competitor at about $24 a share.
The market clearly saw less value in Asarco than does Phelps Dodge. And the fact that Asarco shares were well below Phelps Dodge’s bid indicates that even Wall Street pros were unable to predict that Phelps would make such a bold bid.
Correctly picking takeover targets will generally involve more work than many investors are able to do.
Thus, if bigness in any industry continues to be rewarded on Wall Street, the best investment advice would seem to be: Stick with the giants that are leading the consolidation wave.
That means keeping a hefty chunk of your portfolio invested in blue-chip stocks, however pricey they may be, and come what may in the economy, with interest rates and in other challenges.
Tom Petruno can be reached at tom.petruno@latimes.com.
