My first column last year was headlined "Long and Optimistic." I was quite nervous about this forecast. As it turned out, my view should have been even longer and even more optimistic, for 2006 was quite a year. Astonishingly, not a single significant equity market finished down. The two worst showings were Japan's market, up a modest 6.9%, and Korea's, up 4%. The vast majority of markets increased by somewhere between 12% and 30%, a sweeping success for the bulls. Helping feed the stock surge, of course, is the current bout of merger mania.
The stocks I wrote about last year climbed 18.4%, after subtracting 1% in hypothetical trading costs. Equal investments made in the S&P 500 at the same times would have climbed 9.4%. Only 2 of my 18 recommendations were down at all: Korea's Hyundai Motors (my best performer in 2005), off 25%, and RHJ International, an investment vehicle for Japanese stocks; it slipped 7%.
My 2006 picks were highly eclectic, ranging from Chinese coal companies to big U.S. drugmakers to Norwegian paper producers. Most have done well enough that I suggest selling them, keeping only two U.S. housing-related stocks-- USG (55, USG ) and Home Depot (nyse: HD - news - people ) (40, HD )--as well as the Mexican home builders: Homex (52 HXM ), Corporación Geo (5, GEOB.MX ), Urbi Desarollos (3, URBI. MX )and Consorcio Ara (6, ARA. MX). The domestic housing plays haven't risen much because real estate issues are in foul odor now, but this will change. If you haven't already, get them while they're relatively cheap.
My big advice for 2007 is to be ultracareful about buying corporate bonds, whether investment grade or not. Why? Private equity buyers, who aren't friends to the bondholders of companies they acquire. The buyout guys tend to load too much debt on their acquisitions, hurting the credit quality of existing bonds.
The private equity investors are hell-bent on gobbling up anything, large or small, often by joining forces with other leveraged buyout funds. Such alliances, known as club deals, have produced acquisitions of huge companies on the order of hospital chain HCA, real estate power Equity Office Properties and media empire Clear Channel Communications (nyse: CCU - news - people ). Even behemoths like Home Depot, with a market cap of $82 billion, become plausible fodder for the takeover gristmill.
The fuel that feeds this frenzy is abundant credit. To finance private equity deals many banks, bond funds, insurers, pension plans and foreign investors are happy to make loans and buy bonds at yields that are not much higher than what safe Treasurys throw off. LBO bids today are debt intensive, with debt running to eight or nine times operating income (earnings before interest, taxes, depreciation and amortization). Five years ago the ratio was typically a far less risky five to six times.
Before abundant credit became the order of the day, buyers of corporate bonds were protected by a bulwark of covenants that forbade overleveraging the balance sheet and other sins. No more. Bond issuers lately no longer need to plug covenants into their issues for them to attract buyers.
With any company potentially in play, the bondholders are vulnerable. As soon as an LBO deal is announced, the bonds of the target company often plunge in price. Take the HCA bonds due 2015: In the beginning of 2006, before the buyout offer, they sold at par. Now they trade at 85 cents on the dollar.
In this climate finding a good corporate bond reminds me of the popular children's book, Where's Waldo? Released in 1987, the book contains dense illustrations wherein the child is supposed to find the Waldo character hidden in the jumble.
If you insist on buying corporate paper, you must look really hard to find Waldo, the rare corporate debt that offers fair reward for the risk of default. A good example is Realogy (nyse: H - news - people ), the largest residential real estate broker in the U.S., spun off from the Cendant conglomerate. In mid-December private equity group Apollo Management announced a $9 billion bid for Realogy. But the impact on Realogy's $1.2 billion in bonds issued just two months before was a price increase.
That's because Realogy's notes have excellent and atypical covenant protections: change of control puts and coupon step-ups for any ratings downgrade. Thus bondholders have the choice of either putting the bonds back to the company at par or receiving a higher coupon.
If corporate bond investors demanded such covenants as a matter of routine, they would put a real damper on the LBO mania. LBOs would not be stopped, but at least the bond buyers wouldn't be the easy victims.
Lisa W. Hessis a New York money manager. Visit her homepage at www.forbes.com/hess.
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