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Slower Growth's Upside

Updated from Jan. 23

After the long list of high-profile profit-warnings and/or lackluster guidance hit the market last week, investors might have scaled back their expectations that strong earnings growth will continue to power stocks in 2006.

A slowing economy, which most economists say is in the cards this year, generally means slower sales and, in most cases, slower earnings growth. That may not mean great things for the broad market's prospects this year.

But there's another way to play a slowing economy and sales scenario: Companies are still flush with cash and will continue to look to grow through other means, such as acquisitions, as was apparent with Monday's flurry of public and private deals, which may have helped U.S. stock proxies avoid a repeat of Friday's selloff.

According to a November survey by Bernstein Research, acquisitions continue to top the priority list of CFOs, who on average plan to devote 18% of their firms' cash for acquisitions. That compares with 14% to buy back shares and raise dividends, 13% to hire more people and 11% to boost capital spending.

With companies still sitting on piles of cash, the pace of M&A activity could increase this year, topping the record levels of 2005. According to the research firm TrimbTabs, cash takeovers of public companies amounted to $277 billion last year.

For PNC strategist Jeffrey Kleintop, the trend is expected to continue, if not accelerate. Slower economic growth, low capacity utilization and constrained pricing power are likely to "prompt business to grow via acquisitions rather than increased capacity," he wrote in a research note.

For instance, Intel (INTC - Get Report), which posted disappointing earnings and guidance last week, might be the victim of too much capacity in an already competitive pricing environment for chip manufacturing. Intel dropped 1.9% Monday, extending last week's 15% slide.

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