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Deal Stocks Remain Market Bright Spot

Companies appear to agree with Hottovy that getting smaller is better.

Conglomerates like Kraft Foods (KFT), Sara Lee (SLE), Fortune Brands (FO) and Tyco (TYC - Get Report) have all recently announced plans to split up into smaller companies, each with more simple business lines.

By breaking up, activist shareholders and company executives frustrated by low stock prices may be trying to tempt larger companies to use their cash in a takeover. "Once you break up the businesses, they potentially could become acquisition targets for strategic acquirers," says Hottovy.

Philip J. Orlando, Chief Equity Market Strategist at Federated Investors (FII) says unlike when deal markets froze after the failure of Lehman Brothers in 2008, "The fact that you've got M&A going on tells you that companies have cash, that stocks are cheap and that companies have confidence in the future." He adds, "companies looking to expand may find it more time and price efficient to go and buy a competitor that's selling at a dirt cheap valuation" than to develop new business lines.

In a quarterly assessment of potential takeover targets published at the beginning of the year, Hottovy and his research team at Morningstar identified Constellation Energy and Petrohawk Energy as ripe for a takeover. Exelon (EXC) bought Constellation for $7.9 billion in April and BHP Billiton (BHP), the Australian mining giant, bought Petrohawk for $12.1 billion in July.

Morningstar's index of 80 companies that could be takeover targets outperformed overall stock markets by 3-to-4% before falling to just 1% as of mid-September because Hottovy says, "we've seen takeover premiums work their way out of stock prices."

In its September 14th update of potential takeover targets to reflect worsening merger markets, Morningstar identified Ultra Petroleum (UPL - Get Report), SandRidge Energy (SD - Get Report), Leap Wireless (LEAP), Riverbed Technology (RVBD) , Collective Brands (PSS) and AeroVironment (AVAC) as the most likely takeover candidates citing consolidation in the energy industry, investment by large carriers in communications and network services and a continuation of the breakup trend.

Even if markets continue to find new lows for the year, prepare for more breakups and a steady flow of small merger deals at prices that may increasingly be at a premium to market prices. Even with falling markets, Hottovy says, "I would expect [takeover] premiums to remain pretty high."

-- Written by Antoine Gara in New York
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