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), 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.

Broadcom ( BRCM), which on Monday announced a deal to buy privately held chip company Sandburst for $80 million, received a better endorsement from Wall Street. According to Morningstar analyst Larry Cao, Broadcom has done a good job at growing by diversifying its chip communications assets judiciously, shielding it from temporary downturns in certain sectors. Shares of Broadcom gained 1.2% Monday.

That also helped support semiconductor issues, which took a beating last week after disappointing results and guidance from Intel and Motorola ( MOT). The Philadelphia Semiconductor Sector Index, which dropped 2.7% last week, rose 0.6% Monday. The improving mood might continue Tuesday after Texas Instruments' ( TXN) earnings topped estimates after the close. The stock was recently up 0.4%, and major averages were modestly higher early Tuesday.

Given that profit disappointments also came from the likes of Apple ( AAPL), eBay ( EBAY) and Yahoo! ( YHOO), last week, investors remained cautious about buying tech shares.

The Nasdaq Composite advanced 0.11% to 2250, underperforming the other major stock averages. Stanford Research upgraded Google ( GOOG), helping the search giant's shares recover 5% of their 8.5% plunge on Friday. The S&P 500 advanced 0.3% to 1265, and the Dow Jones Industrial Average rose 40 points, or 0.37%, to 39.95.

Growth via Acquisition

The possibility of slower growth in the tech arena may help remind investors that expectations running into the fourth-quarter earnings season were pretty lofty. But the prospect of slower sales does keep the door open for more M&A activity as companies try to grow in other ways, according to Vadim Zlotnikov, market strategist at Bernstein. That may hold especially true after the Nasdaq's 3% slide last week.

"We hypothesize that companies with decelerating sales and large net cash positions are likely to make further acquisitions," he wrote in a research note, highlighting that EMC ( EMC), Accenture ( ACN) and Research In Motion ( RIMM)all share these characteristics.

Tech deals already accounted for 55% of all U.S. M&A activity in 2005, thanks to serial acquirers such as Cisco ( CSCO), Oracle ( ORCL), Symantec ( SYMC), IBM ( IBM) and Hewlett-Packard ( HPQ), according to Bernstein research.

But the stocks of acquirers have tended to underperform after the announcement of a deal, such as Oracle's 12.5% drop after announcing the acquisition of Siebel Systems ( SEBL) on Sept. 12, through Jan. 11, Zlotnikov notes.

If M&A stays as strong in 2006, betting instead on likely acquisition targets will likely remain a favored game of speculators. On the basis of attractive valuations and low debt levels, Zlotnikov says First Data ( FDC), Automatic Data Processing ( ADP), Fiserv ( FISV) and Affiliated Computer Services ( ACS) are good takeover candidates.

Betting on potential targets also helps, in that more big deals are now coming from private equity, as was the case last year for Linen 'n' Things ( LIN), PanAmSat ( PA), Toys R Us and Georgia-Pacific.

On Monday, Sports Authority ( TSA) said it agreed to be acquired by private firm Leonard Green & Partners for $1.3 billion, or $37.25 per share, representing a 20% premium over its closing price of $31.05 on Friday. The stock soared 18% to $36.20 on Monday.

On Tuesday, Imclone ( IMCL) announced it would seek "strategic alternatives," including a possible sale, merger or strategic alliance; Imclone shares were recently up 4.8%. Meanwhile, Disney ( DIS) is reportedly close to announcing a widely rumored acquisition of Pixar ( PIXR).

According to Morningstar analyst Anthony Chukumba, if the economy and consumption slow, retailers will be among the first to see accrued interest from would-be acquirers. Sports Authority had itself primarily grown through acquisitions to offset sluggish growth in the sporting-goods business.

For private-equity firms, which get rewarded by committing their money, the environment couldn't get any better, Chukumba says. "Interest rates remain very low historically, financing is easy, and the returns are high."

Also on Monday, a consortium regrouping Supervalu ( SVU), CVS ( CVS) and investment group Cerberus Capital Management said they reached a deal to buy Albertson's ( ABS)for $9.6 billion.

Private equity firms like to target companies with low EBITDA (earnings before interest, taxes, depreciation and amortization) and low debt on their books. In the retail space, firms such as BJ Wholesale ( BJ), Costplus ( CPWM), Dollar Tree Stores ( DLTR) and Office Max ( OMX)fit the bill.

Expectations that the Federal Reserve will soon stop raising interest rates is another bonus for M&A activity, which would continue to benefit from the ability of firms', public or private, to borrow money at cheap rates to finance acquisition. In addition, the dollar would also likely fall further, making it cheaper for foreign companies to buy U.S. firms.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

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