(FORTUNE Magazine) – Predicting that the Dow will rise to 3500 by the end of 1990 is quite a change for Russell Thompson, 49, who manages the $1.5 billion United Income Fund for the Waddell & Reed investment advisory firm in Kansas City. ''I was so negative in the 1970s that people called me the Grim Reaper of the Midwest,'' he drawls. Just before the market crashed in 1987, Thompson pulled 65% of his fund's assets out of stocks. But he was back in the market soon after, and in the five years through June 30 scored a total return of 184%, according to Lipper Analytical Services. That put United Income, which carries an 8.5% sales load, ahead of Standard & Poor's 500-stock index, which was up 150%. Thompson, who watches trends in the world economy to predict where the market will go, discussed his favorite stocks with Fortune's Patricia Sellers.

What's feeding your optimism now? Twelve months ago who would have imagined that Russia would make the changes that it has? This reduction in political tensions has enormous, very positive implications for growth in the world. So does the unification of Europe -- fewer trade barriers. In this growth environment companies don't need to raise prices as often. Inflation in the U.S. will remain at 4% or less into the 1990s, and we won't have to go into a recession to stop inflation.

What does this mean for investors? I believe we're only halfway through the recovery cycle that began in the early 1980s. That's good for large growth companies, which cut costs and sold assets when inflation and interest rates were high. Companies like McDonald's, Procter & Gamble, 3M, and PepsiCo do relatively well as you get closer to the end of the cycle. They have control over their operations and have rationalized their product lines. Procter & Gamble, in particular, is cutting costs dramatically and managing the corporation a lot better.

You like heavy-equipment companies too. Yes. With corporate earnings and cash flow up, these companies' customers are reinvesting in their businesses. The U.S. is rebuilding its infrastructure too, and about a year ago we bought the beneficiaries of this trend: Caterpillar, Fluor, Foster-Wheeler, Morrison-Knudsen, and Harnischfeger. Caterpillar is almost a unique company in the U.S. because a lot of its former competitors are not around anymore. It's cutting costs, and in the next year or so we'll see an acceleration of earnings. I like Deere because farmers haven't bought new equipment for a long time. Deere's stock has gone from $45 to $60 a share in a year, and could go significantly higher.

How do you select individual stocks? We look for companies in the process of change. For example, since we're only halfway through the recovery cycle, American electronic companies such as Intel, Texas Instruments, and AMP are going to continue to do well. But Motorola is especially attractive because it's getting into cellular telephones in Europe. Motorola used to be a semiconductor company, then a communications company. Now, because of cellular, there's potential for a dramatic acceleration in earnings.

What else do you like? We bought Bristol-Myers after it announced its merger with Squibb. The deal makes it a worldwide drug company.

Yes, but Bristol-Myers is paying 23 times Squibb's earnings. There will be a dilution of profits. But Bristol-Myers didn't have a big ethical drug business, only a very good over-the-counter business. For them to compete worldwide with Merck and the European drug companies, we believe, they had to become more diversified. Squibb has a billion-dollar hypertension drug, Capoten, that prevents the constriction of blood vessels. It actually reduces high blood pressure and makes you feel good. Most people with high blood pressure have been taking diuretics and beta blockers, which treat only the symptoms and make you feel bad. Squibb is developing a cholesterol-lowering drug as well. The market is enormous.

Are more drug firms ripe for buyout? They're all known to be candidates, so few of the stocks are really cheap. The only one we added recently was Syntex. We believe it's not unlike Marion Laboratories, which was grabbed up by Dow Chemical. Syntex has some reasonably good products, but if you look into the future it will have difficulty growing and competing. There's room for someone to pay up for Syntex. It's selling at $48 a share, and it's probably worth over $60.

You have a knack for spotting takeover candidates. What's the secret? Often it is a company that wasn't doing well until management recognized the difficulty and changed the operation to make it more efficient. Large companies trying to become bigger look to acquire these companies, especially if they have a niche and a high cash flow.

Name some candidates. Whirlpool is well managed, the market leader in the U.S., and it recently bought Philips's appliance business to give it distribution in Europe. The stock is at $31, and it's worth over $50 a share. Stanley Works, which makes hand tools and hardware products, is another candidate, and Avon was recently put in play. Whitman Corp., formerly IC Industries, is worth $55 to $60 a share, and the stock is at $34. Management says it would sell at the right price. The company owns a big Pepsi bottling operation that PepsiCo could buy, and it has Pet foods. Outboard Marine dominates its market, which is motors for pleasure boats and more recently the boats themselves.