(MONEY Magazine) – The wave of mergers sweeping Wall Street today is fundamentally different from the mania of the 1980s. And the potential payoffs are far greater. But to cash in on the boom, individual investors will have to take a more sophisticated approach than simply scouting for cheap stocks. To help you find the best prospects, we've analyzed the dynamics of seven consolidating industries and come up with a promising stock pick in each one.

Size matters. That's the message consumers are sending these days, with their hunger for sport utility vehicles and their record-setting ardor for the ultimate megafilm, Titanic. It is also, of course, the prevailing wisdom in the business community. On Wall Street an unprecedented boom in corporate mergers is in full swing, as corporate managers embrace the mantra that big is beautiful. "Merger-and-acquisition activity is likely to accelerate this year," says Edward M. Kerschner, chairman of Paine Webber's investment policy committee. "Firms need to do deals to generate revenue growth. And after six straight years of profit expansion, they have the financial ability."

Indeed, deals are being executed with a gusto not seen since the glory days of Ivan Boesky, T. Boone Pickens and Carl Icahn. U.S. companies announced more than 11,000 separate deals worth at least $1 million each last year, or some $900 billion worth in total, according to Securities Data Co. That's a 47% increase from '96, and more than double the figure at the peak of the go-go 1980s. Even more striking is the proliferation of megamergers. There were seven deals announced in 1997 worth at least $10 billion, including WorldCom's proposed $37 billion acquisition of MCI. Since then, Compaq has agreed to pay nearly $10 billion for Digital Equipment.

Do these blockbuster mergers make any sense? Or are they just the latest ego trips for corporate chieftains? That's certainly a reasonable question--especially after the proposed $70 billion merger of Brit drug firms Glaxo-Wellcome and SmithKline Beecham unraveled, in part because the two CEOs kept squabbling over who was going to run the combined firm.

But don't dismiss the current round of mergers too soon. Truth is, most of today's deals are not only sound, they're essential. For one thing, globalization is encouraging U.S. companies to join forces to better challenge foreign rivals. (Chase Manhattan, for example, even after swallowing up Chemical Bank two years ago to become the largest bank in the U.S., still doesn't make the list of the 10 largest banks worldwide.) For another, falling inflation has made it harder for companies to generate profits by raising prices, so businesses have to remain relentless about slashing costs. A merger that consolidates operations offers great opportunities to increase efficiency and boost earnings.

To capitalize on such deals, you first have to understand that today's merger mania differs from the '80s version, which was the product of easy money and undervalued stocks. Back then, rapacious raiders aided by junk bonds and other financial alchemy were able to scoop up assets on the cheap. Individual investors just had to look for undervalued stocks in a consolidating industry and then hope that stronger companies bid for them. If you were shrewd enough to spot the next target, you made 20% to 30%--fast.

But often that was all. Today's best mergers are frequently strategic and offer the potential for far greater long-term profits. In some cases, you can still buy likely takeover candidates and wait. But choose carefully: Investors have already bid up the prices of many tempting targets. More often, you'll find that the best opportunities are the companies doing the buying or the ones produced by a merger of equals.

And of course, not every deal will be a winner. In some cases, deregulation may be hastening poorly thought-out combinations. In others, companies are so flush with cash that they may be tempted to overpay to buy out their rivals. Some firms' stocks are flying so high that they can actually boost reported earnings in the short term by purchasing a lower-priced competitor--even if the deal makes little strategic sense.

That's why it's wise to examine each industry's dynamics and study every deal on its own merits to sort out the lions from the lemmings. This story will help you get started. We've analyzed seven industries that are leaders in today's merger boom, and come up with a top stock recommendation for each. (Share prices listed are as of Feb. 25.)

BANKING

Top pick: Nationsbank

The banking industry is in the midst of a remarkable transformation, as national and regional powerhouses rush to gobble up smaller operations--and one another. Deals totaled more than $75 billion last year alone. And the 100 largest banks now control 73% of the industry's assets, up from only 60% in 1996. One big reason: deregulation. "In 1994, Clinton signed the national interstate banking law saying that any bank could buy any other bank," says Tucker Anthony analyst Gerald Cassidy. "As a result, the pace of industry consolidation has accelerated and the deals have been bigger."

You might think that your best strategy would be to buy likely takeover targets. In fact, they aren't that hard to spot. Among large institutions, Pittsburgh's Mellon Bank Corp. is a prime candidate. In addition to enjoying strong market positions in the mid-Atlantic states, Mellon owns mutual fund heavyweight Dreyfus Corp. Then there are many smaller banks with attractive franchises. Two examples: Alabama's Colonial BancGroup, which itself is acquiring small banks in Florida and Georgia; and Summit Bancorp, the largest remaining independent bank in New Jersey, which would appeal to potential acquirers in either New York or Pennsylvania. But because these companies are easy to spot, their share prices already reflect the prospect of a takeover. So while they may all be sound investments, they probably won't be stellar ones.

That's one reason why we think the best approach in banking is to focus on dynamic acquirers. Our choice here is North Carolina's Nationsbank Corp. ($69 a share), which bought Florida's Barnett Banks in December for $14 billion. That deal created the third largest bank in the U.S. by combining Nationsbank's strong base in the Carolinas with Barnett's trophy franchise in a fast-growing state filled with plenty of affluent retirees. "It's the most powerful banking franchise in the country," contends A.G. Edwards & Sons analyst David C. Stumpf. As a dominant player, Nationsbank figures to reward shareholders in two ways, says Prudential Securities analyst Joel W. Silverstein: It is likely to turn in above-average earnings gains of 13% to 15% a year. Also, that growth would justify a price/earnings ratio higher than today's 14.4 multiple; the average bank stock currently trades at a 16.2 times estimated 1998 earnings. Given Nationsbank's brilliant outlook, Goldman Sachs analyst Sally Pope Davis concludes, "The stock is a compelling value that could gain more than 35% over 12 months."

TELEPHONES

Top pick: Sprint

For decades, the telephone industry was boring, and the stocks were suitable for the kind of investors who buy electric utilities. But after the 1984 breakup of AT&T, the telephone business got real interesting. Competition heated up, and new technology from pagers to cell phones turned the stocks into high-tech growth investments.

Over the next five years, as phone companies race to wire the world, it's a good bet that they're going to have to keep merging to stay ahead of the pack. "The industry will consolidate until there are only three or four major companies in each market," asserts BancAmerica Robertson Stephens analyst Timothy K. Horan.

One key reason to merge is to be able to offer both local and long-distance service. But under current U.S. Government rules, it's a lot easier for local companies to buy long-distance firms than vice versa. (For a discussion of other attractive stocks in the industry, see Wall Street on page 60.) And if you're looking to snare a major long-distance carrier, you really have only one to choose from. Giant AT&T will almost certainly be an acquirer, not a target, and WorldCom is already buying MCI. That leaves No. 3 Sprint, ($62.50 a share). "The company's core businesses are strong, and it's trading at a 15% discount to its breakup value of $74 a share," says CIBC Oppenheimer analyst Harry Blount. Moreover, operating income from existing businesses figures to grow at a solid 11% rate.

Sprint would be a natural purchase for an aggressive local Bell operating company (Bell Atlantic reportedly discussed such a deal last year). And since France Telecom and Deutsche Telekom each own a 10% stake in Sprint, a friendly Eurotakeover is a possibility as well.

COMPUTERS

Top pick: Compaq

Studying the history of the computer industry, you might conclude that size is a liability, not an asset. Didn't IBM stock drop from $88 (adjusted for a subsequent split) in 1987 to less than $21 in 1993, even though the company continued to dominate the computer industry? And the real money is made by getting in early on something a gearhead has cooked up in his garage, right?

Well, it's not quite that simple. Domination counts, as long as you dominate the right niche. IBM's problem wasn't size, it was that mainframes were no longer the high-growth sector of the hardware business. But Microsoft and Intel have done quite nicely by maintaining a hammerlock on their booming businesses.

In the future, size is likely to be an even greater plus in technology. As computers become more widely used for more varied purposes--and, in the process, become more complex--customers will increasingly favor the leading brand names. Business users, in particular, will want to deal with a single supplier that offers one-stop shopping and can provide a full range of products and the service to support them.

The company that stands to profit most in this environment is Compaq. Once it acquires Digital Equipment, it will be the second biggest computer company after IBM. But while Big Blue remains mired in the mainframe business, growing less than 10% a year, Compaq is aiming to be fully competitive throughout the range of hardware from personal computers to servers. (We also recommended Compaq in last month's "The Secret to Tech Stocks.")

It's true that Compaq could stumble over the next year or so as it tries to absorb Digital's sales force. And some industry observers worry that Compaq still hasn't cut costs enough to be fully competitive against direct sellers like Dell and Gateway. But Compaq CEO Eckhard Pfeiffer has a record of hitting his marks, and we'd bet that he pulls off this merger. The stock market seems to agree--since the deal was announced, Compaq's stock has moved up 20%, to $34.

Of course, there are plenty of small and mid-size computer companies that are potential takeover targets. Among personal-computer makers, Gateway is a likely one. And Data General, Sequent and Unisys are all possibilities in the server business. But if these firms aren't taken over, they may well have problems keeping up. Whether you buy Compaq today or you wait a bit and hope you get a chance to pick up shares more cheaply when the first negative stories about the merger surface, this is the stock you want to own for the long pull. With earnings growth averaging more than 20% annually, Compaq figures to be a double in less than five years.

CABLE TV

Top pick: Comcast

After languishing for three years, cable-television stocks rocketed 88% last year. And that's just the beginning. New digital technology will soon open the way to high-definition television, instant Internet access and, maybe most lucrative of all, cheaper telephone service. "The industry has become the de facto gateway to the home," says Donaldson Lufkin & Jenrette analyst Dennis H. Leibowitz, who thinks the group could return 20% annually over the next five years.

Industry leader Tele-Communications Inc. may be hobbled by its $15 billion debt load, which has forced the company to halve its capital spending since 1996. Time Warner (the owner of MONEY's publisher, Time Inc.) operates cable systems on a par with those of TCI. But Time Warner is far from a pure play. Cable accounts for less than half the company's operating earnings.

The most promising way to cash in on cable is to buy Comcast ($33.50 a share). The fourth largest cable-system operator, Comcast is a classic trophy franchise, dominating the Philadelphia market. As a result, the company would be appealing to any larger acquirer interested in cable TV. Comcast also provides cellular-phone service in a region with 8 million in population. In addition, the company owns 57% of the QVC shopping channel. "One-quarter of Comcast's value consists of public and private investments that investors aren't giving the company full credit for," says analyst Michael Kupinski at A.G. Edwards & Sons in St. Louis.

Comcast does get full credit, however, from Microsoft CEO Bill Gates, who invested $1 billion in the company last summer for an 11.5% interest in the firm. And it stands to get another $1.6 billion for its 15.5% stake in Teleport, the local phone company that AT&T offered to acquire in January. With plenty of cash and a private market value of more than $40 a share, Comcast looks wired.

GOLD MINING

Top pick: Barrick Gold

Few stock groups offer as many bargains as gold mining, a sector where stocks have fallen 40% or more over the past two years. With the yellow metal's price at $291 an ounce, only $13 above its 11-year low, many mid-size producers are losing money. That creates a spectacular opportunity for industry giants to grab smaller companies for their reserves.

Pass over mid-size firms such as Battle Mountain Gold and Echo Bay Mines, running in the red. Also steer clear of widely known takeover targets, such as Getchell Gold, a Nevada producer that has attractive mining claims. Those stocks are too risky for typical investors.

Your best choice is Barrick Gold, the world's most profitable gold-mining business and the largest producer outside South Africa. Whatever happens to the price of gold, Barrick looks like a winner.

In the unlikely event that the gold market rebounds fast, Barrick's price could double from its current $17.75 a share. "The arguments against gold may seem compelling, but the market dynamics are explosive," says Steven Leuthold, president of the Leuthold Group, an investment advisory firm in Minneapolis. Leuthold believes that short sellers have borrowed 8,000 tons of gold, betting on a continuing slump. If prices rebound, they'd have to buy back that gold to cover their short positions, triggering a rally that Leuthold believes could send the price to $325 or $350 an ounce.

Even if Leuthold is overly optimistic and gold takes several years to recover, Barrick will thrive. The longer the gold price stays down, the greater Barrick's opportunity to acquire smaller firms, as it did in 1996 when the company paid $80 million for Arequipa Resources, a small Canadian firm with valuable properties in Peru.

And eventually, the gold price is going to strengthen. Inflation will likely turn up within the next two or three years, greening the prices of all inflation hedges. In addition, the demand for gold, which comes mostly from jewelry makers, is growing 4% to 7% a year, while the supply is rising less than 3% annually. The result could be booming earnings for firms that scooped up reserves when the gold price was leaden--and enormous profits for investors who bet on the industry leader when it was down.

RAILROADS

Top pick: Burlington Northern Santa Fe

Trains may have a special place in the hearts of country music singers, but these days no one on Wall Street wants to hear lonesome whistles. Last year, railroad stocks returned a mere 10.2% vs. 31% for the S&P 500. Now, however, mergers creating a new class of transcontinental carriers promise to help the industry build up some steam. By connecting major ports on the East Coast, the West Coast and the Gulf of Mexico, these megarails will be able to trim costs, increase efficiency and offer customers all-points shipping. Thus rails give you the chance to invest in a lagging sector of the market just as business is poised for an upswing.

The consolidation began in 1995, when Burlington Northern acquired Santa Fe Pacific for $4 billion. Then Union Pacific bought Southern Pacific Rail for $3.9 billion in '96. Finally, Canadian National Railway bid $2.4 billion for Illinois Central in February; this merger would link Halifax on the Atlantic, Vancouver on the Pacific and New Orleans on the Gulf of Mexico.

None of these transcontinentals is going to be the next Wabash Cannonball, but Burlington Northern is attractive for value investors. For one thing, it's cheap at $99.25 a share, with a 13.6 P/E that isn't far above its five-year lows.

Plus, it has a head start on its two rivals. Canadian National Railway is potentially less powerful than the two U.S. giants. And Union Pacific has had big problems absorbing Southern Pacific. The railroad has had such serious delays in Texas that the Federal Surface Transportation Board declared a transportation emergency. Burlington Northern, by contrast, has already consolidated its operations with Santa Fe Pacific's. It's even benefiting to some extent from Union Pacific's troubles: In response to problems in Texas, Union Pacific has agreed to give half ownership of 148 miles of track in Texas to Burlington Northern, which is gaining market share and building relationships with new clients that can't get out of UP's sidings.

PHARMACEUTICALS

Top pick: American Home Products

The case for drug stocks is simple and persuasive. Two years ago, the 76 million-strong baby-boom generation started turning 50. As boomers' hair goes gray, they'll need more health care--particularly for chronic conditions. "The number of people 45 to 64 will increase almost 50% between now and 2010, and their unmet medical needs are already tremendous," says Gruntal analyst David F. Saks. "For instance, fewer than one-quarter of the people with elevated cholesterol levels receive medical treatment."

Drug therapy is cheaper than just about every medical alternative (except maybe aromatherapy). Since the government is desperate to rein in runaway spending, health-care policy will increasingly favor drugs over other forms of treatment: It's cheaper to control a chronic illness with drugs that cost a few hundred dollars a year than to spend thousands on surgery (when that choice is even available).

Sound like high times in the drug business? Well, there are two problems. First, research-and-development budgets keep ballooning, and fewer and fewer companies have the financial resources to support this massive R&D. Second, government restraints on health-care spending make price hikes difficult. To increase profits, drugmakers must boost sales volume or cut costs. One way to do both is to make an acquisition that expands revenues and offers the opportunity to trim expenses. "We expect one megamerger every 12 to 18 months," says Hambrecht & Quist analyst Alex Zisson.

Our favorite pharmaceutical right now is American Home Products. For starters, it's relatively cheap for a drug stock. While Pfizer, for instance, trades at an infarction-inducing 43 times estimated 1998 earnings, AHP carries only a 25 P/E at its recent share price of $93.50. One reason for the relatively low multiple is that a lot of AHP's products are over-the-counter drugs, such as Anacin and Dristan, that don't have the growth potential of prescription drugs. In addition, the company withdrew its diet drugs Redux and Pondimin from the market in September amid concerns that they could cause heart damage among long-term users. Sales of those drugs will probably never fully recover--but those lost profits are minimal. The real question is how much legal liability AHP faces, and investors seem to be overestimating those risks. "As fears of class-action suits abate, the stock should receive a higher valuation," contends CIBC Oppenheimer analyst Steven B. Gerber.

AHP is also a merger candidate. If you ask drug industry observers which stocks are the most likely takeover targets, they'll probably name mid-size firms with annual sales of less than $10 billion, such as Eli Lilly, Schering-Plough and Warner- Lambert. But none of these three stocks is as cheap as $15 billion AHP. Its low valuation may not last long. A suitable merger could jolt AHP's P/E up to at least average levels. The company was in merger discussions with SmithKline before being outbid by Glaxo, so a second try is a strong possibility. The right match could vault AHP into the top tier of the industry--and provide investors with top-tier returns as well.