<THE EVENING NEWS>
Monday, February 8, 1999
DJIA 9291.11 -13.13 (-0.14%) S&P 500 1243.77 +4.37 (+0.35%) Nasdaq 2404.92 +31.30 (+1.32%) Russell 2000 411.33 -1.39 (-0.34%) 30-Year Bond 98 18/32 unch 5.34 Yield
Seeking to supplement its revenue base with newer and more profitable accounts, property and casualty insurer Chubb Corp. (NYSE: CB) agreed to buy specialty insurance company Executive Risk (NYSE: ER) in a stock swap valued around $850 million as of Friday night. Executive Risk shareholders cheered the $71.71 per share offer, a 63% premium to last week's close, and the shares rose $21 1/8 to $65 1/8. Chubb hopes Executive Risk's operations -- primarily professional liability, but also crime and other areas -- can offset a slowdown in property and casualty business, which pulled earnings below year-ago levels. (Click here for last week's earnings report.) Chubb CEO Dean O'Hare told Reuters his company isn't for sale, despite reports in this week's Barron's magazine that the company might be targeted for takeover by U.S. or European financial services companies. O'Hare said Chubb may itself consider more acquisitions in specialty lines. The company's stock fell $2 5/8 to $55 7/16 today.
February has been a busy month for Ligand Pharmaceuticals (Nasdaq: LGND), which rose $1 11/16 to $13 15/16 after the gene transcription company said late Friday afternoon that the FDA gave the OK to its Ontak protein for treatment of cutaneous T-cell lymphoma (CTCL), a rare and fatal cancer that begins on the skin and can eventually spread throughout the body. Developed in tandem with Eli Lilly & Co. (NYSE: LLY) before Ligand bought the rights to the drug, Ontak is Ligand's second commercial product and is expected to be part of an expanded CTCL line; the company anticipates filing new drug applications (NDAs) for Targretin capsules and gel later this year. Ligand won approval for its first product, the Panretin gel for AIDS-related skin cancer, last week. Capsules are in development.
QUICK TAKES: Microsoft (Nasdaq: MSFT) added $5 1/4 to $165 1/4 following news that the software giant is about to announce a major reorganization. The company also announced an alliance with British Telecommunications (NYSE: BTY) to develop and market wireless Internet services for overseas customers... Wireless phone company Nextel Communications (Nasdaq: NXTL) earned $1 25/32 to $32 1/16 after announcing a partnership with Motorola (NYSE: MOT), Netscape Communications (Nasdaq: NSCP), and software company Unwired Planet to offer Internet access and other wireless data services to its customers... Several semiconductor equipment makers moved ahead today after Merrill Lynch issued a handful of upgrades. Fabrication systems supplier Applied Materials (Nasdaq: AMAT), one of five companies getting the nod today, improved $6 3/4 to $67 7/16 on an intermediate-term boost to "buy" from "accumulate."
Wireless telecommunications services provider Sprint PCS Group (NYSE: PCS) rang up $2 13/16 to $32 1/8 after turning in A Q4 loss of $1.43 per share before items, compared with Wall Street's projected $1.62 loss. Salomon Smith Barney reiterated a "buy" rating on the stock today... Natural gas pipeline company and fiber optic telecommunications network operator Williams Companies (NYSE: WMB) spread $1 11/16 to $36 1/16 after announcing a deal to be the preferred provider of long-distance voice and data services for SBC Communications (NYSE: SBC)... Disk drive maker Seagate Technology (NYSE: SEG) swept up $1 1/2 to $36 3/4 after an executive told reporters the company expects to better the industry's forecasted 20% growth in 1999... Telecommunications company MCI WorldCom (Nasdaq: WCOM) took on $2 13/16 to $79 1/16 after announcing a deal to provide the Army and Air Force Exchange Service with telecommunications services over 10 years for as much as $1.5 billion.
Network engineering and consulting firm Micros-To-Mainframes Inc. (Nasdaq: MTMC) raced ahead $2 3/8, or 37.3%, to $8 3/4 after the company said it plans to have two e-commerce sites online by March 1... Software development and consulting firm Computer Management Sciences (Nasdaq: CMSX) ran up $4 1/16 to $27 9/16 after Computer Associates International (NYSE: CA) agreed to buy the company for $28 per share, a 19% premium over Monday's closing price... Marketing software developer Exchange Applications (Nasdaq: EXAP) got $1 15/16 to $14 7/16 after announcing the sale of its Valex database marketing package to three companies, including Bell Atlantic (NYSE: BEL) and two Australian firms.
Vantive Corp. (Nasdaq: VNTV), a leader in front-office automation software, grabbed $1 11/16 to $12 1/2 after Adams, Harkness & Hill raised its rating to "strong buy" from "accumulate" and set a $15 per share price target... Insurance and reinsurance company NAC Re Corp. (NYSE: NRC) moved up $6 13/16 to $52 1/8 after confirming discussions about a possible merger with XL Capital Ltd. (NYSE: XL), which lost $7/16 to $61 15/16... Telecommunications software and systems firm Evolving Systems (Nasdaq: EVOL) grew $2 7/8 to $7 7/16 after announcing a multi-year agreement to provide software support to Lucent Technologies (NYSE: LU)... Online grocer PeaPod (Nasdaq: PPOD) sprouted $3 5/8 to $11 1/8 after Piper Jaffray Inc. started coverage of the company with a "strong buy" rating.
Women's apparel retailer Cache Inc. (Nasdaq: CACH) wrapped up gains of $1 1/16 to $8 1/16 after announcing plans to nearly double its 184-store base with 150 openings over the next five years... Provident American Corp. (Nasdaq: PAMC) clicked up $1 1/16 to $10 11/16 after its HealthAxis.com e-commerce subsidiary announced the hiring of N2K Inc. (Nasdaq: NTKI) CFO Bruce Johnson as CFO and COO... Discount retailer Ames Department Stores (Nasdaq: AMES) won $1 7/16 to $27 1/2 after NationsBanc Montgomery Securities rated the stock "buy" in new coverage... Telecommunications network switching products maker Excel Switching Corp. (Nasdaq: XLSW) got $2 9/16 to end at $24 11/16 as Morgan Stanley Dean Witter boosted its rating on the shares to "strong buy" from "outperform."
Enterprise storage management software firm Legato Systems (Nasdaq: LGTO) said "domo arigato" after a move of $6 13/16 to $52 9/16 on the strength of a reiterated "buy" rating from BancBoston Robertson Stephens... Electronics contract manufacturer Sanmina Corp. (Nasdaq: SANM) jumped $3 3/4 to $60 3/4 after a revision to "buy" from "market outperform" at Stephens Inc... Athletic shoe giant Nike Inc. (NYSE: NKE) dunked $2 1/4 to $51 after a BancBoston Robertson Stephens analysts upped the stock to "buy" from "long-term attractive"... Healthcare services giant McKessonHBOC (NYSE: MCK) snagged $3 1/16 to $66 7/8 after a group of senior managers agreed to buy about $76 million worth of company stock, about 1.2 million shares as of last week's close. "We also want to... confirm our belief that McKessonHBOC will achieve its earnings target of $3.00 per share for fiscal 2000," executives said in a statement.
Facility and janitorial services roll-up firm Building One Services Corp. (Nasdaq: BOSS) was trashed for $2 5/8 to $17 1/2 after terminating its previously announced $25 per share merger with an affiliate of Apollo Management L.P. The official sticking point was Apollo's "comfort with arrangements with [Building One] management... regarding their stock after the recapitalization," which in laymen's terms translates into the new owners not wanting the old managers to bail out of their holdings after the deal was done, which would leave Apollo alone holding the bag. Instead, the company now plans to recapitalize itself by purchasing 23 million of its outstanding shares at the same $25 per share price. In other news, Building One added that it expects to report Q4 EPS of $0.38, which is a penny ahead of the revised estimate the company said analysts had been expecting.
Nonbank financing company Newcourt Credit Group (NYSE: NCT) fell $6 to $31 on reports that Deutsche Bank has backed out of negotiations to provide the firm with up to $1.2 billion in new funding in the form of a large equity stake. Early this afternoon, Newcourt posted Q4 EPS in line with estimates of $0.71 on a 27% year-on-year jump in earnings to $67.2 million, but that wasn't enough to save its share price today as traders focused on the financing question. While CEO Steven Hudson said the company's "depth and diversity of funding sources" helped it perform during a terrible period for asset-backed lenders last fall, the company's low credit rating vis-a-vis its rivals worries some observers. Nonetheless, Newcourt said an estimated 41% pick-up in loan originations this year should produce fiscal 1999 EPS of $1.93, up 45% from last year's results.
QUICK CUTS: Information technology services firm Electronic Data Systems (NYSE: EDS) slid another $3 1/8 to $45 after falling more than 7% on Friday when it reported Q4 EPS of $0.53, a penny above Street projections before charges. However, analysts reportedly lowered their earnings estimates for Q1 and fiscal 1999 after the company gave a cautious near-term outlook and failed to provide guidance for the full year... Online software retailer Egghead.com Inc. (Nasdaq: EGGS) was fried for $1 1/8 to $19 1/8 after filing a 4.8 million share secondary offering with the SEC... American Airline parent AMR Corp. (NYSE: AMR) descended $2 15/16 to $57 after canceling a total of 330 flights on Saturday and Sunday as pilots protested the company's acquisition of Reno Air (Nasdaq: RENO). AMR said it expected to cancel about 360 flights today.
Singapore-based Internet services provider Pacific Internet Ltd. (Nasdaq: PCNTF) lost $12 7/8 to $35 1/8 after closing at $48 per share on its first day of trading on Friday following an initial public offering of 3 million shares at a price of $17 per stub... Computer services firm Perot Systems Corp. (NYSE: PER) slipped $7 13/16 to $58 3/16 after running up to $66 per share by the close on Friday following its initial public offering of 6.5 million shares at a price of $16 each last Tuesday... Ear, nose, and throat surgical products maker Xomed Surgical Products (Nasdaq: XOMD) wheezed $1 7/16 to $39 1/16 after saying it will no longer distribute ArthroCare's (Nasdaq: ARTC) electrosurgical products after making "virtually no revenue" from a distribution agreement signed last June. ArthroCare fell $2 5/8 to $14 7/8.
Internet portal Yahoo! (Nasdaq: YHOO) slid $14 1/8 to $158 5/8 despite splitting its stock two-for-one today. For more details on splits and what they do and don't mean for companies, head back to this afternoon's Fool Plate Special... Other Web-related stocks fell today as well, as several Wall Street analysts -- including Prudential Securities' Ralph Acampora and Morgan Stanley Dean Witter's Mary Meeker -- made cautious statements about the sector. E-tailer Amazon.com (Nasdaq: AMZN) fell $6 3/4 to $109 1/8, Lycos (Nasdaq: LCOS) slipped $9 3/4 to $127 1/4, and America Online (NYSE: AOL) shed $5 to $159... Given the online bearishness, it was a bad day to add a ".com" to a corporate name. That's exactly what JetFax (Nasdaq: JTFX) did, changing its name to eFax.com (Nasdaq: EFAX), and it dropped $1 5/16 to $5 7/8.
Diversified health care services provider Sierra Health Services (NYSE: SIE) lost $1 1/16 to $14 15/16 after reporting Q4 EPS of $0.46, missing the IBES mean estimate by a penny. BT Alex. Brown lowered the firm's rating to "buy" from "strong buy"... Computer products direct marketer Multiple Zones International (Nasdaq: MZON) dropped $2 11/16 to $15 7/16 after reporting Q4 EPS of $0.04, flat with last year's results and a penny below the IBES mean estimate... Internet domain name registrar Network Solutions (Nasdaq: NSOL) was knocked down $23 5/8 to $174 1/8 after The Wall Street Journal reported that a government-appointed panel was scheduled to release a draft of guidelines today for opening Network Solutions' business up to competition.
Know Business Risk Like an Insurer
As we noted at the top of the news, specialty insurance holding company Executive Risk (NYSE: ER) gained $21 1/8 to $65 1/8 today after Chubb Corp. (NYSE: CB) agreed to buy the firm for $71.71 per share in Chubb stock -- a hefty 63% premium to Friday's closing price. Through its various subsidiaries, Executive Risk develops, markets, and underwrites a number of liability insurance plans, including directors and officers liability insurance (D&O), which constitutes the largest class of business for the company (about 50%).
Executive Risk ranks among the top-five writers of D&O insurance in the U.S. -- with about 10% market share -- and one of the major factors motivating Chubb's move today has to be Executive Risk's underwriting performance. For most of the 1990s the firm's average statutory combined ratio has been about 13 percentage points lower than its "commercial lines" peer group, and about 11 percentage points better than the broader Property/Casualty industry (according to the firm, click on ITEM 1: Business section).
Don't all insurance firms have access to the same information with which to fill their databases and employ in their complex analytical applications, like Equal Employment Opportunity Commission (EEOC) reports on the number of discrimination complaints received by local agencies, or the number of sexual harassment charges filed with the EEOC? Don't all insurance firms that write policies in the D&O business know the permutations of the Americans With Disabilities Act and the Family Medical Leave Act? How can one company outperform? How does Executive Risk assess its own policy risk in such a consistently profitable way?
Without stretching the analogy too far, it's pretty clear that many of the same questions laid at the doorstep of outperforming insurance firms can also be re-packaged for delivery to investment "gooroos." The key question being, how do both groups "act" in a more profitable manner than the rest of the pack when presented with the same information? Insurance companies are really engaged in the "science" of risk on a daily basis, and therefore, are fascinating in my mind -- because risk is all about putting the future at the service of the present (to paraphrase Peter Bernstein). I used to think that analyzing insurance companies was about one step removed, on the boredom hierarchy, from watching paint dry. However, looked at the evolution of risk management, even the most jaded investors have to be amazed at the conceptual underpinnings of the modern insurance company.
Here's what Executive Risk would probably cite as some of the key factors in its success (taken from the 10K):
-- "The Company's general underwriting philosophy stresses two factors: expert consideration of complex insurance submissions, and profitability over premium growth."
-- "A large portion of the company's policies have a one-year term, though the number of multi-year policies has been growing in recent years. One-year terms offer the insurer the advantage of re-underwriting and repricing a risk, to take more frequent account of claims or other changes in the exposure."
-- "The Company emphasizes industry specialization within its underwriting staff, which includes a number of professionals with operational experience from the industries being underwritten."
Paying particular attention to the last item, Executive Risk has noted, "Within each of the principal D&O sectors, ERI has targeted subsectors and developed specialized expertise, a strategy that management believes has allowed ERMA and the Insurance Subsidiaries to develop and adapt their insurance products more knowledgeably and to underwrite submissions and process claims more professionally than competing companies."
While it borders on the absurd to state that success is dependent on really "knowing" a business and having an information advantage, think back to an investment you have made where you felt you were blindsided by a company -- only to conclude later that you really didn't know the business well enough to see the potential outcome. Most of us can probably say that has happened at least once in our investment careers.
A great story attributed to Wells Fargo/Nikko Investment Advisors, and related in the March 1995 edition of Global Currents, can serve to illuminate the problem area. A group of hikers come upon a high, narrow, and rickety bridge during the course of their travels and conclude that if they pass over it, the act will save them a number of hours of hiking time in their attempt to reach "home base." So they outfit themselves with the necessary ropes and harnesses in order to try and prevent any loss of life in the event of a bridge collapse. Finally, once they have all reached the other side successfully -- they encounter a hungry mountain lion that has been patiently awaiting their arrival.
Risk has many different dimensions, but even so-called "exogenous events" like the Asian financial crisis and hungry mountain lions should not come as a "surprise" to the investor who knows the investment "territory." Attempting to quantify these risks has been the province of Modern Portfolio Theory, which ironically has remained pretty much unchanged since Markowitz set the ball rolling in June 1952 with the publication of a fourteen page article entitled, "Portfolio Selection," in the Journal of Finance.
To a statistician, expected return is the probability weighted average of possible returns, and risk refers to the bunching of possible returns around the expected return. A method of measuring this tendency to cluster around an expected return is to come up with the probability weighted average of the deviations of possible returns from the expected return. A common average used in this endeavor is standard deviation. As Peter Bernstein notes in Against the Gods: The Remarkable Story of Risk, Markowitz makes no mention of the word "risk" in describing his investment strategy, but rather, the "objective in 'Portfolio Selection' was to use the notion of risk to construct portfolios for investors who 'consider expected return a desirable thing and variance of return an undesirable thing.'"
Variance, a concept mathematically linked to standard deviation, has since been enshrined by institutional investors as the "undesirable thing." For the last forty years, variance and risk have become synonymous. Perhaps, the best counter to this is offered by Warren Buffett (in both articulating the case, as well as Berkshire's performance returns):
"Finance departments teach that volatility equals risk. Now they want to measure risk. And they don't know any other way -- they don't know how to do it, basically. So they say that volatility measures risk. I've often used the example of the Washington Post stock when we first bought it: In 1973, it had gone down almost 50% -- from a valuation of the whole company of close to say $180 or $175 million down to maybe $80 million or $90 million. And because it happened very fast, the beta of the stock had actually increased. A professsor would have told you that the stock of the company was more risky if you bought it for $80 million than if you bought it for $170 million... we think first in terms of business risk. The key to Ben Graham's approach to investing is not thinking of stocks as pieces of paper or as part of of the stock market. Stocks are pieces of businesses."
If you want to be successful at focusing on business risk you have to be more like an insurance company. By knowing the business inside out and upside down, you also get the best handle on the risks involved.
Of course, an investor's time horizon has the effect of transforming the risk calculus, because as one risk commentator observed, "Volatility per se, be it related to weather, portfolio returns, or the timing of one's morning newspaper delivery, is simply a benign statistical probability factor that tells us nothing about risk until coupled with a consequence." A stock may get clobbered in the short term, but it only means something if you sell it during that same time period. What does volatility mean for the long-term investor?
Jeremy Siegel's book Stocks for the Long Run is not some fuzzy treatise about the "buy and hold" approach, but a relatively sophisticated discussion of managing risk. The thesis being that according to historical return data, risk is minimized over "sufficient" periods of time in such a way that stocks have never offered investors a negative real holding period return yield over blocks of time of 17 years or more (in contrast with bonds or T-bills). So, focus on the business, focus on the long run, and you won't have to focus as much on the returns.
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