<THE EVENING NEWS>
Monday, May 24, 1999
MARKET CLOSE
DJIA           10654.67  -174.61    (-1.61%)
S&P 500         1306.65   -23.64    (-1.78%)
Nasdaq          2453.66   -66.48    (-2.64%)
Russell 2000     440.39    -8.75    (-1.95%)
30-Year Bond   92 25/32    +2/32  5.76 Yield

HEROES

Online transaction processing technologies developer CustomTracks (Nasdaq: CUST) beat it $15 1/16 higher to $76 after an analyst at Boca Raton, Florida-based brokerage Joseph Charles & Associates set a $230 per share price target on the stock based on the expected success of the firm's upcoming "anonymous" online payment technology. Why $230? Simply, the analyst said e-commerce certification services firm VeriSign (Nasdaq: VRSN) has a 1% market share and a $3.5 billion market capitalization. Assuming CustomTracks' product can also capture 1% of the market, it too should logically be worth $3.5 billion, translating to the $230 per share target price. While it would be nice if stocks were priced in this way, Fools know that they are not. As has been written before in this forum, forming an investment opinion based entirely on a single data point -- be it market share, P/E ratio, or anything else -- is "analysis" only in the loosest and most careless sense of the word and ultimately an ineffective way of evaluating a company's prospects.

Information technology and staffing services provider Metamor Worldwide (Nasdaq: MMWW) moved up $4 7/16 to $27 1/2 after saying it will become a "pure-play" IT solutions firm by selling its project support business and also by selling up to a 20% stake in its eBusiness unit in an initial public offering before the end of the year. Goldman Sachs showed its approval of the transactions by raising its rating on the company to "recommended list" from "market outperform." Today's rise puts Metamor's share price back into a range not seen since January, when the stock first started to slip on fears that companies might rein in their near-term IT spending. Its shares eventually dropped as low as $12 9/16 last month before starting the current rebound, which has been prompted by a rosier outlook for the acquisition-happy company.

QUICK TAKES: Fax-to-email services provider eFax.com (Nasdaq: EFAX) picked up $1 13/16 to $15 3/8 after CEO Rudy Prince soothed investors stumped by the 36% slide in the company's share price over the past two weeks by saying in a press release that there has been no "fundamental change" in the business to warrant the drop... Internet software developer Spyglass Inc. (Nasdaq: SPYG) tiptoed its way $1 1/4 higher to $20 5/8 after saying it will provide embedded Internet technologies to the digital set-top box reference platform being designed by IBM's (NYSE: IBM) IBM Microelectronics unit... Portable hospital patient monitors maker Protocol Systems (Nasdaq: PCOL) gained $2 1/16 to $8 13/16 after chairman and CEO David Bolander told Barron's that the company will get a sales boost next year by introducing a new product in Q4 and another in mid-2000.

AK Steel Holding Corp. (NYSE: AKS) rebounded $2 1/16 to $24 7/16 after losing 5% Friday on news it will acquire fellow steelmaker Armco Inc. (NYSE: AS) in a stock swap valuing Armco at about $7.50 per share... Open-system computing platforms designer Texas Micro (Nasdaq: TEXM) tacked on $1 1/4 to $6 1/8 after agreeing to be acquired by embedded computing technologies firm RadiSys Corp. (Nasdaq: RSYS) for about $115 million in stock. RadiSys fell $3 to $31... Information technology solutions provider and consulting firm Keane Inc. (AMEX: KEA) marched up $1 1/16 to $31 11/16 after its Keane Federal Systems unit received a five-year $475 million contract to provide IT support services to the U.S. Justice Department.

Digital video computer boards and video conferencing boards maker Hauppauge Digital (Nasdaq: HAUP) hopped up $2 9/16 to $30 3/8 after grabbing 123% on Friday after a "New York money manager" told Business Week magazine to expect alliances with a streaming media company and an e-commerce company soon... Cable-based Internet services firm WorldGate Communications (Nasdaq: WGAT) added $6 1/16 to $38 5/8 after receiving patents for its Channel HyperLinking technology that links the Internet to TV programming... Lighting systems designer SLI Inc. (NYSE: SLI) brightened $1 7/8 to $32 after forming a North American surface mount light emitting diodes manufacturing joint venture with Japan's Stanley Electric Co... Enterprise storage management software firm Legato Systems (Nasdaq: LGTO) rose $2 3/16 to $51 1/4 thanks to a BancBoston Robertson Stephens upgrade to "strong buy" from "buy."

GOATS

Vacation rental and properties management company ResortQuest International (NYSE: RZT) shuttered $6 1/8 to $8 5/8 today as the company said it expects to report Q2 EPS of between $0.10 and $0.14, short of First Call's $0.18 consensus estimate, because of increased general and administrative costs and other factors. Probably more significant than the earnings news, however, was the company's announcement of plans to withdraw a 4-million-share secondary offering -- half the shares were from ResortQuest and half from shareholders -- expected to raise $30 million to fund acquisition and other corporate needs. While the termination of the offer deals a temporary blow to ResortQuest's expansion plans, management's unwillingness to sell its shares at today's price should hearten investors despite the earnings warning. Indeed, CEO David Sullivan said "overall operations... have performed in accordance with our expectations and [we] are excited about our potential future growth opportunities."

While business and consumer services company Cendant (NYSE: CD) continued its steps to focus its business following a damaging accounting scandal, Avis Rent A Car (NYSE: AVI) set off in a new direction today. Avis agreed to buy Cendant's PHH and Wright Express vehicle management and fuel card businesses in a $5 billion deal that includes $3.2 billion in assumed debt as well as bank loans, high-yield securities, and convertible preferred stock. The purchase marks Avis' entry into the auto-leasing business and gives the company a foothold in Europe. Avis hopes the new units' ties to corporate customers will give it a consistent revenue source to compliment its revenues from the competitive rental market -- much of which is generated by business travelers. But investors questioned the move, since the assumed debt alone is almost 1.5 times Avis's long-term debt and the deal will dilute earnings in the near term. Avis stock lost $7 3/8 to $28 in today's trading, while rental leader Hertz Corp. (NYSE: HRZ) fell $5 7/16 to $51 1/16.

QUICK CUTS: VerticalNet (Nasdaq: VERT), an operator of business-to-business community sites, moved down $12 11/16 to $75 3/16 today. The company said it bought network e-commerce technology developer Isadra for 500,000 shares of company stock and $3 million in cash... Life sciences company Monsanto (NYSE: MTC) put down $3 7/8 to $40 1/2 today, reportedly because on Friday, the FDA approved Merck's (NYSE: MRK) Vioxx, a potential competitor to Monsanto's Celebrex arthritis drug... Internet website co-location services and direct access provider AboveNet Communications (Nasdaq: ABOV) was lowered $2 1/4 to $31 9/16 after agreeing to buy the Palo Alto Internet Exchange from Compaq (NYSE: CPQ) for about $75 million in cash and services.

Casino operator Circus Circus Enterprises (NYSE: CIR) was shelled for a loss of $1 7/16 to $23 after an article in Barron's suggested that the stock may be fully valued... Drugmaker Pfizer (NYSE: PFE) spilled $4 to $106 1/4 following reports that Abbott Laboratories (NYSE: ABT) sued the company for patent infringement concerning a treatment for bacterial infections. Abbott lost $2 1/16 to $45 1/16... Medical and specialty health and life insurance products company American Medical Security Group (Nasdaq: AMZ) gave up $4 7/8 to $8 7/8 after reporting that full-year 1999 EPS is expected to be below market projections because of an $0.36 per share after-tax charge in Q2... Online fashion destination Fashionmall.com (Nasdaq: FASH) frayed $2 to $11 today after adding only $1/8 on Friday, its first session in the public market. The company sold 3 million shares at $13 each... Internet market research company AtPlan (Nasdaq: APLN) closed down $2 11/16 at $13 5/16 after taking $2 on Friday. The company sold 2.5 million shares in its IPO for $14 each.

Several bank stocks fell today as Credit Suisse First Boston analyst Michael Mason cut the ratings on four stocks to "sell" from "hold" amid fears about how the Year 2000 bug might hurt the companies -- particularly because of their exposure to international markets, where spending on millennial software upgrades often lags. Citigroup (NYSE: C) retreated $2 11/16 to $65 1/8, Chase Manhattan (NYSE: CMB) gave up $3 1/16 to $75 7/8, J.P. Morgan (NYSE: JPM) lost $1 15/16 to $136 3/4, and Bank One (NYSE: ONE) shed $1 5/16 to $58 1/2. BankBoston Corp. (NYSE: BKB), cut to "hold" from "buy," was beaned for a loss of $1 11/16 to $46 3/4... Investors continued to put their eToys (Nasdaq: ETYS) back on the shelves, as shares of the online toy retailer lost $11 1/2 to $57 this morning, expanding Friday's $8 1/16 loss. The stock nearly tripled Thursday, the first trading session for the company.

Discount retailer Kmart Corp. (NYSE: KM) fell $1 1/8 to $16. The company may soon be obligated to pay $761 million owed by Hechinger (Nasdaq: HECHH), which bought Kmart's Builders Square unit, The Wall Street Journal reported. Kmart sold the business in 1997 but retained liability for its payments on store leases... The Phantom Menace distributor Fox Entertainment (NYSE: FOX) lost $1/16 to $26 7/8. The film apparently hasn't drawn as expected, with its take from Wednesday to Sunday coming in about $20 million short of the industry's $120 million expectation. The Fool looked at the business behind the blockbuster in a recent feature... Cosmetics company Revlon (NYSE: REV) gave up $2 9/16 to $27 15/16 today. The stock got $1 1/4 Friday on reports that the company is in preliminary talks to be acquired by Coty Inc., a subsidiary of Dutch consumer products company Benckiser NV.

Full-motion "video libraries" producer Visual Data Corp. (Nasdaq: VDAT) checked out $6 5/8 to $29 3/8. The company announced a deal to create an online travel video channel with streaming media aggregator Broadcast.com (Nasdaq: BCST), shares of which lost $9 1/4 to $102. Visual Data's shares gained $3 1/16 on Friday... Last week's mad runup of online health information services firm Healtheon (Nasdaq: HLTH) hit a snag today as the shares retreated $13 3/4 to $91 1/4. Healtheon stock raced ahead $48, an 84% pop, last week on news of the company's plans to buy WebMD. Click here for a Foolish take on the tale... Replacement alternators and starters company Motorcar Parts & Accessories (Nasdaq: MPAA) stalled $4 to $7 after the company said it expects to report a "significant" loss for fiscal Q4 ending March 31, with a loss for the entire year possible.

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Flawed Insurance

In lieu of the regularly scheduled programming, tonight's Fool on the Hill takes us back in time to the late 1980s. Back to a dark and gloomy day, dimly remembered. This article was originally published on October 17, 1997.

Invariably, when the subject of the "Crash of 1987" is discussed, something called "portfolio insurance" is mentioned in association with the decline. To this day few investors are familiar with what it is, and most only have a vague notion that it had something to do with exacerbating the steep fall that occurred in the index averages almost a decade ago. Portfolio insurance was a risk management weapon forged in the raging furnace of market decline, but when tested in battle it quickly revealed a critical flaw.

The concept of portfolio insurance, indeed the name itself, reflects the ardent wishes of its creators for a utopian investment vehicle capable of minimizing the pain of investment loss. The idea was simple, all one would have to do was pay something akin to an insurance "premium," and investment downside could be forever limited. Unfortunately, as so often occurs in the realm of human affairs, reality served an unwilling partner.

The inspiration for portfolio insurance oddly enough came from an academic setting. In September 1976, Hayne Leland, a young finance professor at Berkeley, consumed with worry over his family's finances had a midnight brainstorm. He approached a colleague, Mark Rubinstein, the following morning and the pair became so enamored of their ideas that they decided to form a company to market their new product called "portfolio insurance." However, it wasn't until a full two years later that the duo had ironed out all the kinks in their trading strategy, and with the help of professional marketer and portfolio theorist John O'Brien they scored their first client in 1980.

From inauspicious beginnings came a virtual tidal wave of demand for the group's "product," as well as a whole host of competitors offering similar investment insurance. In fact, by 1987 approximately $60 billion in equity assets were covered by different varieties of portfolio insurance, the majority of which was on behalf of conservative pension funds.

The initial concept underlying Leland's creation was to replicate the performance of a put option in what was referred to as a "dynamically programmed system," where a client was automatically shifted out of a position (via computer) when it began to fall, increasing the client's cash as long as the stock fell and "insuring" that a predetermined amount was all that the client could lose.

Here's how it worked: Say you bought 100 shares of Replicants R Us at $100 a share, and simultaneously bought a put -- the option but not the obligation to sell Replicants stock to someone else at a stated price over a specified period of time -- with an exercise price of $90. In this way, no matter how low Replicants R Us shares dropped due to "malfunctioning" replicants killing humans, you couldn't lose more than $10 on each share. In this example the floor was set at $90, and by the time the stock reached this price in the market, your portfolio would be 100% in cash. The distance then, between the starting point and the floor, was like a deductible on a normal insurance policy -- the $10 per share being the amount that you as a policyholder would have to cover. So if the market fell, the portfolio would slowly liquidate some positions, but still hold some stock. If the market rose, the portfolio would be buying, but still hold some cash. The slight degree of underperformance, in both directions, that results serves as the "premium" for the insurance.

Today, in a period when program trading is routine, this particular scheme looks a little archaic. However, at the time, the mechanics of running an operation in which hundreds of simultaneous buy and sell orders needed to be executed for just one portfolio were understandably complicated as well as costly. In addition, active portfolio managers bristled at being second-guessed by "some computer." The saving grace for human and computer alike came in the form of futures contracts on the S&P 500, made available in 1983. These contracts allowed investors to buy or sell a proxy for the overall market, that is, an index of 500 leading companies in leading industries.

Under the guise of portfolio insurance, the futures transaction in this instance was an agreement to sell the "intangible commodity" of 500 stocks in the index at a specified date and a prearranged price. Portfolio managers would hedge their stock portfolios by selling index futures. Instead of buying and selling hundreds of stocks and options, the S&P index futures promised an effective, inexpensive, and greatly simplified form of portfolio insurance. They functioned almost exactly like the put scenario described previously, with one crucial difference that left the promise unfulfilled.

The owner of the futures contract makes a cash settlement based upon the variation in the index between the signing of the contract and its maturity. Every day investors are required to fork over cash to the exchange (which represents the other side of the transaction, as opposed to an individual or firm) to keep the contracts fully collateralized. The actual construction of the futures contract was not the problem in 1987, it was the selling of shares in the stock portfolio in order to make the hedge worthwhile.

Recall the put scenario. This option was "put" to the seller at the exercise price of $90. Again, that means however low Replicants R Us shares dropped in the market, the seller of the Replicants put is legally bound to buy the shares at $90 if the owner of the option puts the stock. That was the insurance -- Replicants R Us stock could fall to $30, but the seller was obligated to buy at $90! However, with the stock index future, it could be sold and the money could be collected, but in order to make it all worthwhile the stocks in the portfolio had to be sold to prevent the loss.

The crucial difference boiled down to the fact that the market was not obligated to purchase any of that portfolio stock at the price that the portfolio manager wanted. Those who used index futures as a hedge assumed that the necessary liquidity would be available from the market. It wasn't. The truth is, during the crash most "insured" portfolios did better than those that were "uninsured," but the selling of the portfolio stock took place at prices far lower than anticipated. For example, instead of locking in a price at $90 for Replicants R Us shares, those that insured their portfolios with index futures would have undoubtedly received a price below $90 because the buyers were just not there during the waves of selling that occurred.

On the weekend before the crash, an enormous overhang of sell orders had built up, for in the previous week the Dow Jones Industrial Average had fallen 250 points, or about 10% (with half of the drop on Friday). During all this, managers of "insured" portfolios were selling index futures and dumping their portfolio stock. On Monday all the programmed sales kicked in, the market dropped 100 points by noon, another 200 points in the ensuing two hours, and 300 points in the final hour. As Peter Bernstein notes in Against the Gods: The Remarkable Story of Risk, "The cost of portfolio insurance in that feverish market turned out to be much higher than paper calculations predicted."

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