Despite its sizable rally in 2003, over the past three years the
has lost more than one-third of its value. That's a drop twice as deep as the
Dow Jones Industrial Average
and 25% worse than the Wilshire 5000 Index. One key reason could be its managers' singular misadventures with what some traders call "binary" events.
Nobody expects Standard & Poor's to be a
steward of its flagship index, which is responsible for the fortunes of millions of investors through $1 trillion in pension and mutual funds that track its performance. But it would be nice for retirees' and college aspirants' welfare if S&P weren't so consistently ham-fisted, as in its recent handling of make-or-break moments for electric utility
( MIRKQ) and American Airlines parent
A 670% Missed Opportunity
You may recall that in March, a prewar travel slowdown, management missteps and labor disharmony threatened to push AMR into bankruptcy. Most bond-rating agencies thought the airline had a fighting chance to survive, but the debate narrowed to a bet on whether unions would give back enough pay and benefits to match the company's restricted cash flow.
This sort of situation is called a "binary event" because there were essentially two possible outcomes, like the flip of a light switch. If unions voted to accept concessions, the company would avoid bankruptcy and the stock could recoup its losses; if they voted against, the company would probably have to file for Chapter 11 and shares would be worth nothing.
S&P decided not to wait to learn the outcome, however, and jettisoned AMR from its big-cap index on March 13. About a trillion dollars' worth of mutual funds tracking the index were forced to sell the stock at around $1.40 -- a price that would pretty much mark its low. Ultimately, a month later, unions decided to keep the airline flying, and the stock hit $5 in short order. Last week, AMR announced better-than-expected cash flow and earnings results, and shares continued their upward flight, settling around $10.75.
That's a move of about 670% that index holders missed. For perspective, consider that the next-best move over that period among S&P 500 stocks was
, at about 225%.
Fast Ride to Zero
As if that weren't bad enough, fast-forward to the start of this month -- when the index managers' next major move was to ride a stock to nothing.
It was not much of a secret that Mirant, staggering under a terrible debt load, was likely to file for bankruptcy. On July 10, a Merrill Lynch analyst published a report stating that the probability of achieving an out-of-court debt restructuring by a July 14 deadline "has declined below 50%, maybe well below." In her report, analyst Elizabeth Parrella downgraded the shares to sell from neutral. The stock closed that day more than 23% down at $2.28.
Gun-shy after its American Airlines debacle, S&P decided to stand fast with Mirant in the run-up to this binary event. It could very well have pulled the plug on the electricity producer early -- just as it had done with AMR. That would have allowed index funds to sell the stock at around $2. But instead, S&P 500 managers rolled the dice, crossing their fingers and hoping that a last-minute deal would save the utility.
No compromise with lenders materialized, and after Mirant announced it would seek Chapter 11 protection, S&P was forced to announce it would pull Mirant from its big-cap index at a titanic loss to all the funds that mimic its actions. Said its press release: "If Mirant does not resume trading on the
New York Stock Exchange
on July 16, it will be removed from the Index at a price of $0.00." And so it was.
In an e-mail exchange, a spokeswoman for David Blitzer, head of the committee that manages the S&P 500, said that in contrast with AMR, Mirant's liquidity "was holding up near the end." The spokeswoman's e-mail added: "By the time there was a point of comfort that company should be removed, they announced they were going to file for Chapter 11."
Such decisions are responsible for the index's lousy performance in recent years relative to its two major index peers with contrasting management styles: The Wilshire 5000, which passively tracks 5,000 stocks, and the Dow Jones Industrial Average, which tracks just 30. In contrast with Standard & Poor's rather active management of its S&P 500, Dow Jones hasn't made a change in its 30 industrials since 1999.
Vanguard Group, the second-largest mutual fund company in the world, has been pulling away from its long relationship with Standard & Poor's for many of the funds it manages. In April, it switched seven of its funds following passive strategies away from S&P benchmarks to benchmarks managed by MSCI, a division of Morgan Stanley Capital International. Said Vanguard Chief Investment Officer Gus Sauter: MSCI indexes "reflect performance of the funds' targeted market segments more accurately than any other available indexes."
If you have a mutual fund in your portfolio indexed to the S&P 500, the Mirant fiasco alone -- not to mention persistent underperformance -- should encourage you to reconsider your options.
Binary events are more common for small companies than large ones as they face all sorts of life-challenging moments in their first few years as public entities. Biotechnology companies are particularly susceptible, as they must publicly report on the success or failure of drug trials.
Check out the experience last week of
, maker of a drug candidate to treat hypertension. For months, investors knew that its ALT-711 therapy was undergoing make-or-break clinical trials. If successful, analysts said the $4 stock would be worth $14; one called it "the best biotech story of the third quarter." On July 15, Alteon set a date for its trial announcement, and the stock jumped as much as 15%. Yet the news on July 17 was bad; the drug didn't work. And the stock sank 75% in a single session.
There is no way to screen for these high-tension spins of the market's roulette wheel -- moments when all the shades of gray in investing give way to black and white. They are known primarily to people who watch the stocks avidly. If you know of any stocks facing a binary moment, email me with the details and your analysis at
firstname.lastname@example.org and I'll cover them in a column later in the month.
Here are three to get you started.
: Private fund manager John Kuhn says this maker of devices used in minimally invasive cardiovascular-system procedures received Food and Drug Administration approval in 2001 to begin phase II trials for a procedure to treat patients with vascular disease potentially severe enough to warrant limb amputation. The "primary end point," or goal, is to salvage the limb. The last patient enrolled in April 2002 and the six-month follow-up was completed in October 2002. Data were submitted to the FDA in January 2003 and the company anticipates a final FDA decision in late 2003. Kuhn says the modestly profitable micro-cap seems well-run. Failure to win FDA approval for the procedure, he says, will cut the $3 stock in half; approval could send it to $10.
: Kuhn says this small-cap biotech awaits approval of its antibiotic drug candidate Cidecin, which is aimed at treatment of complicated skin infections. An FDA decision is expected by the end of 2003. Kuhn says the price suggests high expectation of approval. Failure "would cause dramatic revaluation, which would not be pretty."
: This one's a little different. It's an independent natural gas producer that's highly leveraged to the price of a single commodity. If you buy shares here at around $9.65, you are betting that the price of natural gas, now at around $5, will return to the $6 to $6.50 range where it spent the spring, rather than falling to the $4 range where it spent the winter. That's a simple binary decision. Chris Bertelsen, managing director of the
( PZAAX)Phoenix-Hollister Appreciation Fund (PZAAX), says the price actually needs only to stabilize at the current level for investors to bid Chesapeake shares up 50% or more over the next year. "The company is hugely profitable here," he said. "The only thing holding it back is that bears think the price of natural gas is going back to $3. If it doesn't, then Chesapeake's price will explode."
As originally published, this story contained an error. Please see
Corrections and Clarifications.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at
email@example.com. At the time of publication, he had positions in none of the equities mentioned in this column, but positions can change at any time.