Thursday, April 16, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (April 16, 1998) -- If you've been following the financial news today, you've undoubtedly heard of the debacle du jour: Cendant Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CD)") else Response.Write("(NYSE: CD)") end if %>. Announcing last night that it must restate last year's earnings because of an accounting error (an "irregularity," they called it), the stock was sliced nearly in half this morning when it finally opened.

I won't go into the fundamentals of Cendant's business here because I really have other points to make about investing in general that can be demonstrated by the use of this unfortunate event today.

First, I've argued for months that individual investors should try to build a portfolio with as many as twenty stocks for sake of risk avoidance. I don't believe in market timing or crystal-ball gazing, so to spread the risk against an unforeseeable event like today's collapse in Cendant (which apparently no one saw coming, with the possible exception of one company insider who sold hundreds of thousands of shares of CD last month -- convenient, huh?), I believe in spreading the risk out.

If Cendant were one of twenty stocks in your portfolio, today's loss of 50% or so represents only a 2.5% drop for your overall portfolio. That's still a stinger that might put you on the bench for a few minutes, but it's not going to end your entire season. But if you're holding Cendant as one of only five stocks, let's say, your entire portfolio dropped 10% overnight -- a much more devastating blow.

I'm not suggesting you need to go to extremes and hold 50 to 100 stocks to limit these risks, but a diversified portfolio is the only form of risk protection you have if you're going to remain fully invested in stocks at all times.

Second, what about sell stops as a form of protection? Well, let's look at their effect today. Cendant closed last night down a buck at $35 5/8. Let's say you had a sell stop entered to bail out of the stock at $33, approximately 20% below the stock's closing high in early April. You're protected against days like today, right? Unfortunately, no.

You see, a sell stop guarantees that you'll get out of the stock if and when it trades below your pre-determined level, but it in no way guarantees that the price you'll get is your price. It only guarantees that your position will be sold as soon as that price level is penetrated.

This morning, Cendant didn't open for trading on the NYSE until the damage had been done. The opening price was only $20 7/8. Despite your sell stop at $33, your position would have been sold at or near the opening price, some 36% lower than your "protection point." So sell stops are not the answer.

Third, this is yet another example of how far we have yet to go before we level the playing field between institutional and individual investors. Before trading was halted even on the after-hours markets, institutional investors were able to react to this news (whether doing so is the right thing or not is a separate question) and buy or sell shares of Cendant, whereas the average retail investor could not. And again this morning, before the stock opened on the NYSE, millions of shares traded between institutional investors.

It's been argued by others that this is not unfair because even after-hours market investors take the same risks as during the regular market and that they must still match up with an opposing trader. I reject this, however. That quick trader who sold a large block of Cendant yesterday afternoon at roughly $26 a share had an advantage you and I don't share. If you had wanted to sell yesterday afternoon… too bad. (I don't own Cendant, incidentally, so this isn't just the result of my having eaten sour grapes.) So despite arguments to the contrary, the playing field is not yet level. It cheers me somewhat to hear that the SEC is looking into the proliferation of such after-hours markets. Either close all trading with the 4:00 bell or open the market fully, 24 hours a day. Anything in between is patently unfair to those who are shut out. One shouldn't have to pony up a huge subscription to one of these markets to trade during certain hours. Either the market's closed or it's open. (I know; call me naive. It won't be the first or last time it's claimed.)

Fourth and finally, it should come as no surprise to anyone that every analyst with a rating on Cendant slashed his or her rating this morning before the bell. Just good sense, right? Well, that and the fact that most firms count the previous day's closing price as the level at which their analyst makes such a call. Since it was obvious to anyone looking that Cendant would get slammed at today's opening, all the analysts just padded their performance records by declaring they issued a sell recommendation at $35 5/8 and the stock's now around $19. Accountability? Not!

All this boils down to a few issues, Fools.

-- Be prepared for unforeseeable events like this by spreading your risks around. There's no way to avoid these blow-ups, even in the largest stocks. But don't let that devastate your whole portfolio or make you question your strategy. If you're using a good approach, these implosions in individual stocks will be overcome by the sheer numbers of good stocks you'll own over the years.

-- Don't pay any attention to analysts' smoke and mirror games. The lack of integrity in this system gives political campaign finance shenanigans a good race.

-- It's still an uphill battle for the individual versus the institutions in terms of access to news and open markets. And even worse for Cendant shareholders, if corporate insiders knew of the problem in March and pocketed a fortune by selling stock as a result, or even as recently as last week, when three major corporate officers left the firm and Cendant brass reassured shareholders that all was well, the SEC should earn its funding by taking some people to the woodshed for a change. The proliferation of insider trading and options activity before major corporate announcements is virtually becoming cliche. It's time the SEC stepped in and played tough cop for a while.

Just imagine my harangue had I owned Cendant! Thus endeth the sermon. Fool on!

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[Robert Sheard is the author of the forthcoming book, The Unemotional Investor, due out from Simon & Schuster on May 12. To pre-order your copy, please visit Amazon.com, where it's available at a discounted price.]