Gustavo Ballvé on July 4th, 2010
Food for thought, Home, Investment Themes, Mental models, Portfolio Management, Signal or Noise

Spinoff & Reorg Profiles’ latest report has a very interesting section on Insider Buying, and we asked for and got Bill Mitchell’s permission to post an excerpt here. Using Sharps Compliance (ticker SMED) as an example, this section of the report discusses when “incentive stock option exercises may act as an insider signal”. Item #5 in his summary (the last paragraph) is vital, as insiders are only human and can get carried away with frothy valuations just like the rest of the market. No matter how powerful one or even a combination of “signals” may seem, there must be “fundamental value” / margin of safety.

This is from the June 30th report of Spinoff & Reorg Profiles.

INCENTIVE STOCK OPTION EXERCISES AND INSIDER BUYING

Sharps Compliance (SMED) is a medical waste disposal company. The most recent quarter’s loss notwithstanding, its trailing return on employed capital is over 200%, and shares trade below 7 times earnings. The company has no debt, and cash reserves of about 10 times last quarter’s loss. Unfortunately, its operating history is too short to satisfy many conservative investors; still, we find it interesting, both on its merits and as a foil to illustrate how and when incentive stock option exercises may act as an insider signal.

SMED shares are down over 60% since November, and over 40% since its first-quarter loss was revealed in May. Yet insiders are suddenly buying, after years of consistent net selling. On June 14, a director purchased half a million dollars’ worth of SMED at market. More interestingly, the CEO exercised options on a quarter million shares in May, but has sold none.

To illustrate the strength of the latter signal, we must first relate a doleful tale of of investment calamity from several bubbles ago. In 1999, one of the author’s former business school classmates was sitting on millions in paper gains from incentive stock options at a frothy dotcom. To minimize taxes, the guileless MBA committed all his cash to exercise all his options, intending to hold shares for a year and qualify for capital gains treatment. At the exercise date, the spread between the strike and market prices was large enough to trigger the alternative minimum tax the following April; but by then, his company had collapsed, leaving him with no income, no cash, worthless stock, and a vast AMT liability. He was wiped out. (We betray no confidences in telling this story, as he confessed it all in a page-one piece in the Wall Street Journal in June of 2000. Perhaps understandably, he later changed his name, but that is for another story.)

The situation faced by the CEO of SMED is not dissimilar, in that his stock options were struck at just 80 cents; the resulting spread could in theory incur a tax liability of as much as three quarters of his recently reported annual compensation. The exercised shares are about a sixth of his total holding in SMED. In short, the numbers are big enough to matter to him. Unlike the author’s classmate of yore,
this CEO is 71 and presumably experienced, so to make such a big decision, he must be highly confident that SMED is now cheap.

To summarize, the exercise of incentive stock options may indeed be a buy signal if (i) the spread is large, yet the exerciser does not sell, thus taking on personal exposure where he had none before; (ii) the amounts are large relative to his estimated net worth and income; (iii) the activity is historically unusual, per company filings; (iv) the activity accompanies unusual cash purchases by other insiders; and, most importantly, (v) the behavioral signal is backed up by fundamental value, such as the low P/E and very high return on capital here.

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