A little less than two years ago, the consensus among market players was that there was “extremely low visibility” for the next few quarters and that “the occasion called for caution”. Considering that the world financial system was close to the abyss, it was indeed advisable to adopt a conservative attitude – though at times like those in 2008, to have high-quality real assets at very low prices seemed to us a more attractive alternative than lending money to governments. The “low visibility” issue, however, is a matter that deserves greater reflection.

Is it true that, over time, investors really alternate between times of “excellent visibility” and “very poor visibility”?  Or is it possible that this is an illusion of the human mind, and in reality investors alternate between times in which they think there is greater or lesser visibility? We believe that the second alternative is the one that best describes the real situation: the future is uncertain by nature and what varies is our perception of it. As Warren Buffett once said: “Forecasts usually tell us more of the forecaster than of the future”.

Many market players live under the illusion that the future is foreseeable, and using worksheets where projections cover from 5 to 10 years, they end up perpetuating situations and circumstantial results, ignoring the natural business cycles. This is one of the traits of the human cognitive system: the tendency to attach greater importance to recent events than to older ones. It is natural, therefore, that in a crisis environment, negative aspects prevail over positive ones, and that at good times the opposite occurs. Perhaps even more worrying is the fact that events with fat-tail[1] characteristics start being neglected in analyses. In another curious trait of our cognitive system, Daniel Kahneman, who won the Nobel Prize for Economics in 2002, calls attention to the difference in individuals’ perception of gains and losses. An individual who loses R$50,000 tends to feel a negative impact greater than the positive impact of a R$50,000 gain.

All these aspects help to explain why the markets are doomed to alternate times of under-valuation and over-valuation. When the economic environment deteriorates, there is a general perception that “visibility” is lower, so that analysts and investors not only revise their projections downward (perpetuating low returns and results), but also their portfolios, usually in order to bring painful financial losses to a halt. During the process, prices start to better reflect the uncertainty of the future. When the economic environment improves and remains positive long enough, the opposite occurs and the visibility illusion appears again. All goes well until a new and “unexpected” adverse event occurs, and the cycle starts again. History shows us that turbulence and adverse events occur more frequently than investors would like: something always happens! That is why discipline and patience are necessary.

Just to illustrate some of the problems that are prowling around us at present: growing domestic inflation and interest rates in a rising trend; slack domestic fiscal policy, including the dangerous use of state-owned banks; default on the debt of several countries in the Euro zone; the sustainability of the Euro as a single currency; the possible mass adoption of mercantilistic policies (which lead to competing devaluations among the main currencies, rising protectionism and reduced world trade); rises in taxes worldwide; the “unexpected” rise in US debt (due to aid for bankrupt states); the Chinese growth model giving signs of  exhaustion; the ageing of the Japanese population and its impacts (difficulty in refinancing Japanese government securities); etc… As Ronald Reagan would say, “Government is not the solution to our problem, government is our problem”.

In the month of May, 431,000 new jobs were generated in the USA, of which 411,000 resulted from government hiring of temporary workers for the 2010 US census. How long will the government manage to support the US economy?

The thing is that, at present, there are a great number of possible adverse events that may trigger a reduction in “visibility” and in the appetite for risk worldwide. And when we look at the Brazilian market, we continue getting the impression that a great many asset prices already reflect optimistic expectations and there is little room for surprises. As Nassim Taleb said: “Beware of calm waters”… In this context, we continue waiting for clearer opportunities where we may allocate more funds safely, and meanwhile we receive over 10% per year in interest for being patient – which is not bad at all.

Where may we be wrong? One possibility, for example, is that Brazilian assets in general might accompany a possible appreciation in the US stock market, which in turn would occur only to offset the continuous issuing and loss of value of the US currency, and the loss of control over US inflation. Thus, the nominal appreciation of assets would only serve to keep the value of companies constant in real terms. We do not believe there is any justification for the Brazilian market as a whole to accompany this appreciation, unless Brazilian domestic inflation also gets out of control. And even if this happened, the risk/return ratio would not be worthwhile. According to Warren Buffett’s teaching in his fantastic article of 1977, “How Inflation Swindles the Equity Investor”, at times of high inflation, investment in equities is only the least mediocre alternative among many others. The perverse effects of inflation also impact companies’ results and investors’ gains. When adjusted for inflation, the gains, in real terms, tend to be very poor.

The article’s title had us thinking of another issue, one that’s just as important.

That’s because the title is obviously inspired by Jon Krakauer’s book “Into Thin Air”, which shared the first-person, dramatic account of a tragic Everest climbing attempt that claimed five lives. In the best-selling book, Mr. Krakauer very elegantly and convincingly singled out russian super-climber Anatoli Boukreev as guilty of omission and almost destroyed his career – until Mr. Boukreev’s own version of the tale appeared in the book “The Climb”, contradicting Krakauer’s book point by point as effectively or more. The debate raged for years until Mr. Boukreev’s death in another climb.

The point is: even EX-post, clear-tempered analysis of mistakes can lead to further mistakes. Just the attitude of looking back isn’t enough; one must be prepared to hear all sides of the tale with an open mind… even if that means a constant “sparring” of contradicting ideas in one’s mind. For every piece of hard-to-dig “evidence” there’s likely a solid counter-argument that should be considered just as diligently.

The second one on the dark side of creativity is much more speculative (research here).

The third one explores the relationship between power and lies.

For people who think they can “read” people very well, the fourth one is interesting.

Finally, the last one is about negativity in “second hand impressions”.

Grumblings aside… we wish we could draw like that.

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.

This NY Times article tells a great story: In 1952, Bell Telephone leaders felt that they needed “more employees capable of guiding the company rather than simply following instructions or responding to obvious crises.” They asked the University of Pennsylvania to elaborate a course for their “rising stars”, and Humanistic studies were heavy in the program so that the technical-minded execs could be exposed to different, mind-opening experiences – which culminated in the reading and discussing of the James Joyce book “Ulysses”.

This concern was new in 1952 and it’s “common sense” today, but the author says that we need leaders who can think for themselves now more than ever. Without talk of incentives this is more a homage to the benefits of a diverse and continuous education than it is a valid “diagnosis” of today’s leaders’ conduct. Still, that is a worthy enough point.

But let’s go back to the article and the program devised for the Learning Knights of Bell Telephone Co. After the program ended, one of the graduates said that “before the program he had been ‘like a straw floating with the current down the stream’(…)”. It’s a way to say that after the program he felt like someone in control of his career, or at least aware of much more than before (which in the 50′s had a different consequence than one would have imagined). The graduates’ knowledge and analytical boundaries had been pushed, pulled and “stressed” and, as a consequence, expanded.

The NY Times Op-Ed contributor, Wes Davis, closes the article with this paragraph “As the worst economic crisis since the Depression continues and the deepening rift in the nation’s political fabric threatens to forestall economic reform, the values the program instilled would certainly come in handy today. We need fewer drifting straws on the stream of American business, and more discontented thinkers who listen thoughtfully to both sides of our national debates. Reading “Ulysses” this Bloomsday may be more than just a literary observance. Think of it as an act of fiscal responsibility.”

A note: we realise the LEX column isn’t free, but it’s worth every cent.

“He has opined on the wonders of modern capitalism but he also has been prescient about its weaknesses. Among these are perverse management incentives, deceptive accounting and a general under-appreciation of risk. More than his folksy wisdom though, the way Mr Buffett has managed Berkshire, a conglomerate in the business of taking large, calculated risks, is instructive. Even at the depth of the crisis, it was never in danger of going under and played the profitable role of backstopping companies such as Goldman Sachs and General Electric.”

(…) “In spite of fame that could send a stock soaring on mere whispers of his involvement, his entreaties on thrift, prudence and governance fell largely on deaf ears.” (…) “Anything Mr Buffett says about risky behaviour on Wednesday will have to wait for another crisis to become conventional wisdom.”

We can’t stress enough how great the book “Poor Charlie’s Almanack” is, since it gathers this speech and nine other talks Mr. Munger gave throughout the years. Some are classics in their own merits. You can find links to most of them in the Wikipedia page, but to have it all in one place saves a lot of time.

LINKS:

The audio to the speech – Found at this blog, many thanks.

Buysiders.com post on the book Think Twice – Mental traps are also discussed in this video with Michael Mauboussin.

Buysiders.com post on the multidisciplinary approach and communication.

Whitney Tilson reviews the speech – Motley Fool, 2002

LINKS:

Fraud detection: Red flags – a KnowledgeLeader “checklist” of sorts that is just that – a list of useful tell-tale signals or warning signs. As we said above, it shouldn’t be taken too seriously.

No one would listen – A Buysiders.com post about Bernie Madoff, whistle-blowers and red flags that remained ignored for way too much time. By the way, we’d now add another book suggestion to the ones we make in this post: The Confidence Game, recording Bill Ackman’s saga against MBIA Corp.

Essentials of Corporate Fraud – We’re not singling out this book as a leading publication on the subject, it’s just a way to open up “related book” searches. There are many many textbooks on fraud, forensics accounting and so on, and this didn’t necessarily save people from Enron, Worldcom, Madoff, etc. – and won’t necessarily prevent the next, big, “unimaginable” fraud either.

US agencies’ fraud-detection effors – As this Federal Trade Comission page shows and other pages not mentioned here corroborate, the US government is very concerned with fraud and tries to increase awareness of the issue. This handbook about the Red Flags Rule for protecting consumers’ IDs is an interesting read.

LINKS:

Audio version of the article on Audible.com – At $1.95, seems like a nice price to pay for the convenience of hearing it whenever you want.

Harnessing the Power of Persuasion – an October 2001 Cialdini article in the Harvard Business Review.

The Persuaders: Bob Cialdini – The Times UK, 2007 – It’s not about this particular article or book, but it’s about Influence.

Link to 5 podcasts by Bob Cialdini – The Times UK, 2007 – How to persuade on eBay, by e-mail, etc.

The Gentle Science of Persuasion – a 6-part series from the Arizona State University’s W.P. Carey business school, where Cialdini is, and we quote, “the Regents’ Professor of Psychology and Marketing at Arizona State University and Distinguished Professor of Marketing in the W. P. Carey School.”