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.

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.

Taken together, it’s a reminder that it’s difficult enough to “learn lessons” from crises, but it’s extremely hard to actually implement changes. We would even point out that when changes are implemented, it’s not always an improvement… This means that the door is still open for human behavior + twisted incentive systems that eventually use these loopholes to create havoc. Recognizing this and controlling oneself is the first step to trying to take advantage of this.

The key point Mr. Loyola touches on is the lack of accountability of our congressmen. There are very little “checks and balances” in the current system other than the elections themselves.

Another key point, and something we will never get tired of saying, is that one cannot forecast that the good times will go on indefinitely and assume that one can increase costs because the income is rising, incur in debt, and so on. There are always downturns, and they are made more troublesome precisely because one has loaded up the costs before the income melts away. This is an ages-old, proven concept that is apparently extremely difficult to accept and work with, and one doesn’t get more popular by saying “calm down, let’s save up instead of spend away our new-found wealth” in politics – yet that’s precisely the commendable conduct.

We try to do it with our money, which is invested alongside our clients’. It tends to make us go up less than the market in euphoric times, but it also tends to dampen setbacks when things go south. “To finish first, first you need to finish”.

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.”

Overconfidence and inefficient markets happen anywhere – it’s only human. For more on independent thinking applied to sports, just click on…

Michael Lewis’ “Moneyball” deals with this subject in the Baseball arena, but it’s a great read for people interested in independent thinking in general.

But for a quicker look at what he means with the book, this 2009 NY Times article is a good read (it’s about basketball). Our impressions on it, pretty much copied-and-pasted from our Intranet:

• Page 2: Defining the problem: What does it even mean to play basketball the right way? The Houston Rockets’ owner questioned that and said: “We now have all this data, and computers to analyze it. I wanted to use that data in a progressive way.”

• Page 3: Defining adequate metrics: Do current metrics matter? What are we going to measure that will help us solve the problem defined earlier? What is really relevant?

• Page 4: Aligning interests: That’s when they started writing correct incentives into the players’ contracts, according to the metrics they defined in the previous step.

• Page 5: It’s the process, stupid! The quote to rule them all: “Knowing the odds, Shane Battier can pursue an inherently uncertain strategy with total certainty. He can devote himself to a process and disregard the outcome of any given encounter.”

Michael Lewis does it again by finding the “value investors”/ analytical-minded managers and players in professional sports. His Moneyball book was pretty amazing, but this article summarizes the issue perfectly. By the way, here’s the link to a review by Michael Mauboussin for that book.

The point: Analytical thinking is not just about making sense of existing data, it is about questioning the very assumption that this data is in any way useful, questioning accepted beliefs, common knowledge and easy conclusions. It’s about QUESTIONING.

- Memos From the Chairman, the book from which we’re taking the following quote, should be mandatory reading for everyone – but especially for government officials. One phrase that seems especially applicable: “When mortals go through a prosperous time period, it seems to be human nature for expenses to balloon.”

- In this post about our Q4 2009 report, we highlight the risk of extending to 2010 the mood seen in 2009 in the brazilian equity markets. One of the reasons to be careful was the election year.

- From our Q3 2009 report:

“There is no doubt that the decrease in interest rates, the outlook for the pre-salt oil and the benefits of Brazil’s growing role in the globalized world have been contributing positively and should continue that way. But two factors concern us: the State’s hypertrophy and prices. Stock prices in general reached a reasonable level for a scenario of harmonious growth. But political trends seem to drive us away from harmony.

The continuous increase in the State’s size compared with the economy as a whole is mathematically unsustainable. In our opinion, this is unsustainable and tends to generate a serious cost if not reversed. Also, its effects are delayed given the inertness of economic mechanisms. We will only feel the consequences of what is being made in a few years.

We have been studying the health sector globally and an analogy is clear: governments are like the immune system. They are central to life, defending the organism from predators and incompatible elements. When they are uncontrolled and exaggerate, such as autoimmune diseases, they attack healthy cells and organs, leading the organism to death if they are not controlled. In our opinion, many countries are suffering from autoimmune diseases.”