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.

Q1 2010 report excerpts

The last few months were a period of much study and few operations. Following a time with plenty of clear opportunities, since the last quarter of 2009 we have found ourselves in a phase with few new situations in which we could have great convictions.

During the first quarter of 2010, we took part in six conferences in Brazil and the USA, including some focusing directly on investors and some to do with companies themselves and sector professionals. There were over 200 presentations and there were advances both in getting to know companies and sectors better and in identifying potential new opportunities. In the short term, however, we did not find any that would fit the “easy as falling off a log” category (high value and low price) that we like so much. As the historic Peter Sellers character would say in the fantastic film “Being There”, “there’s a time for planting and a time for reaping”.

We take the opportunity to thank readers for their participation and suggestions in the Buysiders.com website, IP’s blog. We have recently started using Investidor    Profissional’s    pages    in    Facebook and in Twitter to publicize the new articles released in Buysiders.com. This is still an embryonic use of these tools, but it may make things easier for those who are already well acquainted with them.

PROSPECTS: Brazil

Lately, in addition to all the efforts applied to studying specific companies and sectors, we have allocated more than the habitual amount of time we dedicate to macro and political questions. In fact, we have “worked” more than ever and studied much more than the historical average. Mainly thanks to the maturity reached by the IP model, we have spent less time on commercial and managerial issues.

It is important to make it clear that we have not changed at all our fundamental belief in the way we should operate. Much to the contrary. But we always seek to take care not to allow the “execution mode” to prevent the basic assumptions from being revalidated from time to time. And recent times have clearly called for a revalidation. What is the risk of a swerve towards a more populist agenda, where property rights are less respected? After all, we have lived with movements like the “landless people’s movement”, and with growing rumors of coercion against certain companies and entrepreneurs, as well as restrictions to the press and controversial constitutional amendments proposed by the government. We have the example of “Chavismo”, which has not been repelled by the Brazilian government, indicating a lower degree of aversion than we would like to a regime that is so primitive and harmful to society.

What are the risks involved in the renewal of concessions, or in the creation of new and yet heavier taxes, rates and “contributions”?

Our conclusion up to now? If we have not reached (and are not even close to) an “all in” position, like the famous Warren Buffett declaration regarding the US economy (…) we are moderately optimistic regarding the Brazilian economy in the medium term. By fits and starts, the institutionalization of Brazilian politics is taking place. Even the worst elements are not succeeding in perpetrating greater and more lasting damage to the extent of annulling the advances achieved in the last 16 years (…). Our fears of a greater and longer negative discontinuity in the fundamentals are relatively low.

President Lula is an example of the fact that, with a certain degree of common sense, even historical opponents of a liberal capitalist society end up surrendering to most of the evidence contrary to their ideological beliefs. The government’s efforts to continue the initiatives of the previous Administration in order to make the real-estate market viable are another example. This is a sector that keeps the economy spinning, but one which did not have “wealthy sponsors” (…). Fortunately, the logical thing happened and things are moving.

In economic terms, in addition to the (already commonplace) commodities, the domestic market development case becomes better consolidated day by day, based – by order of solidity and importance – on the demographic profile, the formalization of the economy, credit expansion, and a not-so-bad political scenario.

Companies and their businesses do not exist in the void, and whenever we identify “clouds of change” on the horizon, we pay much greater attention. So far, so good…

So we should explain why we do not “fill up the bucket” in view of such good fundamentals for the Brazilian economy, and manageable disturbances. As always, we have to weigh up the asset price factor. The present levels, in general, already take into account a large portion of the prospects listed. Turbulence does happen, and when it does, many people panic. The best moments to fill the bucket are these: good fundamentals plus panic caused by the situation of the moment. Until then, we maintain our positions in companies that not only have fundamentals that lead them to consistently surpass market expectations, but also have a good cash reserve.

PROSPECTS: Global

We remain quite cautious. The improvement observed in the symptoms are a result of the “liquidity flooding” measures taken since the 2nd half of 2008 – and not of a frontal attack on the fundamental causes that weakened the markets. Populist policies in the main economies continue to set the tone of governments. They all seek an exchange-rate depreciation as a way to improve their trade balances and boost their economies. Obviously, in a scenario like this, this brings us to a race towards the bottom.

Economics is far from being an exact science. The FED, still the great protagonist of the world economy, seeks a narrow path between the precipice of depression and the “dragon” of inflation. In difficult situations like this, the stronger aversion tends to prevail. “Helicopter” Ben was given this nickname because of his thesis in relation to Depression, where he concluded that the solution was to “print” money until the economic agents lost their fear and returned to economic activity. It makes sense, but the risk is obvious. A loose monetary policy brings inflation, with a few years’ lag. The most likely scenario at the moment is that of constant growth in the inflationary risk in the USA, borne by many people who focus on the American Government’s gains arising from the depreciation of its debt – largely fixed-rate, in Dollars. In a scenario like this, the majority lose. Or rather, feel in their pockets the costs of the party, the incompetence, hypocrisy, and irresponsibility of the past. Those with greater power to adjust prices and hold long-term fixed-rate liabilities gain – or suffer less. (…)

An interesting exercise is to try building a counter- case. What could go so right as to neutralize the clouds on the horizon? We imagine events that would radically alter our general perception:

1. Reduction in conflicts based on religious extremism.

2. Radical productivity gain in the healthcare sector – which every day consumes an ever greater part of societies’ resources – in line with what happened to the production of clothes and food.

3. A pick-up in the speed at which knowledge and education are disseminated. This is where we see the strongest driver and the one most often present, which has made itself keenly felt in the last two decades with the advances in telecommunications in general, and the Internet in particular.

4. Improved public governance systems. The predominant government models today seem to us clearly deficient and a much greater threat to the well-being of mankind than the famous global warming, for example (which, if true, reflects a flaw in public governance itself). A reduction in the general hypocrisy is the greatest target to be pursued and the event that would bring the greatest gains to mankind.

Unfortunately, for certain problems, the speed of progress seems to be lower than what is needed to avoid more acute crises, which are historical catalysts for many necessary changes.

Obviously, the short list above says much more about our lack of capacity than about the real probabilities of results. One of the determining factors for advances in History lies in the fact that some societies and civilizations sometimes change on account of a single individual. But, for each case like the US rally of the eighties and nineties, there is a USSR, just to mention the biggest and most recent examples. After all, “lost civilizations” is a very commonplace expression (about 494,000 quotations in Google in 0.28 seconds…).

“Let’s hope for the best but prepare for the worst…”

Last but not least, for those interested in an inside view of the crisis, in the value of an independent view and in yet another report on the general institutional blindness (to say the least), we strongly recommend the videos and articles written by Michael Lewis when publicizing his book “The Big Short” (which we also emphatically recommend). The links to the relevant videos and articles can be found on Buysiders.com.

FOOD FOR THOUGHT

The Italian political scientist Antonio Gramsci was, as is well known, a great thinker. Gramsci’s Marxist convictions do not invalidate many of his ideas and observations. One of his lucubrations is about the significance of the dominant power exercised through ideology and culture, where the values of the bourgeoisie become the “consensus”. Everyone then identifies with this consensus, helping to maintain the status quo. Although Gramsci was obviously referring to the class struggle between the proletariat and the bourgeoisie, one wonders whether this has not been replaced by (or at least is not comparable to) the present situation between the big shots of corporate America (including, of course, the big banks) and the “rest”, here including most investors? Or people in government versus those they govern, in general?

MISCELLANEOUS

“The problem with socialism is that eventually you run out of other people’s money.” – Margaret Thatcher

“Only the paranoid survive” – Andy Grove

“If you want to know where the next crisis will be, then look at where the leverage is being created today. And nowhere is there more leverage being created at the moment than on sovereign balance sheets. What is happening is an experiment never undertaken before.” – Martin Barnes

“The best way to think about investments is to be in a room with no one else and just think (…) What you are looking for is some way to get one good idea a year. (…) Wall Street makes it money on activity. You make your money on inactivity” – Warren Buffett

Seth Klarman

We highlight below a few quotes from the always interesting annual report by Seth Klarman about what lessons investors should have learnt from the 2008 crisis, with which we agree 100%:

• “Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return.”
• “Risk is not inherent in an investment…Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.”
• “Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.”
• “A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.”
• “Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.”
• “Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.”
• “To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.”

Back to Nielsen/ VNU: the controlling group is surveying the markets for an IPO valuing the company’s EV in the $17 to $21 billion range, compared to the $10 bi LBO in 2006. That said, the company is set to earn a respectful $1.6Bi in Ebitda in 2010 (in this case not that many fixed assets, but we’d still prefer to see the free cash flow figures). The debt is $8.6Bi and the annual interest is approx. $500 million, but at least some of the proceeds would likely go towards reducing this debt.

The company is a $10 billion enterprise that caters mainly to the life sciences (drug development) and industrial markets. Thermo is not dear to us for its state-of-the-art technology (albeit it does sport a couple of interesting high-end divisions in mass spectrometry and specialty diagnostics), nor for its powerful distribution channel drawn from the Fisher acquisition in 2006 – it’s for the combination of both strengths (the acquisition was largely misinterpreted by the markets at the time).

The article talks about the company’s definitive entry into the Brazilian market with sales force of its own and technical support staff, aiming at customers in mining, steel, oil & gas. This is an extension of Thermo’s global distribution network and a good opportunity for the company in high-growth emerging markets. The possibility of a future domestic manufacturing operation was also discussed. This could mean a great move on a country with such high import barriers for high-priced goods.

Links:

We’ve mentioned Thermo quite briefly here on Buysiders as it was one of the “picks and shovels” ways to play the increased healthcare spending trend.

The truth is that it’s way too early to assess the full effects, but analysts are already throwing around conclusions. When one thinks about it, most of the reform’s effects will happen after 2014, longer than most people’s investment horizons, which means most investors are either ignoring reform or using it as a means to speculate. Fixed income markets may be looking at greater future fiscal deficit, but haven’t acted on it yet.

IP’s position has always been to recognize our own ignorance and try not to depend on particular outcomes – without neglecting selective Healthcare exposure. We’ve chosen diversified companies over time, whose business is much more associated with a “picks and shovels” theme (such as Thermo-Fisher) or those in which there’s a strong consumer brand poised to benefit (such as Johnson & Johnson).

About the bill in general, politics can be a very volatile field – it’s a governance conundrum one could be happy to stay away from. The long debate on health reform ended with what seems to be a hard outlook for some health plan operators, but a broad tailwind for the general industry: plan coverage, by various means, should increase substantially going forward (estimated 32mm new enrollees over 10 years).

Large pharma companies are, at first, picking up the bill for the entire drug value chain (US$90 Bi fees over 10 years), which makes research equipment providers (upstream from pharma) as well as drug distributors (downstream) prone to benefit from increased coverage without a significant burden. Over time these fees should flow along the chain and, ultimately, to consumers.

There’s lots of interesting content in Amazon.com’s launch page for “No One Would Listen”, the book by Harry Markopolos – the main whistleblower in the Bernie Madoff saga. The timeline in particular is very impressive: it shows that all in all it took ten years to uncover the mess – nine since the first contact with the SEC – by which time the problem was irreversible. And that’s far from the only case, which begs a question…

Apart from the “I want/ need to believe”-type mental traps that individuals fall into, how do we justify still having institutions supposed to keep watch so unready and unwilling to investigate red flags? Lack of funding, qualified personnel, IT infrastructure… they all seem like weak arguments even put together.

We won’t go into the Taleb argument that one must be highly skeptical of “results”, and let’s not recall the Bob Rubin “focus on processes, not outcomes” (great) advice. Let’s just highlight two other books on fraud or lack of oversight – one caught, one still perhaps on the loose.

The most Madoff-like story is David Einhorn’s Fooling Some of The People All of The Time, about his years-long struggle with Allied Capital. Again, the pattern of ignored warnings is troubling, and while the story eventually played out to Mr. Einhorn’s thesis (see the 5-yr chart here), it wasn’t due to regulatory action – the credit crisis almost did the company in.

The other book is a quick read – Barry Minkow’s Cleaning Up – about ZZZZ Best, the company he founded and took public as one of the youngest persons ever to do that (remember that this is quite pre-dot.com days!). Nice story, if it wasn’t all a Ponzi scheme, and one that also took a while to uncover. Since this account is in first person and Mr. Minkow later helped the FBI uncover several corporate frauds, it’s pretty interesting lore. We’ve watched the guy live in the first Value Investing Congress and he’s a decent speaker as well.

UPDATE (March 19th, 2010): Nice and funny video interview with Mr. Markopolos on Jon Stewart’s Daily Show.

The numbers that matter: US$ 131Bi in equity, US$ 62Bi in float => ~ US$ 193Bi in “capital”. Book value grew 20%. Float grew 5.8% (from US$ 58.5 to US$ 62Bi). All insurance businesses operated with underwriting profit again. Cash = US$ 30Bi (US$8Bi used in Q1 to pay part of the BNSF deal). Operational assets = US$ 30Bi but generated only US$ 1.1Bi in net profits, which shows insurance/investments did the heavy lifting. The operating units will hopefully make up their fair share of contribution in a recovery.

Bottom line: investors are still paying about capital value at current prices. It has the best governance we ever saw. If they continue to grow float, have underwriting profits and make good investments, it’s a steal. Never mind the recovery.