How Can You Profit from the Next Rogue Trader?

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Every once in a while you hear about some rogue trader who ran up billions in losses at major financial institutions. Just over the past three years, it happened to Société Général ($4.2 billion) and to JPMorgan Chase ($2 billion). Although these massive losses could potentially run a financial institution to the ground, luckily for Société Général and JPMorgan Chase both are still alive and kicking. In the aftermath, when you investigate what caused these losses, you normally receive the standard type of response: it was a combination of bad judgment, sloppiness, and a lack of proper mechanisms to monitor and review risk and compliance.

Since our financial world is only becoming more complex and less transparent, I believe that such events will become more frequent. There are some noteworthy companies whose core business is to prevent (or diminish) such "black swan" losses from occurring.

The business of risk monitoring 

Nice Systems (NASDAQ: NICE) is the dominant provider of actionable Intelligence solutions and value-added services worldwide. The purpose of these solutions is to capture, distill, and analyze currents and trends in a financial business. In practice, Nice makes programs that, once installed, will provide live alerts regarding any breach of predetermined risk levels. This will assist the compliance department of the organization to monitor and handle failing situations before they turn into billion dollar losses. In this market for compliance software, Nice directly competes with Verint Systems (NASDAQ: VRNT) and with Comverse Technology (NASDAQ: CNSI).

All that cash... 

Nice doesn't have an efficient capital structure. Management knows it, investors know it, and analysts know it. The company currently has over $500 million in idle cash on its balance sheet earning zero percent interest. The company's income from operating activities stands at $140 million--that's more than sufficient to cover the annual $40 million dividend distribution and an $80 million share repurchase program. Ironically, the company neither uses that cash to acquire other companies (its last noteworthy acquisition was Actimize back in 2007) nor to increase the annual dividend ($0.64 annually). I believe that the company can easily triple the dividend yield, which currently stands at 2%, without eroding its powder for future acquisitions. After five long years of piling cash, Investors have grown tired of the company's cash management, and have stopped giving it a typical growth multiple. That's why Nice is trading at a P/E of only 12x--that's much cheaper than other companies in this high growth segment. Verint and Comverse, for example, trade at P/Es of 65x and 23x, respectively. 

Lack of transparency

Nice suffers from transparency issues. First, management insists that double digit growth is underway. The problem is that that's what they've been saying for the past three years. Needless to say, each year revenues grew in the single digits. That's why investors are now wary of promises. 

Another issue having to do with transparency is the much-discussed, yet never confirmed, merger with its fierce rival Verint Systems. Since the beginning of this year, rumors broke out that these two Israeli companies are on the verge of announcing a merger. Take a look at the chart below.

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Note the spike in share price of both companies right at the beginning of January. Rumors of a merger between the two companies have bubbled in the market for over two years. Both Nice and Verint develop and produce compliance software. But interestingly, neither company will confirm nor refute these rumors. Therefore, the "merger premium" still exists, as you can see above. In addition, the merger rumor recently gained credibility after Verint scored a merger deal with its parent company, Comverse. The merger will cancel out the controlling interest in Verint by Comverse shareholders and make Verint an independent company with full public control.

The fool looks ahead

I believe that the sector for compliance software will grow in the next few years, as financial institutions become more complex, and the act of detecting risks becomes trickier. Nice will have to either increase its dividend payout substantially or find new acquisition targets. If Verint happens to be the target, well that's even better. As long as the next rogue trader is detected, and stopped, on time. 

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Shmulik Karpf has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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