Crowdfunding Mailbag

Without investors Crowdfunding will become a footnote in financial history.  The Crowdfunding industry continues to demonstrate that it just does not care about playing by the rules or giving investors a fair shake.

A few weeks ago, I wrote an article about Med-X, the first equity Crowdfunding campaign that the SEC stopped mid-offering. It was only the second time that the SEC’s Enforcement Division had gotten involved in a Crowdfunded offering and I thought it was worthy of an article.

Among other things, Med-X was raising money to research and sell products derived from cannabis. One of the larger cannabis websites re-printed the article and I got e-mails from a lot a people in the cannabis industry.

Several people suggested that the SEC’s action was part of a larger government effort to hold back the cannabis industry by denying it funding. They suggested that some Crowdfunding sites would not accept cannabis related offerings before the Med-X action. They thought that this enforcement action would have a chilling effect on their efforts to raise capital.

Frankly, I doubt this is the case. The SEC originally approved Med-X to sell its shares and there are a number of public companies in the cannabis industry. The SEC cares more about disclosure issues than it does about drug enforcement.

My article was also re-printed on a financial website. I got e-mails from several securities lawyers and people in the mainstream financial markets, many of whom, like myself, marvel  about the fact that the Crowdfunding industry offers securities to investors seemingly thinking that the body of law surrounding the sale of securities does not apply to it. The JOBS Act gives some relief from the registration provisions of the securities laws. The anti-fraud provisions of the securities laws still apply.

My real issue with the Med-X action was with the Crowdfunding portal that offered it, StartEngine. Med-X had failed to file financial information that it was required to file, meaning that investors were not getting information that they were required to get.  StartEngine is registered with FINRA as a Crowdfunding portal.  FINRA’s rules certainly impose a duty on its members to disclose all material information whenever they offer securities to the public.

I got an e-mail from the Compliance Director at StartEngine who told me that the SEC’s action against Med-X was about a missed filing date and the SEC did not mention the word “fraud” in its paperwork. Under the securities laws, fraud is defined as the omission of material facts. The failure to provide required financial information to investors fits that definition like a glove.

The Compliance Director told me that StartEngine was represented by competent counsel which I have no reason to doubt. Regulatory compliance in the securities industry is not something that they teach in law school. You are not likely to become well-versed in day to day compliance issues working for a law firm or regulator. You learn compliance the same way that a surgeon learns surgery; by doing it under the guidance of someone who knows what they are doing.

I was trained in compliance when I worked at two large brokerage firms. I offered to explain the problem that she apparently did not see to the Compliance Director or her counsel, without charge. I told her that I really hated to see someone step in it when this was such an easy problem to fix. She respectfully declined.

There are only about a dozen Crowdfunding portals that have registered with FINRA to conduct Regulation A+ offerings. I have corresponded or been on the telephone with the Compliance Directors of four of those portals. Three of the four had no experience with FINRA compliance.  The one who did have experience stood out like a rose in a garden of weeds.

One correspondent asked me why I brought up Elio Motors, another StartEngine offering in the article as well. Elio has become the poster child for the Regulation A+ offerings because it successfully raised about $17 million from investors. The marketing director from Elio recently spoke at one of the Crowdfunding conferences presumably to regale the attendees with Elio’s fundraising success.

I consider Elio Motors to be a nasty problem that will come back to bite the Crowdfunding industry on its butt. In my opinion Elio is a scam. I am not the only person who thinks so.

I base that opinion on the fact that Elio has been taking deposits and promising to deliver a vehicle to customers since at least 2014. Elio has no vehicles to deliver and is not actually building any. Taking deposits for and promising delivery of a product that you cannot hope to deliver is a deceptive business practice under state and federal laws.

In its Reg. A+ filing Elio disclosed that it was trying to get a loan from the Department of Energy to fund production. To qualify for the loan, Elio would have had to demonstrate that it had a strong balance sheet and that it could reasonably be expected to repay the loan.  Elio is insolvent.

Elio has taken deposits from approximately 65,000 people. I would not bet that these customers will receive delivery of their vehicle in 2017, if ever.

Rather, I would bet that a regulatory action (or a bankruptcy, or both) is going to occur in 2017.  Elio has raised a lot of money from the Reg. A+ offering and the deposits but does not seem have a lot of the cash on hand.  It still needs between $200-$500 million more to deliver on its promises.

Is it possible that a VC fund will make a substantial investment in Elio and bail them out? Yes, but I do not see it. Elio still has not demonstrated that even if developed its vehicle will be street legal.

To me Elio does not pass the smell test. I cannot imagine how a competent due diligence officer gave Elio’s offering a green light.

Another e-mail came from a person who suggested I should not be concerned with Med-X’ failure to make proper disclosures because “everybody” knows that most Crowdfunded businesses will fail and that investors treat Crowdfunding as if they were gambling in Las Vegas.  While I acknowledge that most Crowdfunded businesses will fail, the odds in Las Vegas are actually substantially better that the player will walk away with some of his money.

That person also told me that I do not appreciate that Crowdfunding is intended to “disrupt” the way in which capital is raised. I do appreciate that Crowdfunding is intended to allow companies that would not have access to that market to raise money from investors. I also appreciate that there is a correct, legal way accomplish this.

At the end of the day owning a Crowdfunding portal can be a lucrative business.  All I ever suggested was that every portal needs to play by the rules and offer good investments to investors.

In just one year the SEC has acted twice against issuers who broke those rules. In both cases the issuers were enabled by the Crowdfunding industry “professionals” who were not acting professionally.  If there is any take-away from this article it should be that I offered to set the Compliance Director at StartEngine on a straight path, without charge, and she declined.

There is a lot of promise in Crowdfunding that may be eclipsed by inappropriate behavior. Unless investors are willing to invest, and invest again because it worked for them, Crowdfunding will not fulfill this promise.

The SEC’s Enforcement Division is clearly looking for scam artists who are raising funds in the Crowdfunding market and for legitimate companies that fail to follow often complex rules.  It will keep finding them until the Crowdfunding industry gets serious about its business and makes an effort to protect the investors it cannot survive without.





Any Investor Can Beat an Index

People invest money to make money. That may not seem like a profound statement but a lot of investors think that it is a lot harder than it is and there is an ongoing debate that suggests that most professional investment advisors are not worth what they charge. Personally, I do not buy it.  I would not think of investing any significant sum without a competent advisor.

I know that most large institutional investors still use fundamental analysis and good old fashioned research to select investments.  CALPers, the nation’s largest public employee pension plan has several hundred research analysts on its staff.

The best research analysts are specialists who cover a single industry and have much more than a cursory understanding of the companies that they cover.  It is not unusual to find research analysts with degrees in electrical engineering covering tech companies or doctors who went from medical research to covering drug companies.

When I started on Wall Street the firms would release research reports to their institutional clients first and retail clients a day or two later.  With the advent of discount brokerage firms and DIY investors, a lot of the research available to individual investors has been watered down and is not very insightful.

I am not suggesting that every research analyst is great and there are a great many conflicts that color the reports that some analysts publish. What I am suggesting is that if you cannot read a research report and you do not read several before you make any investment decision, you are shortchanging yourself.

No one has to invest. Leaving your money in the bank where it will currently get you about 1% in interest is better than investing it in the market and losing 10% or more. This is especially true if you have only a minimal amount saved up.  Protect what you have before you start taking market risks.

A lot of people believe that they can just buy an index mutual fund or index ETF, hold it for the long term and everything will be fine.  The “common knowledge” is that the markets will likely be higher years down the road and that an index fund captures a large diversified basket of companies. Neither is necessarily true.

The markets today are higher than they have ever been. No one can tell where they will be next week, next year and certainly not a decade or two from now when you may need your money.  Whether your portfolio will be worth more or less than it is today when you retire is something that is best worked out with a financial planner.

Most financial planners will caution you about effects of inflation. Even if your portfolio is worth 20 years from now, its buying power may be less.

The idea that an index is diversified is also flawed. An index like the S&P 500 has stocks of the 500 largest companies.  The Dow Jones Industrial Average specifically excludes transportation companies and utilities.

To be diversified a portfolio needs to hold stocks that have a negative correlation to each other.  If you buy a large cap index, a mid cap index, a small cap index and a foreign index with the idea that they are diversified from each other, you are incorrect. Each is likely to hold airlines, telecommunications companies and financial institutions. That is not diversification.

Assuming that you could analyze all 500 stocks in the S&P 500, rank them to identify those which have the best value and create a portfolio of the top 150, you would probably beat the overall S&P 500 index every year.  If you identify the best and eliminate the clunkers, beating the entire index should not be difficult.

By best value, I would suggest that you include those companies whose shares are trading at the low end of their traditional P/E range.  Many market professionals look at the price/earnings ratio of individual stocks that they own and the market in general.  Price/earnings ratios move within a fairly standard range and when they get to the high end of the range they usually pull back and revert to the norm.  Both the current price and the outlook for near and medium term earnings for publically traded companies are readily available.

If you are a DIY investor and it is too much work for you to analyze 500 stocks or you do not need a portfolio with 150 stocks in it, there are easier ways to beat an index. One of the simplest is a strategy called “Dogs of the Dow.”

The Dow Jones Industrial Average is made up of 30 mature, blue chip companies. The earnings of the companies will vary depending on where in their particular business cycle the companies are and their stock price will fluctuate with the earnings. Most, however, have a fairly stable dividend payout policy.

The theory suggests that when a company is at the low end of its cycle and its stock price is low; its dividend yield will be high.  As the company bounces back, its stock price will rise and its dividend yield will return to its mid–range.

To execute the strategy you would purchase equal amounts of the 8 or 10 highest yielding Dow stocks, hold them for one year, sell them and repeat.  The strategy hopes to allow investors to capture both a high dividend and good price appreciation every year.

Understand that this is not asset allocation. Asset allocation is a method of balancing a portfolio with multiple market sectors hoping that the good ones will outweigh the bad.

Dogs of the Dow is a specific stock selection strategy.  You are attempting to select stocks that will appreciate in price faster than the other stocks in the Dow Jones Index.  A fair number of people use this strategy because it is very easy and because it works most of the time.

If you research Dogs of the Dow, you are likely to come across the Hennessey Funds.  The Hennessy Total Return Fund (HDOGX) invests 75% of its assets in the ten highest dividend-yielding Dow Jones Industrial Average stocks (known as the “Dogs of the Dow”) and 25% in U.S. Treasury securities.

Neil Hennessey was the person who first introduced me to this strategy somewhere around 1985.  He was working with it successfully back then and still does.

This strategy is not hard to master.  It shows that you do not have to be a rocket scientist to be a successful investor and in most years you will beat the index.