The Future of Investment Advice

In order to understand the future of investment advice I think it is essential to understand how the industry has developed to where it is today.

When I started in the financial services industry back in the 1970’s retail customers got advice about what to buy and sell from their stockbrokers.  At the larger brokerage firms that usually meant that your broker would call you and tell that they or the firm’s research department had identified a stock that was a “buying opportunity”. This was often accompanied by a recommendation of what you should sell to pay for your new purchase so your broker would make not one, but two commissions from the recommendation.

When the stock market suddenly crashed in 1987 a lot of customers asked their stock broker why the broker had not seen the crash coming. The brokers really had no good answer. The crash took a lot of money out of the market and caused a lot of customers to lose faith in their broker’s ability to select investments for them.

Partially to placate those customers with something new and partially to make more money the industry introduced wrap accounts. A wrap account places the customer’s account into the hands of a professional money manager for an annual fee which is shared with the introducing stockbroker.

Wrap accounts introduced the idea that the individual brokers would be compensated on the customer assets under management (AUM) rather than the commissions that their accounts generated. This let the brokers do what they do best (sell) and let the professional money managers manage the accounts.

It also created a conflict of interest. Managers kept investors fully invested because that is what they had been hired to do. If the managers started to accumulate large cash positions in customers’ accounts, the customers might withdraw the cash. That would be counter-productive to the brokers who were being paid to bring in more and more new assets.

By the mid-1990s the market had recovered nicely and people started asking how long the boom would last.  At the end of 1996 Fed Chairman Alan Greenspan attributed the sharp run up in stock prices to “irrational exuberance”.  Neither the brokers nor the money managers advised the customers to sell when they had large profits and maintain a cash position

Much of the run-up in the 1990s was attributed to new tech companies that not everyone understood. Consequently, the firms hired highly qualified research analysts to parse through the various issues and recommend what they considered to be the best.

At the same time, the brokerage firms were making a lot of money by underwriting new issues of these tech stocks. In many cases the research analysts were working to support the efforts of the firms’ investment bankers. They only wrote reports describing why their firm’s banking client’s offerings were a “buying opportunity”.

That also created conflicts of interest.  When the market finally crashed it was revealed that some analysts had never suggested that the price of any of the stocks they covered would not go higher. Some analysts never recommended a “sell” on any stock they followed even when fundamental analysis told them that they should be selling.

Again, when the market crashed in 2001 a lot of people asked their broker why they did not see the crash coming or take some defensive action to protect their profits.  And again, the brokers did not have a good answer other than “no one can really predict the market” which, of course, is exactly the skill that the stockbrokers and money managers had been espousing to customers all along.

The brokers themselves got more than a little frustrated with the large wire houses and many jumped ship. Sometook their clients and set up shop as independent investment advisors.

The accounts were still housed at a brokerage firm that got paid a commission on each trade but the advisors now kept all of the annual account management fees. This was a better deal for the advisor even if they now needed to pay their own rent and overhead. The idea that no one can really predict the market suited these independent advisors well because they were more interested in acquiring new customers and assets than picking good investments.

That led to a concept that as long as a portfolio was diversified it really did not matter which stocks were in it. By diversifying the stock portion of the portfolio into different asset classes the advisors were trying to avoid what had happened in the tech wreck. The theory was that if you bought stocks in different asset classes, the collapse of one sector, like tech, would not hurt you too badly.

This did not help investors when the market crashed in 2008. This crash was caused by a bubble in real estate and foolish lending in the financial sector. Most companies are affected by what occurs with banks and real estate as both effect business and consumer spending. Diversification only mitigates certain risks. This crash involved a systemic risk, not an asset sector risk, a fact that many brokers never understood.

It should not surprise anyone that investors again asked their advisors why they did not get them out of the market before it crashed.  Again the response was “no one can predict the market”.

Since 2008 the advisor industry has seen the rise of robo-advisors.  These are popular with millennial investors who do not trust the Wall Street professionals after 2008.  Robo-advisors select portfolios based upon algorithms. This makes as much sense as throwing darts at a list of stocks and bonds even if you are a champion dart thrower.

Robo-advisors are not even attempting to predict the market and they are not programmed to ever sell the portfolio if the market starts to crash, which we all know, it will. They are just selling diversification at a lower price. They achieve “diversification” by buying mutual funds or ETFs. These contain so many stocks that mathematically, there is no actual diversification.

Robo-advisors advertise that people pay too much for investment advice. I would argue that most customers pay too little.  My current advisor spends countless hours poring over financial statements and research reports to pick individual stocks.  He gets the same 1% of AUM as advisors who put all of their clients into pre-selected diversified portfolios of various funds and ETFs without really knowing a lot about them or how they might be expected to perform. With investment advice, like everything else in life, the rule should be that you get what you pay for.

What I think may be an intelligent alternative going forward is for people to just put their investment advisor on a fixed monthly or yearly retainer.  It would cost more for a larger portfolio than a smaller one because all portfolios need to be constantly monitored and larger portfolios require more time. Advisors would keep their customers and get referrals by keeping their customers happy.

And what makes customers happy?  They want to have more money in their accounts at the end of the year than they had at the beginning of the year. That is true even if the market crashes because there is nothing more foolish than staying in the market when the market is going down.

The customers will never truly be happy and get the results they truly want until advisors thoroughly analyze and review the stocks they recommend and purchase and hold only those that they believe are likely to appreciate. They will never get there if advisors refuse to take profits and move to cash when the market indicates that they should. They will never get there if advisors diversify to mitigate some risks, but not all.

People actually do predict the future performance of individual stocks and the market in general. I doubt that you would be surprised if I told you that the ones who do it well get paid a lot of money by investment banks, mutual funds and large institutions.

The advisor industry needs to understand that parroting the phrase “no one can predict the market” every time the market corrects is the fastest way to be demonstrate that you do not know what you are doing. Providing beneficial investment advice takes time and effort. Advisors are entitled to be paid for their efforts. But first they have to actually do the work and that work is accurately predicting the future price of individual securities and the market in general.

 

 

Any Good Business Can Get Funded

I am always amazed when I get negative feedback to the premise that any good business can get funded. This is especially true when people tell me that businesses owned by women or minorities cannot get funded or that businesses locate outside of New York, Silicon Valley or some other money center have limited access to capital.

Frankly I think that a failure to get funding demonstrates ineptitude on the part of the entrepreneur. Inexperience is a greater impediment to attracting capital investment than gender, race or location.

When I was younger a business had two choices for funding, banks or Wall Street.  Wall Street would not take a company public until it was profitable. Companies often used an IPO to pay down debt and improve cash flow to pay dividends to the shareholders. If you wanted to get funded on Wall Street, it helped if you went to Princeton or Yale or your father did. It was very much a “who you know” network.

Banks provided the bulk of the capital that was available for small business. They still do. They do not care who you are as much as they want to know that you will pay them back.

When I graduated law school in the 1970s women could not get credit cards and minorities could not get even a loan application at any bank. So you cannot tell me that it is more difficult for women and minorities to get funded today.

The US Small Business Administration (SBA) has programs which will guarantee bank loans for about 20,000 small businesses every year.  I speak with entrepreneurs seeking capital all the time. I always ask if they have tried the SBA.  Most of the people I speak with never heard of the SBA or never considered it.  If you are looking for funding for your business, that is mistake number one.

Even if you do not qualify for a bank loan the cost of capital should be your primary concern. Shopping for a loan will give you an idea of how much money costs and how loan payments would impact your cash flow.  If, for example, you intend to borrow $1 million at 6% for 10 years, then the loan will cost you $600,000 and you will need to take $1.6 million out of cash flow to pay it back.

Many people think that venture capitalists will fund their business. That is simply not true. There are actually very few VC funds and they fund very few businesses every year. Some VCs specialize, i.e. they only fund biotech companies. That is great if you are a biotech company and know where to find those VCs with the expertise to evaluate your company. Randomly chasing after VC funds is a waste of time.

The serious money in venture capital is controlled by people who do a lot of analysis and extensive due diligence. Consequently, they like to invest in somewhat larger slices of $10 million or more. If they get 10% of your equity for that amount you are going to have to sell a lot of your product to bring the real value of your company up to the point where they will make a sizeable profit.  Consequently, not many companies will qualify.

The start-up world and especially Silicon Valley are full of stories about start-ups that become unicorns that exceed a $1 billion valuation but they are few and far between. If you are going to swing for the fences, fine. But for most companies this is not an option.

What makes the statement “any good business can get funded” true is the JOBS Act or what most people call equity crowdfunding.  It affords any company the opportunity to sell debt or equity securities directly to investors.

The JOBS Act opened the door for smaller companies to reach investors.  For most companies Reg. D is best because it is the least expensive and it has the largest developed market. Over $1.7 trillion is raised by businesses using Reg. D every year. If you want to raise money for your business, logic would tell you to go where the money is.

The best thing about equity crowdfunding is that the business owner controls the process. You hire an attorney to prepare the legal paperwork for you, prepare the marketing materials, list it on one of many crowdfunding websites and use your marketing program to attract investors.  You do not have to wait for the loan committee at a bank or for a broker/dealer to put you on their calendar. You can usually start raising money in 4-6 weeks from when you start the process.

Despite what you may have heard about crowdfunding campaigns that are not successful, it is really not that difficult if you hire people who know what they are doing.  Business owners call me about crowdfunding all the time. I always ask them the same four questions.

Questions 1 and 2. How much money do you want to raise and what do you intend to do with that money?  If your answer to the second question is that you intend to “disrupt” this industry or that industry, you better be able to demonstrate that you know a lot about that industry and especially about your competitors.

What investors really want to know is that you have a good business plan and that you are raising enough money to execute it.  It is always better to stick with what you know and hire people who know what you do not.  You should be able to show that you are not just building a better mousetrap but that you are building a good, profitable business.

Question 3. What is in it for the investor?  Investors are often disrespected in the crowdfunding universe. This is partially because the crowdfunding platforms compete for issuers and partly because many crowdfunding platforms are operated by people who do not understand what investors want.  In truth all investors want the same thing; they want to end up with more money than they originally invested.

People who are willing to invest in a start-up understand that most start-ups will fail.  It is important to distinguish yourself and convince investors that your company has a better chance to succeed because you have mitigated some of the risk.

Over the years, I have used a variety of financing tools including preferred shares and revenue sharing models to help start-ups manage their cash flow and still make the investment attractive to investors.  No two companies are the same. If you are thinking that you can just download a template for your offering without some real advice about how to structure it, you are not likely to be successful.

Question 4. What is your fundraising budget?  This is what really separates successful fundraising programs from unsuccessful ones.  You should always be prepared to spend a little more than you think you may need.

What is an adequate budget?  Enough to prepare the legal paperwork, marketing materials and to drive enough potential investors to your offering to get it funded. For a Reg. D offering, few companies spend as much a $50,000 unless they are raising $10 million or more.

One of the common mistakes people make is selecting the wrong crowdfunding platform.  Several advertise that they have had 10,000 investors or more but most crowdfunding investors are not loyal to a particular platform. Only a very few platforms are right for any particular offering. You need to make a decision about which platform to use based upon a number of factors including the size of your offering, the industry that you are in and how your offering is structured.

Under the JOBS Act you can make a Reg. D offering on your own website if you wish.  Given the fact that you will be paying for the marketing costs, it may make sense to be on your own platform where there will be no competition from other offerings.

I speak with about a dozen companies every month and I only take on one or two because I do not want to work full time. If I take you on I will walk you through the process and usually get you funded. That goes for companies owned by women and minorities and those located in Toledo or Tallahassee.

Using the JOBS Act any good business can get funded. If you are going to run a business, then you have to get things done and not make excuses. That goes for financing your business as well.

If you cannot fund your business with equity crowdfunding then it is on you not the market. It is actually a lot easier, faster and more certain than chasing venture capital.