Year: 2016

FINRA Reports on Robo-Advisors

Investors ,

A year ago FINRA and the SEC issued a joint investor alert regarding robo-investment advisors and other automated tools that offer advice to investors. The alert clearly suggested that investors should be wary because an automated tool may rely on incorrect economic assumptions.

That warning has dissuaded just about no one. Robo-advisors are a fad that is growing exponentially.  Mainstream brokerage firms have acquired existing robo-advisor firms and launched their own robo-platforms.

I have written several articles where I explained why robo-advisors cannot work. In addition to the fact that they may rely on incorrect assumptions, they are also not connected to the real world in any way.  While most investors are concerned with slowing growth in China, the changing price of oil and the continuing rise in interest rates, robo-advisors concern themselves with none of these.  Robo-advisors do not look at what is happening in the broad economy or what is likely to happen.

FINRA has just published a new report on digital investment advice that demonstrates just how poorly robo-advisors perform.  The report asks a great many important questions about the use of robo-investment advisors but answers none.

You can view the report here.  https://www.finra.org/sites/default/files/digital-investment-advice-report.pdf .

The report defines the investing process in six steps; customer profiling, asset allocation, portfolio selection, trade execution, portfolio re-balancing, tax-loss harvesting and portfolio analysis. I don’t quibble with these steps, however, it is how the robo-advisors execute them that is the problem.

The report notes that there is a wide disparity between the platforms regarding the amount of information that they acquire about a prospective customer.  I wasn’t actually troubled by this. The brokerage industry knows how to open an account and obtain enough information to ascertain a customer’s investment objectives and risk tolerance.  It is a task that the industry performs every day.

Where the report was most enlightening was in its side by side comparison of the portfolios that seven robo-advisors would have constructed for a hypothetical 27 year old who was investing for retirement. The disparities are enormous. The amount of equities purchased ranged from 51% to 90%; the amount of foreign issues from 22% to 48%. One portfolio contained 5% in gold and precious metals; another 14% in commodities. The rest had no investments in either category.

Presumably these allocations would not change over the next 40 years as the customer added to the account every year. The FINRA report defines re-balancing as maintaining the target allocation.  I would assume that risk tolerance declines with age, but the FINRA report makes no mention of how that money would be invested in the future.  Even if the allocations were static, the end result would vary greatly platform to platform.

So what, you say? The end result of a 40-year investment portfolio is going to vary greatly if you compare the portfolios prepared by live advisors as well.  True, but the difference is that live advisors are looking at the real world and absorbing real information.  The algorithm that is at the core of a robo-advisor, once set, may never be modified and never looks at real world events.

I have read a lot of articles about robo-advisors.  Few actually try to evaluate the algorithms of one versus another. The FINRA report suggests that member firms need to effectively govern and supervise the algorithms that they use. An algorithm is a mathematical formula. Exactly how does the investment committee at a brokerage firm supervise it?

The FINRA report gives passing acknowledgement that many of the robo-advisors are based in Modern Portfolio Theory (MPT) and gives a shout-out to Prof. Harry Markowitz who first proposed it and later won the Nobel Prize.  I went back and re-read Prof. Markowitz’ article that was published in 1952.  The math was over my head.

Markowitz was a theoretical mathematician who applied his theory to economics, specifically to investment portfolio construction. He theorized that investors would want to maximize their investment returns while at the same time minimizing their risks.

He accomplishes this by theorizing that a diverse portfolio of non-correlated assets will perform better than a portfolio of concentrated assets.  He creates a series of mathematical formulas (algorithms) to show that it is possible.

As a practical matter it is the idea that the various assets in the portfolio are not correlated to each other that is at the core. As oil prices come down for example, we know that it has a negative effect on the profit of oil companies but a positive effect on the profits of airlines and trucking companies. Higher interest rates are good for banks, but not so good for home builders.

Now go back and look at the categories of equities that make up the robo-advisor portfolios; large, mid sized and small cap domestic securities, developing and emerging foreign markets.  How are these non-correlated?  Haven’t builders, large and small in all countries been helped by low interest rates? Aren’t airlines of all sizes in all countries going to be negatively affected if oil prices shoot back up?

MPT necessarily looks at the effect that interest rates and commodity prices have on portfolio securities. I realize that those 5 categories of equities, large, medium and small cap, developed and emerging markets have become standard in some quarters but in a global economy they are less and less non-correlated.  That correlation is even higher if you use baskets of securities (ETFs) because some number of the securities in every basket will be affected by changes in macro market conditions.

Markowitz’ formulas are based upon what he believed investors should want; good returns with less risk. The “efficient frontier” that evolved from his equations is a point on a graph, not a place on a map.  It is a hypothetical goal.

The algorithms that support the robo-advisors are the same, hypothetical. They do not look at the real world, nor are they concerned with it.  They just tell you, if you do X, Y should happen.  That might be true is the world were stagnant, but it isn’t.

One difference between Markowitz and the new generation of algorithm writers is that Markowitz published his equations in a peer reviewed journal. The robo-advisors will never let anyone see what is behind the curtain.

The fact that FINRA can demonstrate the wide disparity between the portfolios that various algorithms would create makes shopping for a robo-advisor all the more necessary while at the same time demonstrating that it is an impossible task.

If you hire a human investment advisor you can sit down and talk to them first. You can ask them what they know and what they think. You can ask them about the markets and about the future. Chances are because they deal with a lot of people they have heard the same questions before and have had an opportunity to consider their answers.

Robo-advisors are a fad. They are popular because they are cheaper. They are sold by disparaging human investment advisors who some people think cannot do any better than average. That begs the question that I have asked before: why would anyone want to hire an average investment advisor?

 

 

Raining on Crowdfundings’ Parade

Capital Markets, Issuers , ,

If you follow my blog, you know that I am very much in favor of the crowdfunding market place developing and succeeding. However, I need to throw a bucket of cold water over the exuberance that the industry exhibits. I want to inject some much needed reality and perspective into the discussion.  I want to ask some of the hard questions that people do not seem willing to ask. I want to de-bunk some of the major claims that form the foundation of the crowdfunding industry and to set the record straight.

There has been an enormous amount of hype around equity crowdfunding. In mid-May, the last of the JOBS Act sections will take full effect allowing a registration process for equity offering up to $50 million. This section allows mom and pop investors to invest in start-ups and smaller companies, albeit for only a limited amount of money.

Up until now equity crowdfunding (buying shares of stock in small companies and start-ups on crowdfunding websites) has been limited primarily to wealthier, accredited investors.  The equity investments that are being offered on crowdfunding platforms are among the most risky investments available.  Should small investors actually be encouraged to take these risks with their hard-earned money?

The crowdfunding industry expects that these small investors will fund a multitude of new companies and that this new source of capital will greatly boost the industry’s income. It is the income that the industry will earn, not the profits that investors will make that drives the hype.

It is not difficult for a crowdfunding platform to generate a seven-figure annual income for its owners.  Crowdfunding platforms can actually net more profit per dollar raised than a traditional investment bank because they perform a fraction of the work and provide few of the valuable services that a company needs to make a successful offering.

The crowdfunding industry is remarkably cavalier about investors’ money. Nothing about equity crowdfunding respects investors or cares whether investors get a fair shake, let alone a legitimate opportunity to make a profit for the substantial risk that they are taking.  The crowdfunding industry is focused on itself and upon companies that want to raise money. The investors are an afterthought.

What, exactly, does a crowdfunding platform do to help a company seeking funds to succeed? Before the offering not much; after the offering, even less.

Every investor in every market has the same goal; they invest their money to make money. In crowdfunding that has not happened and there is nothing on the horizon that suggests that it will happen.  This is not just about the lack of liquidity for crowdfunded offerings; it is about the fact that most crowdfunded businesses fail.

So let me start with the simple declarative sentence that should counterbalance much of the hype: if you invest in shares of a start-up on a crowdfunding website, it is very, very doubtful that you will ever see your money again.

According to the SEC, the common refrain is that 9 out of 10 start-ups fail, but an equally interesting statistic from one post-mortem analysis is that 70 percent of failed start-ups die within 20 months after their last financing and have raised an average of $11 million.  In other words, not only are these investments highly risky, they also fail quickly.

That statistic is for the larger start-ups funded by institutions and professional venture capital funds.  Smaller start-ups funded on crowdfunding sites cannot expect to do better and most likely will do worse. These are companies that frequently cannot attract venture capital, which is why they come to ordinary investors on crowdfunding websites in the first place.

Unless something is done about this enormous failure rate, equity crowdfunding is not a sustainable model. While this is just my opinion, it is supported by basic math and economics.

If Wall Street brings an IPO to market raising $50 million, the company issuing its shares gets the money that it can use to create new products and new jobs.  Almost immediately, the investors can sell the stock for more or less and re-invest the same money into another IPO.

The same $50 million might fund a handful of smaller businesses on crowdfunding platforms but the great bulk of those funds cannot be recycled into new businesses because the investment are illiquid and most initial businesses will fail.  It is not even fair to say that the crowdfunded offerings create new jobs when the companies and the jobs are usually gone within 2 years.

Assuming that equity crowdfunding grows to where it can raise $500 billion in a given year, the bulk of that money will be lost so another $500 billion in new money will need to enter the market the next year for new companies to get funded.  For how many years is that likely to occur?

This model is unsustainable if for no other reason than investors will not keep going into their pockets again and again if they only lose.  Long term, equity crowdfunding can only be successful if the businesses that it is funding succeed. Right now very few people in the crowdfunding industry are focused on that fact.

The vast majority of the key players and “experts” in the crowdfunding arena have little or no experience in the mainstream financial markets.  Most have no history of dealing with investors even though investors supply the capital upon which the entire crowdfunding market depends.

One of the common excuses that the crowdfunding industry makes is that the current problems are the result of “growing pains” because the industry is still in its infancy. Many people in the crowdfunding industry believe that crowdfunding began with the JOBS Act (2012) and is governed solely by it. Actually, equity crowdfunding has been around for more than 20 years, more than enough time to get its act together.

The first direct to the public stock offering (DPO) done via the internet is generally credited to the Spring Street Brewing Company which successfully raised about $1.5 million in 1995. It was ground breaking at the time, because no underwriter (Wall Street firm and those pesky salespeople) was involved in selling the stock.  No video accompanied the offering as I do not believe that the internet supported video in those days.

The offering was done under the watchful eye of a forward thinking SEC.  Many of the crowdfunding “experts” that you might hire today are not aware of this offering or the serious discussions about DPOs that were engaged in by many regulators and market professionals at the time.  Tell an expert that offerings can be done without a video and they will look at you as if you said the Chicago Cubs just won the World Series.

By 2000, the SEC had already brought a hand full of enforcement actions against other firms that had sold stock via the internet because investors were being defrauded. Wall Street was not interested in DPOs then or now. Scam artists jumped right in. Those scams are the likely reason that the anti-fraud provisions of the federal securities laws are specifically incorporated into every JOBS Act offering.

When an “expert” tells you that the paperwork for a JOBS Act offering is less cumbersome than a regular public offering; they should also tell you that companies still need to disclose all of the material facts to potential investors, no matter what the forms suggest or how cumbersome the disclosures might be.  They should also tell you that the video that accompanies the offering must be in compliance as well.

Every equity offering made on a crowdfunding platform should have the disclosure THIS IS A SPECULATIVE INVESTMENT. INVESTORS CAN EXPECT TO LOSE ALL OF THE MONEY THAT THEY INVEST, in bold, on the first page.  It is the same type of disclosure that is routinely made to accredited investors in the REG. D, private placement market.

The SEC has already brought its first enforcement action against a company funded under the JOBS Act, Ascenergy.  The SEC went out of its way to spell out that the company’s website was a part of the offering. That certainly would apply to any video that accompanied any equity offering.  Most of the people selling videos to the crowdfunding industry are unaware of the Ascenergy case and do not appreciate that the videos they create to support a crowdfunded equity offering need to comply with the law.  That applies to social media campaigns and “tweets” as well.

Many people seem to believe that investors (the crowd) are expected to investigate the offerings themselves. It was never realistic to believe that investors could evaluate a new issue. That is what many people wanted but it is not what the JOBS Act and the SEC regulations delivered.

The JOBS Act places a great deal of the fraud avoidance responsibilities on the crowdfunding platforms. The Ascenergy case called out 4 crowdfunding platforms by name. You would certainly think that these firms have a target on their backs not to repeat their deficient performance.

There is a remarkable absence of trained compliance personnel at the crowdfunding platforms. I spoke with 2 lawyers at one of the larger Crowdfunding platforms a few weeks ago. They were certainly bright attorneys. They had previously worked at law firms and at regulators and had no specific training in investment banking.  There is a big difference between understanding federal securities law and evaluating specific transactions, marketing materials and accompanying social media campaigns for compliance.

I have a particular issue with securities attorneys who are spreading the crowdfunding hype.  Some actually recommend specific platforms and specific offerings. Putting your law firms’ reputation behind a securities offering was always considered a problem.  If you do not believe me, you might want to check with your professional liability carrier.

There are several securities attorneys who are selling technology-based services to the crowdfunding industry.  I started out as a young lawyer with a secretary who took my dictation in shorthand, so nobody has to sell me on the idea that technology can help reduce the costs of practicing law.

The cost of preparing a securities offering or running a crowdfunding platform is important, but should never be the driving issue. Qualified and experienced securities lawyers are still essential to the process of selling equity. Offering securities to public investors incorrectly can be very, very expensive to all concerned.

A few of the crowdfunding platforms carefully vet each offering before they list them.  These platforms reject more offerings than they accept which has to cost them a lot of money.  It is against these platforms that the rest of the industry will be ultimately judged by investors, regulators and class action juries.

Small businesses were funded before crowdfunding. Many entrepreneurs saved up or worked two jobs to get their nest egg to open the business of their dreams.  Others tapped family and friends for seed capital. The Small Business Administration has funded millions of businesses and continues to do so.  Angel investor funds are often made up of groups of smaller investors and are more prolific than ever before.

A good business could often find capital if the entrepreneur tried hard enough and surrounded himself with the right advisors. Better mousetraps get funded and will continue to get funded with or without crowdfunding.  There is nothing “essential” about this new industry.

I spend a lot of my time reviewing pitch books and speaking with founders of companies who are seeking investors. A great many start-ups are not worthy of funding. A great business idea is not the same as a great business.  A great many people with good ideas do not understand what it takes to run a successful business.

Most small equity crowdfunding campaigns fail to raise the minimum amount of capital that they seek.  This inefficiency also suggests that equity crowdfunding is not a sustainable model. In part it is because the owners read a book or two or listen to crowdfunding experts who have no actual expertise. It is also because many entrepreneurs do not want to spend what it takes to do it right.

Traditional underwriters raise the amount of money that they set out to raise virtually every time.  That is the Holy Grail of equity crowdfunding which the industry does not come close to achieving. It is usually because the company raising the money is not willing to spend what it takes to sell their offering to investors.  They fantasize that if they just put the offering onto a platform and send out a few e-mails or tweets, investors will come running with checks.

While no one can guarantee success of a crowdfunded offering that is raising equity for a start-up or small business, there is one group that I have watched that clearly understands how to bring a significant amount of investors’ to each offering that they present.  I suspect that they charge a little more because they obviously do a better job.

I have already had this discussion with several people who are preeminent in the crowdfunding industry and whose best response has been, sadly, that the crowdfunding industry will eventually work things out.  In the meantime, the industry is working things out using money from many thousands of small investors.  The industry is tooting its own horn over its success in being able to separate those investors from their money knowing that the vast majority of those investors will get nothing in return.

The simple truth is that if you have a few hundred extra dollars in your pocket and would like to help a small business succeed, you can go to a local restaurant, order a meal and a bottle of wine and know that the owner will be very happy to have your patronage.  The odds are that the owner stands on his/her feet for many hours a day for 6 and maybe even 7 days a week.

If you are not hungry and have a few extra dollars you know that there is a food bank not far from you no matter where in the US you are that will appreciate your money as much any crowdfunding entrepreneur, probably more so.  I would argue that a food bank donation gives an excellent return on your money in the form of inner satisfaction.

I expect some blow-back from this article, especially that last paragraph.  If anyone would like to debate me on this subject, publicly, I would be happy to appear at any conference. I would expect the topic of the discussion to be “what is the financial benefit of crowdfunding for the crowdfunding investors?”  I know that it is a buzz kill but that is the point.

I have been criticized, repeatedly, because of my negativity toward crowdfunding.  I am not negative about crowdfunding. I just get angry and frustrated by the experts who think they know what they are doing but don’t.  If you do not want me to call out your foolish behavior, stop acting like fools.

Several dozen crowdfunding portals have lined-up to become FINRA members and offer equity offerings to ordinary investors. I am not particularly looking for a job, but I would be happy to sit down with any crowdfunding platform that is actually interested in only offering good investments to investors. I would think that it is the least that they should want to do.

In the next few years a lot of people will be lured into crowdfunding by the hype and will lose their money. It does not usually happen with offerings made by Wall Street firms. It does not need to happen on crowdfunding platforms either.

FINRA Arbitration- Where Winning Is Not Everything

Law , ,

The Public Investors Arbitration Bar Association (PIABA) has issued a troubling report to the effect that customers who receive monetary awards in FINRA arbitration forums frequently cannot collect.

Using data from 2013, PIABA demonstrated that more than $62 million in awards made to public customers by FINRA arbitrators in that year went unpaid. That amounts to 1 out of 3 cases where investors went through the arbitration process and won, or nearly $1 of every $4 awarded to investors in all of the arbitration hearings that took place that year.

This is a problem that has been ongoing for many years. FINRA has done little over that time to keep track of unpaid awards and has been reluctant to take any remedial steps. In theory, an award made to a customer by a FINRA panel is due within 30 days. After that it becomes a charge against the firm’s net capital and may lead to disciplinary charges and the firm’s expulsion from FINRA. The latter, of course, hinders collection rather than helping it.

Obviously it is the larger awards rather than the smaller ones that do not get paid. Just as obviously, if the customer dealt with one of the larger firms such as, Merrill Lynch, Morgan Stanley or Charles Schwab, even a large arbitration award is rarely going to be a problem.

Because it is the smaller firms that often opt to go out of business rather than pay a substantial award, PIABA has offered a number of potential solutions including an increase in the minimum requirement for net capital, mandatory liability insurance, broadened SIPC coverage and an industry-wide pool to cover unpaid awards.

I cannot see Merrill Lynch and the larger firms agreeing to fund a pool to cover customers at other firms that they would just as soon have as their own.  And just to be clear, most error and omissions policies carried by FINRA firms specifically exclude actions based upon fraud.

The $62 million in unpaid awards for 2013 is skewed by a single $19 million award that went unpaid and which illustrates the actual problem. The firm that did not pay the award, Western Financial Planning (WFP) actually had insurance, just not enough for its business model.

WFP did not decide to close up shop after the large arbitration award or because of it. It was put out of business by the SEC. A receiver was appointed and assets were managed and sold. Not enough was recovered to pay general creditors like the recipients of the arbitration awards (there were more than a few).

The record does however reflect that WFP sold private placements almost exclusively. Several of the private placements were large Ponzi schemes that resulted in billions of dollars of customer losses causing dozens of small FINRA member firms to close their doors. The only reason that these Ponzi schemes were sold to anyone is that the FINRA firms who sold them did not even attempt to conduct legitimate due diligence investigations to detect the fraud.

Years ago I worked for a law firm that was preparing both public and private real estate offerings. We carried professional liability insurance. The cost was scaled to the dollar amount of offerings that we prepared each year. The more money raised by offerings we prepared, the greater amount of coverage we needed and the premium we were charged went up.

The insurance company sent a representative to our offices. He handed out a multi-page detailed list of documents. “We hope you never have to call upon us to defend you”, he said, “but if you do, this is list of documents about the issue that we would hope to find in your files.” Anyone who thinks that a due diligence investigation is anything other than a way for the issuers, lawyers and brokers to CYA does not understand it.

FINRA has a realistic requirement for due diligence investigations of private offerings that requires member firms to independently verify all of the representations being given to investors.  I had several due diligence officers from smaller firms on the witness stand after the 2008 real estate crash. Almost all just took what the issuer was telling them as gospel. None conducted an independent investigation. You could rarely find a title report or title insurance in their files. None had attended the closing for the property where adjustments are frequently made.

The next crash will assuredly result in arbitrations based upon losses from oil and gas private placements. Where the argument can be made that an office building is an office building, due diligence in the oil and gas industry is very different.

Over the years, I worked on offerings for shallow oil wells in Pennsylvania, deep wells in West Texas, gas wells in Louisiana and at least one shale oil project in Colorado. The due diligence investigation required to verify the facts can differ project by project and state by state. One of the few things that they have in common is they can require multiple experts to conduct an adequate investigation which can obviously run up the cost.

The chance of a small FINRA firm doing an adequate due diligence investigation of an oil and gas offering is slim. I am available as a consulting expert witness for both arbitrations and class actions and I expect that I will be busy.

The problem of unpaid arbitration awards is very much centered in the Reg. D private offering market. It is from investments in the Reg. D market that customers take the huge losses that are the subject of many FINRA arbitrations. Many of the largest Ponzi schemes are sold through private offerings for no other reason than crooks do not want government scrutiny on their offerings.

These offerings are most often sold to retail customers by small firms that specialize in private offerings because the commission on each sale may be many times what it would be on a sale of a similar dollar amount of British Petroleum or ExxonMobil. A broker selling $1 million worth of private placements might take home as much as $90,000 in commissions.

In a registered offering, due diligence is performed by the lead underwriter on behalf of the other firms in the selling group. The issuer pays the lead underwriter for the due diligence process up front before the issue comes to market. In the Reg. D market, each member of the selling group frequently performs their own due diligence and is reimbursed after the fact based upon a fixed percentage of the monies that each firm raises.

This business model where the firms do not get paid for due diligence if they reject the offering and then only get paid based upon how much of an offering that they sell is at the root of the problem. For a large firm doing registered offerings due diligence is a profit center with positive cash flow. For small firms in the Reg. D market it can be an out of pocket cost with questionable reimbursement. Therein lays the problem and the solution.

FINRA might consider requiring a lead underwriter for all Reg. D offerings that mimics the investment banking function for registered offerings. As this is a potentially very profitable enterprise, it is reasonable to believe that some firms would be happy to step up. These firms and only these firms would need enhanced insurance coverage which would be folded into their cost of operations and reflected in the fees that they charge the issuers.

Asking each of the small firms selling Reg. D offerings to purchase insurance against offering statement fraud and adding to the cost of what is already an unprofitable part of their business is not going to gain traction at FINRA. A way to shift the risk profitably to a well compensated lead underwriter might do the trick.

The benefit of loss avoidance in the financial markets which is certainly part of FINRA’s charter should take precedence over insuring recovery costs for the few people who deal with the wrong firms.  It should surprise no one that many people in the brokerage industry do not particularly care for lawyers who make their livings filing customer arbitration claims. The PIABA study, while important, is not likely to stir the industry into action.

Arbitration claims based upon the sale of these offerings to unsuitable customers will still occur, but the aggregate losses will be far less and the number of Ponzi schemes foisted upon the public will likely be dramatically reduced. That is good for everyone.

I do have sympathy for the frustration suffered by the PIABA lawyers but the issue of collection is not limited to securities claims or arbitrations. Thousands of people are injured every year by uninsured drunk drivers .I would argue that it would be easier to substantially reduce the number of Ponzi schemes offered through FINRA firms than getting all the drunk drivers off the road.

 

 

 

Fiduciary Investing Made Easy

Investors, Uncategorized

Every so often a client or colleague would seek my advice about what is really a very simple problem. They served on the board of their alma mater or a local charity. They had been tasked to help select an investment advisor for the endowment. They usually find themselves in this position because they know something about investing. Frequently it is because they handle their own portfolio through one of the discount brokerage firms.

But that is not the same as evaluating a professional investment advisor to handle other people’s money.  They want to find a good advisor for the fund and they do not want to make a mistake.

The same methodology that I am going to suggest would be appropriate for a business owner or investment committee seeking an advisor for a corporate pension plan.  The money in the plan belongs to the employees. They are counting on that money to fund their retirement.

The Department of Labor (DOL) has proposed new regulations that will shortly become effective and will hold all stockbrokers that handle pension or retirement accounts to a fiduciary’s standard of care. Registered Investment Advisors have been held to this standard for decades and if you are overseeing a pension plan or endowment you should hold yourself to the same standard as well.

The DOL regulation deals primarily with the costs or fees of the investments. It targets high commission investment products like private placements, hedge funds and variable annuities that are also high risk. I find it amazing how many large pension funds have allowed themselves to “diversify” into these alternative investments that they know very little about.

You should know that there are significant shortfalls in a great many large pension funds both public and private.  By shortfall, I mean that they do not have enough money to pay out the benefits that they have promised to their employees.

In many cases, this is a result of the managers trying to “do better” than the market to get higher returns for the fund.  Seeking higher returns means that they took higher risk and got burned.  Getting an underfunded pension fund back to par is very difficult without taking on even more risk.

Pension fund managers do get sued by plan participants for losing money. Corporate executives who oversee the advisors do as well. A good perspective for anyone who is sitting on a committee overseeing investments for a pension fund or an endowment is to adopt the same rule that doctors apply to their practice: first, do no harm.

You should also know that asset allocation for a pension plan or endowment may be a little different than you might think.  For a purely long term portfolio, funds are allocated between stocks, bonds and cash according to a pre-determined risk profile and re-balanced as market conditions shift.

If the pension plan is already paying out benefits or the endowment is being tapped to cover operating expenses or grants, then the fund must have enough income producing investments to cover the cash outflow. It is never appropriate to selloff portfolio securities to fund expenses. This is a mistake that a lot of individuals make in their own retirement accounts.

That leaves the selection of the equities that the fund will hold for the long term, stocks that will appreciate over time and allow the fund to grow. It is at this point that the investment committee is likely to have the most difficulty.

Many people believe that the cost of an investment advisor to help select the investments in the fund should be a determining factor. People seem to think that no-load mutual funds or ETFs are the way to go because an annual fee will diminish their returns.

At best you will get returns that are average, because you are investing in the good stocks in the sector or index along with the poorer stocks. You can and should hire a good advisor who does their own research to select a portfolio that will do better than the index.

There is an ongoing discussion regarding the merits of using a passive investment strategy (index funds or ETFs) versus using an active portfolio manager. In addition to higher costs, there are studies that suggest that the average investment advisor does no better than the indexes and many do worse. In my mind, it begs the question: why would you hire an average investment advisor in the first place?

So the real problem is to identify an investment advisor who is better than most or at least can reasonably be expected to get better results than an index.  If there are 30 airline stocks in an airline sector fund or ETF, then you would want an advisor who could research and rank those stocks and buy not all, but only the best.

A really good research shop is a rarity. All of the large brokerage firms and investment banks have research departments. Many of the analysts are excellent and insightful. But the research department is still often an adjunct to the firm’s investment banking operation and may be conflicted.

There are, of course, independent research reports that are provided by discount brokers who have no investment banking operations and others that are available by subscription that are used by many advisors. But none of these can be called anything but middle of the road and may be the reason that many active advisors get average results.

There is, in my opinion, a research based investment advisory firm that rises above the rest.  It is called Dimensional Fund Advisors (DFA).  You will not find their ads on most financial websites. They do not fill your e-mail account with spam or pop-ups. They do not write magazine articles aimed at mom and pop investors.

They actually do not even employ relationship managers (salespeople) in the traditional sense. You can only approach DFA to manage your funds through a limited group of pre-screened independent advisors.

I have known about DFA for decades. Several years ago I attended a presentation by one of their analysts and came away very impressed. They employ a bottoms-up, book value versus market value approach with the goal of picking the best stocks, one at a time.

This type of text book, academic approach to portfolio management is not that easy to find. The primary principals of the firm, Ken French and Eugene Fama are academics. Prof. Fama won the 2013 Nobel Prize for Economics.

Even if you are a DIY investor managing your own modest portfolio at a discount brokerage firm, I would encourage you to visit the DFA website, search out some articles and learn their approach to stock selection. Knowledge, after all, is powerful. I actually shudder when someone managing a few million dollars of their own money has never read a textbook on fundamental securities analysis.

If you have a larger account or find yourself in the position of overseeing a pension fund or endowment and would like more information or an introduction to DFA, I can refer you to one of the independent advisors who has a relationship with them. It is the same gentlemen who secured me a seat at their analyst’s presentation

Understand that I receive no compensation for this in any way.  If you follow my blog, you know that I routinely point out foolishness in the marketplace. I have written several articles on why people are foolish to manage their funds with robo-advisors.  This article, I hope, provides some balance.

It is the methodology employed by DFA that puts them above other advisors. It is the same methodology that you  should employ in your own account and seek out in an advisor for yourself or if you are asked to find an advisor for an endowment or company pension plan.

And telling your employees that you value their contribution to your company so much that you hired a Nobel Prize winner to manage their retirement funds, in my opinion it is not likely to get you sued.

 

Making the new capitalism efficient

Capital Markets, Economics , ,

Economic theory teaches us that capital in a perfect world would always be allocated to its best use. The best use is always viewed from the perspective of the person or entity that is deploying the capital. Consequently we normally calculate the best use as the highest rate of return that the capital can reasonably achieve. The object is always to use money to make money.

To further this goal, capital has always been deployed to companies that have had the best chance of success. A due diligence process is employed to separate the best companies from those that the market deems less worthy. While far from perfect, this system has historically worked well enough to create our modern society with few truly innovative ideas left by the wayside, meaning unfunded.

In the last 20 years, some people with capital have been content to deploy it for other, more altruistic reasons. Specifically, they want to make capital available to people who have no access to the mainstream capital markets and others who for a variety of reasons could not get funded.

This new capitalism has taken two innovative forms, micro-lending and crowdfunding. Each has the potential to put capital into the hands of people who otherwise would never have access to it. Both have the potential to be transformative at the lowest tier of the global economic system. Neither is focused on highest rate of return as its primary goal.

In its purest form a micro-loan is very small and will often help a subsistence level individual transform into a capitalist. Micro-loans are frequently used to purchase one sewing machine to create a manufacturer; one shipment of goods at wholesale to create a merchant. Some micro-loans are used by a rural community to purchase one used truck or tractor. The benefits of these loans are obvious.

As originally envisioned, micro-loans were often interest free or loaned at an interest rate low enough to cover only the lender’s overhead and the costs of defaults. Even though no one who gets a micro-loan has a FICO score, statistics show the rate of default worldwide to be very low. As much as 97% of the loans are repaid. As conceived, micro-lending is a model of market efficiency.

Unfortunately, as this industry has developed and matured, there are some places where micro-loan programs are managed by bloated bureaucracies. There are stories of interest rates that would make loan sharks blush, corruption and exploitation in the lending process and misappropriation of funds intended for borrowers.

Crowdfunding, which is still in its infancy, is still remarkably inefficient. Fraud is prevalent because no one really vets the companies that seek funding. Far too many companies sell products that they can never deliver. The process itself can be expensive and is often hit or miss. Only about 30% of the rewards based crowdfunding campaigns successfully raise the funds that they seek.

Investors who buy into the equity of a small company on a crowdfunding platform must understand they may take a total loss. Even if the company is initially successful, there is no liquidity for the equity that investors purchase. Despite all of the enthusiasm for crowdfunding, this much risk and inefficiency cannot be sustainable.

There is, I would think, a way to combine the micro-loans with crowdfunding in a way that would remove much of the inefficiency, at least in the developing world.

In most developing countries there are universities whose students are  themselves often making the transition to the middle class. They should appreciate that strengthening the underclass will provide a greater market for the products and services that they themselves will eventually make and/or sell.

What I would propose is that each university creates a crowdfunding platform to enable students to fund micro-loan programs in their own communities.

Most peer-to peer lending platforms allow companies in need of loans to borrow from multiple individuals, essentially syndicating each loan. I envision the university students creating a single fund from which to make micro-loans to many borrowers.

I would ask the students to fund the program by purchasing shares in the fund with a small yearly tithe for the 4 years that they are students and for a few years after they graduate. Call it a 10 year voluntary commitment to purchase shares.

Additional funds would come from sale of shares to faculty, alumni, local banks, businesses and importantly, each country’s expatriate community. University students in western countries could partner with university students in developing countries. All anyone need do to participate is buy one share.

I have intentionally left out any local government involvement or participation. Direct government participation rarely adds efficiency to anything.

Business students and volunteer faculty at each university would administer the fund. This would remove much of the costs and corruption. It would give these students valuable experience evaluating business proposals and detailed knowledge about the local economy that will not be found in their textbooks.

Borrowers would pay a fixed interest rate. A rate of 6% might be sufficient to cover the risk of defaults and provide some amount of internal growth. Real growth will come from new students who will join the program each year as they enter college.

At some point each fund would reach a predetermined principal amount and be closed. In the US and elsewhere a closed-end mutual fund can become registered and be listed and traded in the regulated securities markets. This would provide liquidity to these crowdfunded investments where none exists.

Even after it is closed, a fund can continue to collect payments on existing loans and make new loans year after year. There would be no reason or requirement for it to liquidate. As the fund grows after it is closed the per-share value will continue to appreciate. Providing for growth and a liquid market would mean that shareholders could expect to make a profit from their investment.

The closing of one fund will be followed by the opening of a new fund to replicate the process. Over time, multiple funds will exist in every country that wants them, sponsored and funded by university students and others who will see both the benefits of the program and the potential for their own modest profit.

Replicated university to university and country to country a program like this would have a demonstrable effect within a decade. On a continuing basis it has the ability to transform communities and economies in the developing world from the bottom up.

It is an opportunity to demonstrate that altruism and capitalism are not mutually exclusive.

On the art of being a securities lawyer

Law

One of the benefits of having been a lawyer for so many years is that I have heard a great many jokes about lawyers. Most hinge on the idea that lawyers are not very good people or not very good at what they do.

Overall, there is a general theme that suggests that 80% of lawyers give the other 20% a bad name. I bring this up because there is always a modicum of truth in anything that we find to be funny.

For me two jokes stand out.

The first I heard while I was still in law school. A professor suggested that the A students would go on to become judges and law professors while the B students were destined to spend their careers working for the C students.

The second I heard after I became ill with a cancer from which most people do not recover. One of my doctors cheered me up by suggesting that in his experience it was true that good people die young. He told me that he felt any patient who was a lawyer was good for his batting average.

I am not here to defend lawyers; quite the contrary.

I recently read an article that reported that the hourly rate for the top partners in the best Wall Street law firms had broken through $1500 per hour. The comments (more than 100) were universally disparaging.

Certainly this rate would apply to the best securities lawyers. I was never a partner in a major Wall Street law firm, but I have been the client of more than one.

Right out of law school I went to work as an in-house attorney for one of the larger brokerage firms. Certain trades required approval from the legal department before they could be routed to the trading desk or exchange floor for execution. I was one of the attorneys who gave that approval.

If the manager of a branch office wanted approval for a customer to buy or sell 10,000 shares of any stock, they would call the legal department. I would ask for the details and make a decision to allow the trade or not. If I delayed and the stock price moved even ¼ of a point while I was thinking about it, it could cost the customer $2500.

Once in a while I needed help. If I could not get it from one of the other in-house lawyers, I could put the manager on hold and speed-dial a partner at one of the top law firms who was on retainer. If I told his secretary that a trade was pending, he would take my call immediately and help me make a decision.

The experience taught me that to be successful as a lawyer I needed to know what I was doing and not just in a superficial way. It taught me that when I did not have the answer at my fingertips, to admit it and find someone who did.

What makes any lawyer valuable to a client is having the right answer to the questions that the client is asking. Sometimes you need to tell the client what questions they should ask and you have to know why those questions are important.

Last week I spoke to a businessman who had a complicated and fairly unique securities law issue. He was quoted thousands of dollars by other lawyers to research his problem. None had ever encountered it before and none could tell him what he should do.

I told him that I had seen another lawyer solve the same problem back in the 1980s by restructuring the transaction so that the regulation that he was struggling with would not come into play. It was the right answer for him and I was pleased to send him off without charge.

Not one of the commentators on the article about lawyers charging more than $1500 per hour stopped to calculate the enormous value of problems avoided by consulting the right lawyer before you act. Problem avoidance is probably the greatest value that any lawyer can give to their clients.

Perhaps the most valuable answer any lawyer can give to a client is “I don’t know.” It is an answer too many lawyers are reluctant to give.

Good clients often have questions about taxes, patents, immigration and frequently, matrimonial law. I have only a cursory knowledge about any of these subjects. But, I know whom to ask. Part of the value of any good lawyer is their professional contacts, both inside and outside their specialty.

Where even good lawyers get into trouble is by taking on matters that they do not fully understand.

In my own practice I know that the US Supreme Court validated and enforced the arbitration clauses that brokerage firms include in their customer agreements in 1987. Notwithstanding, over the years since then, I have run into lawyers who are prepared to file their clients’ claims in court, confident that the court will let them proceed. It does not happen.

They file in court, spend time, effort and some amount of their client’s money on what is essentially a fool’s errand. A trial court judge is going to go with the Supreme Court every time, if for no other reason than they are themselves overworked and moving a case off their calendar and back to FINRA is a no brainer.

The reason that these lawyers do not want to proceed with FINRA arbitration is because they are not familiar with the forum. FINRA does not permit pre-hearing depositions which can freak out even the best litigators.

Many lawyers do not believe that they can effectively question the stockbroker at the hearing without a deposition beforehand. Having worked in the industry, defended more than a few stockbrokers and having participated in a great many FINRA arbitration claims, I am confident that I know how a broker is likely to testify without a deposition.

Even though I was never a $1500 per hour partner at a Wall Street law firm, I could still give the same advice to my clients. There were always treatises and articles written by lawyers who worked in those firms that addressed my clients‘ issues. Lawyers have always valued scholarship and there has always been enough top-flight literature to keep me educated and up to date.

Equity Crowdfunding is a marginal practice for mainstream securities lawyers. These are smaller issues that do not usually generate enough fees to attract the top law firms. But Equity Crowdfunding is still the issuance of securities. The Equity Crowdfunding portals should have experienced securities attorneys on staff. Many do not. The result is a lack of compliance that can only result in problems in a highly regulated industry.

One of the benefits of blogging is that I read the blogs of others. I learn a lot. Some of the blogs written by lawyers who practice in this area are excellent. Some are mediocre. A few are dangerous because the authors are way out of their element.

There is no excuse for practitioners in this or any area of the law to publish advice that is substantially different than would be published by the top firms. Reading and writing about the law is one thing; offering practical advice without having a fair amount of practical experience quite another.

For all the discussion about how expensive some lawyers have become, and all the jokes, I would invite those lawyers who read my blog to start a discussion about how mediocre many practitioners in our profession have become. How using technology to cut costs has replaced hard work and good judgment. How there is so much careless blogging that we are confusing consumers and others with bad advice.

A little self criticism will not stop all of the jokes, but it might make us better lawyers. Our goal should be to offer advice that is worth $1500 per hour even if we charge less.

Med-X – Crowdfunding, cannabis and chicanery

Investors, Issuers, Law , , ,

As a college student during the 1960s, I was exposed to marijuana and had friends who were out and out stoners. As a young lawyer I represented a wholesale head shop company that Time Magazine referred to as “the Dunhill of the industry”. Through them I met many entrepreneurs who had profited in the wholesale and retail paraphernalia industry.

Being a cancer patient I am familiar with medical marijuana. I have read the literature and discussed it with my doctors. I know many people who have used marijuana as part of their recovery from cancer and other illness.

This article is not about the pros and cons of legalizing pot. It is about Crowdfunding, the cannabis industry and a questionable investment.

Sales of marijuana in states where it is legal are expected to top $5 billion this year. Still, I cannot see the loan committee of a major bank or any Wall Street firm step up to finance the cannabis industry in any major way. Even though its use is legal in an increasing number of states, the cultivation, distribution or sale of marijuana is still a federal crime and banks and brokerage firms are regulated by federal agencies.

It is not surprising then, that the cannabis industry has found Crowdfunding to be a source of new capital to fund its growth. Rewards based Crowdfunding campaigns for new vaporizers and similar products are easy to find.

What surprised me was that the Securities and Exchange Commission (SEC) has recently approved a $15 million offering for a cannabis related company under the new Reg A +. The offering for a Southern California based company, Med-X, became effective in early February.

The company has no sales or current business to speak of. The company states that it will use the money from investors to: “research and develop, through state of the art compound identification and extraction techniques, and market and sell medically beneficial supplements made from the oils synthesized from the cannabis plant.”

The Company’s planned compound identification and extraction research and development operation will be conducted primarily at the Company’s existing 600 square foot indoor cultivation center in Chatsworth, California, where controlled quantities of high quality cannabis are being grown, harvested and stored for research and medical use to the extent permitted by California law.

The company has several physicians on its Board of Directors. However, none has disclosed any published research paper on cannabis and none, apparently, works fulltime at the company’s 20’x30’ cultivation center to direct that research. Cannabis is apparently being grown, although the equipment needed to conduct the promised research will not be purchased until the offering is funded. In any event, the research is for future products.

In the meantime the company will use some of the investors’ money “to acquire, create and publish high quality cannabis industry media content through the Company’s media platform, (a website) to generate revenue from advertisers as well as through the sale of industry related products.”

If this were styled as a media company I would not question it. But the website is only a few months old, has no revenue and again the company lacks personnel with a media background to run it.

The company’s other revenue generator will be sales of a product called NatureCide® to cannabis cultivators throughout the world. NatureCide® is an insecticide and pest repellant. This product is owned, manufactured and distributed by a company called Pacific Shore Holdings, Inc. an affiliated company that is controlled by the same person who controls Med-X, Mathew Mills.

Med-X acquired an exclusive license from Pacific Shores Holdings to market NatureCide® products to the cannabis industry in exchange for 10,000,000 shares of Med-X stock. An exclusive license can be valuable, however, in this case the products are readily available on Amazon.com making the value of the exclusive license questionable.

Pacific Shores Holdings is a classic penny stock. Mr. Mills was sanctioned, twice, first in Pennsylvania in 2011 and later in California in 2013 for selling shares in Pacific Shores Holdings to investors he had no business selling shares to. The structure employed here, with one penny stock company acquiring a large block of stock in another pursuant to a licensing agreement is also a classic penny stock tactic.

Like any Crowdfunded offering, shares of Med-X are being sold by the company directly to the public. In theory investors should be able to make an informed evaluation of the company before they invest their money. But most investors cannot.

I expect that many people will line up to send their money to invest in this company’s shares. It certainly will not be because this company represents a good investment.

More likely, if you will forgive the pun, the buzz about this offering will be about its asserted link to the cannabis industry. The minimum investment is $420. (No kidding).

Stop to consider that its main product, NatureCide®, was pre-existing. Its only connection to the cannabis industry is the statement that it can be used by cannabis growers in the same way that people growing virtually anything else can use it.

Mr. Mills was apparently content to sell shares of Pacific Shores Holdings without adequate advice from a securities lawyer. He now proposes to conduct cannabis research without a cannabis researcher on staff and publish a website without an experienced website publisher.

Remember, I want the Crowdfunding industry to succeed. To do so it will need to offer investors the opportunity to invest in companies that at least have a likelihood of success. I do not believe that investors will find that here.

Instead, Med-X is poised to give both the evolving Crowdfunding and cannabis industries a black eye and to leave many investors holding the bag. The cannabis industry will survive.

If Med-X turns out to be a $15 million scam, (and there are others) investors may begin to realize that there are better places to invest their money than a Crowdfunding portal.

Expungement- FINRA’s dirty little secret

Investors, Law , , ,

Both FINRA and the SEC encourage investors to investigate the record of a financial professional before hiring them. It would certainly be valuable for any customer to know if the stockbroker to whom they are considering turning over their life savings had previous problems with other customers.

For more than 20 years FINRA has provided a free online tool called BrokerCheck. It provides potential customers with a history of where the broker has worked and in which states the broker is licensed to do business.

A BrokerCheck report is supposed to provide accurate information about regulatory problems that the broker may have had and basic information about complaints and arbitration claims that other customers may have asserted against the broker. Unfortunately arbitration claims, even those with serious allegations of misconduct are frequently not reported to the public.

From the outset brokers have strongly opposed this disclosure. They believe that many arbitration claims filed by their customers are frivolous, false or factually incorrect. There have never been any facts or data to support that assertion.

FINRA has always had a rule in place that permitted arbitrators to expunge the claim from the broker’s BrokerCheck record after the hearing or if the claim settled. The rule and the procedures have been tightened up over the years, but the fact remains that BrokerCheck’s record of a broker who has been the subject of multiple customer complaints and arbitration claims may reflect none of them.

There are actually reports of brokers who have been the subject of more than 20 customer complaints or arbitrations having some or all of these complaints expunged. In other words the worst offenders may get the most benefit from expungement. Brokers who have had the most serious problems may have those problems affirmatively concealed from investors.

Over the years there have been multiple studies, law review articles and comments regarding the pros and cons of permitting the expungement of customer claims against stockbrokers. The issue is lot easier to understand if you put it into some context.

If your neighbor slips and falls in front of your home on a snowy morning before you have had a chance to shovel the sidewalk and sues you for medical bills and lost wages, the lawsuit is matter of public record and will be a matter of public record forever. If you fail to pay your student loans or are late with a mortgage payment it will be noted on your credit report for many years.

FINRA arbitrations are private matters. If they are not reported on a BrokerCheck report they are unlikely to show up anywhere else that a prospective customer might access.

Some commentators have suggested an arbitration claim is similar to a bad review on Yelp or similar website. But they are not. A FINRA arbitration claim often means that a customer has lost money that they did not expect to lose. This usually means that the broker did not make a full disclosure of the risks involved.

As an attorney who has represented a great many customers in FINRA arbitrations I always understood that my job was to recover as much of my client’s losses as I could. No claim is perfect and every claim has its strengths and weaknesses. It is for this reason that the vast majority of arbitration claims that are filed with FINRA end up settling.

The question of expunging the broker’s record comes up in settlement discussions almost every time. Most of the defense lawyers with whom I have dealt over the years have been ethical and rarely made expungement a condition of the settlement which is not permitted.

More often, I would offer not to oppose the broker’s request for expungement if they made one to the arbitrators because the client rarely cared about anything more than getting the best monetary settlement they could. That is not the same as suggesting that I believed or in any way acquiesced to the idea that the claim was frivolous, false or factually incorrect in the first place.

Any attorney will tell you that clients do not always walk in the door with all of the paperwork that you would like to see or a firm recollection of all of the relevant facts. It was always my practice therefore to send a draft of the claim, with the client’s approval, to the brokerage firms’ compliance department before I filed the claim with FINRA. I would ask them to tell me if I had the facts correct and would solicit their interest in an early disposition of the matter.

Occasionally, they would respond that the broker named in the claim was actually out of the office when the offending transaction occurred and that a different broker had actually spoken with the client and was the official broker of record. Better to deal with these factual glitches up front than to fight over expungement later.

Understand that both FINRA and the SEC consider information about customer complaints to be information that any customer would consider to be important before they began doing business with a stockbroker.

In the context of an offering of securities the SEC routinely sanctions issuers who omit material facts. In the context of a BrokerCheck report, the Commission has sanctioned the omission of facts that everyone agrees are material.

Every year there are articles in industry publications bemoaning the public’s lack of confidence in the industry. Wouldn’t full disclosure of prior complaints instead of burying them help to restore the public’s confidence?

I have every reason to expect that this controversy will continue, in part because many people in the industry will never get over the arrogance of a customer who dares to file an arbitration claim. Even those with the most to gain, the honest brokers who work for years without a single customer complaint are silent.

For this reason FINRA is unlikely to acquiesce to allowing BrokerCheck to report any and all claims made against a broker without providing some type of escape mechanism. In the meantime, it is impossible for a customer to know if the BrokerCheck report that FINRA urges them to read is accurate. As a practical matter a BrokerCheck report is worthless.

Allow me to offer a practical solution.

If you are considering hiring a new broker and find that BrokerCheck reports no complaints or arbitration claims, send the broker the following e-mail:

Dear Mr. Smith: We have done some research and were very pleased to learn that throughout your many years in the brokerage business you have never had a complaint or arbitration with a customer. Please confirm that this is true and that none have been removed from your record.

That should protect any customer and level the playing field. It is one thing for a broker to have arbitration claims expunged from their record and quite another to lie about it.

How I know that the stock market is coming down

Economics, Investors

Every investor would like to be able to predict the future. It is not always easy to do, but neither is it that difficult. It helps if you stick to the math.

Income investors aside, most people buy stocks that they believe will appreciate in value. If you own a stock and do not believe it will go up any higher then why wouldn’t you sell it?

The majority of shares in all financial markets trade between large banks and institutions. They have access to much more relevant information about the shares they trade, the world economy and the markets in general. Good research is the key to purchasing good investments.

For the average investor good research is a non-starter. Most people do not know how to do basic research on a company or where to obtain it. That has not deterred millions of people from investing trillions of dollars based upon bad information. Much of that bad information comes from the financial services industry itself.

Companies in the financial services industry need to grow and to be profitable. They grow by adding new customers and by encouraging existing customers to add more money into their accounts.

It should be obvious then that the one word that the industry is least likely to utter is: sell. If you sell, you might ask for a check and take your money elsewhere. That is something that the industry would like to avoid at all cost.

This is the reason that many financial professionals will tell you not to “panic” when markets start to go down. They will tell you to “stay the course” and that you should not worry because the market will “always come back”.

This is a sales pitch. It is not based upon facts or analysis. The charts that you will see accompanying this advice are bogus. The facts the charts assume are never about you and the facts they assume about the market are never real.

Consider that the market decline in the last month has been widely attributed to two factors, slower growth in China and a sharp decline in oil prices. Upon examination neither would seem to have a negative effect on the US economy.

The Chinese market for US goods is not growing as fast as it has in the recent past. China is not in recession. Certain industries and certain companies will surely be impacted. Overall, there is no indication that China will buy substantially fewer goods from US companies this year than it did last year.

Volatility in the Chinese stock markets is also cited as problematic for the US markets. In truth, very little US capital is at risk in the Chinese capital markets. Volatility and higher risks in the Chinese markets will usually cause capital to seek safer markets. That means more capital coming to the US. This is positive for the US economy.

Oil has been priced by a cartel since the 1970s. The current sharp decline in its price is being caused by a political decision to increase the international supply and to force US suppliers out of the market. Dramatically lower prices are not good for domestic oil companies and domestic oil workers.

Lower prices are also not good for the very largest oil producers whose margins and profits are likely to decrease. Shares of large oil companies are found in many portfolios and account for a significant amount of the weight in the Dow Jones Industrial Average and other indexes. So, yes, declining oil prices will bring averages down, but do not negatively impact many industries like pharmaceuticals or housing.

For the rest of us, dramatically cheaper gas prices increase our buying power for other goods and services. They should reduce the price of any goods that are shipped by truck which is almost everything.

Cheaper gas prices should not crash the market. Indeed low gas prices coupled with lower prices for other commodities and low borrowing costs should all continue to bode well for the US economy.

Why then do I believe that the market is coming down?

The upcoming market “correction” will be the 7th or 8th of my career going back 40 years. Throughout, the single factor about which most professional investors concern themselves is a stock’s price to earnings ratio.

Historically, across the market those ratios fluctuate between 10 to 1 and 20 to 1 with a mean in the middle at 15. It should cost $15 dollars to purchase one share of a stock in a company that is earning $1 per share.

So ingrained is the notion of price to earnings ratio as a market indicator that each of the corrections that I have witnessed over 40 years has been characterized as beginning from a point where P/E ratios where at the high end of the range. Markets usually fall from there to a point below the mean and then begin to level off.

That P/E ratios will always revert to the mean is a verifiable and well known fact.

At January 1, 2016 the average P/E ratio for the overall market was in the neighborhood of 20 to 1, which is at the higher end of the range. It might go up a little higher first, but history and mathematics would suggest that it is likely to drop to the 12 -13 to 1 range before it starts back up.

If you stay in the market, your portfolio will sustain that loss. It might take several years for the value of your portfolio to return to where it is today. If you “stay the course” you will have wasted the earning power of those years. You will have ridden the market down and back up and essentially be back to where you are today.

The better strategy would always be sit on the sideline while the market is going down and to invest in the companies that you like when they are cheaper. There has never been a better investment strategy than “buy low, sell high”.

If you do stay in the market then your portfolio should contain stocks that pay dividends. Dividend paying stocks generally decline less than stocks that do not pay a dividend. If you do sell now and accumulate some cash, you will be able to buy these stocks at lower prices and lock in a more attractive yield going forward.

I know for certain that all but a few market professionals will tell me that I am out of my mind. I submit that a great many of these professionals will have a personal stake in your decision to leave the market or stay the course. If every customer decides to sit on the sidelines these market professionals will be washing cars or waiting tables.

If you would like to “gut check” your broker, ask him/her what the average P/E of your portfolio is today and what your portfolio’s value would be if you do stay the course and your portfolio’s value does decline to a ratio of 15 to one or less. Like I said, do the math.

If you stay the course, you will be robbed of the profits that this bull market has given to you.

Equity Crowdfunding – What the Crowd Expects

Investors, Issuers

As the crowdfunding industry moves from rewards programs to equity offerings companies that are seeking funding will need to step up their game. Investors will not receive your product at a discount. They will have very different expectations.

When you make a debt or equity offering for your company on a crowdfunding portal you are asking investors to help you to fulfill your dreams with their money. That is perfectly fine and in many ways is a process that is at the very core of the capital markets.

What do investors expect in return? If you have not asked that question and if you are not prepared to answer it, raising debt or equity capital in the crowdfunding market may be more difficult than you think.

Investors invest their money to make money. It may sound obvious until you realize that for crowdfunding investors it is very unlikely that it will happen. Most crowdfunding investors will lose their money.

Even if you are successful and profitable for many years crowdfunding investors will not be able to cash out of their investment in your company until you sell the company. That is one reason that many investors will select investments that pay dividends (preferred shares) or interest (debt offerings).

Your investors will be prepared to lose the money that they are giving to you. They know that all crowdfunded investments are speculative. They know that the best deals are likely to be scooped up by angel investors or venture capitalists. They know that despite your best intentions and best efforts most new businesses fail.

For smaller companies that want to use a crowdfunding portal for financing I cannot over emphasize the importance of being able to demonstrate to investors that your company can succeed. At the very least, you should be able to show investors that you have put the pieces into place to give your company a fighting chance.

Equity crowdfunding can be expensive and cutting corners can lead to problems and a campaign that does not get you the funds that you need. You are going to need an experienced securities attorney to prepare your disclosure documents and to guide you through the regulations. You are going to pay a portal for the privilege of listing your offering and you are going to need to fund the marketing effort to reach out to potential investors. If you are going to spend this money to reach investors, your offering needs to be strong.

Remarkably, many of the experts in the crowdfunding arena have never raised any significant amount of money from investors. Many cannot, themselves, tell a good deal from a bad deal. They certainly cannot gauge whether your offering will be well received by investors.

I have reviewed business plans and pitch decks from dozens of companies that want to raise funds through crowdfunding. From an investor’s point of view, many of these offerings are weak. Many people do not seem to appreciate that having a great idea or product is not the same as having a great business.

Equity crowdfunding will necessarily tap into a pool of investors who have had experience in the mainstream financial markets. If you expect them to invest in your business, you should be prepared to demonstrate at least the following:

1) That you understand your business, not just your product. Investors appreciate that you want to tell them that your product will sell millions of units, cure disease or become a ubiquitous part of everyday life. What they really want to know is about your business. Show them not only that people will want to buy your product but that you can produce it profitably, deliver it efficiently and sustain both.

2) That you will follow the rules. The most common abuse in the private securities market is that the marketing materials accompanying the offering are not complete or balanced. The sales pitch frequently exaggerates the positives to the exclusion of the negatives. If the video that accompanies your offering shows people saying things about your business that are very different from the disclosures in your official prospectus, you have a problem.

3) That you can tell investors what you really intend to do with their money. Vague statements in your prospectus that allocate funds for “research and development” or for “general corporate purposes” do not encourage investment. Specific details help investors to better gauge your business.

4) That you will spend investors’ money wisely. Hewlett and Packard, Jobs and Wozniak started out in garages. Why do you need an expensive  loft with a cappuccino machine and foosball? Make money first, buy toys later.

5) That you will allocate some money for reserves. The last thing that either you or your investors want is for you to run out of money just before you get to the finish line. You should plan for problems, delays and contingencies because they will happen.

6) That you have a full management team. Investors know that 4 techies and a CFO do not make a company. It starts with people with experience in the industry in which you will be operating. Investors like to see a marketing director with real experience selling similar products and a lawyer to help with contracts, problems and problem avoidance. If you are not yet ready for a full time marketing director or general counsel, at least have someone with marketing or legal experience on your board of directors.

7) That you have good, experienced and active advisers and directors. Frequently companies seeking investment dress up their board of directors with people with good resumes. Investors want to see a board with the experience to give you the advice that you will need. The same is true for your corporate attorney and accountants. However, if these people are not available to actually help you, then they do not belong on your board.

8) That you have a supply chain in place. It is fine if all you have is a prototype at this point, but if you expect to sell 100,000 units in the first year, please be ready to tell investors that you know where you will get those units and what they will cost.

9) That you know your competition. A formal market research report is preferable but if you plan to market a new toy, you should at least be able to say that you have been going to the New York toy show for a few years to see what other people are offering and that you have spent hours at Toys-R- Us or similar toy stores looking at other products.

10) That you are making realistic projections. Do not tell investors that 100 million consumers might buy your product. Tell them how many units you might reasonably procure and sell. Investors like to know that you know what it will take for your company to break even. Talk about astronomical profits after that.

11) That you have taken steps to protect investors and the company. If your product or design is patent-able, apply for a patent. If you are raising money from the public without Directors & Officers’ insurance you are just plain foolish.

12) That you have some skin in the game. Before crowdfunding the only option for people seeking to fund their small business was the Small Business Administration (SBA). The SBA requires collateral for the loans that they make. Usually the company owners or their family pledge the family home to get the funds. Sweat equity is fine, but if you, your family and friends do not have enough faith in your success to have put their hands into their pockets to get you started, why should investors?

This list is by no means inclusive. If you really want to raise capital from investors, your offering needs to be strong and you need to give investors what they want and expect.

If you would like to know how investors are likely to view your offering my partner and I will be happy to review the offering before you put it out on a portal. We will give you the benefit of our combined 85 years of experience raising money and dealing with investors.

We will charge you a ridiculously small amount for a detailed point by point written report, telling you how to make your offering stronger and how to make it stand out from other companies seeking the same funds from investors. We offer feedback, perspective and some constructive criticism that you will not find elsewhere. Call us when you decide to make an equity offering on a crowdfunding portal. We will save you time, money and disappointment.