Category Archives: Investment firms

accredited investors and the JOBS Act

November 19, 2013 By in accredited investors, Getting financial advice, Investment firms, Securities regulation, the SEC Tags: , , , , , , 1 Comment

“accredited” investors

When you open a brokerage account in the US, you fill out a form that requests information about your income, risk tolerances and investment knowledge.  From what I can see, it gets only superficial scrutiny.  But saying that you have some money and understand the risks of investing in various types of publicly traded securities does two things.  It gets you a seat at the table and it protects your broker from customer lawsuits claiming they lost money because they didn’t understand what they were getting into.  In a sense, passing this vetting process makes you accredited–but that’s not what the term “accredited” usually means.

Instead, it refers to the same kind of vetting process, but for private placements–purchases of securities not registered with the SEC and not sold through the traditional (expensive and time-consuming) IPO process carried out by the big brokerage houses.

For individuals, “accredited” means you have $1 million in assets, not including your principal residence, or you earn at least $200,000 a year.  (There’s a different criterion for institutional investors who want to trade in non-registered–usually foreign–securities.  To be accredited in that sense means having $100 million in investable funds under management.)

The bottom line:  “accredited” means either you’re in the top 1% or pretty close.

not good enough for the 21st century

In the pre-internet, pre-JOBS Act, pre-Mary Jo White world, that was ok.  Private placements were restricted to a very small number of individuals, whose main characteristic is that they can afford losses they might incur in buying risky securities.  The wealth criterion also effectively preserved the near-monopoly on public issuance of securities of the big brokerage houses on Wall Street.

That’s all changing.

the new order

There are already special rules to allow crowdfunding sales of securities.

For the JOBS Act (which allows smaller, early stage companies to raise funds with only limited disclosure) to be truly effective as a  capital raising vehicle for business startups, the pool of investors has got to be larger than just the usual “accredited” suspects.

Interestingly, at the same time as the newly active SEC is saying it sees some merit in things like bitcoin, the agency is also preparing to overhaul the definition of what an accredited investor is.

The new emphasis appears to be on accrediting people who have knowledge, training or experience that gives them insight into the risks and rewards of investing in a startup rather than just being able to take their lumps if an investment goes south.

I don’t know whether this is a good thing or not.

But Washington passed the JOBS Act last year to make it much easier for startups to raise money.  And, contrary to Mary Shapiro’s foot dragging, Mary Jo White is certainly going to set rules of procedure to allow the Act to function.  And that means opening this class of investments to more potential buyers.

I do think, however, that this will turn out to be another instance of a new internet-based business model undermining an older higher-cost pre-internet one.  It will be interesting to see how–and if traditional brokerage/investment banking firms will adapt.  I suspect that this change will have far greater ripple effects than anyone now expects–maybe even momentous ones.

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(not so) “Happy Meal” convertible bond offerings

October 20, 2013 By in Convertibles, Current Market Thoughts, hedge funds, Investment firms, the Happy Meal Tags: , , , , , , 2 Comments

Pinky, the more astute of the two eponymous stars of the long-running documentary on genetically engineered mice, once opined that “if they called them Sad Meals, no one would buy them.”  So true.

Wall Street “Happy Meals”

Recently, the Wall Street Journal has been writing about a convertible bond offering technique, known as the Happy Meal, which has come under SEC scrutiny.   It shows what a colorful, inventive but cold-blooded place Wall Street is.

The Happy Meal is/was an offering of convertible bonds, in which the issuer arranged at the same time to lend large amounts of company stock to buyers so that they could sell the stock short.

Got that?  …probably not.

So let’s pull the pieces apart.

1.  A company issues convertible bonds.

Convertibles are bonds with a provision that allows them be exchanged for a specified number of shares of the issuer’s common stock under certain circumstances.  Until they are converted, the buyer collects interest income.

Generally speaking, a company would rather issue common stock or straight bonds, or borrow from a bank.  The fact that the firm is issuing a convertible almost always means these other, more attractive, avenues aren’t open to it.

2.  In the case of the Happy Meal companies, the convertible form wasn’t inducement enough.

Conventional long-only buyers turned thumbs down.  Who would these buyers usually be?  …specialized convertible securities funds, or bond funds looking to boost their returns by holding equities.  They avoid violating the letter of their investment mandates by buying stocks wrapped up in a bond package.

3.  That left hedge funds willing to do convertible arbitrage.

That is  to say, the hedge funds would simultaneously buy the convertibles and sell the stock short.  Exactly what a given hedge fund would do varies.  One technique would be to sell short enough stock to eliminate entirely any effect of stock movements (up or down) on the position–leaving the hedge fund to collect a stream of interest payments.  But a fund could also shade its holding to the positive or negative side.

4.  There’s more.

To sell stock short, you typically borrow the stock from a third party who owns it, using a brokerage firm as a middleman.  In the Happy Meal case, that wasn’t possible–either because there weren’t enough holders of the stock or because holders were reluctant to lend.  So the issuing company itself lent the stock that hedge funds dumped out into the market right after the offering.

What a mess!  A company would have to be really starved for cash, in my view, to contemplate serving up a Happy Meal.

not so appetizing any more

Companies have begun to turn sour on Happy Meals.  Two reasons:

–enough Happy Meal issuers have suffered significant stock price declines after their offerings that simply announcing a Happy Meal issue is now enough to make the common stock swoon, and

–according to the WSJ, a retired investment banker has turned whistleblower and reported the Happy Meal to the SEC.

His claim? …that issuers and their brokers are negligent by failing to disclose in the offering documents  how aggressive post-issue short selling is likely to be.

A concerned citizen, yes.  But one who also stands to collect a bounty under the Dodd Frank Act if the SEC investigation leads to significant fines.  In other words, a vintage Wall Streeter.

securities analysis in the 21st century: fifty years of changes

September 19, 2013 By in Current Market Thoughts, Getting financial advice, index funds, Industry Analysis, Investment firms, Portfolio management, using research Tags: , , , , , , Leave a comment

Fifty years ago, the financial services industry in the US was a backwater, somewhere people went to work if they couldn’t find a job elsewhere.  But powerful changes were on the cards.  Americans were becoming wealthy, at least in part because the country’s industrial base was the only one in advanced economies left standing after World War II.  And they were developing an appetite for stocks.

reasons for rapid growth of financial services during 1970-90

–the maturing of the Baby Boom

–1974 ERISA legislation, which more or less compelled companies to hire competent third parties to manage their employees’ pension assets

–ERISA also established IRAs

–1978 tax legislation established 401ks

–the rise of discount brokers and no-load funds (even in the 1980s, load funds charged purchase fees of up to 8%) that made investing cheaper and easy

–the crash of 1987, which, I think, caused a fundamental shift by individual investors away from traditional brokers and individual stocks, to mutual funds

–a shift in the 1990s, motivated by wanting to reduce their legal liability, by traditional brokerage houses to convert brokers from “stock jockeys” into salesmen of packaged products like mutual funds

The result of all this was the spectacular rise of the money management industry during the second half of the last century.

seeds of decline

–downward pressure on commission rates

ERISA requires that when money managers transact, they obtain the best execution (buying/selling price) as well as the lowest transaction cost.  As technology developed, this meant that trading rooms had a legal obligation to use electronic crossing networks (“dark pools”) instead of routing orders through traditional brokers. Fidelity was a leader in this.

The move also had the positive side effect of denying brokers to opportunity to use client trading information for their own benefit–either by trading on it themselves or by blabbing about it to other money managers.

–questioning of “soft dollars”

money managers routinely buy information from research organizations, including brokers, by allowing them to charge commissions that are 50%-100% higher than normal (called “research commissions”).  Fidelity, the industry standard of best practice, has been working for years to restrict the amount of shareholder money that is being spent this way.  Yes, this is good for Fidelity–by being bad for smaller rivals.  And its efforts have been very effective in cutting the diameter of the firehose spraying commission dollars at research sources.

in recent years, there’s been a small but growing trend for big clients of money managers to demand that a portion of their soft dollar allotment be earmarked for buying services for the client, not the money manager

–the move to index funds, and ultimately to ETFs, which don’t require active management

–massive redemption of equity mutual funds during the Great Recession, reducing further the assets in the hands of active managers.  Since managers are paid a percentage of the assets they oversee as their fee, fewer assets means less money to pay employees like securities analysts and portfolio managers

–large-scale firings of experienced securities analysts by brokerage firms during the Great Recession.  Over the course of my career on Wall Street, brokerage companies have been gradually changing themselves into trading firms–because, rightly or wrongly, they regard trading as much more profitable.  They’ve been laying off experienced analysts for over a decade,  disgorging even the most deeply entrenched during 2008-9.

The net result:  the big brokerage research departments of the 1980s-90s are gone.  There may be bodies occupying seats today, but they generally lack training, supervision and experience.

Active managers, who had cut back their (mostly ineffective) research staffs in the 1980s,  in favor of buying information from brokers with soft dollars instead, have few internal assets to rely on.  They also have lower fee income.  Are they going to rebuild their own research?  If so, whose current pay gets cut?  Will new research be any better than the sub-par operations they ran last time around?

for individual investors, like you and me…

THIS IS GREAT!!!

Yes, less well-informed institutions means that day-to-day volatility may be higher.  But it also means that we have a much better chance than we did a decade ago to discover valuable information that Wall Street doesn’t know yet.

Tomorrow, what companies are doing–with an aside on AAPL.

where is the stock market headed?: Wall Street strategists vs. analysts

May 13, 2013 By in Industry Analysis, Investment firms, securities markets, sell-side analysts vs. strategists, stock market, using research Tags: , , , , , , , , , , Leave a comment

 Factset:  what Wall Street thinks

Last week I got a press release from Factset, a financial data collection and analysis service, on the topic of where the S&P 500 is headed over the coming twelve months.  The short answer from Factset:  brokerage house analysts think the market is going up a little bit, strategists think the market is going down–again by just a touch.

I’m going to write about this over the next few days.  My short answer:  if history is any guide, neither outcome is likely.  The market seldom drifts along.  It either goes up a lot, or down a lot.

strategists vs. analysts

Who are these people?

First of all, they’re both sets of “researchers” who work for brokerage houses.  Now, they don’t call brokers the “sell-side” for nothing.  The number-one job of any sell-side researcher–analyst or strategist–is to persuade customers to do their trading business with their firm.  In other words, they’re primarily salespeople.  That’s important because it means that at least to some degree they both tailor what they say to fit what their buy-side audience wants to hear.

strategists

Strategists are typically economists or statisticians by training, although they are also sometimes former portfolio managers (snide pms would probably say failed portfolio managers).

Strategists normally work “top down.”  That is, they use data about the macroeconomy to make forecasts about GDP growth and  the course of interest rates.  They then derive expected future earnings growth for the overall stock market and the price earnings multiple at which they think the market will trade.  That gives them a forecast of the future stock market price.  For the S&P over the next year, Factset says the strategists’ consensus is down, but my less than 10%.

Based on their analysis, strategists also recommend sector- and industry-based portfolio structure.  In conjunction with analysts, the may also suggecst individual stock holdings.  They may also help set policy–like the official forecast of the oil price–that analysts more or less adhere to in making their company earnings forecasts.

Strategists are normally much more conservative than sell-side analysts.  Their earnings growth projections are almost always lower than analysts’.  Clients occasionally permit strategists to be bearish, and–as is the case now–to say the market is headed south.  But a prolonged bearish tilt is almost like buying a ticket for the unemployment line.

analysts

Analysts are specialists in specific industries or economic sectors.  They may have academic training in engineering or other subjects pertinent to the industry they cover.  They may have worked in the industry, often in strategic planning or M&A.  They’re invariably deeply knowledgeable about company financials and about the competitive dynamics of their coverage. They often also have privileged access to the top management of the firms they analyze.

That access usually comes at a price.  Analysts can come under considerable pressure not to deviate–either up or down–from the official earnings guidance announced by these firms.  A “sell” recommendation can sometimes trigger a violent reaction from the company in question.

Many investors–childishly–don’t like to hear bad news about the companies they own.  At the same time, the analyst won’t earn much if he doesn’t have good things to say about at lease some firms in his industry.  As a result, analysts tend to err very substantially on the side of optimism.  They turn bearish, even for a short time, at their peril.

year-ago predictions

Industry analysts make projections of earnings growth and set stock price targets for the companies they cover.  They don’t make projections for the S&P.  Factset gets an implicit analyst forecast for the market by aggregating the analyst projections for each company in the S&P 500.

Getting a strategist forecast is much more straightforward.  Factset just takes a median.

Anyway, in April 2012 the implied analysts’ forecast for the S&P was much more bullish than the strategists–at +11.9% vs. +2.6%.

No surprise there.

What is a surprise (“shock” may be a better word), however, is that the analysts were a lot closer to the actual S&P 500 results of +13.8% (capital changes only).

year-ahead projections for the S&P

That’s tomorrow’s topic.

current equity market money flows

April 2, 2013 By in Current Market Thoughts, ETFs Vs. Mutual Funds, index funds, Industry Analysis, Investment firms, securities markets, stock market Tags: , , , , , , , , 1 Comment

There’s been a lot of press recently about investors suddenly waking up after four years of strong market gains and deciding to take their money out of “safe” fixed income investments and put it into stocks.

What’s implied in many of these articles is that this flow is what’s putting the recent zip into the S&P 500.  What’s also implied, and sometimes stated, is that this is the “dumb money” whose arrival on stage is a signal that we’re entering the closing act of the current bull market.

Both implications might have some truth to them.  But neither is anything like the full story.   Most people are a lot smarter than that.  Money flows are a lot more complex.

This is what I see:

1. Any money going into stock market mutual funds or ETFs is not coming out of bonds.  Bond funds have had large inflows every month since January 2009, except for tiny outflows in December 2010 and August 2011.

Money coming into bond mutual funds accelerated in 2012, to around $25 billion a month, according to the Investment Company Institute, the mutual fund trade organization.

2.  Bond inflows have been matched by steady though smaller, outflows from stock mutual funds.  The lost stock mutual fund money may be feeding part of the bond buying binge.  But there are also two important trends within the equity world.

–There’s a big multi-year shift away from actively managed equity mutual funds toward index ETFs.  Two reasons:  better performance, and lower costs.  ETF flows are clearly much healthier than equity mutual funds’.

–Virtually all the net equity mutual fund outflows have been coming from US-only funds.  Global, international and emerging market mutual funds have been at least treading water.  Similar ETFs are seeing large inflows.  Again, this has been happening for years.

3.  So far in 2013 over $60 billion in net new money has come into equity mutual funds, breaking an almost two-year stretch of outflows.  Two-thirds of that has gone, as usual, into global etc. funds.

Much more interesting, to my mind, but almost completely unnoticed, is the HUGE outflow of over $112 billion from equity funds that occurred last year, from August through December.

Why this rush to the door?  My guess is that this is the final shoe dropping from the stock market collapse of the Great Recession. In my experience, some investors will panic and sell at the bottom.  Others will nurse their wounds and refuse to sell until they get back to breakeven.  Then nothing on heaven or earth can persuade them not to take their money and run.  I’ve turned around two woefully underperforming global funds for two different organizations.  In both cases, this sort of almost inexplicable outflow was the last step in the healing process.

If that’s what happened during the second half of 2012, it’s a significant bullish sign for stocks.