We put together a board of directors that has a great business pedigree (the former CEO of this, the ex-chairman of that, etc.).There are some stock market land mines that will invariably destroy anyone foolish enough to stand on them for an extended period of time.
My friend The Fly, an anonymous blogger who writes the popular if misanthropic trading Web site iBankCoin, has a term he likes to use for these. He calls them murder holes, and a more apt description for these investments couldn’t be conjured if Shakespeare himself came out of a creative writing workshop and checked his portfolio. I think the term was (relatively) recently popularized when it was used in Saving Private Ryan, but it perfectly describes the types of investments we’re about to discuss.
Until you’ve been blown up by a few of these murder holes yourself, it’s hard to recognize them. Below is a list of the dark alleys you never want to wander down for your own future financial well-being. These alleys are strewn with various land mines, any of which could become your very own murder hole at any time. You probably won’t listen anyway, but don’t say I didn’t warn you.
SPACs. NASA engineers working at full tilt for 18 months couldn’t draw up a worse product than what a handful of investment banks began selling to retail customers in the mid-2000s. SPAC stands for special-purpose acquisition corporation, but it may as well mean selling promises and craziness. The basic premise of the SPAC is this:
We put together a board of directors that has a great business pedigree (the former CEO of this, the ex-chairman of that, etc.).
We go public and raise a big pile of cash that we have a year or so to put to use.
The bankers bring us acquisition candidates until we pick one.
We buy the company and change our name from the SPAC to the company’s name, and our directors and execs assume those roles at the newly merged entity.
Now you are a shareholder in an operating business that we have bought. Congrats!
Sounds interesting, right? The reality is that it sucks for everyone except the investment bankers. Here’s the deal …
For starters, promising companies with no flies on them are able to just go public the regular way through a traditional IPO. They don’t need to be backdoored into the market via a merger with a SPAC. Only the dregs of the private company barrel need to do a deal like this to hit the public markets. American Apparel (APP) is one example; it is one of the most disastrous stocks of the past decade. The founder and CEO was not only accused of cooking the books; he also had a history of sexually tormenting the barely legal models who worked for him.
Another thing to keep in mind is that many well-known and respected corporate chieftains have merely been lucky; they are not automatically going to succeed at ventures. Look at Microsoft’s Paul Allen as an example. Here’s a guy who, once he left the software company that made him one of the world’s wealthiest men, couldn’t wait to set fire to his cash. Everything he touched turned to compost. It was almost as though he was in some kind of Brewster’s Millions type of situation where he had to blow $5 billion in order to inherit $50 billion. There are lottery winners from log cabins in the back woods who’ve been smarter with their investments.
So anyway, a SPAC trots out someone like Steve Wozniak (from Apple), and it makes a deal to buy some also-ran company like Jazz Semiconductor. Yay! Wrong, you will lose. The same thing went on with the hapless losers who ran Jamba Juice into the ground and countless other SPAC stories over the years. No one who invests in these things makes any money—before the merger or after it.
Also, hedge funds typically are hooked up with shares from the SPAC’s IPO. They will bail the moment there is any kind of premium in the stock price over that initial cash-per-share amount the company raised. You will be holding the bag, señor, not them.
According to Reuters, the last big wave of 57 SPACs that debuted at the height of the credit bubble in 2007 had raised a combined $11.3 billion. That’s a whole lot of “dumb money.” The best thing that could’ve transpired for those 57 companies would have been the return of cash that occurs when the clock runs out and a deal hasn’t been consummated. In fact, there were a few hedge funds involved with some of those SPACs that were forcing that dissolution to occur using the voting power of their stock positions.
Finally, let’s understand what this vehicle really is—a way for investment bankers to pay themselves multiple times. First, they take the SPAC public; that’s a fee. Then they consult for the company on retainer as a potential acquisition is sought, another banking fee. OK, they’ve found a company for the SPAC to buy. Guess what? Another fee, a big one this time. Then there is the arduous 12-month process during which the SPAC seeks shareholder and regulatory approval for the deal. Fees, fees, fees. Finally, the deal is closed. Now of course, the SPAC has probably bitten off more than it could chew, and so a secondary stock offering or some kind of convoluted debt or warrant offering needs be done. You guessed it, another round of fees. The SPAC structure is an ATM machine for the bankers. And how have the investors done? Murdered. Like down 80 percent murdered. If it weren’t so true, it would almost be laughable how horribly and slowly these things die. And by the way, many of these SPACs have been China-related in recent years. For investors, the China-SPAC combination is like being beaten up after school and then coming home to find that your parents have moved away without telling you.
And just so you know, the investment banks that make these stepchild IPOs are almost always connected to an aggressive brokerage sales force. How else could $100 million be raised for such a harebrained scheme?
Chinese Reverse Mergers. Nobody does accounting fraud like China. It should come as no surprise that small corporations from a country that invents its own GDP statistics are themselves cooking the books. What’s adorable is that much of the fraud in U.S.-listed Chinese small caps is aspirational in nature; three company-owned shipping facilities become six in the quarterly filing, $50 million in revenues becomes $60 million … who’s going to know the difference? Corporate China’s worst element meets the underworld of the U.S. banking complex, and together they release hundreds of scams onto the American Stock Exchange, the NASDAQ, and even the once prestigious NYSE.
Here’s how it works: Let’s say that you are a Chinese business owner looking to raise investment capital. You happen to read and hear about how foolishly U.S. investors are being herded into all manner of “emerging market” investments. Well, you want your piece too, don’t you? So you make contact with a U.S.-based investment banker (these bankers are crawling all over China these days), and a deal is struck to “take you public” on a U.S. exchange. The first thing that happens is that a shell company with a public stock but no actual business operations is located on either the Pink Sheets or the Bulletin Board market. Why these things are even permitted to trade is beyond me, but fine, there are tons of shells for sale. You then work with a law firm or accounting outfit that specializes in the reverse merger of your company into the shell. Your corporate filings are upgraded so that they pass muster with the exchanges, and you are leapfrogged from one to the next until you can get to the big show—the NASDAQ. At this point, you will have added tens of millions in market cap as more investors hear your story—“They are the leading provider of dried seafood snacks in all of Guangdong Province!” And while your business may be legitimate, there’s a good chance that your accounting is a circus wrapped in a carnival.
And then a short seller tugs a few loose threads, and before you know it, your stock craters. It is eventually delisted, and everyone is crushed.
Bloomberg keeps an index of these Chinese RTO stocks (RTO meaning reverse takeover). This index was essentially cut in half during the first half of 2011, as fraudulent companies large and small were dismantled by intrepid short sellers and fleeing investors (see Figure 21.1). Even John Paulson, one of the most successful investors in history, had gotten himself caught in a Chinese fraud called Sino-Forest. Media reports had estimated that Paulson’s losses on the way out of the pump-and-dump timber stock may have been in the $700 million range. Even in the context of a $37 billion hedge fund, losses of that magnitude will leave a mark.
Figure 21.1. Interactive Chart
The short sellers who have attacked and unmasked the Chinese RTO fraud machine have done investors a favor in the long run. I’ve advised people to avoid the entire China stock sector until the companies grow up a bit and start acting like professionals. After all, if the legendary John Paulson can be taken in by these charlatans, what chance do you have?
One-Drug Biotechs. One of the great things about the U.S. capital markets is that a small biotechnology company with nothing other than some scientists and a promising protein compound can be a publicly traded company while it tests and proves the efficacy of a drug. But while this is a testament to the strength and depth of our capital markets, it doesn’t mean that you’d want your own capital to be in harm’s way like that. One of the easiest mistakes to avoid in the stock market is believing in a biotech story too early and for too long. After all, the vast majority of drug trials fail to satisfy the FDA, and approvals are the exception, not the rule.
According to a Wall Street Journal report, the FDA approved just 26 new drugs in 2009 of which only 7 were biotechnology compounds. The year before, there were 25 new drug approvals with only 4 of them from the biotech arena. How do those odds sound to you as a betting person? How about as an investor in one of the 400 or so small and midsized biotechs with under a billion dollars in market cap? One of the evergreen pieces of investing advice that almost all of the masters agree with is to stack the odds in your favor when entering an investment. With one-drug biotechs, you are willfully doing the opposite.
Retail brokers love to pitch these things because the stories sound incredible and the potential percentage gains are in the four-digit range when they work. Unfortunately most of them don’t, like 19 out of 20. And when they fail, it’s not like shareholders have the chance to sell and walk away. The stocks are typically halted preceding the inevitable gap down before the market’s open, as investors realize that it’s back to the drawing board for the next four quarters. By the time you can sell the stock, it is already reduced to rubble at your feet.
I’ve seen many a broker blow up an entire book of clients with just a single biotech stock that failed to get approval. The broker typically will spend a weekend in Atlantic City recovering from a disaster like losing a few million in assets under management, and by Monday morning he is back on the phones. “I’m in rebuilding mode,” he tells his desk mates as he smiles and dials with the next sexy story. His clients will probably be called a week later when the broker needs to book a loss and move into something else for the commission. That C Class Benz and the bar tab from Atlantic City certainly aren’t going to pay for themselves!
If you must own biotechnology, try to go with a larger company that has several drugs on the market or in development. It may not produce a 10× return, but it also won’t vaporize your portfolio on an FDA setback.
Private Placements. Almost every private placement you have ever been pitched or will ever be pitched is a scam. Yes, you heard me correctly. I’ve witnessed over 200 private placements be brought into brokerage firms, sold to “accredited investors,” and then basically disappear into a black hole of unreturned phone calls and shareholder communications that simply stopped coming.
According to Registered Rep magazine, just two private placements (Medical Capital and Provident) have been responsible for the shuttering of 21 well-known broker-dealers since 2010. GunnAllen, QA3, Empire Securities, Jesup & Lamont, and Securities America were just some of the casualties when these two diseased privates blew up and took the brokerages’ clients with them. Class-action settlements in the tens of millions forced these firms under and left many of the employees without jobs. And these were supposed to have been two of the more reputable deals.
I am fortunate in that I have never in my entire career pitched or sold a private placement. It was pure luck that I had learned very early on to avoid these murder holes, no matter what. In the late 1990s, as an intern at a brokerage firm, I watched as two men made the rounds all over Long Island and Manhattan pitching private shares of Ranch 1, the popular southwestern fast-food chain. They wined and dined brokers from firm to firm during due diligence lunches and boardroom presentations. All the brokers bought in with their clients’ money—“It’s the next McDonald’s,” went the pitch, “and you’re getting in on the ground floor before it goes public!”
A week later, we found out that the two Ranch 1 representatives were, in fact, just franchisees of a few stores. They had nothing to do with Ranch 1 the corporation. Their documents and private placement memorandum (PPM) packets were a work of fiction. Supposedly, they took all the money they had raised and ran away to Israel. At least that’s how the story goes. I never even considered pitching a private placement once I had witnessed that particular debacle; it was all the education I needed.
While this anecdote is an extreme example, the vast majority of private placements end the same way, with a disappearance. The brokers have all been paid their commissions, and the companies that have raised the money aren’t expecting any more, and so no one has a vested interest to find out what happened.
So I’ll tell you what happens and what will always happen when retail brokers bring their clients private banking deals. By the time a company is desperate enough to go to broker-dealers for funds, it means that it is already at the end of its rope. It can’t secure more funding from a commercial bank or a middle-market lender. Its founders and current shareholders are also tapped out. The company has also been rejected by the larger investment banks that have serious corporate finance departments. So the executives put together a PPM, put on clean suits, and do a road show of brokerage firms with a banker or investor relations clown in tow. The retail brokers are offered a 10 percent commission to show the deal to their clients. They are also promised warrants and stock options should the company end up going public (it won’t). This exorbitant compensation for the brokers is a huge red flag. “Brown’s law of brokerage product compensation” states the following:
The higher the commission or selling concession a broker is paid to sell a product, the worse that product will be for his or her clients.
Using this law as a guideline, a 10 percent commission is off the charts, the brokerage equivalent of someone yanking the emergency cord on a speeding bullet train. Brokers take note: selling a client a private placement that pays you a tenth of that money back is the same thing as telling your client to go f*ck himself.
And by the way, the more interesting the company, the more dangerous the private placement offering. In 2007 Lou Pearlman was sitting in my firm’s conference room pitching us his newest venture, Talent Rock, a summer camp for American Idol wannabes. If the name Lou Pearlman sounds familiar, it’s because he was the producer who first assembled the Backstreet Boys and N*Sync using kids from the Disneyfied song-and-dance ghettos of Orlando, Florida. He had supposedly made around a hundred million dollars or so, and here he was asking for us to call our clients to send him more. In addition to sweating like a pedophile on one of those hidden camera sting shows, he was also completely ludicrous when going over the specifics of his offering. One of my fellow brokers asked him, “If it’s true that you’re worth a hundred million and own your own private jet, why are you here looking to raise 50 grand?” Pearlman’s answer was that he needed to buy out his old partners from the deal and they refused to take money from him. This was so nonsensical that even the troglodytes in the firm who would sell anything to anyone knew it was fishy. Six months later Lou Pearlman was arrested in Germany and extradited back to the United States for this very scam. He had run this Ponzi scheme for years and had raised tens of millions, much of it from retail brokers and their clients.
Another celebrity had come to pitch us a private placement that was supposedly “a sure thing” and on the verge of going public. You had to be in the room to believe this one. Standing in front of a PowerPoint projection screen, and wearing a black blazer with a red rose in the lapel, was the legendary Gene Simmons of the band Kiss. The rocker was sans stage makeup and flanked by a cadre of television and Internet executives as he pitched us on a venture of his called No-Good TV. The premise was that he was starting an Internet and cable TV network that would air all the outtakes of interviews and television shows that contained the naughty bits that regular TV wouldn’t broadcast. We were shown clips of Ben Affleck cursing up a blue streak and Colin Farrell’s just-leaked sex tape and told that this was “the next HBO.” The brokers took pictures with Gene, and one of the sales assistants tried to find out what hotel he was staying at in Midtown. We were given the due diligence packages after the road show, and we laughed like bastards at how ridiculous it all was. Gene went on to launch a TV show on the A&E network that attempted to turn his family into The Osbournes. It didn’t work, and neither did No-Good TV, thank heavens for the American viewing public.
These days there are huge questions surrounding the selling of private real estate investment trusts (REITs), in which many brokerage firms are currently engaged. The private REIT pays the brokers somewhere around a 7 percent commission on average. And while the real estate holdings and management capabilities of these private REITs may be fantastic, I still couldn’t understand why the clients wouldn’t be better off investing in one of the hundreds of public REITs. And then a broker explained that because the private REIT is nontraded, it means that “there will be less volatility in the client’s portfolio.” I know, completely insane. And of course that 7 percent commission is built into the offering price; the client never sees it or feels it (and in many cases doesn’t even know about it).
I won’t go so far as to say that all private REITs are murder holes, like all private placements are, but I will say to think twice about the advantages of buying a private one when there are scores of perfectly attractive public ones that offer daily liquidity and price discovery.
And there are other investor traps out there, too numerous to expound on each of them here. They include:
Oil and gas limited partnerships. (If you’re being cut in on them, the wells are dry.)
Principal protection funds. (They always come out after the market’s been killed and cap your upside on the recovery.)
Insurance brokers selling asset management. (Does your hairdresser also repair the roof on your house?)
Stockbrokers selling guaranteed-return equity-linked annuities. (Yeah, that’ll end well.)
Reverse convertibles and other structured products. (They will pit you against both the market and the banker—good luck!)
Brokers with one day left in their pay period. (They will call you with the news that “we need to rotate and move some things around.”)
Brokers with thick New York accents and Boca Raton area codes. (Florida’s Homestead Act has led to a preponderance of bad guys from New York setting up shop in southern Florida; the civil courts can’t touch their property.)
Anyone who claims to have a “system.” (Why? Because there is no such thing, and if there were, you would be the last person to hear of it.)
Anyone who calls himself a “financier.” (He’s guaranteed to be full of sh*t and probably wears a suit and dress shoes with no socks.)
Financial advisors who self-clear or self-custody client funds. (Always be sure there is another pair of eyes on your money, preferably a large corporation’s.)
Currency brokers and forex sites. (Nobody knows anything; this is all highly leveraged speculation, and the brokers are actually trading against you when you take a position.)
Managed futures funds. (The fees are so over the top that your actual return will look nothing like the advertised return.)
Movie investments. (The latest telemarketing scam; no studio worth investing in is going to unleash an army of cold callers to raise funds.)
Closed-end fund IPOs. (These funds should only be bought at a discount in the secondary market. Within 90 days of the IPO, the “penalty bid” phase ends and brokers can freely dump shares while keeping their commissions—you will be down 15 percent in a blink.)
So much product is being churned out that a financial advisor like myself can feel more like a bouncer than anything else. Lucky for me, I look good in a black t-shirt with my arms folded across my chest. Many of my clients know to run these ideas past me before acting on an aggressive pitch. My answer is almost always no.
I’d love to be wrong, but that hasn’t happened yet when dissuading the people I care about from these types of murder holes. Consider yourselves warned.
