In this excerpt from his book Backstage Wall Street: An Insider’s Guide to Knowing Who to Trust, Who to Run From, and How to Maximize Your Investments, Joshua Brown comes clean about some of the more dangerous investment products Wall Street sells to largely unsuspecting investors. A financial advisor and the blogger behind ReformedBroker.com, Brown is a frequent contributor to Registered Rep.
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 website 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.
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. 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 backwoods 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.
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 hare-brained 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.
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. 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.
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?
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 seven were biotechnology compounds. The year before, there were 25 new drug approvals with only four of them from the biotech arena.
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-fold return, but it also won't vaporize your portfolio on an FDA setback.
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 that were brought into brokerage firms, sold to “accredited investors,” and then basically disappeared into a black hole of unreturned phone calls and shareholder communications that simply stopped coming.
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.
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.
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.
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.
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.
- 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 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.
Joshua Brown is a financial advisor and blogger at TheReformedBroker.com.
This article was adapted from Joshua Brown's new book, Backstage Wall Street-An Insider's Guide to Knowing Who to Trust, Who to Run From, and How to Maximize Your Investments.