March 1, 2021

There is an old joke about three general contractors that die and go to heaven.  St. Peter welcomes them and asks for a favor. The pearly gates to heaven are broken could each of them provide an estimate for the repair.  The first contractor from the Midwest, looks over the gates thoroughly and tells St. Peter it will cost $300; $200 for parts and $100 for labor and the gates will be just like new.  The second contractor is from San Francisco, he spends a couple minutes looking over the project and mentions to St. Peter how busy he is and if he needs it done right away it will cost $3,000; $1,500 for parts and $1,500 for labor.  The third contractor is from New York City and without looking at the gates he says $2,300.  When asked how he determined the price the NYC contractor responds - $1,000 for you, $1,000 for me and $300 for the guy from the Midwest to do the job.  

While humorous, the joke essentially describes how much of the investment business works.  Many years ago, Wall Street firms figured out if they wanted to grow their business it was more effective to raise the price and bribe the financial advisor to betray their clients rather than do a good job managing investments.  Since I've started writing these letters, I have reviewed several reader’s financial plans and have found the same issue over and over.  Their advisor charges a fee for financial planning services and then is prescribing high fee products where they receive another large commission.  They are supposed to be acting in your best interest, instead, they are double-dipping and padding their bank account instead of yours.  A lot of people go to the biggest financial firms thinking they are getting the best and brightest in the industry, when in fact it’s the worst possible place.

 

"If you see fraud and do not say fraud, you are the fraud" Nassim Taleb
A few years ago, I was invited by my in-laws to attend a dinner and presentation by their financial advisor.  Their advisor had a new investment opportunity in a real estate company that he wanted to share.  Because I owned a rental house at the time and was looking to purchase another, they thought I too might be interested in their advisor's idea.  Prior to the meeting I printed off the notes to the financial statements (the ultra-boring fine print in the SEC filings), which is where the real information is found.  As an investor I find digging into footnotes invaluable and well… almost not boring.  What I discovered in a few minutes of reviewing the footnotes was shocking.  I read aloud some of the details to a co-worker and asked, should I cancel and not attend the meeting?  Or should I go and point out what looks like fraud and possibly save a dozen other families in attendance from a financial disaster?  My co-worker recommended I should go and do my good deed for the day.

I arrived early and was greeted enthusiastically by the advisor; we made small talk about this exciting idea he wanted to share.  Once the group had gathered the advisor and a representative from the real estate company began their presentation.  It started with some nonsense industry jargon about the "efficient frontier" and the benefits of "diversification." It was quite clear they were trying to establish credibility on a subject they knew nothing about.  The representative then discussed how his company was going to make everyone  lots of money and pay a "6% tax-advantaged dividend."  At that moment the room full of retirees lit up.  Desiring safe income in a world with  inadequate interest rates, I could see they were all sold.
 

But now it was my turn, and by this point I was Samuel L. Jackson-Ezekiel 25:17 angry.  I interrrupted the advisor and representative and asked for their fee on this "investment."  They replied, "12% but we'll make that back for you right away."  I pulled out the footnotes and read them aloud to the room.

     1. Load fee for initial purchase - 12%
     2. Shareholder servicing fee - 1.125%
     3. Management fee - 1%
     4. Acquisition Expense Fee to Management- 6% of property contract price
     5. Acquisition Fee - 2% of the cost of the property
     6. Loan Coordination Fee - 0.75% of the loan amount
     7. Construction Manager Fee (for oversight of the construction manager) - 6% of the total cost of work
     8. Property Management Fee (for oversight of the property manager) - 1% of property management costs
     9. Property Disposition Fee - 1.5% of the property price
     10. Subordinated Participation Fee - 15% of the net proceeds after return on total investment
     11. Listing Incentive Distribution - 15% of total market value upon public listing

I let everyone know this real estate project has been fully occupied for years and has not turned a profit because the managers had their hands in the company till.  I then asked the representative since the managers were also the Construction Manager and Property Manager why the shareholders needed to compensate them to supervise themselves.  I also inquired as to why they had a cease and desist from soliciting investors in Ohio.  The advisor and company rep tried to shut me up by asking to speak privately, but I wasn't finished.  I informed everyone in the room the "6% tax-advantaged dividend" is merely them sending a portion of their own money back and we were here today because they needed an influx of cash to keep this scheme going.  Sometimes the footnotes are juicer than a day-time soap opera.  Sensing I was no longer welcome, I told the advisor that I would be having a chat with the SEC, ordered a steak and two bottles of wine on his tab, and then hit the road.

I did speak with FINRA and the SEC. The real estate company was investigated and a privately negotiated settlement and fine were made.  The moral of the story: if all the details are in the footnotes its okay to hide behind "buyer beware."


"It is difficult to get a man to understand something when his salary depends upon his not understanding it."  Upton Sinclair
After that mic drop moment, I realized the system doesn't work for regular Main Street people.  I have read thousands of SEC filings and was able to identify fraud in less than 30 minutes.  Lawyers, accountants and doctors are legally bound to have a fiduciary duty to their client, but for some reason, financial advisors are not held to that standard.  The industry has two different types of advisor, there are advisors who follow the fiduciary standard and are legally obligated to act in your best interest and an advisor who follows the "suitability" standard.  The second type, which is most common, has no obligation to act in your best interest, which allows them to charge you a 1.5% fee for financial advisory services AND accept commissions from Wall Street paid from your account.  The key difference between the two is both types will say to you "I am acting as a fiduciary," but once and advisor accepts money from Wall Street the standard is broken.  You need to ask your advisor if they are a fiduciary 100% of the time, OR, are they dually registered which means they can double-dip from your account.  The US is one of the few developed nations that has this incredibly confusing system and it will be this way until Congress does something about it.  

I love what I do for a living: evaluating businesses and investment opportunities is like solving puzzles.  Some people like cross-words or sudoku; I prefer annual reports and spreadsheets.  I have been fascinated by markets since the tech boom of the 1990s and obsessed with figuring out their operations.  I have contempt for the culture and ways of Wall Street, but have also figured out how to put the odds of success in your favor.  The house can be beat.  For many years I have been reluctant to get involved in personal finance, but now feel compelled to keep my family and friends from being hurt by the system.  As a small part-time operation in the past year, I have saved individuals tens of thousands of dollars in unnecessary fees and collectively well over $100,000.  A second-opinion is commonplace with your health, but what about your financial health?  Its important too, do you know what is in your portfolio, what about your 401K; how about your life insurance policy?  Don't expect Wall Street to be looking out for your best interest.  


Skin in the Game
The problem with this business is most people do not have skin in the game.  I believe that if you have the rewards, you must also get some of the risks and not let others pay the price of your mistakes.  It's the golden rule: treat others as you would like to be treated.  If I give an opinion and someone follows it, I am morally obligated to also be exposed to the consequences.  Therefore, I begin by just telling you what is in my portfolio and then we can make adjustments for your specific situation and risk tolerance.  With 100% of my money in the same portfolio, you are assured I have a laser focus on yours as well.  I cannot think of a more fair approach than to share a common destiny.  

Most financial advisors will imitate other financial advisors to be safe, and that creates a monoculture and collective mirage.  When I have reviewed the statements and materials of other advisors, they are flooded with numbers and graphs and lack any substance of logical arguments.  I've learned from experience that if someone floods you with tons of graphs and tables to prove a point, you should be suspicious.  It means they are likely hiding behind jargon, playing a part and are only familiar with the cosmetic details of the subject matter.  The monthly statements I provide are a short narrative of what is going on and what we are doing.  My letters contain few charts and graphs because I want to distill the logic down to its simplest points.  The goal is to teach, inform, and engage in dialogue.  


Thoughts on the Market
Last week, I made my first change to my portfolio in several months.  For my partners, those who I am working with, you know what we are buying.  If you would like to know what changes my partners and I are making, please reach out and I would be happy to discuss.  


Reminder to stay the course, keep it simple and don't complicate the process
With investing you don't have to do exceptional things to get exceptional results.  I believe the following process is likely to produce satisfactory results over a long period of time by minimizing mistakes.

This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice.  Past performance of any market result is no assurance of future performance.  The information contained herein has been obtained from sources deemed reliable but is not guaranteed.