Thursday, December 22, 2011

5 Ways to Protect your Portfolio from Wall Street’s Excesses

For the past couple of days, I’ve written about some of the Wall Street shenanigans such as the greed that drove MF Global into bankruptcy A Lesson About Greed From MF Global | InvestorPlace and rogue traders who lose billions for their firms Rogue Traders: Not as Rare as You Think | InvestorPlace. These are just a couple of the tricks in Wall Street’s bag that result in costly scandals that rock investment markets, wreaking havoc on investors like you and me.

But there are ways that investors can protect themselves. The excesses of MF Global and rogue traders come from proprietary trading that puts the firm’s interests before its customers. This is the crux of the problem with MF Global. But not only did they risk their own company funds, but they seem to have misplaced $1.2 billion in client funds—suspected to have been traded on the company’s behalf.

And this is precisely how rogue traders get their power. They are authorized to trade, mostly, for their companies, and often have the ability to trade millions of dollars worth of investments in one transaction—with little oversight. As you can see from my report yesterday, when they come down on the wrong side of the transaction, even billions of dollars can be lost, leading to company failures and massive investor losses.

Another tactic that puts the screws to their own investors is when the brokerage firm’s proprietary trading desks trade opposite of what the company’s agents are recommending to their clients. Goldman Sachs was charged by the SEC during the recent financial crisis for selling subprime mortgages to its clients at the same time it was allowing those investments to be chosen by client John Paulson, who was shorting them. And just two weeks ago, it was reported that at the same time Goldman upgraded European investments, their trading desk was selling them!

Now, I’m not picking on Goldman; these kinds of transactions occur daily on proprietary trading desks around the world.

The fallout from the 2010 financial collapse has created calls for additional regulatory oversight, but don’t get your hopes up. The new Volcker Rule, proposed in the 2010 Dodd-Frank Act and due to take effect July 21, 2012, supposedly bans proprietary trading at institutions who also take customer deposits, but it’s been watered down, has numerous exceptions, and the investment community continues to blast it. Consequently, I don’t expect it to have any major impact. As I said yesterday—a lot of lip service and no results.

I’ve made my living for a couple of decades from recommending the shares of small and mid-sized companies—those who are experts in a handful of products, services or technologies, and whose financial statements are visible. I’ve purposely avoided huge conglomerates—like the Enrons of the world—whose legions of subsidiaries makes a true picture of their finances almost impossible to read.

And I think most investors would do well, likewise, by avoiding the big banks and brokerage firms that have too many sources and uses for their money. Most of us aren’t rich enough to deal with hedge funds like MF Global, but during the recent scandal, even respected firms like Merrill Lynch and Bank of America illustrated that they couldn’t be trusted with investors money, riding the coattails of the subprime debacle right to the end.

There are plenty of smaller firms that don’t have thousands of traders trading on behalf of their companies or creating esoteric complex instruments to maximize income. Choose one whose business is transacting business for its customers, not itself. That way, you won’t end up paying for their mistakes.

There are numerous other ways that Wall Street separates investors from their money, including:

1.     Biased analyst reports. I’m not sure how many investors still believe that analyst reports are objective, but, just in case—you should know, that most are not.  Brokerage firms make a hearty percentage of their income from underwriting fees—bringing stocks to market in initial or secondary offerings, as well as fixed income underwritings. And one of the ways they help sell those issues to the public is by releasing very complimentary reports on the shares.

Since the 1929 stock market crash, the Securities & Exchange Commission has issued numerous rulings, establishing—and trying to strengthen—the “Chinese Wall”, separating investment banking from research. But in reality, the bricks in that wall have been increasingly loosened. Even when I was a brokerage analyst 20 years ago, that wall was continuously breached, with investment banking mavens constantly requesting the research analysts to write a “nice” report for their newest clients.

Investors should read the fine print to determine if that “glowing” research recommendation they’ve received was written about one of the brokerage firm’s investment banking clients. I’m not saying they are all fluff jobs, but it pays to be aware of the tendency, and to always seek a second, more unbiased opinion before investing your hard-earned money. Often, one of those unbiased opinions can be found at a brokerage firm that doesn’t have anything to win—or lose—from its analysis. In many cases, that firm will be a “boutique” brokerage firm—a small, local company that keeps track of public companies in its geographic region, and who does little investment banking.

2.     Incompetent ratings agencies. The three major credit rating agencies—Moody’s, Fitch and S&P—are still cleaning the mud from their faces from being caught “pants-down” in their blatant neglect in recognizing the subprime mortgage crisis that brought world financial markets to their knees in 2008.

But that’s not the first time they’ve proven their unreliability. You may recall that they rated Enron’s bonds “investment grade” right before the company’s accounting fraud came to light in 2001. That ultimately caused its bankruptcy, sent executives to prison and cost its shareholders more than $11 billion. The raters didn’t see the fraud coming at India’s Satyam, either, in which the company told investors it had $1.04 billion assets that never even existed.

There are plenty of other examples, too, including the insurance and bank failures of the early 1990s that were largely unpredicted by the major ratings agencies. Only Weiss Ratings, a much smaller company in Florida, actually had the nerve to downgrade many of those companies early on.

The biggest problem is that the major ratings companies are paid by the very people they rate. If that doesn’t sound like a conflict of interest, what does?

It’s investor beware, when it comes to credit ratings. Each agency has its own set of methodologies, many of which are questionable. The SEC sent S&P a Wells letter in September, heralding an investigation of their practices, and I won’t be surprised to see further investigations of the major agencies. The takeaway for you is don’t put all of your faith in the ratings agencies. Like analyst reports, the general information contained within the ratings will be worthwhile, but the end result (the rating, or recommendation) is suspect.

It’s best to do your own homework, ask the right questions, and try to find a second, unbiased opinion from a credible analyst, again, perhaps that boutique brokerage firm that knows its market.

3.     Hidden fees for recommending certain investments. Investment firms are pros at hiding fees, often cloaking them in legalese that even the most astute investor can’t decipher. The only way you are going to find out if your broker or fund manager has a vested interest in recommending a particular investment is in those disclosures that no one wants to read. You can ask them, but be aware that they may not be truthful. Again, read the fine print. If someone is getting paid (just like the ratings agencies and the investment brokers) to give a sterling recommendation, you should automatically be skeptical that it is, indeed, unbiased.

4.     Hypesters and “expert endorsements”. Most investors know that if they hang out in chat rooms, they need to be suspicious of folks who tout stocks—especially penny and resource stocks—as the hypesters are often just trying to drive the prices up so they can cash in and leave you with a stock on a rapid descent.

But what you may not realize is that those thick envelopes you receive in the mail—or fabulously written missives to your email box—that promise untold riches in certain companies, are often cut from the same cloth. Many times, you will see a well-known financial advisor promoting the stock. Be careful. They are not all legitimate. I’m constantly approached by folks asking to pay me to use my name to “recommend” a company in what is nothing more than a public relations effort. I don’t do that and neither do legitimate advisors. When you see my name recommending a company, it’s because I have done the analysis on it myself. So please, buyer beware. Don’t believe everything you read; do a little research on your own.

The bottom line is this: Your broker is probably not your friend; he’s someone trying to make a living, and he’s generally not looking out for you. It’s obvious that the investment industry is a failure at “self-regulation”.  And the government is too tightly aligned with the industry and doesn’t have the will or the muscle to actually make the needed regulatory changes that might serve the public.

But you can take steps to protect yourself. Question everything you hear; take nothing at face value; and do your own homework. One of the best adages that will keep you from harm is this: “If it sounds too good to be true, it is”.

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