AAII Investor Update: Be Wary of Crowd Funding Start-ups

Thursday, April 5, 2012
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

The IPO Prospectus
This document can alert to you to potential risks.

April AAII Journal
Features include an allocation strategy for retirees.

AAII Discussion Boards
Would you participate in crowd funding?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 38.2%, down 4.3 points
  Neutral: 34.0%, up 2.0 points
  Bearish: 27.8%, up 2.3 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


March 29, 2012

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March 03, 2011

Later this year, or early next year, you will have the chance to buy shares in small, growing companies through a process known as crowd funding. If an offering seems interesting, tread carefully, do as much research as you can and do not commit any money you are not willing to lose.

Crowd funding is the process of raising money from a group of people. It is currently used for a variety of purposes, from charitable efforts to political campaigns. Some websites, such as Prosper.com, allow businesses to access crowd funding to obtain loans. Others, like RocketHub, allow organizations to raise money for a certain goal in exchange for rewards such as a music album or a book. (Crowd funding is also called crowd financing.)

The Jumpstart Our Business Startups Act (aka the JOBS Act) turns crowd funding into a source of venture capital. The act, which President Obama signed in to law today, authorizes companies to sell shares via crowd funding. Specifically, companies can sell up to $1 million worth of shares to just about any investor during a 12-month period, regardless of an investor’s financial resources. This is a very significant change. Existing regulations limit such equity offerings to accredited investors. To qualify as an accredited investor, an investor has to have individual (or joint) net worth in excess of $1 million, excluding the value of his primary residence, or a minimum annual income of $200,000 ($300,000 for a couple) for each of the past two years and a reasonable expectation of this year’s income matching or exceeding those levels. The idea is that affluent investors have the financial risk tolerance to participate in stock offerings for non-publicly traded companies.

The JOBS Act replaces these rules. It allows any investor to participate in a private equity offering as long as they don’t commit more than $2,000 or 5% of their annual income or net worth, if either annual income or net worth is less than $100,000, to a single non-publicly traded company. (Nothing in the bill bars them from participating in offerings for other companies, however.) An investor merely has to attest that he understands the risks involved of investing in a start-up and the risks of illiquidity (strict restrictions are placed on the transfer of shares) and has read the investor education information. Note that there is no requirement that the investor actually read the material, only that he give his word that he has.

Now that I’ve given you some background, read the next paragraph very carefully.

Companies seeking to raise less than $100,000 merely have to have their principal executive officer certify that the financial statements are correct. Companies seeking to raise between $100,000 and $500,000 are required to have a public accountant review the financial statements. Audited financial statements are not required unless the offering amount is above $500,000. All companies are required to provide investors with the results of operations “not less than annually.”

In very simple terms, any investor can tie up his money in a risky start-up company that has no public market for its shares and that may not have had an independent accountant audit the financial statements. This is a recipe for losing money.

I have no problems with a person funding a business he believes will be successful, if he fully understands the risks of the investment and has the financial risk tolerance to make the investment. My concern is that the Internet opens up crowd funding to affinity, social networks and pure hype. More importantly, it will play off of people’s greed—their desire to get in on the ground floor of the next Facebook (FB). And just as there were people who spent way too much money on Mega Millions lottery tickets last week, there will be people who spend more they than should on crowd-funded investments.

Will crowd funding create some very successful companies that make a lot of money for their early investors? Possibly. Will a far larger number of people lose money because of their crowd-funding-related investments? Yes. Most start up companies never make it to the IPO stage.

Participate in crowd funding if there is a business you believe in. But only do so after you have read the prospectus and when you have money that you are financially and emotionally capable of losing.

More on AAII.com

The Week Ahead

As a reminder, the U.S. equity markets will be closed tomorrow, April 6, in observance of Good Friday. To those of you observing the holidays, happy Easter and happy Passover.

First-quarter earnings season “officially” starts on Tuesday afternoon when Alcoa (AA) reports. Joining Alcoa will be fellow Dow component JPMorgan Chase (JPM) on Friday. Also reporting will be fellow S&P 500 members SUPERVALU (SVU) on Tuesday, Fastenal (FAST) and Google (GOOG) on Thursday and Wells Fargo (WFC) on Friday.

The week’s first economic report will be February wholesale trade, published on Tuesday. Wednesday will feature March import and export prices and the periodic Federal Reserve Beige Book. The March Producer Price Index (PPI) and the February international trade report will be published on Thursday. Friday will feature the March Consumer Price Index (CPI) and the preliminary April University of Michigan consumer confidence survey.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday, and $13 billion of 30-year notes on Thursday.

No Federal Reserve officials are scheduled to speak next week.

AAII Sentiment Survey

Bullish sentiment is below its historical average for the first time in 15 weeks, according to the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.3 percentage points to 38.2%. This is the lowest level of optimism recorded in the survey since December 22, 2011. It is also just the second time in the past 17 weeks that bullish sentiment has been below its historical average of 39%.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, rose 2.0 percentage points to 34.0%. This matches the 2012 high set on January 5. It is also the second consecutive week that neutral sentiment has been above its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.3 percentage points to 27.8%. This is the 14th consecutive week and the 15th out of the last 16 weeks that bearish sentiment has been below its historical average of 30%.

The difference between bullish and bearish sentiment, the bull-bear spread, narrowed to 10.4 percentage points. This extends the streak of positive double-digit differentials to 14 weeks, the longest such streak since March 2004. The bull-bear spread stayed in positive double digits for 35 consecutive weeks between July 2003 and March 2004.

A combination of rising gasoline prices, worries about the European sovereign debt crisis, uncertainty about China's economy and concerns that the market's rally may be losing steam helped to reduce the level of optimism recorded in our survey. Notably, bearish sentiment has stayed fairly stable over the past four weeks, with readings of 27.2% (March 15), 27.8% (March 22), 25.5% (March 29), and now 27.8%. Continued signs of economic growth in the U.S. and the stock markets performance are giving many investors reasons to stay optimistic.

This week’s special question asked AAII members if there are any catalysts they are looking for over the next several months. Responses varied, though the health and direction of the U.S. economy was cited most often. Several members said they were looking for changes in employment, housing, gasoline prices or interest rates. Other potential catalysts included a worsening of the European sovereign debt problems, a slowdown in China’s economy and first-quarter earnings for U.S. companies.

» Take the sentiment survey

AAII Asset Allocation Survey

March Asset Allocation Survey results:
Stocks/Stock Funds:
    60.7%, up 1.6 points
Bonds/Bond Funds:
    19.0%, down 3.6 points
    20.4%, up 2.1 points

Asset Allocation details:
    31.6%, up 1.0 points
Stock Funds:
    29.1%, up 0.6 points
    4.4%, down 1.2 points
Bond Funds:
    14.6%, down 2.4 points

Take the survey »

Individual investors modestly increased their allocations to stocks and stock funds last month, even as cash allocations rose to a three-month high, according to the March AAII Asset Allocation Survey.

Stock and stock fund allocations rose 1.6 percentage points to 60.7% in March. This is just the second time in the past eight months that equity allocations have been above their historical average of 60%.

Bond and bond fund allocations fell 3.6 percentage points to 19.0% last month. This is the lowest allocation to fixed income since October 2011. Even with the decrease, bond and bond fund allocations were above their historical average of 16% for the 33rd consecutive month.

Cash allocations rose 2.1 percentage points to 20.4% in March. This is largest allocation to cash since December 2011. It is also the fourth consecutive month that cash allocations have been below their historical average of 24%.

Individual investors remained upbeat about the short-term direction of stock prices throughout March. This and rising stock prices helped to boost stock and stock fund allocations back above their historical average. At the same time, bond yields rose, which raised concerns about the outlook for fixed-income investments. In the backdrop of these two factors are frustration with low interest rates and worries about the pace of U.S. economic growth and global sovereign debt.

This month’s special question asked AAII members what factors have the biggest influence on how they allocate their portfolios. The most common responses cited macro factors, particularly current and expected market and economic conditions. Many respondents also cited their age, a desire for portfolio income (especially dividends) and a focus on preserving capital.

» Take the Asset Allocation Survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor