Should You SPAC?

Special-Purpose Acquisition Companies, or SPAC’s, are the hottest thing on Wall Street. In 2020 alone, the year of Covid, SPAC IPO’s have raised over $57 Billion with two months to go, dwarfing the previous high of $13.6 Billion, raised in 2019. By investing in a SPAC IPO, investors are giving a “blank check” to a management team to go out and purchase a business and operate it as a publicly-traded company. The acquisition target is likely not identified at the time of the IPO. Does this sound like a good investment opportunity to you? It may be, but unless you really do your homework, you are setting yourself up for failure.

SPAC’s

SPAC’s are sort of a way for average investors to invest in private equity-type deals. Only institutions or accredited investors are eligible to invest in traditional private equity, and they do so because returns can be high, but so can corresponding risk. Often, in private equity deals, a business is targeted followed by a search to find a team to manage the business, but it can also happen the other way around.

Anyone Can Invest

Anyone can invest in a SPAC – you don’t need to be an accredited investor. In a SPAC, as opposed to traditional private equity, the management team comes first, followed by the business acquisition after the IPO money has been raised. That’s why SPAC’s are referred to as “blank checks” – investors are giving money to a team and it’s up to the team to spend it how they want. The valuation and the fundamentals of the acquisition target are not known to the SPAC investors at the time of the SPAC IPO. SPAC investors are therefore giving over the right to analyze and negotiate a good deal to the SPAC management team. Of course, the SEC has guidelines for how SPAC’s are to spend their IPO money, but, still, an investor has to take a leap of faith to entrust their investment just in a team of people and let them go for it without your pre-approval.

Is It Really That Far-Fetched?

Though investing your good money with a management team in search of a business sounds different, it really isn’t. Think about mutual funds, which most investors own in some capacity. An actively-managed mutual fund operates somewhat in the same way: investors give money to the mutual fund managers, who in turn take the money pool and invest it typically in publicly-traded companies that they believe to be undervalued or that they believe have potential to appreciate such that their returns will outperform market returns. Investors trust that the mutual fund manager is superior at doing their investment analysis better than they can working on their own. Though mutual funds diversify by investing in many public companies, SPAC’s typically are less diversified, investing in only one or a couple of businesses. That said, the concept of delegating the acquisition and investment decision to someone who is more able is not that strange, and is a common element between actively-managed mutual funds and SPAC’s.

Should You SPAC?

Should you invest in a SPAC? In my opinion, if you do so, you better have a very strong knowledge, belief, and experience with the management team in charge of the SPAC. Since you can’t do your homework on whatever company they plan to acquire, you had better be darn sure that the team are comprise of people with integrity (so that they won’t just make off with your money) and acumen. Beyond that, there are other things to consider. For instance, typically a management team has experience in a certain type of business or industry. You as a possible investor should consider whether there are good opportunities in that industry for acquisitions. If it is a “hot” industry, perhaps there are a lot of other money pools out there trolling for potential acquisitions, in which case the price of those acquisitions could be bid up. On the flip side, perhaps this team’s experience is in a market that is petering out. If so, is there a catalyst within that market that could cause it to either stabilize or turn back in the right direction? These are the type of questions that you should consider before you invest.

IMO

Caveat Emptor – buyer beware – is very appropriate for investors who are looking to invest in a SPAC because they think they can earn private equity-type returns. While there are other types of investments out there that fit a similar profile, SPAC investors have to be extremely comfortable with whoever is in charge of the SPAC. While the investor may not be able to do their homework on the target company, there are elements they can bone up on, and so there are ways they can and should get more comfortable before they open their checkbooks.

Insider Trading

Question: Is insider trading illegal? No, it is not always illegal, and that answer may surprise some people. Insider trading, meaning the buying and selling of shares and the exercise of options among corporate “insiders” is perfectly legal as long as the insider follows the requirements set by the Securities and Exchange Commission and most likely trades during an open “window” established by the company. Illegal inside trading occurs when the SEC rules aren’t followed – usually because the trading occurs by someone who is not an insider and who is in possession of “inside information” that only insiders should know and who likely trades outside of the corporate window.

Bad Reputation

Insider trading gets a bad reputation because of those who don’t follow the rules and ended up in prison, but it is an important part of corporate governance. Without the ability to buy or sell their corporate stock, corporate officers and directors would not have a way to raise money and diversify their holdings. Instead, they would be stuck owning their stock until such time they are no longer corporate insiders. Not being able to sell stock would be demotivational for management and thus bad for business.

Public Information

Any corporate insider who wants to buy or sell their own company’s stock must file a Form 4 with the SEC. By doing so, their filing becomes public information that is tracked by any number of services. The tracking website that I look at is through Finviz.com, but there are many others that you can use Google to discover. Tracking is done on a daily or even real-time basis so this is public information that you can use to do your own trading.

What Does It Mean?

You might think at first that an insider who is buying is bullish for the future of that company and hence that stock and an insider selling is bearish. In my experience, that is not entirely the case. Insider buying is more bullish than insider selling is bearish. Corporate officers and directors sell their stock for all sorts of reasons: desire to buy something else like a house; needing to pay taxes; the stock has hit a pre-determined target in a 10b5-1 plan, which is a pre-approved plan for orderly stock sales; or just plain portfolio diversification. These sellers need money for some reason and they sell stock to raise it.

Insider Buying

On the other hand, an insider filing to buy additional stock or to exercise existing stock options can be viewed as a re-commitment or a “doubling down” on the company and could be a bullish signal in the broadest sense about the future of the company. Insiders of companies whose stock has been beaten down may stake their future on buying the stock at a low point so as to steady the stock’s fall and try to get the ship pointed in a different direction. In my opinion, if you as an investor spot this type of corporate insider buying at a low point, you may want to consider buying into that company as well. It may be an opportunity for a deep value play that will make you big money – or maybe it won’t. In any event, you need to have a keen eye for this type of play, and perhaps you want to “paper trade” or pretend to invest a few times before you actually put any real money into it, just to see if your instincts were correct.

IMO

Insider trading is perfectly legal as long as the rules are followed. If you are so inclined and if you are diligent in tracking these transactions, it might be a way to pick out a plum value play if you are astute enough. Also, don’t sell your stock if you see that an insider is selling, because they may have good reasons unrelated to the future of the company to be selling.

Stocks Are Up Because Rates Are Down

This point is directly from the latest Insight Memo from Howard Marks, the legendary investor and head of Oaktree Capital Management. Mr. Marks says he believes (and I agree) the major stock indexes have risen so dramatically since March because interest rates have been reduced to near zero. The Fed reduced the Fed Funds rate by 150 basis points to near zero in one fell swoop in March, and longer-term rates soon followed suit. This decline in rates reset return expectations across the gamut of asset classes. If bond investors are willing to accept 150 – 200 basis point lower returns on their investments, then stock investors will accept lower returns on their investments, which means that stock prices increase, as long as returns (i.e., earnings) remain constant.

The following two charts (created by me using my admittedly wanting level of technical skill but taken directly from Howard Marks’ memo) illustrate what I mean. The blue line on the first chart shows the returns that investors expect with different investments with increasing levels of risk. Riskier investments require higher rates of return, from “risk-free” US Treasuries up to private equity capital. Before Covid, investors were looking at a return of perhaps 2% or thereabouts on Treasuries and upward from there – that’s what this chart attempts to portray:

This next chart adds an orange line that shows how investors’ expected returns have shifted during this Covid era. Notice that expected returns during the Covid era are lower across the board from the pre-Covid era:

The Fed

It is the Fed that took the first step when it dropped the rate on the Fed Funds Rate to near 0%. That step took down the yields on all Treasuries across the entire yield curve. With “risk-free” Treasury returns at near zero, investors searching for return quickly began to invest farther out on the risk spectrum, particularly in “quality” and “aggressive” stocks, thereby bidding their prices up and expected returns down. Without the Fed Funds and US Treasury rates as low as they are, we would not have had the stock market rebound to the extent that it has.

The Future

The Fed has been explicit that rates will remain low for the next several years. The long end of the yield curve has seen higher rates in recent days, meaning the yield curve is less flat and more upward sloping, which is probably a good thing. Investors therefore don’t need to guess which way the Fed is leaning, which eliminates an element of uncertainty from the forecast of where stock prices are headed. The point is that interest rates that are this low and will remain this low for the next several years are bullish for stocks. This is not to say the stock market will head straight up because there are a lot of other uncertainties out there related to Covid, geopolitics, US elections and ensuing governance, as well as fiscal policy. There will also continue to be technological disruptions through which some companies will win and others will lose. Yet we have seldom had a situation wherein rates are this low and we have been told that they will remain this low for a period of time. Understand that the Fed has given us investors this knowledge and this investing environment. We ought to take advantage of it.

Going Viral

Most social media-savvy people know that “going viral” means something that gains rapid popularity due to acknowledgements, re-postings and re-tweets in social media. Things or people that were unheard of yesterday suddenly become the talk of the town today. The thing or person has achieved that currently much sought-after attribute: popularity. Also, don’t forget that it is the CoronaVirus that has the world economy in peril, and so it seems Virus is trending in all sorts of ways these days.

Remaining Viral

It is one thing to go viral, but it is another thing to remain viral. People have short memories, especially in social media, so it seems the trick to remain viral is constantly to reinvent one’s self and go viral over and over again. No small feat to do so. Perhaps this is who “celebrities” who become and remain viral are so handsomely paid – it is a difficult trick to pull off. Kudos to those who understand this world and capitalize on it.

Stocks Are Viral

As I write this, it appears that stocks and investing in the stock market are becoming viral. A big chunk of the US work force is still working from home, and some of them have financial media such as CNBC and Fox Business News on their TV’s while they Zoom in to work. This is feeding a boost in interest in stock investing, options trading, and the amassing of one’s own capital. These have been abetted by easy-to-use trading platforms such as Robinhood.com, as well as by free commissions for some trades. Those companies that are doing well in this stay-at-home economy have benefitted, and this has driven the tech-heavy Nasdaq 100 index up about 26% this year and about 73% since it hit a Covid-influenced low of about 7000 this past March. Investing in one particular stock, Tesla, and its options, has caused its price per share to increase almost 3 1/2 times this year. That is as viral as it gets in the stock market.

Is Viral Good?

A virus itself is not a good thing; see: Coronavirus. But it seems that going viral is a good thing in the short term. For stocks, going viral means everyone is jumping on the bandwagon and investing, perhaps regardless of the underlying company fundamentals. As with one-hit wonder social media stars who become viral but flop back to earth when they can’t maintain their popularity, so to can “viral” stocks return to earth quickly without any substance. One example: Eastman Kodak, which went from the $2-range up to a high of $60 (!!) in the course of a couple of days in late July due to its apparent involvement in a government program to help with the manufacture of Coronavirus medications. When that deal didn’t pan out as hoped, Kodak fell back to the $8/range – still higher than $2 but nowhere near $60. So, for every Tesla, which so far has maintained its viral nature, there are many Kodaks.

IMO

Don’t fill your investment portfolio with viral stocks. Make diversified funds the bulk of your portfolio. If you must, designate a small portion of your wealth as “fun money” to play the viral game. The ability now to buy fractional shares in some companies make it easier to get involved, especially for lower net-worth investors. Or, buy call options on what you think may hit it big soon, keeping in mind that call options expire at some point. If you load up too much on viral stocks, you run the risk of infecting your entire portfolio with losses, and losses are hard to overcome.

A Fly On His Head

A fly that alit on Vice President Pence’s head and stayed there for a long time became the talk of Wednesday’s Vice Presidential Debate between Pence and Senator Kamala Harris. What does that say about the state of our political dialogue, that a fly can become the star of the show? But I digress. The dark-colored fly became prominent against the contrasting background of Vice President Pence’s light gray hair. Light gray hair – black fly: You will see the fly. Had the fly alit in Senator Harris’ dark hair, we viewers may not have seen it. As a result of the contrast of Pence’s head, it is a “viral” news item.

Contrasting Background

Something that is visually different will likely stand out from the crowd. What about you and your personal finances? Would you like to be the one with a black bug on your white hair and thereby stand out from the crowd and attract attention? Or would you prefer to blend in to the background? Here are some examples to think about:

  • College: Your high school senior is a good student and would likely be admitted to any number of elite private colleges, but they would have to borrow a lot of money to do so. Your child’s closest high school friends will also likely go to private college, so your child would better blend in if they also did so. However, the better financial decision is to go to State U., or even your local CC for a couple of years. Should you contrast with your neighbors just to save some money?
  • Investing: The stock market has been bullish and the TV “experts” think the bull run will continue. However, you think things are about to take a turn. Do you stick with the experts (blend in) and hold your positions, or do you liquidate now (contrast) and stick to your own intuition – or maybe it’s more than just intuition?
  • Retirement: Your childhood friends are all taking early retirement and seem to be having the time of their lives. They are all urging you to retire and join in with their fun. However, you figure you need to work a few more years (God willing) to complete your financial goals. Do you blend in with your friends and retire early (it does sound like a lot of fun!)? Or do you contrast with your friends and work until you feel you can retire more comfortably?

Not Easy

Although my examples seem so, the “contrast” option is not always the correct decision. Sometimes everyone else is right and you are wrong. It is difficult to make a decision when you right in the middle of a situation and you are perhaps not objective in your reasoning.

IMO

The point that I am making is that you should not be afraid to go with the crowd and blend in with your financial decisions, nor should you be afraid to be the fly on Pence’s head and contrast with the crowd. You are not always right and the background crowd is not always wrong, and vice-versa. The trick is to recognize which way to go when you have a fork in the road. That said, if you are concerned about saving for the future, decisions that boil down to “spend less money today” are usually good decisions that perhaps result in some sacrifice in the current for good stuff in the future. Rather than focusing on the background color – i.e., what other people will think or say – focus instead on how this decision will help you achieve your own financial goals. That’s the better way to make a tough decision.

Beware Indexed Variable Annuities

We all know that interest rates are low, which means that your rates on bonds, bank CD’s, or any other fixed-income investment are also low. Investors are reaching for anything that might improve their current return. One such “reach” that is being heavily promoted by the insurance companies that issue them is an Indexed Variable Annuity. If you have seen any of these promotions and are considering a purchase of an Indexed Variable Annuity, my advice is: Beware!

Annuity

I say Beware because you at least have to understand all of the vocabulary of this part of the investment world and how each word relates to your money and your investment. An Annuity is a steady stream of income over a period of time. Typically the income stream is fixed, and therein lies one issue with an indexed variable annuity: Its income stream is not fixed.

Variable

Having dealt with the noun in this type of investment, let’s move to the adjectives. Variable means just that – not fixed. The owner of a variable annuity doesn’t know for sure what the income stream will be, at least for a period of time, based on the type of variable annuity it is. This isn’t necessarily a bad thing; just different than traditional fixed annuities. If you can deal with the uncertainty of the variable payout rate, then the investment could work for you. The current return of variable annuities depends on the performance of a portfolio of securities (usually mutual funds) that the issuer (typically an insurance company) invests in. A variable annuity will often have a “floor” return that provides the annuity holder some safety, but your principal can be at risk when you invest in a variable annuity. Current returns of such investments are difficult to search and find on the internet – a lot different than traditional bond rates or dividend rates of stocks.

Indexed

The second adjective means that the annuity’s return is tied to a major stock index, such as the S&P 500 index. Often there is a provision such as your return will be no lower than 0% (i.e., you don’t lose money) and will be up to 70% of the performance of the S&P 500 index. That may sound like not such a bad deal, but the return is variable, not fixed; your money will be tied up in the investment for the long term and it may be difficult to get your money out if you need it; and there are high fees.

Other Vocabulary

Other terms you need to be comfortable with if you consider an indexed variable annuity:

  • Term Cap: The most you can earn during a given term, usually a number of years, and usually expressed as a percentage (such as 70% in my example above) of the underlying index.
  • Participation Rate: The percentage rate of return that you earn, up to the expressed Cap.
  • Trigger: If the underlying index has a positive return for the year, that “triggers” participation in that return for the annuity holder.
  • Floor and Protection Level: If the underlying index goes down, the insurer will “eat” the loss up to a certain floor amount. Sometimes the floor is 0%, but other times it may be a negative number, meaning you as the annuity holder could lose money.

IMO

Indexed Variable Annuities are complicated, and it is said they are “sold” rather than “bought.” Go ahead and Google “Rates on Indexed Variable Annuities”, and you will not see a percentage rate that is easily explainable or comparable among different issuers. The current returns on traditional fixed income investments are low, and you may be looking out there for alternatives. Unfortunately, I don’t see the upside of owning an indexed variable annuities as commensurate with the downside of owning such an investment. That said, it may work for you, but at least make sure you understand what you are getting yourself into. Contact me if you think I might help.