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INVESTING LOCALLY

Local investors seek to maximize both their social rate of return and their personal rate of return, while keeping risks to a minimum. Many worry, however, that local companies generate smaller returns than global companies. And they have been told by financial advisors they trust that most local businesses fail. Both concerns, we shall see, are incorrect. But another concern is very real. The entire field of local investment is immature, and the institutions that make global investment easy largely do not exist yet at the local level. So smart local investment—for the moment—requires significant work.

Are Local Businesses Less Profitable than Global Companies? Riskier?

Strong and weak companies come in all sizes. Many large and small companies are highly profitable, and many large and small companies suddenly go out of business. The challenge for any investor, global or local, is to pick wisely. But are there larger patterns that can inform these choices?

Indeed, there are! And not a few of you will be surprised to learn that smaller companies are more profitable than big ones. The most recent data from the Internal Revenue Service (IRS), from the year 2013, show that sole proprietorships, which most small businesses are or start out as, are three times more profitable than C Corporations, with the profitability of partnerships falling in between.¹ In our not wildly dissimilar neighbor to the north, Canada, the most current data suggest that the most profitable companies have ten to twenty employees, while the least profitable are the largest, with more than five hundred employees.²

In well-functioning capital marketplaces, higher profit rates of return for small businesses should translate into higher rates of return for local investors. The problem right now, however, is that the marketplace for local investments is immature.

In a mature marketplace, like the one that has developed over the last century around big businesses, there are professionals who help you find promising investments, evaluate them, trade them, put them into funds, and connect them with your retirement accounts. These professionals barely exist in the local investment universe, so you have to do more of this work yourself. This is changing—more and more finance professionals are reading books like this and rethinking their business models—but for now the burden is on you.

What about risk? If you were to ask a typical investment advisor what she thought about your taking some of your money and putting it into a bookstore you love, she would probably say something like, “You’re crazy! You’ll never get your money back. Most small businesses fail.”

Your advisor just made a surprisingly common mistake, conflating all small businesses with small business startups. Your bookstore, it turns out, has been around for twenty years, has an excellent track record of profitability, and wants to do a modest expansion—it’s not a startup. All startups, big and small, nonlocal and local, have a high failure rate. Most don’t survive past five years or so. But well over 90 percent of all small businesses are not startups. If you are risk averse, the key is not to stay away from local businesses but to stay away from startups.

That’s not to say, however, that investing in proven local businesses is without risk. Your bookstore’s expansion plan could be a dud. Amazon might have a plan for a new popup store across the street. And there are some special risks posed by local investment that are worth paying attention to. If you continued the conversation with your investment advisor, she would probably give you at least four other reasons not to invest in even existing local businesses. Pay attention to all of them:

• Limited Investors—If you’re a business looking exclusively for local investors, it’s going to be harder for you to find them. Compared to the universe of Wall Street investors, the universe of investors in your community is tiny.
• Limited Businesses—If you’re an investor looking exclusively for local companies, you will have fewer options to choose from, and your chance of choosing wrong is greater.
• Geographic Risk—Every regional economy naturally goes through ups and downs. If your investment portfolio is made up exclusively of local business and your region goes through a recession, your losses may be more extreme. That’s why some investment advisors believe that, at a minimum, your portfolio might have locally owned businesses from different places.
• Limited Information—When you want to invest in a Wall Street company, you can go to Google Finance or hundreds of other data providers and get key facts about companies before investing in them. If you are a professional investor, you might buy special analytical reports from companies like Moody’s. Right now, there are no uniform reports you can obtain about local companies.

Again, on all these points your investment advisor is right. But your reaction should be caution, not fear. And curiosity. If your advisor were to give you the complete picture, she would go on and tell you the ways in which local investing also can reduce your risk.

• Better Information—Even though there are not formal information sources about local business, you can find most of the information you need. You can walk into the business, pose questions to the manager, and kibitz with the workforce. You can ground truth what you think about the company’s products or services. Frankly, it turns out this is the best way of evaluating companies anyway. We know this because community banks with long relationships with companies have lower default rates than global banks that rely strictly on computer-generated credit scores.
• Social Returns—Remember that a local business delivers both a private return and a community (or social) return. Unlike a nonlocal investment, there are multiple ways a local investment can benefit you. Even if the company doesn’t deliver much of a profit to you personally, you still will enjoy the benefits of a stronger local economy, cleaner streets, better schools, and so forth. We can argue about how much weight to give this return, but it’s something.
• Local Synergies—A third advantage of local investment is the opportunities it presents for new investment strategies. Remember the risk of geographic concentration? It’s real but there’s a flip side. Your portfolio can enjoy potential synergies if it contains interconnected local companies. If you invest in an established restaurant that puts its second eatery in an otherwise dead downtown, that new business might bring the foot traffic that will help every other new business in that area succeed. A smart local investor might invest in the restaurant and the movie theater next store and the coffee house across the street. And if you wanted to be mindful of the risks of geographic concentration, you might invest like this in multiple downtowns across the country.
• Increased Diversification—The idea behind having a diversified portfolio of investments is if one fails, the others will be unscathed. We want our investments to be different enough so that they cannot fail in the same way, at the same time, or because of some common cause. The essential problem with your portfolio right now is that almost everything in it—stocks, bonds, commercial paper, mutual funds, even currencies—is tied to the performance of global companies. A trade war, a global capital crisis, the collapse of major currencies will adversely affect everything in your portfolio. Truly local investments, in contrast, are somewhat more insulated.

But there is one additional risk inherent in local investing that you need to be aware of, because it dictates how a smart investor needs to approach today.

What’s the State of the Local Investment Marketplace?

Inchoate. Spotty. Full of potholes.

Think about the investment universe that exists today with the world’s biggest companies. Thousands of publicly traded companies have issued stocks and bonds that welcome investments from grassroots investors. Grassroots investors can buy these stocks and bonds individually and then resell them on various stock exchanges. Or they can put their money into index funds, pension funds, or mutual funds that hold various kinds of stocks and bonds. And the law permits anyone with an IRA or a 401k to invest tax-deferred dollars into any of these opportunities.

Very few of these investment institutions exist yet for local investors. Only a tiny number of small businesses welcome grassroots investors, despite recent changes in the law. For small businesses that issue stock for grassroots investors, there are almost no institutions like Moody’s or Standard & Poor’s to evaluate them and give investors confidence they won’t be swindled. There are also no local stock exchanges to facilitate the trading of local stocks and bonds. Without transparent trading mechanisms, it’s hard to know exactly what these investments are worth. Funds that hold investments without clear valuations have difficulty attracting investors. This is one explanation of why so few funds exist for local investors (though their numbers are expanding). And the types of IRAs and 401ks offered to most investors now make it challenging to move funds into any local businesses or local investment funds.

The absence of these institutions means that a local investor today has to spend more time, effort, and even money to do smart investing. And once the investment is made, the investor has a tougher time getting out of the investment. In the professional lingo, many local investments are not very “liquid.” Some students of the stock market argue that half or more of the “price” of stocks is not for a share of the company per se but for the right to resell that share any day, any time, to anyone.

The good news is that the local versions of these institutions are beginning to emerge. And in a decade or two, there will be many local brokerages, local investment advisors, local securities evaluators, local stock exchanges, and local mutual funds. As archaic securities laws get updated, as word spreads about local opportunities, as examples of local investing success multiply, these innovations are almost guaranteed. Where there are markets for new kinds of investment, finance entrepreneurs will appear to take advantage of these opportunities. That’s capitalism at its best.

But before we get into specifics of how to invest locally, it’s worth pausing for a moment and reflecting on how we got here. How did we wind up with a system that rewards big businesses rather than the small and medium businesses that make up most of our economy?

What’s Wrong with the Capital Marketplace?

According to regular reports put out by the Federal Reserve, Americans now have about $13.8 trillion sitting in banks and $56.5 trillion in stocks, bonds, pension funds, mutual funds, and insurance funds.³ If the investment marketplace were operating properly, between 60 and 80 percent of these investment dollars (again depending on how we define “local”) would be going into 60 to 80 percent of the economy comprised of local business. Somewhere between $34 and $45 trillion would be shifted from global companies to local ones. In fact, a small fraction of short-term banking deposits is being lent to local business, and almost all the $56.5 trillion in long-term investment is going into big business.

What would be the impact if Americans shifted 60 percent of their investment into local businesses? A shift of this magnitude would mean that every community in the United States would have at least $100,000 more capital to invest in local businesses for every resident living in it. If you lived in a small town with 10,000 people, that could mean a billion dollars more of capital to regenerate your economy. If you lived in a small city with 100,000 people, you would have $10 billion more. It is hard to imagine any policy or governmental program that could deliver even a tiny fraction of the potential impact of residents changing their investment choices.

The unequal flow of capital right now is a reminder that the current capital marketplace effectively is a gigantic subsidy for Wall Street. The perceived “competitiveness” of many global businesses has depended on easy money from this tilted investment system. Take that bias away, shrink the available capital, and much of Wall Street crumbles. The activists who pushed to “Occupy Wall Street” should have branded their campaign as “Defund Wall Street.”

How did this unequal flow of capital happen in the first place?

How Did Financial Institutions Come to Disfavor Local Business?

Historically, the go-to place for local business in America was the bank. Small banks opened in communities, took in local capital, and lent it back out to residential and commercial customers. Over the past half century, however, there has been a huge consolidation of banks, savings and loans (also called “thrifts”), and even credit unions. Since 1990, the number of FDIC-insured commercial banks has shrunk from 12,343 to 4,630 and FDIC-insured savings institutions from 2,815 to 673.⁴ The number of insured credit unions in the United States peaked in the late 1960s at 23,866 and has since shrunk to 5,014.⁵ Tens of millions of Americans have had the experience of doing business at a community bank, only to wake up one morning and find that a bigger bank just bought it out.

Why did this happen? Some conservative economists argue that mergers have made banks more efficient. Maybe. But other studies have found that bigger banks actually have higher fees, higher overheads, and more defaults. Mergers are often the result of perverse incentives. The managers of acquiring banks get bonuses for enlarging their institutions, and the shareholders of the acquired bank get a short-term price boost for their stock. It’s an unfortunate alliance, because the losers include the long-term shareholders, the customers, and the employees. Meanwhile, antitrust regulators who once policed mergers because of the adverse effects on competition now have effectively fallen asleep at the wheel and, zombie-like, approve almost everything.

After the financial crisis of 2008, Congress passed the Dodd-Frank Act (named after the two key architects, Senator Chris Dodd and Congressman Barney Frank) to tighten regulatory standards on banks, but perversely this has actually accelerated the rate of mergers and acquisitions. Bigger banks absorbed the costs of the new regulations more easily than smaller banks. Congress could have fixed the law by granting exemptions to smaller banks but, instead, in the name of cutting red tape, decided to repeal the whole law. Yes, this might have helped smaller banks’ survival a tad, but at the cost of permitting all banks to resume the risky practices that almost blew up the entire financial system.

Here’s why consolidation matters. The probability that a dollar deposited in a small bank or credit union will make its way into a small business is three times greater than that of a dollar deposited in a big bank.⁶ Even though small- and medium-scale banks represent less than 20 percent of all bank assets, they are responsible for more than half of commercial lending to small business. This explains why one grassroots response to the crisis of 2008 was to launch a campaign called Move Your Money (from global banks to local ones). Local banks, almost by definition, lend almost all their money locally.

But go back to the numbers describing American household financial assets. The securities sector is four times the size of the banking sector. That means that even if Move Your Money had been 100 percent successful, only a small percentage of the financial sector would have been localized.

Why is the securities sector all about big business?

Let’s pause for a second and define the term “securities.” A security is basically any financial instrument, usually some kind of agreement on paper, that pays a return. It can be a loan paying interest, a stock appreciating, or a royalty payment (usually a percentage of profits or revenue, up to some ceiling). Most securities are regulated by the federal Securities and Exchange Commission (SEC) and its equivalents in every state, which require anyone who issues a security to disclose key facts to purchasers. Where the law gets tricky is that some things that would appear to be securities are exempt. You don’t need to register a loan to your spouse or kid, for example. And banks and credit unions are exempt because they are covered by specific banking laws.

But back to our question: How did it become the case that everyone’s money is tied up in Wall Street, rather than in the 60–80 percent of the economy made up of local businesses? Why is it that very few local businesses issue securities for grassroots investors?

One explanation is economies of scale. All things being equal, an investment institution prefers big investors in big companies. No matter the size of the company or its long-term profitability, smart investment practice and the law require due diligence before any money changes hands. Say that work costs $100,000 per company. Since your fees will be a percentage of the deal, you’d much rather do the $100,000 of work for Home Depot than Joe’s Hardware Store. In fact, when you tell Joe that the work will cost at least $100,000, Joe will likely run out the door cursing and start thinking about early retirement.

Another reason is history. High finance used to be exclusively for a small number of tycoons. Very few Americans, for example, could afford a seat at the New York Stock Exchange. Various reforms pried open finance—stock purchasing now can be done by anyone on E-Trade, for example—but none touched how businesses raise money by issuing securities.

The foundation of US securities law can be found in four pieces of legislation: the Securities Act of 1933, the Exchange Act of 1934, the Investment Advisers Act of 1940, and the Investment Company Act of 1940. Let’s focus on the Securities Act. It basically said that every company that wants to sell securities first has to register them with the SEC. The burdens imposed on companies depend a lot on who’s buying the securities. If the buyers of the securities are rich people, then the paperwork is pretty light. The law presumes that people with money know what they’re doing and, even if they don’t, they can afford the loss. But if you want to sell the securities to any average investor, you are required to complete a mountain of legal paperwork and sometimes must get a permission slip from the government first.

In one way, the logic is unassailable. The Securities Act protects Americans from getting swindled and buying swampland in Florida. But the law had another consequence as well, probably unintended. The burden of complying, often $25,000 to $100,000 per securities offering, was reasonable for large companies but not small ones. Local businesses mostly concluded that the legal expenses associated with soliciting nickels and dimes from grassroots investors were not worth it. This explains why most local businesses seeking outside money tend to go to angel investors, venture funds, or other vehicles involving only rich people. The entire investment market thus evolved primarily to serve rich people. Even the first retirement vehicles for the grass roots—the Individual Retirement Account and the 401k—were designed primarily to give wealthy individuals another way to save. It was only later that these were packaged and marketed to grassroots investors.

Securities law calls investors who are rich enough to do what they want “accredited investors.” Depending on how you do the math, accredited investors constitute between 1 percent and 5.5 percent of the US population. (See the box.) The rest of the country is “unaccredited”—and that probably means you. Being unaccredited does not mean you can’t be an investor. It just means that any loan you give or stock you buy must have the proper legal paperwork done first, before a seller of securities can even talk to you.

The ability of unaccredited investors to buy securities is now changing, thanks in part to the JOBS Act and similar reforms at the state level. Local investment options for unaccredited investors are opening dramatically. But because the marketplace is immature, you can’t depend on investment professionals to find good investments, evaluate them, and create a portfolio of them. That falls to you.

The Bottom Line

Most of the US economy—by jobs and output—can be found in locally owned enterprises. The evidence suggests that, on balance, these companies are at least as profitable as their global counterparts. And while all businesses are risky, there is no good evidence that local businesses are riskier than their global counterparts, at least if you focus on existing local businesses rather than startups. Some features of local businesses pose special risk, but other features make them less risky. A smart local investor must weigh all these factors.

Perhaps the biggest risk facing a local investor is the immaturity of the existing marketplace. But because of the peculiar evolution of banking and securities law, nearly all our investment dollars are flowing into global business, and that’s where most finance professionals are focused as well. This means, for the moment, you need to invest serious time to find local businesses, evaluate them, manage your investments, and create your own local portfolio. It’s satisfying work, however, when you weigh the ways in which these investments boost your community.