8

EVALUATING LOCAL INVESTMENTS

A good local investor must be a good investor in general. You need to learn how to discern your own investment goals, evaluate investment opportunities, and create a good portfolio to manage risk. For the moment, all these tasks will require some work. Until there’s a local investment fund or a local-friendly registered investment advisor (RIA) in every backyard, you probably will have to find, evaluate, and select local investments on your own, one by one. And just like learning any skill, like tennis or woodworking, becoming a good local investor requires commitment and practice.

That said, there are ways to make the workload manageable. You might focus on one type of investment to gain expertise in it—perhaps small bond issues from your local government, or local real estate. You might take advantage of the expertise you already have in one field, perhaps in local food businesses or local energy businesses. Or you might put together a local investment club so that you can share with others the work and the fun.

But let’s start with you.

How Should You Think about Your Own Local Investment Goals?

Why are you investing locally? To make money for your retirement? To support your community? To enjoy yourself? Some combination of these?

There are two issues you especially should do some hard thinking about—risk and liquidity. How much risk are you willing to tolerate? The entire universe of local investment carries special risk because it’s immature. We already talked about some of the risks, such as the risk of not finding enough investment options and choosing the wrong one, or the risk of the entire community entering a recession and tanking your portfolio. To that end, let’s add the risk that everyone participating in this universe—you, other local investors, local businesses, local government—is on a steep learning curve.

But that doesn’t necessarily mean that continuing to invest in Wall Street carries less risk. To the contrary, there are profound risks that the traditional markets could crash again. And the rise of local investment alternatives will actually increase the riskiness of traditional investments, because as investors move to local securities, the value of traditional stocks and bonds could plunge.

There’s risk no matter what you do. When you review any investment document, whether for a local or global deal, it typically warns you—be prepared to lose everything. You’ll sign, even though you are not prepared to lose everything. But you do need to ask yourself about your tolerance for loss. How much of your retirement savings are you really prepared to lose next year?

If the answer is “zero”—if you can’t afford any losses—then perhaps you should consider putting all your money into federal government bonds or bank certificates of deposit. Those are pretty much the lowest-risk securities available. But their rates of return are anemic. If you want to make some money, you will have to take on more risk. But how much? How about putting half your investments in very low-risk securities and half in higher-risk things? Does this feel right? Do you want to risk more still for more reward? Risk less?

Angela Barbash, whom we met in Chapter 7, is one of the few RIAs in the United States who actually helps her clients find local investments. Her company, Revalue, based in Ypsilanti, Michigan, works with clients to integrate local businesses into their portfolios. After the financial meltdown of 2008, Angela’s clients were eager to find local alternatives to Wall Street, and she realized that she had no good answers. Local securities were never part of her RIA training or exams. So she went to a Slow Money conference in San Francisco in 2011 and was thrilled to meet other RIAs who were being asked the same questions.

Fast forward eight years and Barbash now is reinventing the entire RIA practice. She’s done enough research in her region to identify promising local investment opportunities, some for accredited clients and some for everyone else. She has developed enough discernment that she has not introduced her clients to any local losers. Still, she’s careful to make sure her clients look carefully at their own tolerance for risk before investing locally.

She asks her clients to look at risk from three angles. The first is their emotional tolerance for risk. How far would the stock market have to drop, she asks, for you to convert all your investments to cash? Here’s a related question: How did you respond when the market did precipitously collapse in 2008? If a small drop spooks you, if you sold everything in 2008, then your tolerance for risk is low. These people, Barbash says, should not do anything that ruins their sleep, their health, and their relationships.

Barbash recommends that highly risk-averse people invest no more than 1 percent in local business. Those with a moderate risk tolerance might invest 5 percent. Those who enjoy higher risk taking could move to 10 percent. She concedes she is only referring to investment in local businesses and community capital funds. The other forms of local investing in yourself, such as getting out of credit card debt or investing in your own home, are low risk and can justify a substantially higher allocation. In fact, Barbash admits that nearly all her own retirement savings are in her house and her business.

Next, Barbash has clients plan out their expected financial needs for the rest of their lives. Most financial advisors divide life into two stages—“accumulation” during your working life and “distribution” during your retired life. Barbash insists on more nuance. When will you need to pay for your kids’ college? When do you think you will need a new car? Have you planned for a vacation each year? Do you have at least $20,000 tucked away for emergencies? Do you plan to continue working, but maybe fewer hours, in your seventies? Barbash helps clients map out all their anticipated periods of need through scenario planning and tries to make sure they have all the cash they need in each life stage ahead.

When you’re young and you have a lot of investing years ahead of you, you’re usually willing to take more risk. If the market suddenly collapses, you have many potentially great market years ahead to make up for the loss. When you’re old and nearing retirement and you can’t afford a loss, you need to shy away from risk.

The third question—and the most obvious—is your financial needs. Objectively, what can you afford to lose? The wealthier you are, the more you can tolerate risky investments. If you’re living from paycheck to paycheck, you need to stick with low-risk options.

It’s worth emphasizing again that some local investments are actually low risk. For the low risk part of your portfolio, you might want to focus on getting out of debt and paying off your house. Or you will want to put money into your local bank or municipal bonds. For money you’re willing to take more risk with, you might invest in local companies—but only those that have been around for a while and whose products, services, and management you trust. You should only invest in very high-risk companies, like startups, if you’re really prepared to lose that money.

Note that the riskiness question is different from whether the investment is supportive of your community. Almost all local investment options will meet that criterion. Whether high or low risk, almost all local investment options boost local jobs, spending, and taxes.

If you’re still stumped by how to get started, here’s one suggestion in line with Barbash’s earlier advice: Begin slowly and cautiously. How about investing 1 percent of your portfolio in local stuff immediately? If you’re happy with how you are doing after a year, then add 1 percent more. Then another 1 percent at the end of year two. And so forth.

Implicit in a risk analysis is liquidity. Liquidity represents your ability to turn your investment into cash. No one want to hold ownership certificates or paper bonds forever, especially when your kids are going to college or you face huge medical bills. Putting money on deposit in a bank is almost perfectly liquid, unless you’ve bought CDs with a certain number of years to mature. Investing in local business is relatively illiquid, because it’s hard to find marketplaces where you can resell your stock shares. Other local securities—say, local bonds or local loans—will have fixed dates for their repayments and are somewhat liquid.

Like your tolerance for risk, your need for liquidity will change throughout your life. Earlier in your life, you won’t need the funds. As you near and proceed through retirement, you will want to start cashing things in.

Even though the lack of liquidity poses risk, it is also different from risk. Think about certificate deposits at your local bank that fully mature in ten years. These are not liquid but very low risk. Alternatively, you might hold deposits of Russian rubles—a currency that’s very liquid but, given the instability of that part of the world, very high risk.

One helpful way to think about these questions is to create a very simple grid with four quadrants. This is a methodology developed by two colleagues of mine: Amy Pearl, who led the campaign to change Oregon’s crowdfunding laws, and Marco Vangelisti, a PhD economist and mathematician who was a founding member of Slow Money. Both teach classes with this technique.

Take a look at Chart 7. Put numbers into each quadrant so that all four add up to 100 percent. For example, if you were very risk averse, you might put 5 percent in each of the two “High Risk” boxes, 10 percent in “Low Risk, Low Liquidity,” and 80 percent in “Low Risk, High Liquidity.” If you were young and adventurous, your highest percentages would go into the “High Risk” boxes.

Chart 7. What Are Your Own Risk and Liquidity Requirements?

As you make local investment decisions, try to match your choices with this allocation. Chart 8 shows some examples of local investment opportunities for each category.

Chart 8. Examples of Local Investment by Risk and Liquidity

How Should You Evaluate Local Investment Opportunities?

Once you’ve figured out how you wish to allocate your portfolio in theory, you should assess all your local investment options for their return, risk, and liquidity. You can do this yourself, but it will be better if you join up with friends and neighbors who share your interest in local investing.

Be aware that the information formally presented to you is almost always incomplete. Even a company that has gone through the elaborate process of preparing a direct public offering or a Reg A offering statement will employ dense, inscrutable boilerplate in critical sections. You might find a section, for example, called “risks,” where every conceivable risk short of a Martian invasion is listed—and you will still have no real idea which risks are most serious. By law, federally licensed crowdfunding portals cannot share their business judgments about the deals they present. They have a checklist they must go through—board members must not have a shady history, your accounting firm must sign off on your financials, your materials cannot contain any fraudulent promises—but they cannot make any pronouncement like “the chances of this wobbly business surviving another twelve months is slim to none.” This means that you will need to do some serious research yourself.

Barbash encourages clients to “find your tribe.” Some people who are inherently social like to work in a local group. Others, like engineers, prefer to dig deep into data, and will gravitate toward other engineers in online chat groups. Still others, who Barbash calls professors, will develop national networks and share information about the performance of, say, microbreweries.

Whatever your tribe, you will want to scrutinize each potential local investment and begin the process of “due diligence.” Imagine yourself as a banker interviewing a potential loan applicant. If the client were a business, here are some top items you might inquire about:

• Intuition—What does your gut say? (Barbash says that if you don’t understand the business, it’s probably a bad investment. That’s Warren Buffett’s philosophy as well.)
• Core Business—How strong is the core business? Do you love its products or services?
• Competitors—How many competitors does the business have locally? How does the business distinguish itself from its peers?
• Intellectual Property (IP)—Has the company done enough to protect its IP through patents and trademarks? If the company does not have unique IP, what’s the danger of the model being copied?
• Management—Is the business under strong leadership? Do you have faith in the promises made to you as an investor? Do you trust the managers?
• Workforce—Does the company have a talented, enthusiastic workforce? Are they compensated well, not just with wages but with benefits? Are they loyal to the company? Do they have a role in management? Do they share in ownership?
• Financials—Do you have access to the company’s recent financials? Its profit-and-loss statements? Its balance sheet? If you don’t know much about accounting, you might ask a friend who does to help review these reports.
• Projections—Do the company’s assertions about its projected growth make sense, given its past performance?
• Social Performance—What’s the company’s environmental record? Social performance? How much does it give to charity? Companies with high social performance tend to be more trustworthy.
• Exit—What’s the end game for the company? Does it want to thrive locally? Grow into a franchise or chain? Be bought out? How will this affect your return?

You will also want to ask questions about the nature of the investment you’re considering:

• Loans—If you are being promised a steady payment over a term of years, what happens if a payment is missed? What are your rights then?
• Stock—Are dividends being promised? When can you sell the stock? Are there limits on who you can sell the stock to? Will the company buy back stock and, if so, when and at what price?

All these factors will give you a sense of the riskiness of your investment. There’s no question that this takes time and is but another reason to share the burden with partners. But the effort will help you develop personal trust in the firm and excitement about it. How many Wall Street companies would allow you to run through these questions with a senior manager? A strong local business prospect will gladly provide you with this information.

If the potential investment involves not a business but an individual, your questions will be a little different. If you were making a loan to a neighbor, you’d want to know about her job, her likely income, her assets, and her reliability. You also might want to ask for collateral. A loan with collateral or some other form of security is a lot less risky than a nonrecourse loan.

With either a business or an individual, you will want to assess the liquidity in the years ahead. Loans, especially those paid back in steady installments over a small number of years, are relatively liquid. The same is true of royalty agreements, which pay you based on revenues or profits over a certain period. Stock certificates, in contrast, usually come with some restrictions on resale. Make sure you understand these before you buy.

How Can You Put Together a Sound Local Investment Portfolio?

Another way to hedge your risk is through a diversified portfolio. A stock’s price, for example, can go up or it can go down. Most of us just bet on the price going up. But a savvy and risk-averse investor will make two bets—one on the assumption that the price will go up (investing “long”) and the other on the assumption that it will go down (investing “short”). That investor is said to be hedging one bet with the other. And using some pretty wild math, a hedging investor can figure out how to make money either way.

Most investors hedge by diversifying their portfolios. You want a bunch of investments that cover a wide range of possibilities. If one of your investments does poorly because of some unforeseen event, you want your other investments to be unaffected.

This explains why investment advisors might encourage you to diversify your portfolio with stocks and bonds or with “value” and “growth” stocks. Except these kinds of hedges do very little to diversify your holdings, because you are really holding different kinds of securities from the exact same Fortune 500 companies. If there’s a national recession—another 9/11, tech meltdown, or mortgage-market implosion—all these companies and all their securities will suffer.

That’s one of the unique advantages of local investment. The economy of some communities and some local industries may be unaffected by national events. During the last recession in 2008, some states—like Vermont, Wyoming, and North Dakota—remained largely unaffected and maintained full employment. By gradually replacing some of your global securities with local investments, you can actually achieve greater diversification. Up to a point.

Remember, there’s also risk in putting all your eggs in one geographic basket. If something causes your community’s economy to plummet—maybe a hurricane hits, or an anchor factory suddenly departs for Vietnam—all the local companies will be adversely affected. The solution, however, is not to shun local companies. Instead, you might want to invest in local companies in several different regions. Or if someone ever creates a fund of investments supporting local food businesses all over the country, that could diversify your holdings as well.

Economists and business professors have done a lot of research on this question, and many believe that even a half-dozen truly different kinds of investment will provide you with enough diversity. You might split your local investment into different buckets—some in real estate, some in local businesses, and some in local student-debt relief.

The Bottom Line

If you want to be a smart local investor, follow these simple rules:

• Be aware of your own tolerance for risk and need for liquidity for the years ahead and pick local investments that match your needs.
• Perform due diligence on all companies, securities, and individuals in your community that you might invest in.
• Make sure your portfolio is diversified by mixing national and local securities, holding different kinds of local investment, or holding local investments from different regions.