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Title: How to Invest Money
Author: Henry, George Garr
Language: English
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HOW TO INVEST
MONEY
BY
GEORGE GARR HENRY
_Vice-President Guaranty Trust Company, of New York_
[Illustration]
FUNK & WAGNALLS COMPANY
NEW YORK AND LONDON
1908
COPYRIGHT, 1908, BY
FUNK & WAGNALLS COMPANY
[_Printed in the United States of America_]
Published April, 1908
CONTENTS
PAGE
PREFACE 5
I. GENERAL PRINCIPLES OF INVESTMENT 7
II. RAILROAD MORTGAGE BONDS 23
III. RAILROAD EQUIPMENT BONDS 40
IV. REAL-ESTATE MORTGAGES 51
V. INDUSTRIAL BONDS 63
VI. PUBLIC-UTILITY BONDS 76
VII. MUNICIPAL BONDS 91
VIII. STOCKS 100
IX. MARKET MOVEMENTS OF SECURITIES 108
PREFACE
The aim of this book is to present in clear form the simple principles
of investment, and to afford the reader a working knowledge of the
various classes of securities which are available as investments and
their relative adaptability to different needs. The book is an outgrowth
of the writer's personal experience as an investment banker. Most of the
matter which is presented has appeared in the pages of "System"
Magazine, through the courtesy of whose editors it is now rearranged and
consolidated for publication in book form.
G. G. H.
HOW TO INVEST MONEY
I
GENERAL PRINCIPLES OF INVESTMENT
With the immense increase in wealth in the United States during the last
decade and its more general distribution, the problem of investment has
assumed correspondingly greater importance. As long as the average
business man was an habitual borrower of money and possest no private
fortune outside of his interest in his business, he was not greatly
concerned with investment problems. The surplus wealth of the country
for a long time was in the hands of financial institutions and a few
wealthy capitalists. These men, the officers and directors of banks,
savings-banks, and insurance companies, and the possessors of hereditary
wealth, were thoroughly equipped by training and experience for the
solving of investment problems and needed no help in the disposition of
the funds under their control. During the last ten years, however, these
conditions have been greatly altered. The number of business men to-day
in possession of funds in excess of their private wants and business
requirements is far greater than it was ten years ago, and is constantly
increasing. These men are confronted with a real investment problem.
While they have not always recognized it, the problem which they are
called upon to solve is really twofold--it concerns the safeguarding of
their private fortune and the wise disposition of their business
surplus. They have usually seen the first part of this problem, but not
all have succeeded in clearly understanding the second. When the
treatment of a man's business surplus is spoken of as an investment
problem, it is meant, of course, not his working capital, which should
be kept in liquid form for immediate needs, but that portion of his
surplus which is set aside for emergencies. It is coming to be a
recognized principle that every business enterprise of whatever kind or
size should establish a reserve fund. It is felt that the possession of
a reserve fund puts the business upon a secure foundation, adds to its
financial strength and reputation, and greatly increases its credit and
borrowing capacity. The recognition of this fact, combined with the
ability to set aside a reserve fund, has brought many men to a
consideration of the best way in which to dispose of it. It is obviously
a waste of income to have the surplus in bank-accounts; more than that,
there would be a constant temptation to use it and to confuse it with
working capital. Its best disposition is plainly in some safe
interest-bearing security, which can be readily sold, so that it will be
available for use if necessity demands.
Confronted with the double problem thus outlined, what measure of
success has attended the average business man in its solution?
It is safe to say that the average man has found it easier to make money
than to take care of it. Money-making, for him, is the result of
successful activity in his own line of business, with which he is
thoroughly familiar; while the investment of money is a thing apart from
his business, with which he is not familiar, and of which he may have
had little practical experience. His failure to invest money wisely is
not due to any want of intelligence or of proper care and foresight on
his part, as he sometimes seems to believe, but simply because he is
ignorant of the principles of a business which differs radically from
his own.
The investment of money is a banker's business. When the average man has
funds to invest, whether he be a business man or a pure investor, he
should consult some experienced and reliable investment banker just as
he would consult a doctor or a lawyer if he were in need of medical or
legal advice. This book is not intended to take the place of
consultation with a banker, but to supplement it.
The advantage of such consultation is shown by the fact that if a man
attempts to rely on his own judgment, he is almost certain not to do the
best thing, even if his business instinct leads him to avoid those
enterprises which are more plainly unpromising or fraudulent. It should
be remembered, however, that widows and orphans are not the only ones
ensnared by attractive advertisements and the promise of brilliant
returns. In most cases, widows' and orphans' funds are protected by
conscientious and conservative trustees, and it is the average business
man who furnishes the money which is ultimately lost in all propositions
which violate the fundamental laws of investment.
The average man is led into these unwise investments through a very
natural error of judgment. Accustomed to take reasonable chances and to
make large returns in his own business, he fails to detect anything
fundamentally wrong in a proposition simply because it promises to pay
well. He forgets that the rate of interest on _invested money_, or pure
interest, is very small, and that anything above that can only come as
payment for management, as he makes in his own business, or at the
sacrifice of some essential factor of safety which will usually lead to
disaster.
For the successful investment of money, however, a good deal more is
required than the mere ability to select a safe security. That is only
one phase of the problem. Scientific investment demands a clear
understanding of the fundamental distinctions between different classes
of securities and strict adherence to the two cardinal principles,
distribution of risk and selection of securities in accordance with
real requirements.
One of the most important distinctions is that between _promises to pay_
and _equities_. Bonds, real-estate mortgages, and loans on collateral
represent somebody's promise to pay a certain sum of money at a future
date; and if the promise be good and the security ample, the holder of
the promise will be paid the money at the time due. On the other hand,
_equities_, such as the capital stocks of banking, railway, and
industrial corporations, represent only a certain residuary share in the
assets and profits of a working concern, after payment of its
obligations and fixt charges. The value of this residuary share may be
large or small, may increase or diminish, but in no case can the holder
of such a share require any one, least of all the company itself, to
redeem the certificate representing his interest at the price he paid
for it, nor indeed at any price. If a man buys a $1,000 railroad bond,
he knows that the railroad, if solvent, will pay him $1,000 in cash when
the bond is due. But if he buys a share of railroad stock, his only
chance of getting his money back, if he should wish it, is that some
one else will want to buy his share for what he paid for it, or more. In
one case he has bought a _promise to pay_, and in the other an _equity_.
It is not the intention, from the foregoing, to draw the conclusion that
_equities_ under no circumstances are to be regarded as investments,
because many of our bank and railroad stocks, and even some of our
public-utility and industrial stocks, have attained a stability and
permanence of value and possess sufficiently long dividend records to
justify their consideration when investments are contemplated; but it is
essential that the investor should have a thorough understanding of the
distinction involved.
The principle of distribution of risk is a simple one. It involves no
more than obedience to the old rule which forbids putting all one's eggs
in the same basket. The number of men who carry out this principle with
any thoroughness, however, is very small. Proper distribution means not
only the division of property among the various forms of investment, as
railroad bonds, municipals, mortgages, public-utility bonds, etc., but
also the preservation of proper geographical proportions within each
form. Adherence to this principle is perhaps not so important for
private investors as for institutions. A striking instance of the need
for insistence upon its observance in the institutional field was
furnished by one of the fire-insurance companies of San Francisco after
the earthquake. It appeared that the company's assets were largely
invested in San Francisco real estate and in local enterprises
generally, where the bulk of its fire risks were concentrated. As a
result, the very catastrophe which converted its risks into actual
liabilities deprived its assets of all immediate value. This instance
serves to show the importance of the principle and the necessity for its
observance.
The principle of selection in accordance with real requirements is more
complex. It involves a thorough understanding of the chief points which
must be considered in the selection of all investments. These are five
in number: (1) _Safety of principal and interest_, or the assurance of
receiving the principal and interest on the dates due; (2) _rate of
income_, or the net return which is realized on the actual amount of
money invested; (3) _convertibility into cash_, or the readiness with
which it is possible to realize on the investment; (4) _prospect of
appreciation in value_, or that growth in intrinsic value which tends to
advance market price; and (5) _stability of market price_, or the
likelihood of maintaining the integrity of the principal invested.
The five qualities above enumerated are present in different degrees in
every investment, and the scientific investor naturally selects those
securities which possess in a high degree the qualities upon which he
wishes to place emphasis. A large part of the problem of investment lies
in the careful selection of securities to meet one's actual
requirements. The average investor does not thoroughly understand this
point. He does not realize that a high degree of one quality involves a
lower degree of other qualities. He may have a general impression that a
high rate of income is apt to indicate less assurance of safety, but he
rarely applies the same reasoning to other qualities. When he buys
securities, he is quite likely to pay for qualities which he does not
need. It is very common, for example, when he wishes to make a permanent
investment and has no thought of reselling, to find him purchasing
securities which possess in a high degree the quality of convertibility.
From his point of view, this is pure waste. A high degree of
convertibility is only obtained at the sacrifice of some other
quality--usually rate of income. If he were to use more care in his
selections, he could probably find some other security possessing equal
safety, equal stability, and equal promise of appreciation in value,
which would yield considerably greater revenue, lacking only ready
convertibility. Thus he would satisfy his real requirements and obtain a
greater income, at the expense only of a quality which he does not need.
The quality of convertibility divides investors into classes more
sharply than any other quality. For some investors convertibility is a
matter of small importance; for others it is the paramount
consideration. Generally speaking, the private investor does not need to
place much emphasis upon the quality of convertibility, at least for the
larger part of his estate. On the other hand, for a business surplus,
ready convertibility is an absolute necessity, and in order to secure
it, something in the way of income must usually be sacrificed.
Again, some investors are so situated that they can insist strongly upon
promise of appreciation in value, while others can not afford to do so.
Rich men whose income is in excess of their wants, can afford to forego
something in the way of yearly return for the sake of a strong prospect
of appreciation in value. Such men naturally buy bank and trust-company
stocks, whose general characteristic is a small return upon the money
invested, but a strong likelihood of appreciation in value. This is
owing to the general practise of well-regulated banks to distribute only
about half their earnings in dividends and to credit the rest to
surplus, thus insuring a steady rise in the book value of the stock.
Rich men, again, can afford to take chances with the quality of safety,
for the sake of greater income, in a way which poor men should never do.
In practise, however, if the writer's observation can be depended upon,
it is usually the poor men who take the chances--and lose their money.
In the quality of safety, there is a marked difference between safety of
principal and safety of interest. With some investments the principal is
much safer than the interest, and _vice versa_. This can best be
illustrated by examples. The bonds of terminal companies, which are
guaranteed as to interest, under the terms of a lease, by the railroads
which use the terminal, are usually far safer as to interest than as to
principal. While the lease lasts, the interest is probably perfectly
secure, but when the lease expires and the bonds mature, the railroads
may see fit to abandon the terminal and build one elsewhere, if the city
has grown in another direction, and the terminal may cease to have any
value except as real estate. On the other hand, a new railroad, built in
a thinly settled but rapidly growing part of the country, may have
difficulty in bad years in meeting its interest charges, and may even go
into temporary default, but if the bonds are issued at a low rate per
mile and the management of the road is honest and capable, the safety of
the principal can scarcely be questioned.
Stability of market price is frequently a consideration of great
importance. This quality should never be confused with the quality of
safety. Safety means the assurance that the maker of the obligation will
pay principal and interest when due; stability of market price means
that the investment shall not shrink in quoted value. These are very
different things, tho frequently identified in people's minds. An
investment may possess assured safety of principal and interest and yet
suffer a violent decline in quoted price, owing to a change in general
business and financial conditions. In times of continued business
prosperity very high rates are demanded for the use of money, because
the liquid capital of the country, to a large extent, has been converted
into fixt forms, in the development of new mines, the building of new
factories and railroads, and in the improvement and extension of
existing properties. These high rates have the effect of reducing the
price level of investment securities because people having such
securities are apt to sell them in order to lend the money so released,
thus maintaining the parity between the yields upon free and invested
capital.
As an illustration of this tendency, within the last few years New York
City 3-1/2-per-cent bonds have declined from 110 to 90, without the
slightest suspicion of their safety. Their inherent qualities have
changed in no respect except that their prospect of appreciation in
quoted price has become decidedly brighter. Their fall in price has been
due to two factors, one general and the other special--first, the
absorption of liquid capital and consequent rise in interest rates,
occasioned by the unprecedented business activity of the country, and,
second, to the unfavorable technical position of the bonds, due to an
increased supply in the face of a decreased demand.
It will be seen that the question of maintaining the integrity of the
money invested is a matter of great importance and deserves to rank as a
fifth factor in determining the selection of investments, altho it is
not an inherent quality of each investment, but is dependent for its
effect upon general conditions. If it is essential to the investor that
his security should not shrink in quoted price, his best investment is a
real-estate mortgage, which is not quoted and consequently does not
fluctate. For the investment of a business surplus, however, where a
high degree of convertibility is required, real-estate mortgages will
not answer, and the best way to guard against shrinkage is to purchase a
short-term security, whose approach to maturity will maintain the price
close to par.
The foregoing comments, in a brief and imperfect way, serve to indicate
the main points which should be considered in the selection of
securities for investment. The considerations advanced will be amplified
as occasion demands in the following pages. For the present, the main
lesson which it is sought to draw is the necessity that a man should
have a thorough understanding of his real requirements before he
attempts to make investments. For a private investor to go to a banker
and ask him to suggest a security to him without telling him the exact
nature of his wants is about as foolish as it would be for a patient to
go to a physician and ask him to give him some medicine without telling
him the symptoms of the trouble which he wished cured. In neither case
can the adviser act intelligently unless he knows what end he is seeking
to accomplish.
It is plainly impossible within the limits of a small volume to consider
the needs of all classes of investors. Special attention will be paid to
the requirements of a business surplus and of the private investor. In
the field of private investment two distinct classes can be
recognized--those who are dependent upon income from investments and
those who are not. Both classes will be considered. For the investment
of a business surplus, safety, convertibility, and stability of price
are the qualities to be emphasized; for investors dependent upon income,
safety and a high return; and for those not dependent upon income, a
high return and prospect of appreciation in value. In the following
chapters railroad bonds, real-estate mortgages, industrial,
public-utility, and municipal bonds and stocks will be considered in
turn; their advantages and disadvantages will be analyzed in accordance
with the determining qualities above enumerated, and their adaptability
to the requirements of a business surplus and of private investment will
be discust.
II
RAILROAD MORTGAGE BONDS
A railroad bond is an obligation of a railroad company (usually secured
by mortgage upon railroad property) which runs for a certain length of
time at a certain rate of interest. It is apparent, from this
definition, that the price of a railroad bond, as distinct from its
value, is affected by two _accidental conditions_ quite apart from the
five determining qualities described in the preceding chapter.
These accidental conditions are the length of time that the bond has to
run and the rate of interest that it bears. To understand clearly the
influence of these accidental conditions is a matter of the utmost
importance. It is evident, for instance, that a 5-per-cent fifty-year
bond, based on a given security, will sell at a widely different price
from a 3-1/2-per-cent twenty-year bond, based on the same security; yet
the only difference is in the accidental conditions which are under the
control of the board of directors.
In order to eliminate these accidental features from the situation, it
is customary for bond-dealers to classify bonds purely on the basis of
their yield, or net income return. As a thorough understanding of this
point is essential to an accurate judgment of bond values, whether
railroad bonds or otherwise, it must be developed in detail, even at the
risk of carrying the reader over familiar ground.
If a bond sells above par, it does not yield its purchaser a net return
as great as the rate of interest which the bond bears, for two reasons:
first, because the loss in principal, represented by the premium which
the purchaser pays, must be distributed over the number of years which
the bond has to run, and operates to reduce the rate of interest which
the holder receives; and, secondly, because the rate is paid only on the
par value of the bond instead of on the actual money invested. Thus, if
a 6-percent bond with eight years to run sells at 110-3/4, it will yield
only 4.40 per cent, which means that if the holder spends more than
$48.73 (4.40 per cent of $1,107.50) out of the $60 which he receives
annually, he is spending the excess out of principal, and not out of
income. Conversely, if a bond sells below par, it yields more than the
rate of interest which the bond bears.
These yields have been calculated with the utmost exactness for all
bonds paying from 2 per cent to 7 per cent and running from six months
to one hundred years, so that it is only necessary to turn to the tables
to discover what will be the net return upon a given bond at a given
price. This net return is generally known as the "basis," and bonds are
spoken of as selling upon a 3.80 per cent basis or a 4.65 per cent basis
or whatever the figure may be, with no reference whatever to the price
or to the rate of interest which the bond bears. Indeed, so exclusively
is the basis considered by bond-dealers that very often bonds are bought
and sold upon a basis price, and the actual figures at which the bonds
change hands are not determined until after the transaction is
concluded.
It is not expected, of course, that the average business man will
purchase bonds in quite as scientific a way as this, but it is essential
that he should understand that while the intrinsic value of a bond is
determined only by the five general factors described, its money value,
or price, is affected also by these two accidental conditions. Exprest
in other words, he must realize that the general factor described as
_rate of income_ does not mean the coupon rate of interest which the
bond bears, but the scientific "basis," derived by elimination of the
accidental features.
Within the past year there has been a good deal of uninformed comment
about the safety of railroad bonds. Before the era of popular agitation
and governmental antagonism, railroad bonds enjoyed a large measure of
public confidence; but it can not be denied that some part of this
confidence has been shaken as a result of the recent exposures. Even
clearheaded men have exaggerated the importance of the developments; and
too often railroad officials, who should have insisted upon the
soundness and stability of their properties, when they elected to talk
for publication, have given way instead to dismal and unwarranted
forebodings.
There is no mystery involved in determining the safety of railroad
bonds. Any man of business experience, keeping in mind the general
principle which measures the value of all obligations, can easily
determine, with the aid of two documents, the degree of safety which
attaches to any particular railroad bond. The general principle to be
observed is that the safety of any obligation depends upon the margin of
security in excess of the amount of the loan; and the two documents to
be consulted are the mortgage or trust indenture securing the bonds,
which describes the property mortgaged, and the last annual report of
the railroad, which shows its financial condition.
Confining the analysis, for the present, to mortgage bonds upon the
general mileage of a railroad, the following points should be
considered:
(1) _Rate per mile at which the bond is issued._ Applying the general
principle indicated above, it must be learned what proportion the bonded
debt of a railroad bears to the total market value of the property. It
is much easier to make this comparison on a per-mile basis. In
determining whether the rate per mile is excessive, reference must be
made not so much to the particular bond in question as to the total
bonded debt per mile of the railroad, and to the relation which that
figure bears to the total market value of the property per mile. The
total market value per mile is obtained by adding the market value of
the stock per mile to the par value of the bonded debt per mile. A
single issue of bonds varies all the way from $5,000 to $100,000 per
mile, according to the location of the railroad. Total capitalization
per mile--stocks and bonds at par--varies in about the same proportion,
from $35,000 to $300,000. The average for all the railroads of the
United States is $67,936 per mile. The actual cost of the railroad, as
shown by the balance-sheet, must be taken into consideration, and also
the estimated cost of duplicating the property. Physical difficulties of
construction must be weighed, for a railroad through a flat, sandy
country should not be bonded for as much, other things being equal, as a
railroad through a mountainous country, where much cutting, filling, and
bridging are required. The section of country in which the railroad is
located must be considered, for $35,000 per mile on a single-track line
in a poor country may be higher than $300,000 per mile on a four-track
trunk line which owns valuable terminals and rights of way through
several large cities.
(2) _Amount of prior lien bonds outstanding per mile._ The amount of
bonds which come ahead of the bond in question on the same mileage is a
matter of great importance and works directly against the security of
the bond. Purchasing a bond which is preceded by a prior line bond is
like taking a real-estate mortgage on property already encumbered. If
the bond is not followed by other bonds, then the margin of security in
the property is represented wholly by the market value of the stock per
mile, and the investor must figure carefully the value of this equity.
(3) _Amount of junior lien bonds outstanding per mile._ The amount of
bonds which come after the bond in question, on the other hand, works
directly in favor of the bond, for it increases the margin of security.
It shows also that other people have had sufficient confidence in the
property to invest their money in obligations subject to the one in
question. In the event of a receivership this is often a matter of great
importance; for if a foreclosure sale is ordered the junior bondholders,
in order to protect their own interest, must buy in the property for an
amount at least equal to the par value of the prior lien bonds.
The foregoing considerations apply particularly to the safety of the
principal invested in railroad bonds; the following points affect the
safety of interest:
(4) _Gross earnings per mile._ The gross earnings of a railroad must be
compared with those of other roads occupying the same field, and the
returns for a number of years must be examined to determine whether such
earnings have increased or decreased. The position in which the railroad
stands for obtaining new traffic must be noted. This is dependent
somewhat upon the railroad's ability to take traffic from other
railroads, but more upon the probable growth and development of the
territory which the railroad serves, and the increased traffic which
will probably be offered. In this connection the rate of increase in
population in the road's territory is important. The proportion between
passenger and freight earnings, the diversity and density of freight
traffic, and passenger and freight rates should be examined. The
reputation of the management for ability and integrity should be
considered. Gross earnings run from about $3,000 to $40,000 per mile
with the average $10,460.
(5) _Net income per mile._ Net income is obtained by subtracting from
gross earnings operating expenses (and sometimes taxes) and adding to
the net earnings so obtained whatever income from other sources the
railroad may derive. This is a very important figure. As with gross
earnings, the reports should be examined to determine whether net income
is on the increase or the decrease, and it should be compared with the
net income of other railroads occupying the same field. It involves a
criticism of operating expenses. The payments of the railroad must be
analyzed to determine whether the proper sums have been expended for
maintenance of way, replenishment of rolling stock, and other
improvements sufficient to keep the road in good physical condition.
Normally speaking, operating expenses should absorb about 65 per cent of
gross earnings. If it is found that a railroad operates for 60 per cent,
however, it does not always follow that its operating officials are
exceptionally efficient, so that the cost of conducting transportation
is relatively small; it may mean that the physical condition of the
property is being neglected, or that ordinary improvements, which should
be charged to maintenance, are being paid for by increase in
capitalization. It is very important for the investor to find out which
is the case. If analysis leads to the suspicion that the earnings result
from neglecting the property or capitalizing every trivial improvement,
the railroad's bonds should be rejected. Net income varies from $1,500
to $12,000 per mile, with an average of $4,702.
(6) _Fixt charges per mile._ The fixt charges of a railroad include
interest on its bonds, rentals, and taxes (when the last-named are not
reported with operating expenses). The importance of this figure lies in
its relation to net income. If a railroad does not earn well over double
its fixt charges, its obligations can not be regarded as in the first
investment rank. Of course, when a railroad earns more than twice the
interest requirement upon its entire bonded debt, it is probable that
some of the underlying bonds are protected by three, four, or five times
the interest requirement upon them, and their position is
correspondingly strengthened.
The foregoing analysis applies particularly to mortgage bonds upon the
general mileage of a railroad and not to such special issues as
collateral trust, terminal, bridge, or guaranteed bonds. It will not be
necessary, however, to lay down any rules as to these classes of bonds,
for the general principles outlined above, with slight modifications of
detail, will be found equally applicable to a judgment of their value.
Equipment bonds, on the other hand, owing to their want of similarity to
any other railroad issues, will receive separate treatment later.
It is of interest, in view of the present diminished confidence in
railroad securities, to advance certain considerations touching upon the
safety of railroad bonds in general.
The last published report of the Inter-State Commerce Commission, year
1906, furnishes interesting testimony on this subject. A table on page
60 shows that the total railroad capital of the United States for that
year was $14,570,421,478, of which $7,766,661,385, or 53.31 per cent,
was in the form of bonded debt, and the rest in capital stock.
These figures indicate a substantial equity, but are somewhat misleading
because they refer to par value. A fair estimate of the market value of
this stock equity, which is the margin of security in the properties
from the bondholder's point of view, can be obtained from a table on
page 82, which shows a balance available for dividends, after paying all
operating expenses and fixt charges, of all the railroads of the United
States for the year ended June 30, 1906, of $457,060,326. This amount is
equivalent to nearly 7 per cent upon the total par value of the stocks.
Estimating that a railroad stock should earn 10 per cent upon its market
price--and even the most prejudiced will admit that a stock earning 10
per cent is worth par--the total market value of American railroad
stocks would be $4,570,603,260, or more than half the par value of the
bonds. In other words, the bonded debt would represent something less
than 63 per cent of the total market value of the property. This
compares favorably with the security of first mortgages upon real
estate.
When the safety of interest is considered, the showing made is equally
strong. Page 82 of the report above quoted shows that the net income of
the railroads of the United States for the year ended June 30, 1906,
after payment of all operating expenses, was $848,836,771, and the total
fixt charges, including interest on bonds, interest on current
liabilities, and taxes, amounted to $391,776,445, leaving a balance
available for dividends of $457,060,326. It is apparent, therefore, that
the net earnings of the railroads of the United States, considered as
one system, could be cut in half without affecting the payment of
interest upon the railroad's obligations. This affords a large measure
of protection.
The following analysis shows that the actual market value of the
railroads is probably greater than the estimate made above.
The table shows the percentage of bonded debt to total market
value of some of the more important railroad systems. Two trunk
lines in the East, a north and south line in the middle West,
and two transcontinental have been chosen. No attempt has been
made to select railroads which would make a favorable showing.
Indeed Pennsylvania, and Union Pacific, by reason of their
recent heavy bond issues, probably compare unfavorably with
others which might have been chosen. The figures showing the
par value of bonds outstanding have been taken from last annual
reports, with additions made for recent issues. The figures
showing the market value of stocks are based on the amounts
outstanding April 1st, 1908, at the market price.
Par value of Approx. market Per cent
bonds outstanding value of stock of bonds
outstanding to total
value
Pennsylvania $270,974,645 $361,000,000 42.8
New York Central 255,414,845 174,000,000 59.4
Illinois Central 156,053,275 120,000,000 56.6
Great Northern 207,517,939 260,000,000 44.3
Union Pacific 274,827,000 324,000,000 45.9
In view of the enormous decline which has occurred in railroad stocks
during the past eighteen months, the showing above is truly remarkable.
It is plain that the entire bonded debt of any of these standard
railroads is less than 60 per cent of the total market value of the
property, while in the cases of the Pennsylvania, Great Northern, and
Union Pacific, _more than half of the present market value of the
property could be erased before the lien of the bonds least well secured
would be impaired_.
Of course, where the entire bonded debt is protected by such a margin,
it is evident that the underlying bonds (the prior liens and first
mortgages) are protected by several times as great a margin and their
position is correspondingly strengthened.
The foregoing analysis, in the judgment of the writer, affords
convincing proof not only that the prevailing want of confidence in
railroad obligations is without foundation, but that railroad bonds
compare favorably in point of safety with any other form of investment.
It remains to point out the amount of income and degree of
convertibility which they afford and the extent of appreciation in value
which they promise. It is impossible to do more than indicate the
general characteristics of railroad bonds in these particulars.
Railroad bonds cover a wide range of income return. They yield all the
way from 3-3/4 per cent to 9 per cent, the general average being from 4
per cent to 6 per cent. As a class they yield more than government or
municipal bonds, and less than public-utility or industrial bonds. With
equal security they probably yield less than real-estate mortgages.
Compared with stocks they return more than bank stocks, average about
the same as railroad stocks, and yield less than public-utility,
industrial, or mining stocks. These comparisons are intended to apply to
the classes as a whole, and remain generally true in spite of specific
cases to the contrary.
Convertibility is the distinguishing mark of railroad bonds. Generally
speaking they may be more easily marketed than any other class of bonds.
Compared with stocks they exceed public-utility, mining, and bank stocks
in point of convertibility, and yield only to railroad stocks. It is
hard to say whether or not they possess greater convertibility than
industrial stocks, but it is probable that they do, allowing for the
fact that an undue impression is created by the activity of certain
prominent shares.
Railroad bonds as a class possess great promise of appreciation in
value. American railroads, generally speaking, have adopted the
conservative policy of putting a considerable part of their annual
earnings back into the property in the form of improvements. To the
extent to which this policy is followed, an equity is created back of
the bonds which raises their intrinsic value. This policy contrasts
favorably with the general practise of English roads to pay out all
their earnings in dividends, and to capitalize their improvements. In
addition, new capital for American railroads is largely raised by stock
issues, which further increases the margin of security for the
bondholders. Taken together these facts insure a steady enhancement in
the intrinsic value of railroad bonds, which is bound to be reflected,
other things being equal, in higher prices.
We shall not attempt to discuss at this time the degree of stability of
market price which railroad bonds enjoy. As explained in the first
chapter, stability of market price is dependent upon general financial
and business conditions. It is sufficient to point out here that the
maintenance intact of the principal sum invested can only be rendered
certain by the purchase of short-time securities whose near approach to
maturity will keep their price close to par. In a later chapter the
general principles which determine this question will be elucidated.
The ideal investment may be defined as one combining ample security of
principal and interest, a good rate of income, ready convertibility into
cash, and reasonable promise of appreciation in value. Measured by the
requirements of this definition, the conclusion seems justified that
well-selected railroad bonds, if purchased under favorable money-market
conditions, afford a highly desirable form of investment.
III
RAILROAD EQUIPMENT BONDS
As its name implies, an equipment bond is one issued by a railroad to
provide funds with which to pay for new rolling stock--cars and
locomotives. The issues are variously described as car trust
certificates, equipment bonds, or equipment notes. They conform in
general to one of two standard forms: (1) The conditional sale plan: In
accordance with specifications furnished by the railroad, the trustee
selected (usually a trust company) contracts with the builders for the
purchase of the equipment. From 10 to 20 per cent of the cost of the
equipment is paid in cash by the railroad and the rest is represented by
the equipment bonds. The bonds are the direct obligation of the railroad
company. They are secured by a first lien upon the entire equipment
purchased. The title to the equipment remains in the trustee for the
benefit of the bondholders until the last bond has been paid, so that
under no circumstances can the general mortgages of the railroad attach
as a first lien on the equipment ahead of the car trust obligations.
After the final payment, the trustee assigns title to the railroad
company, which thereupon becomes the owner in fee of the equipment.
Under the terms of the deed of trust the railroad is always obliged to
keep the equipment fully insured, in good order and complete repair, and
to replace any equipment which may become worn out, lost, or destroyed.
The bonds are usually issued in coupon form, $1,000 each, bearing
semiannual interest, with provision for registration. They are generally
paid off in semiannual or annual instalments of substantially equal
amounts, the last instalment usually falling due in ten years, a period
well within the life of the equipment as estimated under the master car
builder's rules. Occasionally this method of payment is altered by the
substitution of a sinking fund, the bonds having a uniform fixt
maturity, but subject to the operation of a sinking fund which is
sufficient to retire the entire issue well within the life of the
equipment. In either case the security, ample at the outset, increases
proportionally with the reduction in obligations outstanding against
it.
(2) The so-called "Philadelphia plan." Under this plan the equipment is
purchased by an individual, association, or corporation which leases the
equipment to the railroad for a term of years at a rental equivalent to
the interest and maturing instalments of the bonds. The contract of
lease is then assigned to a trust company as trustee, which thereupon
issues its certificates in substantially the form described in the plan
above, these representing a beneficial interest in the equipment, which
are usually guaranteed both principal and interest by the railroad. The
lease runs until the last bond has been paid, after which the trustee
assigns title to the railroad as above. The chief advantage of this plan
over the other is that in some States, notably Pennsylvania,
certificates issued in accordance with its terms are exempt from
taxation, whereas under the conditional sale plan, as the direct
obligation of the railroad, the bonds would be taxable.
It is evident from the foregoing description that equipment bonds differ
in two important respects from all other classes of railroad issues.
First, the title to the property which secures the bonds does not vest
in the railroad; and, secondly, the property is movable and not fixt in
any one locality.
By virtue of these two points, the holders of equipment bonds possess a
great advantage over the holders of mortgage bonds in the event of a
railroad's becoming bankrupt.
If a railroad is unable to meet its interest charges, the mortgage
bondholders can rarely do better than have a receiver appointed who will
operate the railroad in their interest; but if, with honest and
efficient management, the railroad can not be made to earn its interest
charges, the mortgage bondholders usually have to consent to the scaling
of their bonds to a point where the railroad can operate upon a paying
basis.
With the holders of equipment bonds the case is quite different. If the
receiver defaults upon their bonds they have only to direct the trustee
to enter upon possession of the equipment and sell it or lease it to
some other railroad. The knowledge that they possess this power renders
its exercise generally unnecessary. The equipment of a railroad is
essential to its operation. It is the tool with which the railroad
handles its business. If the receiver were deprived of the equipment it
would be impossible for him to operate the road, and so he could never
satisfy its creditors. Consequently the courts, both State and Federal,
have ruled that the necessary equipment of a bankrupt railroad must be
preserved, and have placed the charges for principal and interest of
equipment obligations upon an equality with charges for wages,
materials, and other operating expenses, and in priority to interest of
even first-mortgage bonds.
These points sufficiently explain the remarkable record which equipment
bonds have made during reorganizations. Careful investigation has been
made of the various railroads which were reorganized, either with or
without foreclosure, between the years 1888 and 1905. This covers the
chief period of railroad receivership. It was discovered that sixteen
different railroads, aggregating nearly one hundred thousand miles and
located in widely different parts of the country, had outstanding
equipment bonds at the time of default. In every case the principal and
interest of equipment bonds were paid in full, while all other
securities, with a few exceptions, were reduced in rate or amount or
both. Two of these railroads offered to the holders of equipment bonds
the option of an advantageous exchange of securities, which amounted to
more than payment in full.
The foregoing facts justify the conclusion that equipment bonds possess
security equal or superior to that of any other form of railroad bonds.
Let us now consider their remaining characteristics--their rate of
income, convertibility, prospect of appreciation in value, and stability
of market price.
One of the strongest features of equipment bonds is the relatively high
rate of income which they yield. The amount realized varies in
accordance with the financial strength and credit of the issuing
railroad, and the margin of security in the equipment itself. As a
general rule, the net return on the equipment bonds of a given railroad
is usually from 1/2 per cent to 3/4 per cent greater than on the
first-mortgage bonds of the same railroad. This is owing to the fact
that while banks and scientific investors have bought equipment bonds
for many years, the general public is not sufficiently familiar with the
inherent strength of these issues to create much of a demand for them.
This insures a good return.
Equipment bonds vary in point of convertibility. The reader will
remember from the description above that equipment bonds are usually
issued in serial form, with instalments maturing semiannually from six
months to ten years. By confining purchases to the shorter maturities,
say within two or three years, a high degree of convertibility may
usually be obtained because the short maturities are greatly sought by
banks and other financial institutions which regard equipment bonds in
much the same light as merchant's paper or time loans secured by
collateral. At a price equivalent to the rate which the best commercial
paper commands, there is always a good demand from the banks. Many banks
prefer equipment bonds to loans or paper on account of their greater
convertibility. As the length of maturity increases, the degree of
convertibility generally decreases, because the chief demand for the
longer dates comes from insurance companies, which do not, in the
aggregate, constitute as great a demand as the banks. When the demand
from private investors increases, as it undoubtedly will when they
become more familiar with the desirable points of these issues, all
maturities will probably possess ready convertibility.
In the same way, equipment bonds vary as to stability of market price.
Compared with other classes of railroad issues, equipment bonds are all
relatively stable, but the stability is especially marked in the shorter
maturities.
Equipment bonds possess little prospect of appreciation in value.
The attentive reader who has carefully followed the foregoing
description of equipment bonds, may have noticed a special adaptability
on their part to the requirements of a business surplus. Broadly
speaking, for such investment, a security is required which will combine
perfect safety of principal and interest, a good rate of income, ready
convertibility into cash, and unyielding stability of market price. The
necessity for insistence upon these requirements in the investment of a
business surplus will appear upon a moment's reflection. Safety is
required in all forms of investment, but is particularly important in
the handling of business funds; a good rate of income is always
desirable; convertibility is necessary for a business surplus so that
the reserve funds may be converted into cash at any time; and it is of
the utmost importance that the security should not shrink materially in
quoted price, no matter what changes may take place in financial and
business conditions, so that if the need should arise for realizing on
the reserve fund, it would be found unimpaired in amount. As explained
in a former chapter, this point can not be covered by the selection of
securities perfectly safe as to principal and interest, but only by the
purchase of short-term obligations.
The point may be illustrated as follows: Let it be supposed that a firm
or company has decided to invest $100,000 in the 5-per-cent equipment
bonds of a good railroad maturing in three years, which can be obtained
at par, merchant's paper then commanding about 5-1/2 per cent. After two
years it becomes necessary for the firm to realize on its investment at
a time when commercial paper is floated with difficulty on a
6-1/2-per-cent or 7-per-cent basis. Under such money conditions the
equipment bonds could be sold on about a 6-per-cent basis, which would
mean a price of 99 for a 5-per-cent bond with one year to run. The firm,
in liquidating its investment, would therefore lose 1 per cent in
principal, but would have received 5 per cent interest for two years,
making the net return 4-1/2 per cent. Compare this showing with the
result if the bonds when originally bought had had ten years to run
instead of three.
After two years, when the firm wished to dispose of its bonds it might
experience some difficulty in doing so in the stringent money market
which has been supposed, but even if it succeeded in selling them upon a
6-per-cent basis, that would mean a price of only 93-3/4 and would
represent 6-1/4-per-cent loss in principal. If it were necessary to sell
the bonds upon a higher basis or if the firm had purchased a bond with
more than ten years to run, the relative disadvantage of the longer bond
would be still more apparent. These points sufficiently demonstrate the
importance of buying only short-term securities for the investment of a
business surplus. Of course, if money conditions improve instead of
becoming worse between the dates of purchase and sale, then a greater
profit would be made with the longer-term bond. This, however, should
not be allowed to influence the choice, first because it is not the
object of a reserve fund to make a speculative profit, and secondly
because a firm or corporation is only likely to want to realize upon its
reserve fund when money is hard to obtain otherwise, and that is
precisely the time when any long-term bond would be apt to show
considerable depreciation.
The foregoing considerations indicate a special adaptability on the part
of equipment bonds to the usual requirements of a business surplus. The
points have been brought out at some length because of the importance of
the subject to the average business man. The purpose in concentrating
attention upon a single instance has been to illustrate more clearly the
principles involved and at the same time to acquaint the business man
with details of a highly desirable and somewhat unfamiliar form of
security.
IV
REAL-ESTATE MORTGAGES
In the preceding chapter the discussion of railroad bonds was brought to
a close. Before passing to the consideration of real-estate mortgages,
which is the next form of investment to be taken up, it may be well to
review briefly the general principles advanced in the first chapter of
this book, in order that the reader may have clearly in mind the main
points upon which judgment of the value of investments should be based.
There are five chief points to be considered in the selection of all
forms of investment. These are: (1) safety of principal and interest;
(2) rate of income; (3) convertibility into cash; (4) prospect of
appreciation in intrinsic value; (5) stability of market price.
Keeping these five general factors in mind, the present chapter will
discuss real-estate mortgages as a form of investment, both as adapted
to the requirements of private funds and of a business surplus.
The average American business man is so familiar with real-estate
mortgages that the details may be passed over briefly. A real-estate
mortgage, or a bond and mortgage, as it is sometimes called, consists
essentially of two parts, a bond or promise to pay a certain sum of
money at a future date with interest at a certain rate per annum, and a
mortgage or trust deed transferring title and ownership in a piece of
real estate, with the provision that the transfer shall be void if the
interest is regularly paid and the bond redeemed at maturity. Before
advancing money on the security of a mortgage it is necessary to
determine whether the title to the property legally vests in the maker
of the mortgage; and during the continuance of the mortgage it is
necessary to have proof that the taxes and assessments are being
regularly paid, and, in the case of improved property, the
fire-insurance as well.
The safety of real-estate mortgages, in common with the safety of all
obligations, depends upon the margin of security in excess of the amount
of the loan. In the case of real-estate mortgages the amount of this
margin may be determined without great difficulty. It is only necessary
to have the property carefully appraised by an expert in real-estate
values. It does not follow, however, because a mortgage has been shown
to possess substantial equity, that it is perfectly safe as an
investment, unless it satisfies also another condition of great
importance. A mortgage may not exceed 50 per cent of the selling value
of the real estate pledged, and yet be a poor investment. This point
involves a serious objection to real-estate mortgages which sometimes
escapes notice.
The holder of a mortgage is at a great disadvantage in regard to the
changing value of real estate. If the value of the property upon which
he holds a mortgage increases, the additional value enhances the
security of the loan, but does not add to the principal which he has
invested, while if the value of the property diminishes, not only is the
security proportionately lessened, but if the impairment be great, the
holder is frequently compelled to take over the property and may suffer
loss of principal. In other words, he receives no direct benefit from an
increase in the value of the property, but has to stand the larger part
of the risk of a decline in its value.
This is not the case with investments represented by negotiable
securities subject to changing market quotations. All such securities,
railroad bonds for example, are acted on equally by changes in the value
of the property which secures them. Except for the influences of
money-market conditions, railroad bonds advance with an increase in the
value of the property and decline with a decrease in its value.
Well-selected bonds usually increase in value with time, and all such
increase goes directly to the benefit of the holder. The failure of
real-estate mortgages to respond similarly to changes in the value of
property places the holder of a mortgage at a great disadvantage.
Owing to this characteristic, real-estate mortgages should be purchased
only when general conditions in the real-estate market are distinctly
favorable. Not only should the purchaser of a mortgage have sufficient
margin of security in the particular piece of property upon which he is
loaning money, but he should also be satisfied that general real-estate
values are relatively low, that there has been no undue speculation, and
that conditions favor an advance rather than a decline in real-estate
prices.
No class of property is subject to more rapid changes in value than real
estate. After an extensive advance the holder of a mortgage may be
insufficiently protected by the equity in the property, even if his
mortgage represents only 60 per cent of the current appraised value of
the real estate pledged. It may be that the 60 per cent which he has
loaned represents the total value or more than the total value a few
years before. When a rapid advance in values occurs, tho it may be
largely justified by the growth and development of the territory, there
is sure to be present an element of speculation which is likely to carry
prices beyond the point of reason. When the turn comes and a severe
collapse takes place, its effects are extremely disastrous, because,
unlike speculation in stocks or commodities, no short selling exists in
real estate to temper the fall, and the immobile form of capital makes
liquidation impossible. These considerations serve to show the need for
great prudence in the purchase of real-estate mortgages. If the investor
exercises due care in these particulars, he is reasonably sure of
obtaining a very high-grade security; if he neglects these precautions,
he may suffer severe loss of principal.
No general figures are available which would indicate the degree of
certainty attaching to the payment of interest upon real-estate
mortgages. Certain classes of mortgages, such as those secured by
unimproved real estate or dwellings, afford no direct security of
interest payment other than the threat of foreclosure. Other classes,
such as mortgages upon stores, hotels, or office-buildings, are often
protected by a large income from the direct operation of the mortgaged
premises, thus furnishing a security for the annual interest payment.
The margin of protection in these cases varies greatly, so that no
general conclusion can be drawn.
The other characteristics of real-estate mortgages may be passed over
more briefly. It is generally conceded that mortgages return a higher
rate of income than can be obtained upon any other form of investment
which affords equal security. This constitutes their chief advantage.
Their chief disadvantage, on the other hand, lies in their entire want
of convertibility. There is no market for real-estate mortgages, and
except in special instances they can not be readily sold. The fact that
they are not subject to quotation prevents them also from holding out
any prospect of appreciation in value. Their very deficiency in this
respect, however, constitutes an important advantage from another point
of view. Since they are not quoted they can not shrink in market price
in obedience to changes in financial and business conditions. The buyer
of a mortgage is assured that he can carry his mortgage at par through
periods when it may be necessary to mark down all negotiable securities
subject to changing market quotations. This is frequently a matter of
great importance.
The general characteristics of real-estate mortgages may be summarized
as follows: (1) When carefully selected and purchased under favorable
conditions, great safety of principal and interest; (2) a relatively
high return; (3) a low degree of convertibility; (4) no prospect of
appreciation in value; and (5) the practical certainty of maintaining
the integrity of the principal invested.
Is a security possessing these characteristics a suitable investment for
a business surplus? Only to a limited extent. The safety, high return,
and assurance against loss in quoted value of principal are all highly
desirable qualities for this purpose, but the lack of convertibility is
a fatal defect. No consideration is of greater importance in the
investment of a business surplus than a high degree of convertibility,
so that if the need should arise the investment may be instantly
liquidated. The fact that real-estate mortgages can not be readily
disposed of makes it practically impossible to employ them for the
investment of a business surplus.
Where convertibility is not an essential requirement, and where the want
of promise of appreciation in value is not a serious matter, mortgages
afford a very desirable form of investment. The characteristics which
they possess in an eminent degree--safety, high return, and assurance
against loss in quoted value of principal--are exactly suited to the
ordinary requirements of savings-banks. Generally speaking, only a small
proportion of a savings-bank's assets need be kept in liquid form or
readily convertible, and accordingly they find mortgages highly
desirable.
For the purpose of private investment the attractiveness of mortgages is
not so easy to determine. Ordinarily, fluctations in quoted values are
of no great importance to the private investor, so that the absence of
quotation which mortgages enjoy is not especially valuable. Their safety
and high return are attractive qualities, but their want of
convertibility and of prospect of appreciation in value are drawbacks.
On the whole, the private investor may probably employ with advantage a
certain part, but not too much of his estate in mortgage investments.
As part of a scientific and comprehensive scheme of investment, the
special advantages of real-estate mortgages appear most prominently in
the years following a business depression. During such a period
real-estate values are usually relatively low, but beginning to advance,
so that mortgages present their maximum margin of security. At such a
time they compare most favorably with bonds and other investment
securities which are subject to changing quotations, because such
securities are then apt to be at their highest point under the combined
influence of restored confidence and the low money rates which usually
prevail. After several years of continued and increasing business
prosperity the positions are just reversed.
No discussion of real-estate mortgages would be complete without
allusion to the guaranteed mortgages which have been placed upon the
market in great quantities within the past few years. Guaranteed
mortgages are real-estate mortgages guaranteed as to principal and
interest by substantial companies having large capital and surplus. In
addition to the guaranty, the companies usually search and guarantee the
title, see to it that the taxes, assessments, and insurance are paid,
and perform the other services of a real-estate broker. Their
compensation varies somewhat, but probably averages 1/2 per cent--that
is, for example, they loan at 5 per cent and sell guaranteed mortgages
to the investor at 4-1/2.
The value of the guaranty may be considered from two points of
view--first, in the event of a general decline in real-estate values,
and, secondly, when a fall occurs in a particular piece of property or
in a particular locality.
If a severe decline in real-estate values takes place, affecting all
localities, it might become necessary for the holders of guaranteed
mortgages to test the value of their guaranties. In such a case the
question would arise how far the capital and surplus of the guaranteeing
companies would extend in liquidating the mortgages which they had
guaranteed. This would depend entirely upon the proportion between the
capital and surplus of the companies and the total amount of outstanding
mortgages guaranteed. Ordinarily the capital and surplus do not exceed 5
per cent of the mortgages, so that the average guaranty is good for
about 5 per cent additional equity. On a piece of property worth
$100,000, upon which a guaranteed mortgage of $60,000 exists, the
guaranty would be worth $3,000, and would margin the property down to
$57,000. This additional equity is of little value. It is probably
unlikely that a 40-per-cent depreciation in value will take place, but
the guaranty is not needed unless it does, and if it should occur, the
depreciation is quite as likely to go to 50 per cent or more as to stop
at 43.
From the second point of view the value of the guaranty is much greater.
The distribution of risk, as in the case of fire-insurance, protects
the holder against loss in the event of a fall in the particular piece
of property upon which he holds a mortgage, or even in a particular
locality. It can not be said, however, that the records are yet
sufficiently complete to form a conclusion as to what is a safe
proportion between capital and surplus and outstanding mortgages.
Further than that the guaranteeing companies, generally speaking, have
been operating since their inception upon a rising market, so that their
success hitherto has not been remarkable. Allowing for these drawbacks,
however, the private investor, unless so situated as to give personal
attention to the details of his investments, will probably do well to
purchase his mortgages in guaranteed form.
V
INDUSTRIAL BONDS
Industrial bonds include the obligations of all manufacturing and
mercantile companies, and miscellaneous companies of a private
character. They form a class quite distinct from railroad bonds or
public-utility bonds.
I. _Safety of Principal and Interest._ The safety of industrial bonds,
in common with the safety of all forms of investment, depends upon the
margin of security in excess of the amount of the obligation. In the
case of industrial bonds the amount of this margin is not always easy to
determine. Even when determined, the rule is difficult of application
because a margin which may seem insufficient from the point of view of
physical valuation may be satisfactory when considered as the equity of
a working concern. The indications most to be relied upon in estimating
the safety of industrial bonds are as follows:
(_a_) _Value of real estate._ The first point to be determined in
considering the purchase of an industrial bond is the value of the real
estate upon which it is a first mortgage. If the appraised value of the
ground, irrespective of the buildings and machinery upon it, is greater
by a substantial sum than the amount of the bond issue, the obligation
is practically a real-estate mortgage. In such a case, while possibly
"slow," _i.e._, secured by an assets difficult to realize upon--the
safety of the bond can hardly be questioned. In judging a bond upon its
real-estate value, it is not always safe to take the cost price of the
land as shown by the company's books, because frequently the cost upon
the books is artificially raised by payment having been made in
securities whose market value is less than par, or in other ways. As
stated above, judgment should be based upon the _appraised_ value of the
land.
If the bond meets this test satisfactorily, the prospective investor may
feel reasonably sure that the safety of his principal is not in
question, and may buy the bond without anxiety if it satisfies his other
requirements. On the other hand, if the bond only partially meets this
test, and it appears that some part of its value comes from plant and
equipment and from the strength of the company as a working concern,
then it is necessary for the investor to consider carefully several
other factors.
(_b_) _Net quick assets._ The balance-sheet of every industrial company
can be divided horizontally into two parts. Its assets are of two
kinds--property assets, which are fixt, and current assets, which are
fluid. Similarly, its liabilities are of two kinds--capital liabilities
and current liabilities. It requires no very extended business
experience to pick out the items which make up these totals. Plant and
property assets are usually lumped together under the head, "Cost of
Property." Current assets include inventories, bills and accounts
receivable, agents' balances, marketable securities, and cash on hand
and in banks--everything, in short, which can be quickly converted into
cash. On the other side of the balance-sheet, capital liabilities are
easily determined. They consist of the par amounts of bonds and stocks
outstanding. Current liabilities comprise bills and accounts payable,
including borrowed money, pay-rolls, and interest and taxes accrued but
not due.
The real strength of every industrial concern is to be learned from the
figures relating to its current accounts. Property assets and capital
liabilities are not of the same significance. If the cost of plant and
equipment as shown by the books exceeds its real value, the market
usually makes the necessary adjustment by putting a price less than par
upon the bonds and stocks.
No such process is possible in the case of the current accounts. If the
current liabilities exceed the current assets the company shows a
deficit, whatever its surplus may show on the books. On the other hand,
if the current assets are greater than the current liabilities, the
company possesses a working capital, represented by the difference
between the two, and known as net quick assets.
There are three things to consider in connection with net quick assets:
First, the proportion between current assets and current liabilities. To
put a company in good shape its current assets should be at least twice
as great as its current liabilities. Two for one is a fair proportion,
tho some companies show as much as six to one. The stronger a company is
in this proportion the better.
Secondly, the proportion between net quick assets and bonded debt. The
bonded debt should never exceed net quick assets, except when the
company possesses real estate, in which case two-thirds of the
real-estate value plus the net quick assets should cover the bonds. Some
companies do much better than that. One prominent company in this
country, altho it possesses real estate of considerable value, has
agreed in the indenture securing its bonds to keep net quick assets at
all times greater by a substantial margin than the amount of bonds
outstanding.
Thirdly, the proportion between net quick assets and the surplus as
shown in the balance-sheet. If the capital liabilities exactly balance
the property assets, it is plain that the surplus will exactly balance
the net quick assets. If the surplus is smaller than net quick assets,
it is usually a sign that capital liabilities have been created to
provide working capital. Opinions differ as to the wisdom of this
course. Generally speaking, it is better to provide working capital by
means of a stock issue than to depend upon the banks for accommodation.
The exception to this rule occurs in the case of companies that require
a great deal of working capital for part of the year and only a little
at other times. If they have the best banking connections, such
companies may be safe in depending upon their banks to carry them, but
if they do so, they should have no bonded or other fixt indebtedness
which would prevent their paper from being a first lien upon their
entire assets.
If working capital is to be created by the issue of capital liabilities,
it is much better that it should be done by stocks than by bonds. The
ideal method, however, is to provide only such an amount of working
capital at the organization of a company as is necessary for the conduct
of its business, and then, as the volume of its business grows, to
accumulate the additional amount necessary out of earnings, refraining
from the payment of dividends until the fund is complete.
Before leaving the subject of net quick assets, it is well to note the
importance of the figure showing the actual amount of current
liabilities. If a company has outstanding large amounts of bills and
notes payable, it occupies a vulnerable position. Inability to renew
maturing notes was the cause of most of the industrial failures of last
year.
(_c_) _Net Earnings._ The amount of net earnings is of great importance
in estimating the strength of an industrial company. The figures for a
number of years should be examined to determine whether the earnings are
increasing or decreasing, and to discover whether or not the earning
power of the company is stable. This will depend largely upon the nature
of the article which the company produces or trades in. If its product
enjoys a steady demand at a fairly uniform price, it is justifiable that
some of its capital should be in the form of bonds; but if its earnings
are subject to violent fluctations due to rapid changes in the price of
its product, there is little justification for conducting the business
on borrowed money.
In this connection it should always be considered how greatly a falling
off in gross earnings will affect net earnings; and the proportion
between net earnings and fixt charges should be carefully noted.
In order for an industrial bond to receive favorable consideration, the
average yearly net earnings of the company should amount to about three
times the annual bond interest, taxes, and sinking funds. The greater
the protection is in this respect the better.
(_d_) _Form of Issue._ The form in which an industrial bond is issued is
a matter of some importance. If the principal of the bond does not
become due for a number of years, there is danger that the property will
depreciate so far in value as to leave the bond without sufficient
margin of protection. There are two ways to overcome this difficulty.
One way is to establish a sinking-fund which will retire a certain
proportion of the bonds by lot each year. Another way is to issue the
bonds in serial form, with a definite instalment maturing every year. In
either case the annual sinking-fund or annual instalment should be
greater than the probable depreciation so that the margin of security
will be constantly increasing.
(_e_) _Management and Control._ No question is of greater importance in
estimating the strength of an industrial company than the reputation of
the men in charge. The ability and integrity of the men who control the
policy of the company and the efficiency of the operating officials are
the principal factors in the success of an industrial undertaking.
Vacillating policies, weakly executed, will ruin the most promising
enterprise. This is particularly true in the case of small companies.
Every man of business experience will understand the importance of this
factor and be guided by it in the selection of industrial securities.
Based upon the foregoing considerations it is of interest to inquire
what degree of safety really attaches to the average industrial bond?
How far does it meet the foregoing requirements? The question is
difficult to answer. Industrial bonds vary greatly in point of safety,
some issues possessing great strength and others being highly
speculative. No general conclusions can be depended upon, and the
investor is forced to consider each issue upon its own merits.
II. _Rate of Income._ The average net return upon industrial bonds is
probably higher than upon any other form of funded corporate obligation.
This constitutes one of the chief advantages of industrial bonds.
III. _Convertibility._ It is impossible to make any general statement in
regard to the convertibility of industrial bonds. Some industrial
bonds, notably the larger issues of well-known trusts, command a broad
and active market. Such bonds can be sold in large amounts at almost any
time without seriously affecting the price. On the other hand, small
underlying issues of such companies, usually high-grade in point of
security, or the obligations of smaller companies, are almost as
unmarketable as real-estate mortgages. Between these two extremes all
varieties of industrial bonds are to be found. The degree of
convertibility which a security possesses is usually a matter of some
importance, and the investor should make a careful examination of each
bond in this respect.
IV. _Prospect of Appreciation in Value._ To what extent a bond may
improve in security during the time that an investor holds it is of
little importance unless the improvement be reflected in the market
price of the bond. Only so can the investor take advantage of its
appreciation in value. In order for the improvement in security to be
reflected in market price and thus add to the principal invested, it is
necessary that a bond should possess a fairly active market. For this
reason the industrial bonds which hold out the greatest promise of
appreciation in value are the larger, more speculative issues, which
possess the greatest convertibility. The purchase of such bonds
frequently results in substantial profits.
V. _Stability of Market Price._ The four points above touched
upon--safety, rate of income, convertibility, and likelihood of
improvement in intrinsic value--are all inherent characteristics of
every bond. The likelihood of favorable or unfavorable fluctation in
market price is largely external in its nature and depends upon general
financial and business conditions.
As a class, industrial bonds can not be said to possess much stability
of market price. Some of the smaller issues enjoy a fictitious stability
because of their inactivity, but generally speaking industrial bonds are
subject to wide fluctations in accordance with changes in the business
outlook.
The foregoing is a summary, necessarily brief and imperfect, of the main
points to be considered in judging the value of industrial bonds. The
question remains whether such securities are desirable for the
investment of a business surplus and of private funds.
Except in special cases industrial bonds are not suitable for a business
surplus. It is impossible to find an industrial bond which combines all
the characteristics necessary for that purpose. The requirements are
great safety of principal and interest, a relatively high return, ready
convertibility, and stability of market price. Many industrial bonds can
be found which combine two of these requirements, some even which
combine three, but the full combination, if it exists at all, is unknown
to the writer.
In addition, the principle of distribution of risk should prevent one
industrial company from investing its reserve funds in the securities of
another industrial company.
For private investment the case is somewhat different. A man of good
business judgment, who desires to obtain a high yield for which he is
prepared to sacrifice something in the way of convertibility and
prospect of appreciation in value, may buy the underlying issues of
strong companies with every confidence in the safety of his principal.
Again, the investor who wants a high yield and quick convertibility, who
is prepared to take a business man's risk and to sacrifice stability of
market price, may make a large profit by buying second-grade industrial
bonds. No investor, however, should deceive himself with the idea that
any industrial bond will satisfy all the requirements of the ideal
investment.
VI
PUBLIC-UTILITY BONDS
It was a common saying among bond-dealers a few years ago that the day
of the municipal bond had passed, the day of the railroad bond was
passing, and the day of the public-utility bond was to be. Municipal
bonds were selling at fancy prices in consequence of the low rates for
money which then prevailed, and railroad bonds appeared to be following
in their wake. Public-utility bonds alone afforded a satisfactory yield,
and it was felt that the investing public would be forced to turn to
them.
This prediction, like many others which were based upon the assumption
of continued ease in money, was destined to be unfulfilled. Almost
immediately there appeared an added demand for capital, and in the face
of this demand, supplies of capital which had before seemed ample became
suddenly scarce. Money rates rose rapidly and as a necessary
consequence municipal and railroad bonds fell in price to a point where
their net return was commensurate with that obtained from the loaning of
free capital. The investment situation was thus completely reversed. It
was no longer a question as to what form of security investors must seek
in order to obtain a satisfactory yield, but rather could the highest
grade of municipal and railroad bonds be floated at any price. Under
these circumstances the contemplated necessity of turning to
public-utility bonds never arose, and the general investing public
remains for the most part unfamiliar with their elements of strength and
of weakness.
The term "public-utility company" denotes a private corporation
supplying public needs under authority of a public franchise. The
franchise may be of definite date or perpetual, and may be partial or
exclusive.
Public-utility companies include street-railway, gas, electric-light and
power, and water companies. Properly speaking, telephone companies
should also be included, but they are not usually regarded as belonging
to the class of public-service corporations.
It is impossible, within the limits of a single chapter, to discuss each
kind of company separately. The investment value of street-railway bonds
will be here considered, and it is felt that the general principles
advanced, with slight modifications of detail, will be found equally
applicable to a judgment of other forms of public-service securities.
I. _Safety of Principal and Interest._ In order to determine the safety
of a street-railway company's bonds, the company must be subjected to a
threefold examination, physical, financial, and political.
An examination must be made into the extent and condition of the
physical property in order to ascertain whether the bonded debt is
secured by property having a real market value in excess of the face
amount of bonds issued. The first point to be determined is the extent
and valuation of the company's real estate. If the appraised value of
the land upon which power-houses and car-barns have been erected is
alone greater than the amount of bonds outstanding, the investigation
need go no further, for the bonds, in such a case, would be practically
a real-estate mortgage. In most instances, however, this is very far
from being the case; and after careful appraisal of the real estate it
is then necessary to make a careful valuation of the other physical
property; namely, power-plants, depots, car-sheds, roadway, and
equipment.
It is usually impossible for the average investor to make such an
examination himself, nor is it likely that he would possess sufficient
technical knowledge to render his investigation of much value. For an
accurate estimate of the value of a street-railway's physical property,
it is usually necessary to depend upon the expert opinion of a trained
engineer. It is a matter of regret that the average street-railway
report can not be relied upon to furnish an accurate valuation of the
physical property; and it is accordingly customary for careful
bond-dealers, when they contemplate taking an issue of street-railway
bonds for distribution among their clients, to have the property
examined by a competent engineer, whose report then determines for them
the question of taking the issue.
Disregarding the figures which show the cost of property and equipment
upon the company's books, the engineer proceeds to make a careful
estimate of the replacement value of the property, including real
estate. If the result of the examination shows that the property could
not be duplicated for the amount of the bond issue, the company occupies
an unusually strong position--altho even in such a case some part of the
value of the bonds comes from the strength of the company as a going
concern.
In most cases, however, it is probably found that the bond issue is in
excess of the value of real estate and the replacement value of the
physical property, the balance representing a capitalization of the
franchise.
To determine the real value of the franchise or franchises is a
difficult matter and involves the whole question of the company's
relations with the community which it serves and with the local
lawmaking bodies.
The first question which arises is whether the franchise is perpetual or
for a definite time, and the second whether it is partial or exclusive.
Franchises vary greatly in these respects. Sometimes a franchise,
apparently partial, is practically exclusive, owing to the fact that
all the available space in the streets is already occupied by the
company's own tracks. If the franchises of a company are limited as to
time, it is expedient, if not imperative, that the bonds should mature
before the expiration of the franchises.
If the company whose bonds are under examination satisfactorily passes
this physical test--if it possesses real estate of considerable value,
if the replacement value of the property is as great or nearly as great
as the amount of the bonds, and if the franchises, while perhaps not
perpetual or exclusive, are yet of longer duration than the bonds and
render successful competition unlikely--the next step may then be taken;
that is to say, an examination of the company's financial condition and
earning capacity may be made.
The amount of its gross earnings should be examined and the figures
scrutinized for a number of years back to discover whether its earnings
are increasing or decreasing. The position in which the company stands
for obtaining new traffic must be noted, and some estimate must be made
of the stability of its earning power. In this connection the relations
of the company to the public are of great importance. It must be learned
whether the company follows the policy of conciliating or ignoring
public sentiment.
The net earnings of the company must then be examined. This involves a
criticism of operating expenses. The payments of the road must be
analyzed to determine whether the proper amounts have been expended for
renewal of track, replenishment of rolling stock, and other improvement
sufficient to keep the property in good physical condition. This is the
most intricate subject in the investigation of a street-railway
property. Unless proper allowance be made for depreciation, in addition
to the expenses of direct operation, it is only a question of time
before the strongest company will become bankrupt.
Deterioration of plant and equipment, which goes on constantly, can only
be offset in two ways: one is out of earnings and the other is out of
the security-holders--that is, by decreases in the market value of the
securities. The first takes prosperity or courage; the second leads to
bankruptcy. It is difficult to measure depreciation accurately, but a
safe rule is to write off ten per cent of gross earnings each month for
depreciation. In this way the charge for depreciation will be
proportionate to the traffic, which provides automatic adjustment.
If the net earnings, after making this allowance for depreciation, and
after providing all expenses of operation including ordinary repairs,
amount to as much as twice the interest charges upon the bonds
outstanding, it is probable that the bonds may be taken with safety.
Before finally determining the question, however, certain political
factors must be taken into consideration. The relations of the company
to the leaders of the dominant political party must be investigated. The
likelihood of agitation looking toward a reduction of fares must be
considered and the possibility of increase in taxes (if below the legal
limit) must be weighed. The probable attitude of the legislature on the
question of renewing the franchises when they expire must be considered.
In general, it must be learned whether any real ground of contention
exists between the company on the one hand and the public and its
representatives on the other, because it is inevitable that the company
will weaken its independence of position by too close a connection with
politics, and that the physical property will suffer if there is any
lack of uninterrupted attention to it.
Finally one other thing should be investigated--the amount of the
accident account and its proportion to the net earnings of the company.
On small lines a single case of heavy damages will sometimes make
serious inroads upon the earnings.
The foregoing is a summary, necessarily brief and imperfect, but true in
its essential outlines, of the main points which should be considered in
judging the safety of street-railway bonds. The question remains, how
far does the average street-railway company satisfy these requirements?
Broadly speaking, street-railway bonds are not yet to be classed in the
first rank of investment securities. The troubles which have come to a
head in the financial operations of the traction systems in New York and
Chicago are typical of troubles which are likely to occur elsewhere from
the same general causes--overcapitalization in the first place and
insufficient allowance for depreciation in the second place. In both New
York and Chicago the crisis was hastened by open and obvious
overcapitalization, which is almost inevitable when many independent
lines are merged into one system. The same trouble, however, is apt to
occur in other traction systems where this evil appeared less flagrant
at the outset.
The advantages of electricity over horsepower naturally led to the
multiplication of electric street lines, as the system ten or fifteen
years ago passed beyond the experimental stage. As in all new
enterprises, speculation ran ahead of the reality and financing built
upon oversanguine calculations has too often had difficulty in squaring
accounts when brought face to face with facts. In most of the
calculations insufficient allowance was made for the wear and tear of
service; in other words, for renewal of road and equipment. After a few
years' test of earnings against expenses, it became evident that a
proper allowance for depreciation of plant would show a heavy deficit in
the income account. In most cases therefore no allowance or only a
meager one was made. For a time this method of bookkeeping proved less
disastrous than might have been expected owing to the rapid growth of
population and business in American cities. It was possible in many
cases to consider the enhanced value given to the franchise by growth of
business as an offset to the depreciation of tracks and equipment. In so
far also as the plant was kept up to a high degree of efficiency by
charging the expense of repairs to operating expenses, the absence of a
depreciation account was partially offset.
With the progress of recent years, however, a new factor has been
entering into the problem which promises to make the situation still
more serious for the traction systems. This new factor is the rise in
prices and wages. Temporarily the influence of this factor may be
checked by diminished business activity, but when normal conditions are
restored, it will commence to act again upon the railways with
accumulated effect.
In most cases a proposition to increase the standard street-railway fare
above five cents as an offset to the increased operating expenses would
be so revolutionary a proposal that it could hardly be carried through.
With the line of cost converging upon the line of receipts and with no
proper allowance made for depreciation, the traction systems of the
country seem to be facing a difficult problem. In the long run it can
not be doubted that the problem will be met and solved in a way to
afford justice alike to the public who use the cars and to the
capitalists who have made street traction on a large scale possible, but
in the meantime the investor who desires perfect safety should exercise
great care and discrimination in his purchases of street-railway
obligations.
II. _Rate of Income._ As a general rule, street-railway bonds in common
with the obligations of all public-service corporations sell upon about
the same income basis as high-grade industrial bonds--that is to say,
under normal conditions they return considerably more than railroad or
municipal bonds.
III. _Convertibility._ It is difficult to speak of the convertibility of
public-utility bonds as a class for the reason that they differ widely
from one another in this respect. In general, it is certainly more
difficult to dispose of public-utility bonds than railroad bonds. They
do not possess sufficient convertibility to justify their purchase by
any one who may need to realize quickly on his holdings.
IV. _Prospect of Appreciation in Value._ Public-utility bonds, except
such issues as are convertible into stock, possess little prospect of
appreciation in value. It was pointed out above that depreciation is not
properly allowed for, and it is very difficult for the securities to
advance in the face of this obstacle.
V. _Stability of Market Price._ The bonds of public-service corporations
are relatively more stable than railroad bonds because their earnings
are not subject to the fluctations which occur in railroad properties
between years of prosperity and years of depression. At the same time,
it should be pointed out that their stability of price is largely
fictitious, owing to the comparative inactivity of the issues. In other
words, while the quotation may be maintained, it is usually difficult to
sell any large quantity of a public-service corporation's bonds in a
period of financial disturbance, while railroad bonds are more easily
liquidated even if at a sacrifice.
The question remains, do public-utility bonds afford a desirable
security for the investment of a business surplus and of private funds?
In regard to the former, it may be said at once that public-utility
bonds do not meet the necessary conditions. The security is too
doubtful, the convertibility is too small, and the stability of price
too uncertain.
For private investment the case is somewhat different. Keeping in mind
the desirability of diversifying investments and admitting the
attractiveness of investing in a class of property whose earnings are
comparatively stable, it seems clear that public-utility bonds can not
be dismissed without consideration. When a company is found whose
property is substantially equal in real value to its bonded debt, whose
allowance for depreciation is ample, whose franchises are satisfactory,
whose earning capacity is large, and whose management is capable and
upright, the investor is justified in giving careful consideration to
its issues. Unless all these points are found to be satisfactory,
however, the investor should content himself with some other form of
security. For some years to come it is to be feared that many of our
public-service corporations will suffer from the war of discordant
elements--disregard of the rights of the public on the part of the
management and socialistic agitation for control on the part of the
community. Until these warring factions are reconciled and the questions
at issue adjusted with fairness to the security-holders and the public,
the investor should be most prudent in his purchases of public-utility
obligations.
VII
MUNICIPAL BONDS
The previous chapters have considered, in turn, the investment value of
railroad bonds, real-estate mortgages, industrial bonds, and
public-utility bonds. The desirability of each of these different
classes of security has been judged in accordance with the general
principles laid down in the introductory chapter; that is to say, each
class has been analyzed in relation to safety, rate of income,
convertibility, prospect of appreciation in value and stability of
market price. The same determining factors must now be applied to a
judgment of government, State, and municipal bonds.
Bonds issued by a national government, by a State, or by a municipality
are based primarily on some form of the power of taxation, tho the bonds
are usually tax exempt within the political unit which creates them.
When the power of taxation is unlimited, as in the case of the national
government and the sovereign States, there can be no question as to the
ability of the political unit to meet its obligation, and the question
becomes entirely one of good faith. It is probable that the obligations
of the United States Government, by reason of the fact that the
per-capita debt of the country is so small, the wealth of the country so
great, and the good faith of the American people so clearly established,
represent the highest type of security to be found in the world. It is
quite possible, therefore, that the 2-per-cent United States Consols
would sell in any case at a relatively higher price than the obligations
of any other country, but it can not be denied that the chief reason
which causes them to sell at the remarkably high price which they have
attained is the fact that they are required by national banks as
security for circulation. This fact is doubtless the controlling element
in their market position, and at once accounts for their special
strength and removes them from the field of private investment.
Only less secure than United States bonds are the obligations of the
sovereign States of the Union. State bonds usually sell upon a basis
which may be taken as the equivalent of pure interest, with no element
of risk or speculation involved. The obligations of different States
sell at different prices, in accordance with market conditions and the
relations of supply and demand, but there can be no question of the
equal ability of all States to pay their obligations. Repudiation of
State debts has occurred in our history, but only in cases where an
overwhelming majority of the citizens were opposed to the creation of
the debt at the time of its issue, but lacked the means to control the
situation. Such instances are chiefly to be found in the case of the
so-called carpet-bag governments of the Southern States after the Civil
War.
Municipal bonds--_i.e._, the bonds of cities, counties, and
townships--are indirectly a first lien upon all taxable property in the
municipality, and take precedence of every form of mortgage or judgment
lien. This lien is enforced through a tax levy to meet interest and
principal, and this tax levy the courts will compel in the rare cases in
which a municipality attempts to repudiate a valid bond. This priority
of the tax lien is the foundation of the prime position of municipal
bonds. The case rarely occurs where a bond held valid by the courts
proves uncollectable if sufficient taxing power existed when the bond
was issued to provide for its redemption. It is only when the
municipality itself diminishes in population and taxable property to the
vanishing-point that such a default can occur. An investor can judge for
himself as to the likelihood of such a catastrophe in any particular
community, and can feel sure that his bond, if valid and protected by a
sufficient taxing power, is as secure in its principal and interest as
the municipality which issues it is secure in its continued existence.
The following are the chief points which should be considered in the
investigation of a municipal bond: (1) The proportion which the total
debt of the municipality bears to the assessed valuation of the property
subject to taxation. Usually a maximum rate is fixt by constitutional
provision which rarely exceeds 10 per cent. (2) The purpose of issue.
This must be a proper and suitable one. (3) The proceedings under which
the bonds were issued. These proceedings, the form of bonds, their
execution, and their legal details must be in full compliance with the
law.
If these points are found to be satisfactory, the investor may rest
content that no other form of security is so greatly safeguarded and
that his bond ranks upon a substantial equality with government and
State obligations.
The rate of income to be derived from investment in municipal bonds
varies in accordance with the obligations selected. Like other forms of
security, municipal bonds are controlled by market conditions, and their
price is determined by the relations of supply and demand, and by
adjustment to prevailing money rates. While differing only moderately
from one another in point of safety and income return, municipal bonds
may be divided into two distinct classes in accordance with the degree
of convertibility which they possess. Some municipal bonds possess great
convertibility; others almost none. The feature which chiefly determines
the activity or inactivity of a municipal issue is the size and
importance of the municipality, together with the amount of bonds which
it has outstanding. The bonds of large and important cities, whose
outstanding debt reaches considerable proportions, usually possess great
activity. They are constantly traded in and command a broad market
because dealers are willing to buy or sell them in blocks at prices
within a fraction of 1 per cent apart.
On the other hand, the bonds of counties, townships, and small cities
are usually quite inactive. Transactions rarely occur in them, dealers
do not make a market in them, and they can be sold only to genuine
investors. It is often impossible to have them even quoted.
At first sight, it would appear that active municipal bonds would be
much more desirable, but inactive municipals possess a special advantage
which the active ones do not enjoy. They possess more stability of
market price. It is true that their stability of value is due to the
fact that they are not traded in or quoted and is, therefore, largely
fictitious, but nevertheless it accomplished a useful purpose. It
enables the investor to carry inactive municipals at cost price upon
his books through periods in which active market bonds would require
to be marked down in conformity with prevailing market prices. No
other class of investment except real-estate mortgages possesses to
the same degree this quality of price stability. For many classes of
buyers--savings-banks, for example--stability of price is a consideration
of prime importance. The preservation of the savings-bank's surplus and,
indeed, the continued solvency of the institution depend upon maintaining
the integrity of the principal which it has invested. A savings-bank
requires, also, great safety of principal and interest; _i.e._, the
certainty that principal and interest instalments will be paid at
maturity. It needs only a fair but not high yield, and it does not need
to place emphasis upon convertibility or prospect of appreciation in
value. Comparison of these requirements with the characteristics of
inactive municipal bonds discloses a striking adaptability on their
part to the real needs of the case. As a consequence, it is not
surprizing to discover that inactive municipals are greatly sought
by savings-banks.
The desirability of inactive municipals for savings-bank investment was
never more forcibly illustrated than on the first of last January, when
the savings-banks came to make up their annual statements. Broadly
speaking, there can be no doubt that they were saved by the large
quantity of inactive municipals and real-estate mortgages which they
carried. Had any considerable portion of their assets consisted of
railroad bonds and active municipals, upon which they should have had to
write off a loss of ten to fifteen points, their solvency would almost
certainly have been impaired.
But we are chiefly concerned in these pages with the advantages and
disadvantages of different forms of investment from the point of view of
a business man, both for the investment of his business surplus and of
his private funds. Do municipal bonds, either active or inactive,
conform to the requirements of the business surplus? It can not be said
that they do. Municipal bonds possess either convertibility without
stability of price or stability of price without convertibility. Both
qualities are necessary for a business surplus. The only form of
municipal security which is at all adapted for the investment of a
business surplus is a short-term issue of an active municipal bond. If
it has only a very few years to run, its constant approach to maturity
will invest it with the necessary stability of price. But even in this
case equal safety and equal stability of price combined with a higher
yield can probably be found in some high-grade railroad issue--either a
short-term mortgage or equipment bond.
For private investment the case is somewhat different. Enough has been
said in the preceding chapters to impress upon the reader the importance
of buying securities only in accordance with his real requirements. If
any investor, after careful comparison of the characteristics of
municipal bonds, either active or inactive, with his necessities,
decides that he can more closely satisfy his requirements with
municipals than with any other form of security, he should not hesitate
to purchase them. It is the opinion of the writer, however, that a
thorough survey of the field of investment will generally disclose to
the investor some security in either the railroad or corporation field
which will suit his requirements as well as the municipal bond and at
the same time provide him with a greater income.
VIII
STOCKS
Passing to the consideration of stocks as investments, it is necessary
at the outset that the reader should have clearly in mind the
fundamental difference between stocks and bonds. This distinction was
drawn in the introductory chapter, but it will be well to amplify it
here, even at the risk of carrying the reader over familiar ground.
The distinction between bonds and stocks is that between _promises to
pay_ and _equities_. Bonds, loans on collateral, and real-estate
mortgages represent some one's promise to pay a sum of money at a future
date; and if the promise be valid and the security ample, the holder of
the promise will be paid the money on the date due. Stocks, on the other
hand, represent only a beneficial interest or residuary share in the
assets and profits of a working concern after payment of its obligations
and fixt charges. The value of the residuary share may be large or
small, may increase or diminish, but in no case can the holder of such a
share require any one, least of all the company itself, to take his
share off his hands at the price he paid for it, or, indeed, at any
price. If a man buys a $1,000 railroad bond, he knows that the railroad,
if solvent, will pay him $1,000 in cash when the bond matures, but if he
buys a share of railroad stock his only chance of getting his money
back, if he should wish it, is that some one else will want to buy his
share from him at the price he paid for it or more. If he buys a bond he
becomes a creditor of the company, without voice in its management, but
entitled to receive his principal and interest when due under pain of
forfeiture of the security which the company made over to the trustee to
insure payment. If he buys stock, he becomes a partner in a business
enterprise, exercising his proportionate share in the direction of the
company's affairs, and sharing ratably in its profits and losses. In the
one case he buys a promise to pay and in the other an equity.
This distinction, which appears plainly marked in theory, has been
much obscured in recent years by the influence of two factors. As the
country grew in size, the large corporations--the railroads, for
example--required greater capital in order to provide facilities for the
handling of their growing business. It was impossible to provide this
capital wholly by means of bond issues without destroying the proportion
between bonds and stocks, which alone could give to the bondholders the
protection of a substantial equity. It was therefore necessary to obtain
a large part of the capital required in the form of stock. The
railway-managers were thus confronted with a difficult problem. It was
imperative that they should obtain more capital, and it was impossible
to dispose of sufficient stock on the basis of a speculative risk in a
business venture. It was therefore necessary for the railway-managers to
emphasize, as far as possible, the investment character of their stock,
and various expedients were adopted to accomplish this purpose. In some
cases preferred stocks were created or resulted from reorganizations,
which possest a first lien upon the assets after payment of the
obligations, and which were entitled to a certain stipulated dividend
before the common stock obtained any distribution from the earnings. In
this way the railway-managers created a compromise security which could
be regarded as a stock, and would thus provide equity from the
bondholders' point of view, and, at the same time, one which could be
disposed of to investors. In other cases, which were probably more
numerous, railway-managers attempted to give their stock an investment
value through stability of income return. In good years when the company
earned 10 or 15 per cent on its stock, their policy was to pay only 5 or
6 per cent in dividends, and hold the rest in their surplus fund in
order to have the means of paying the same dividends the next year if
only 2 or 3 per cent should be earned. By giving their stock stability
of income return they hoped and expected to give it some stability of
market price, and thus make it attractive to genuine investors. The
effect of this policy was unquestionably successful, and one after
another the stocks of our more important transportation systems and
other large undertakings passed into the hands of investors.
The successful adoption of this policy on the part of the
railway-managers and other captains of industry has had one curious
effect which was not contemplated by the originators of the movement,
and which brings us to the second influence mentioned above as having
tended to obscure the distinction between bonds and stocks. When a case
has been brought before the courts in which the contention was advanced
that the charges of the railway or public-service corporation were too
high, the courts appear to have taken the ground that stocks and bonds
should be classed together in order to determine the aggregate
capitalization of the company, and that the justice or injustice of the
contention that the charges are too high should be determined by
ascertaining whether if the charges were made lower the net earnings
would still be sufficient to pay a fair return on the total capital
invested. This is the general line of reasoning pursued by the courts,
both in the case of the Consolidated Gas Company in New York and the
Pennsylvania Railroad in Pennsylvania. The effect of this attitude on
the part of the courts has been to obscure still more greatly the real
distinction between bonds and stocks. It is too early as yet to judge
what will be the final outcome of the changed attitude toward stocks,
but it can not be doubted that the present tendency of opinion on the
subject, so far as large corporations are concerned, is to limit the
return on stocks to a strictly investment basis, instead of leaving the
stockholders free to reap all possible profit from their business
venture subject to the restraints of competition.
The adoption of this attitude by the courts should be a matter for
serious consideration on the part of present and prospective
stockholders. If the maximum return on stock is to be limited to 6 per
cent, or any fair investment basis, and charges reduced to consumers so
that they obtain the benefit of any greater earning power, it would
appear that the stockholders occupy an undesirable position. With their
possible profits limited, but with no fixt return insured to them and no
guaranty against possible loss, it can not be held that the purchase of
stock seems attractive.
These questions, however, will doubtless be settled in the long run in
justice both to the public and to the stockholders, and in the meantime
the stocks of our large and successful railway and industrial
corporations, which have attained a certain stability and permanence of
value, are entitled to consideration when investments are contemplated.
It is not worth while to lay down rules for judging the investment value
of such stocks, because the general principles advanced in the preceding
chapters will be found sufficient for a judgment of their values.
One class of stocks, however, deserves special mention. Bank and
trust-company stocks possess one characteristic in higher degree than
other classes of stock. Owing to the general practise of self-regulated
banking institutions to distribute only about one-half their earnings in
dividends and to credit the rest to surplus account, a steady rise is
assured in the book value of the stock. No other class of stock
possesses quite the same promise of appreciation in value. Bank and
trust-company stocks are especially sought by wealthy men, who can
forego something in the way of income return for the sake of increasing
the amount of their principal. The general characteristics of bank
stocks are great safety, a low rate of income, limited convertibility,
and practical certainty of appreciation in value.
With the present chapter the discussion of specific forms of investments
has come to an end. The next and concluding chapter will explain the
general principles which control the market movements of all negotiable
securities, and will endeavor to point out the indications which may be
relied upon in determining whether or not given conditions are favorable
for the purchase of securities.
IX
MARKET MOVEMENTS OF SECURITIES
There is no question connected with the investment of money more
important than the ability to judge whether general market conditions
are favorable for the purchase of securities.
After learning how to judge the value of every form of investment, a man
may still be unsuccessful in the investment of money unless he acquires
also a firm grasp upon the general principles which control the price
movements of securities. By this it is not meant that a man needs to
have an intimate knowledge of technical market conditions whereby to
estimate temporary fluctations of minor importance, but rather that he
should have clearly in mind the causes which operate to produce the
larger swings of prices. If an investor acquires such a knowledge, he is
enabled to take advantage of large price movements in such a way as
materially to increase his income, and, at the same time, avoid
carrying upon his books securities which may have cost much more than
their current market quotations. If he can recognize the indications
which point to the beginning of a pronounced upward swing in securities,
and if he can equally recognize the signs which indicate that the
movement has culminated, he can liquidate the securities which he bought
at the inception of the rise or transfer them to some short-term issues
whose near approach to maturity will render them stable in price,
allowing the downward swing to proceed without disturbing him. It is not
expected, of course, that the average business man will be able to
realize completely this ideal of investment, but it is hoped that the
following analysis will give him a clearer conception of the principles
involved.
Broadly speaking, the market movements of all negotiable securities are
controlled by two influences, sometimes acting in opposition to each
other and sometimes in concert. One of these influences is the loaning
rate of free capital; the other is the general condition of business. A
low rate of interest or the likelihood of low rates has the effect of
stimulating security prices, because banks and other money-lending
institutions are forced into the investment market when they can not
loan money to advantage. Conversely, a high rate of interest or the
prospect of high rates has the effect of depressing prices, because
banking institutions sell their securities in order to lend the money so
released. The automatic working of this process tends to produce a
constant adjustment between the yields upon free and invested capital.
When money rates are low, securities tend to advance to the point where
the return upon them is no greater than that derived from the loaning of
free capital. When rates are high, securities tend to decline to a point
where the return is as great. This explains the influence of the first
factor.
The other factor is the general condition of business. Good business
conditions, or the promise of good conditions, tend to advance security
prices, because they indicate larger earnings and a stronger financial
condition. Poor business conditions, or an unpromising outlook, have the
reverse effect.
The larger movements of security prices are always the resultant of the
interaction of these two forces. When they work together the effect is
irresistible, as when low interest rates and the prospect of good
business conditions occur together, or when high money rates occur in
the face of an indicated falling off in business activity. At such times
all classes of securities swing together. For the most part, however,
money rates and business conditions are opposed in their influence,
rates being low when business is bad and high when business is good.
Usually the worse business conditions become, the easier money grows;
while the more active business becomes, the higher money rates rise. The
effect of this antagonism between the controlling causes is to produce
movements of different proportions and sometimes in different directions
in different classes of securities. High-grade bonds may be declining,
middle-grade bonds remaining stationary, and poor bonds advancing, all
at the same time. This serves to give a very irregular appearance to the
security markets, and appears to justify the widely held opinion that
security prices are a pure matter of guesswork, and that they are
controlled only by manipulation and special influences. A clear
conception of the nature of the influences which are always silently at
work reconciles these apparent inconsistencies and makes it plain that
general price movements are determined by laws as certain in their
operation as the laws of nature.
This may be illustrated by a single example. Let us assume that interest
rates are low and business conditions bad with prospect of still lower
interest rates and still more unpromising business conditions. What will
be the effect upon different classes of securities? High-grade bonds,
such as choice municipals, whose safety can not be impaired by any
extent of depression in business, will advance because their market
price is influenced almost wholly by money rates. If their interest is
certain to be paid, no matter what business conditions may become, they
can not be greatly affected by a reduction of earnings, and consequently
the influence of low money rates is left to act practically alone.
Middle-grade bonds, such as second-class railroad issues, will remain
almost stationary, low money rates tending to advance their price and
the fear of decreased earnings tending to depress them. The lowest grade
of bonds and stocks, whose margin of security even in good times is not
very great, will probably suffer in price because the fear of default in
interest and of reduction in dividends will operate much more strongly
than the mere stimulus of low interest rates. Of course, securities can
not be clearly separated into these three classes, but shade
imperceptibly into one another. The classification is adopted only for
purposes of illustration.
Up to this point we have been concerned merely in showing that the
market movements of negotiable securities are controlled by the
influence of certain factors. A more important question now remains to
be considered, viz.: whether the effect of these two influences is to
produce general swings in prices which may be depended upon with
comparative certainty, and, if so, what indications are afforded to the
investor of the commencement or culmination of such a movement. The
answer must be that the combined effect of the two influences described
is to produce definite and regular swings in prices, and that the
indications which define the movements are not difficult to follow.
A general survey of the history of every industrial nation reveals the
fact that business conditions undergo alternate periods of prosperity
and depression extending in clearly defined cycles of substantially
uniform length. By tracing the usual course of interest rates and of
business conditions throughout one of these cycles, a general idea can
be formed of the way in which the joint influences operate to produce
price movements. To what extent the course of interest rates is a cause
as well as a result of changing business conditions, we shall not
attempt here to estimate, but will be content to note carefully the
general course which rates for money pursue throughout the cycles.
Immediately after a financial crisis, which usually closes an era of
great business prosperity, money rates become abnormally easy. Within a
few months from the climax of the crisis, money accumulates in enormous
volume in financial centers. This is caused by the great diminution of
business activity which renders unnecessary a large part of the
circulating medium that was formerly required to transact the greater
volume of business. To the extent to which this accumulation of money
merely reflects a redundancy of currency as distinguished from real
liquid capital, it can have little effect in encouraging the resumption
of business activity. As time passes, however, and economies in
operation commence to make themselves manifest, and especially as waste
and extravagance are curtailed, the country as a whole commences to
accumulate real liquid capital; that is to say, its total production
leaves a surplus over the amount of consumption. In the state of
business feeling which has been pictured, the undertaking of new
business ventures or additions to existing properties would not be
approved, so that the surplus wealth created finds its way into bank
deposits as liquid capital. The competitive attempt to loan this capital
at a time when borrowers are few produces merely nominal interest rates.
This continues for some time. It is only gradually as confidence returns
and as the spirit of initiative begins to reassert itself that some part
of the liquid capital created each year is diverted into fixt forms.
Here and there some enterprising group of men will develop a mine, lay a
new piece of railway, or make some addition to an existing undertaking.
For some length of time, however, the liquid capital of the country not
only remains unimpaired, but is continually increasing. After a time a
change comes. The annual surplus of production, tho larger than before,
is only sufficient to provide for the new undertakings which the growing
optimism demands. Interest rates rise moderately in response to the
added demand for capital. A few years further along, as business
activity increases and success appears plainly to wait upon new
ventures, the demand for new capital with which to develop increased
facilities and new enterprises exceeds the annual supply of wealth
created. Prosperity having increased, another factor commences to assert
itself. The spirit of economy and thrift which had prevailed throughout
the years of depression gives place to extravagance, the demand for
luxuries, and other unproductive forms of expenditure. While the total
production is much greater than in the lean years, the margin of
production is not proportionately as great, and this amount is
insufficient to meet the demands upon it. The supplies of liquid capital
stored up during the years of depression are resorted to, and they serve
to provide the new capital for a few additional years. Interest rates at
once reflect the encroachment upon stored-up capital, and their rise
gives the first real warning of the country's true position. The
optimistic business men do not heed the warning. After exhausting all
the real capital available in the country, they proceed to borrow
extensively from foreigners or from government banks--in this country
from the national government through bank deposits. Every step which can
be taken to induce foreigners to part with their capital is resorted to.
If foreigners will not buy long-term bonds, short-term notes are
created. If the foreigners refuse these, they are asked to make loans
secured by the new bonds and notes. The rates of interest offered are so
attractive that considerable sums are usually obtained, and the pressure
of business activity continues further. Finally the day of reckoning
arrives when some incident, usually unimportant in itself, first
suggests to the lenders of money that their debtors whom they know to be
overextended may not be able to pay their loans. The attempt to collect
their loans produces a financial crisis which brings to an end the
period of prosperity.
The foregoing is a description of the more important stages through
which business conditions pass from crisis to crisis. Different cycles
vary in particular details, but all agree in essential outlines.
Sometimes special influences are at work which operate to shorten or
prolong the cycle. The approach of a crisis will be retarded by
inflation of the currency, for the excess finds its way into bank vaults
and increases the volume of loanable credit. The effect of such
inflation, however, is wholly disastrous, because the addition to the
supply of capital is fictitious, not real, and only defers the day of
reckoning for a greater catastrophe. On the other hand, the approach of
a crisis can be greatly hastened by wars, conflagrations, and other
agencies which destroy capital, and by attacks upon capital and the
conduct of corporate business, for such attacks tend to render capital
timid and produce the same effect as a violent curtailment of the
supply. These are only some of the many influences which might become
operative, but they serve to show the necessity for careful
consideration of all the factors at work if a true conception of the
condition and tendencies of business is to be formed.
From the general account given above of the successive phases of a
credit cycle, it is possible to summarize the course of interest rates
and the course of business conditions. Money rates become suddenly easy
after a crisis, remain low or grow easier for a period of several years,
and then rise continuously until the next crisis, advancing with great
rapidity toward the close of the cycle. Business conditions remain poor
or grow worse a few years after a crisis. Liquidation is taking place,
prices are going down, and the uncertainty of the outlook causes
diminished activity. Thereafter, however, conditions improve and
activity increases with fair uniformity until it reaches the high
tension of the period immediately preceding the crisis. The course of
interest rates and the course of business conditions may both be
deflected by the operation of special influences, but the general
tendencies are substantially as outlined. The result of the operation of
these joint factors may be traced in the market movements of any class
of security desired. For the sake of simplicity, let us consider their
effect in producing the market swings of the highest grade of investment
issues and of the lowest grade, those which are affected only by money
rates and those which are affected almost wholly by business
conditions.
Emerging from the strain of the crisis at their lowest point, high-grade
bonds, such as the best municipal and railroad issues, advance rapidly
as interest rates decline, continuing their advancing tendency
throughout the period of business depression which follows upon the
heels of the crisis. As business conditions improve, their position,
while perfectly secure before, is further strengthened and an added
stimulus is given to their rise. About the middle of the cycle when the
business outlook is very promising, and before interest rates have
sustained any material advance, the prices of high-grade bonds are
usually at their highest point. From that time forward they commence to
decline, in spite of the increasing prosperity of the country, under the
influence of rising money rates. They make their lowest prices in the
midst of the crisis, when the strain upon capital is greatest and the
outlook for business most unpromising.
The lowest grade of bonds, on the other hand (whose margin of security
is least), do not commence to recover materially in price, in spite of
the influence of low money rates during the hard times which follow the
crisis, the influence of reduced earnings and the fear of default of
interest holding them in check. As the outlook becomes brighter, they
advance rapidly and continue to improve in price so long as they yield
more than current money rates. At some point, difficult to determine in
advance but usually well along toward the end of the cycle, they reach
their high point and thereafter decline under the influence of the
growing stringency in money.
Between these two extremes, every class of security is to be found. The
better ones will tend to resemble, in their market movements, the course
pursued by the choicest bonds; the poorer ones will approximate the
lowest class. In every case, however, unless special influences operate
to produce variations, the market swing of a given security should be
easily conjectured by an investor who gives careful attention to the
relative weight which is likely to attach to each determining influence.
* * * * *
Transcriber's Note: Spelling remains as in the original except
"qualities to be emphasied; for investors" has been changed to
"emphasized".
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