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 fluctuations 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.