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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.