description of equipment bonds, may have noticed a special adaptability
on their part to the requirements of a business surplus. Broadly
speaking, for such investment, a security is required which will combine
perfect safety of principal and interest, a good rate of income, ready
convertibility into cash, and unyielding stability of market price. The
necessity for insistence upon these requirements in the investment of a
business surplus will appear upon a moment's reflection. Safety is
required in all forms of investment, but is particularly important in
the handling of business funds; a good rate of income is always
desirable; convertibility is necessary for a business surplus so that
the reserve funds may be converted into cash at any time; and it is of
the utmost importance that the security should not shrink materially in
quoted price, no matter what changes may take place in financial and
business conditions, so that if the need should arise for realizing on
the reserve fund, it would be found unimpaired in amount. As explained
in a former chapter, this point can not be covered by the selection of
securities perfectly safe as to principal and interest, but only by the
purchase of short-term obligations.
The point may be illustrated as follows: Let it be supposed that a firm
or company has decided to invest $100,000 in the 5-per-cent equipment
bonds of a good railroad maturing in three years, which can be obtained
at par, merchant's paper then commanding about 5-1/2 per cent. After two
years it becomes necessary for the firm to realize on its investment at
a time when commercial paper is floated with difficulty on a
6-1/2-per-cent or 7-per-cent basis. Under such money conditions the
equipment bonds could be sold on about a 6-per-cent basis, which would
mean a price of 99 for a 5-per-cent bond with one year to run. The firm,
in liquidating its investment, would therefore lose 1 per cent in
principal, but would have received 5 per cent interest for two years,
making the net return 4-1/2 per cent. Compare this showing with the
result if the bonds when originally bought had had ten years to run
instead of three.
After two years, when the firm wished to dispose of its bonds it might
experience some difficulty in doing so in the stringent money market
which has been supposed, but even if it succeeded in selling them upon a
6-per-cent basis, that would mean a price of only 93-3/4 and would
represent 6-1/4-per-cent loss in principal. If it were necessary to sell
the bonds upon a higher basis or if the firm had purchased a bond with
more than ten years to run, the relative disadvantage of the longer bond
would be still more apparent. These points sufficiently demonstrate the
importance of buying only short-term securities for the investment of a
business surplus. Of course, if money conditions improve instead of
becoming worse between the dates of purchase and sale, then a greater
profit would be made with the longer-term bond. This, however, should
not be allowed to influence the choice, first because it is not the
object of a reserve fund to make a speculative profit, and secondly
because a firm or corporation is only likely to want to realize upon its
reserve fund when money is hard to obtain otherwise, and that is
precisely the time when any long-term bond would be apt to show
considerable depreciation.
The foregoing considerations indicate a special adaptability on the part
of equipment bonds to the usual requirements of a business surplus. The
points have been brought out at some length because of the importance of
the subject to the average business man. The purpose in concentrating
attention upon a single instance has been to illustrate more clearly the
principles involved and at the same time to acquaint the business man
with details of a highly desirable and somewhat unfamiliar form of
security.
IV
REAL-ESTATE MORTGAGES
In the preceding chapter the discussion of railroad bonds was brought to
a close. Before passing to the consideration of real-estate mortgages,
which is the next form of investment to be taken up, it may be well to
review briefly the general principles advanced in the first chapter of
this book, in order that the reader may have clearly in mind the main
points upon which judgment of the value of investments should be based.
There are five chief points to be considered in the selection of all
forms of investment. These are: (1) safety of principal and interest;
(2) rate of income; (3) convertibility into cash; (4) prospect of
appreciation in intrinsic value; (5) stability of market price.
Keeping these five general factors in mind, the present chapter will
discuss real-estate mortgages as a form of investment, both as adapted
to the requirements of private funds and of a business surplus.
The average American business man is so familiar with real-estate
mortgages that the details may be passed over briefly. A real-estate
mortgage, or a bond and mortgage, as it is sometimes called, consists
essentially of two parts, a bond or promise to pay a certain sum of
money at a future date with interest at a certain rate per annum, and a
mortgage or trust deed transferring title and ownership in a piece of
real estate, with the provision that the transfer shall be void if the
interest is regularly paid and the bond redeemed at maturity. Before
advancing money on the security of a mortgage it is necessary to
determine whether the title to the property legally vests in the maker
of the mortgage; and during the continuance of the mortgage it is
necessary to have proof that the taxes and assessments are being
regularly paid, and, in the case of improved property, the
fire-insurance as well.
The safety of real-estate mortgages, in common with the safety of all
obligations, depends upon the margin of security in excess of the amount
of the loan. In the case of real-estate mortgages the amount of this
margin may be determined without great difficulty. It is only necessary
to have the property carefully appraised by an expert in real-estate
values. It does not follow, however, because a mortgage has been shown
to possess substantial equity, that it is perfectly safe as an
investment, unless it satisfies also another condition of great
importance. A mortgage may not exceed 50 per cent of the selling value
of the real estate pledged, and yet be a poor investment. This point
involves a serious objection to real-estate mortgages which sometimes
escapes notice.
The holder of a mortgage is at a great disadvantage in regard to the
changing value of real estate. If the value of the property upon which
he holds a mortgage increases, the additional value enhances the
security of the loan, but does not add to the principal which he has
invested, while if the value of the property diminishes, not only is the
security proportionately lessened, but if the impairment be great, the
holder is frequently compelled to take over the property and may suffer
loss of principal. In other words, he receives no direct benefit from an
increase in the value of the property, but has to stand the larger part
of the risk of a decline in its value.
This is not the case with investments represented by negotiable
securities subject to changing market quotations. All such securities,
railroad bonds for example, are acted on equally by changes in the value
of the property which secures them. Except for the influences of
money-market conditions, railroad bonds advance with an increase in the
value of the property and decline with a decrease in its value.
Well-selected bonds usually increase in value with time, and all such
increase goes directly to the benefit of the holder. The failure of
real-estate mortgages to respond similarly to changes in the value of
property places the holder of a mortgage at a great disadvantage.
Owing to this characteristic, real-estate mortgages should be purchased
only when general conditions in the real-estate market are distinctly
favorable. Not only should the purchaser of a mortgage have sufficient
margin of security in the particular piece of property upon which he is
loaning money, but he should also be satisfied that general real-estate
values are relatively low, that there has been no undue speculation, and
that conditions favor an advance rather than a decline in real-estate
prices.
No class of property is subject to more rapid changes in value than real
estate. After an extensive advance the holder of a mortgage may be
insufficiently protected by the equity in the property, even if his
mortgage represents only 60 per cent of the current appraised value of
the real estate pledged. It may be that the 60 per cent which he has
loaned represents the total value or more than the total value a few
years before. When a rapid advance in values occurs, tho it may be
largely justified by the growth and development of the territory, there
is sure to be present an element of speculation which is likely to carry
prices beyond the point of reason. When the turn comes and a severe
collapse takes place, its effects are extremely disastrous, because,
unlike speculation in stocks or commodities, no short selling exists in
real estate to temper the fall, and the immobile form of capital makes
liquidation impossible. These considerations serve to show the need for
great prudence in the purchase of real-estate mortgages. If the investor
exercises due care in these particulars, he is reasonably sure of
obtaining a very high-grade security; if he neglects these precautions,
he may suffer severe loss of principal.
No general figures are available which would indicate the degree of
certainty attaching to the payment of interest upon real-estate
mortgages. Certain classes of mortgages, such as those secured by
unimproved real estate or dwellings, afford no direct security of
interest payment other than the threat of foreclosure. Other classes,
such as mortgages upon stores, hotels, or office-buildings, are often
protected by a large income from the direct operation of the mortgaged
premises, thus furnishing a security for the annual interest payment.
The margin of protection in these cases varies greatly, so that no
general conclusion can be drawn.
The other characteristics of real-estate mortgages may be passed over
more briefly. It is generally conceded that mortgages return a higher
rate of income than can be obtained upon any other form of investment
which affords equal security. This constitutes their chief advantage.
Their chief disadvantage, on the other hand, lies in their entire want
of convertibility. There is no market for real-estate mortgages, and
except in special instances they can not be readily sold. The fact that
they are not subject to quotation prevents them also from holding out
any prospect of appreciation in value. Their very deficiency in this
respect, however, constitutes an important advantage from another point
of view. Since they are not quoted they can not shrink in market price
in obedience to changes in financial and business conditions. The buyer
of a mortgage is assured that he can carry his mortgage at par through
periods when it may be necessary to mark down all negotiable securities
subject to changing market quotations. This is frequently a matter of
great importance.
The general characteristics of real-estate mortgages may be summarized
as follows: (1) When carefully selected and purchased under favorable
conditions, great safety of principal and interest; (2) a relatively
high return; (3) a low degree of convertibility; (4) no prospect of
appreciation in value; and (5) the practical certainty of maintaining
the integrity of the principal invested.
Is a security possessing these characteristics a suitable investment for
a business surplus? Only to a limited extent. The safety, high return,
and assurance against loss in quoted value of principal are all highly
desirable qualities for this purpose, but the lack of convertibility is
a fatal defect. No consideration is of greater importance in the
investment of a business surplus than a high degree of convertibility,
so that if the need should arise the investment may be instantly
liquidated. The fact that real-estate mortgages can not be readily
disposed of makes it practically impossible to employ them for the
investment of a business surplus.
Where convertibility is not an essential requirement, and where the want
of promise of appreciation in value is not a serious matter, mortgages
afford a very desirable form of investment. The characteristics which
they possess in an eminent degree--safety, high return, and assurance
against loss in quoted value of principal--are exactly suited to the
ordinary requirements of savings-banks. Generally speaking, only a small
proportion of a savings-bank's assets need be kept in liquid form or
readily convertible, and accordingly they find mortgages highly
desirable.
For the purpose of private investment the attractiveness of mortgages is
not so easy to determine. Ordinarily, fluctations in quoted values are
of no great importance to the private investor, so that the absence of
quotation which mortgages enjoy is not especially valuable. Their safety
and high return are attractive qualities, but their want of
convertibility and of prospect of appreciation in value are drawbacks.
On the whole, the private investor may probably employ with advantage a
certain part, but not too much of his estate in mortgage investments.
As part of a scientific and comprehensive scheme of investment, the
special advantages of real-estate mortgages appear most prominently in
the years following a business depression. During such a period
real-estate values are usually relatively low, but beginning to advance,
so that mortgages present their maximum margin of security. At such a
time they compare most favorably with bonds and other investment
securities which are subject to changing quotations, because such
securities are then apt to be at their highest point under the combined
influence of restored confidence and the low money rates which usually
prevail. After several years of continued and increasing business
prosperity the positions are just reversed.
No discussion of real-estate mortgages would be complete without
allusion to the guaranteed mortgages which have been placed upon the
market in great quantities within the past few years. Guaranteed
mortgages are real-estate mortgages guaranteed as to principal and
interest by substantial companies having large capital and surplus. In
addition to the guaranty, the companies usually search and guarantee the
title, see to it that the taxes, assessments, and insurance are paid,
and perform the other services of a real-estate broker. Their
compensation varies somewhat, but probably averages 1/2 per cent--that
is, for example, they loan at 5 per cent and sell guaranteed mortgages
to the investor at 4-1/2.
The value of the guaranty may be considered from two points of
view--first, in the event of a general decline in real-estate values,
and, secondly, when a fall occurs in a particular piece of property or
in a particular locality.
If a severe decline in real-estate values takes place, affecting all
localities, it might become necessary for the holders of guaranteed
mortgages to test the value of their guaranties. In such a case the
question would arise how far the capital and surplus of the guaranteeing
companies would extend in liquidating the mortgages which they had
guaranteed. This would depend entirely upon the proportion between the
capital and surplus of the companies and the total amount of outstanding
mortgages guaranteed. Ordinarily the capital and surplus do not exceed 5
per cent of the mortgages, so that the average guaranty is good for
about 5 per cent additional equity. On a piece of property worth
$100,000, upon which a guaranteed mortgage of $60,000 exists, the
guaranty would be worth $3,000, and would margin the property down to
$57,000. This additional equity is of little value. It is probably
unlikely that a 40-per-cent depreciation in value will take place, but
the guaranty is not needed unless it does, and if it should occur, the
depreciation is quite as likely to go to 50 per cent or more as to stop
at 43.
From the second point of view the value of the guaranty is much greater.
The distribution of risk, as in the case of fire-insurance, protects
the holder against loss in the event of a fall in the particular piece
of property upon which he holds a mortgage, or even in a particular
locality. It can not be said, however, that the records are yet
sufficiently complete to form a conclusion as to what is a safe
proportion between capital and surplus and outstanding mortgages.
Further than that the guaranteeing companies, generally speaking, have
been operating since their inception upon a rising market, so that their
success hitherto has not been remarkable. Allowing for these drawbacks,
however, the private investor, unless so situated as to give personal
attention to the details of his investments, will probably do well to
purchase his mortgages in guaranteed form.
V
INDUSTRIAL BONDS
Industrial bonds include the obligations of all manufacturing and
mercantile companies, and miscellaneous companies of a private
character. They form a class quite distinct from railroad bonds or
public-utility bonds.
I. _Safety of Principal and Interest._ The safety of industrial bonds,
in common with the safety of all forms of investment, depends upon the
margin of security in excess of the amount of the obligation. In the
case of industrial bonds the amount of this margin is not always easy to
determine. Even when determined, the rule is difficult of application
because a margin which may seem insufficient from the point of view of
physical valuation may be satisfactory when considered as the equity of
a working concern. The indications most to be relied upon in estimating
the safety of industrial bonds are as follows:
(_a_) _Value of real estate._ The first point to be determined in
considering the purchase of an industrial bond is the value of the real
estate upon which it is a first mortgage. If the appraised value of the
ground, irrespective of the buildings and machinery upon it, is greater
by a substantial sum than the amount of the bond issue, the obligation
is practically a real-estate mortgage. In such a case, while possibly
"slow," _i.e._, secured by an assets difficult to realize upon--the
safety of the bond can hardly be questioned. In judging a bond upon its
real-estate value, it is not always safe to take the cost price of the
land as shown by the company's books, because frequently the cost upon
the books is artificially raised by payment having been made in
securities whose market value is less than par, or in other ways. As
stated above, judgment should be based upon the _appraised_ value of the
land.
If the bond meets this test satisfactorily, the prospective investor may
feel reasonably sure that the safety of his principal is not in
question, and may buy the bond without anxiety if it satisfies his other
requirements. On the other hand, if the bond only partially meets this
test, and it appears that some part of its value comes from plant and
equipment and from the strength of the company as a working concern,
then it is necessary for the investor to consider carefully several
other factors.
(_b_) _Net quick assets._ The balance-sheet of every industrial company
can be divided horizontally into two parts. Its assets are of two
kinds--property assets, which are fixt, and current assets, which are
fluid. Similarly, its liabilities are of two kinds--capital liabilities
and current liabilities. It requires no very extended business
experience to pick out the items which make up these totals. Plant and
property assets are usually lumped together under the head, "Cost of
Property." Current assets include inventories, bills and accounts
receivable, agents' balances, marketable securities, and cash on hand
and in banks--everything, in short, which can be quickly converted into
cash. On the other side of the balance-sheet, capital liabilities are
easily determined. They consist of the par amounts of bonds and stocks
outstanding. Current liabilities comprise bills and accounts payable,
including borrowed money, pay-rolls, and interest and taxes accrued but
not due.
The real strength of every industrial concern is to be learned from the
figures relating to its current accounts. Property assets and capital
liabilities are not of the same significance. If the cost of plant and
equipment as shown by the books exceeds its real value, the market
usually makes the necessary adjustment by putting a price less than par
upon the bonds and stocks.
No such process is possible in the case of the current accounts. If the
current liabilities exceed the current assets the company shows a
deficit, whatever its surplus may show on the books. On the other hand,
if the current assets are greater than the current liabilities, the
company possesses a working capital, represented by the difference
between the two, and known as net quick assets.
There are three things to consider in connection with net quick assets:
First, the proportion between current assets and current liabilities. To
put a company in good shape its current assets should be at least twice
as great as its current liabilities. Two for one is a fair proportion,
tho some companies show as much as six to one. The stronger a company is
in this proportion the better.
Secondly, the proportion between net quick assets and bonded debt. The
bonded debt should never exceed net quick assets, except when the
company possesses real estate, in which case two-thirds of the
real-estate value plus the net quick assets should cover the bonds. Some
companies do much better than that. One prominent company in this
country, altho it possesses real estate of considerable value, has
agreed in the indenture securing its bonds to keep net quick assets at
all times greater by a substantial margin than the amount of bonds
outstanding.
Thirdly, the proportion between net quick assets and the surplus as
shown in the balance-sheet. If the capital liabilities exactly balance
the property assets, it is plain that the surplus will exactly balance
the net quick assets. If the surplus is smaller than net quick assets,
it is usually a sign that capital liabilities have been created to
provide working capital. Opinions differ as to the wisdom of this
course. Generally speaking, it is better to provide working capital by
means of a stock issue than to depend upon the banks for accommodation.
The exception to this rule occurs in the case of companies that require
a great deal of working capital for part of the year and only a little
at other times. If they have the best banking connections, such
companies may be safe in depending upon their banks to carry them, but
if they do so, they should have no bonded or other fixt indebtedness
which would prevent their paper from being a first lien upon their
entire assets.
If working capital is to be created by the issue of capital liabilities,
it is much better that it should be done by stocks than by bonds. The
ideal method, however, is to provide only such an amount of working
capital at the organization of a company as is necessary for the conduct
of its business, and then, as the volume of its business grows, to
accumulate the additional amount necessary out of earnings, refraining
from the payment of dividends until the fund is complete.
Before leaving the subject of net quick assets, it is well to note the
importance of the figure showing the actual amount of current
liabilities. If a company has outstanding large amounts of bills and
notes payable, it occupies a vulnerable position. Inability to renew
maturing notes was the cause of most of the industrial failures of last
year.