in estimating the strength of an industrial company. The figures for a
number of years should be examined to determine whether the earnings are
increasing or decreasing, and to discover whether or not the earning
power of the company is stable. This will depend largely upon the nature
of the article which the company produces or trades in. If its product
enjoys a steady demand at a fairly uniform price, it is justifiable that
some of its capital should be in the form of bonds; but if its earnings
are subject to violent fluctations due to rapid changes in the price of
its product, there is little justification for conducting the business
on borrowed money.
In this connection it should always be considered how greatly a falling
off in gross earnings will affect net earnings; and the proportion
between net earnings and fixt charges should be carefully noted.
In order for an industrial bond to receive favorable consideration, the
average yearly net earnings of the company should amount to about three
times the annual bond interest, taxes, and sinking funds. The greater
the protection is in this respect the better.
(_d_) _Form of Issue._ The form in which an industrial bond is issued is
a matter of some importance. If the principal of the bond does not
become due for a number of years, there is danger that the property will
depreciate so far in value as to leave the bond without sufficient
margin of protection. There are two ways to overcome this difficulty.
One way is to establish a sinking-fund which will retire a certain
proportion of the bonds by lot each year. Another way is to issue the
bonds in serial form, with a definite instalment maturing every year. In
either case the annual sinking-fund or annual instalment should be
greater than the probable depreciation so that the margin of security
will be constantly increasing.
(_e_) _Management and Control._ No question is of greater importance in
estimating the strength of an industrial company than the reputation of
the men in charge. The ability and integrity of the men who control the
policy of the company and the efficiency of the operating officials are
the principal factors in the success of an industrial undertaking.
Vacillating policies, weakly executed, will ruin the most promising
enterprise. This is particularly true in the case of small companies.
Every man of business experience will understand the importance of this
factor and be guided by it in the selection of industrial securities.
Based upon the foregoing considerations it is of interest to inquire
what degree of safety really attaches to the average industrial bond?
How far does it meet the foregoing requirements? The question is
difficult to answer. Industrial bonds vary greatly in point of safety,
some issues possessing great strength and others being highly
speculative. No general conclusions can be depended upon, and the
investor is forced to consider each issue upon its own merits.
II. _Rate of Income._ The average net return upon industrial bonds is
probably higher than upon any other form of funded corporate obligation.
This constitutes one of the chief advantages of industrial bonds.
III. _Convertibility._ It is impossible to make any general statement in
regard to the convertibility of industrial bonds. Some industrial
bonds, notably the larger issues of well-known trusts, command a broad
and active market. Such bonds can be sold in large amounts at almost any
time without seriously affecting the price. On the other hand, small
underlying issues of such companies, usually high-grade in point of
security, or the obligations of smaller companies, are almost as
unmarketable as real-estate mortgages. Between these two extremes all
varieties of industrial bonds are to be found. The degree of
convertibility which a security possesses is usually a matter of some
importance, and the investor should make a careful examination of each
bond in this respect.
IV. _Prospect of Appreciation in Value._ To what extent a bond may
improve in security during the time that an investor holds it is of
little importance unless the improvement be reflected in the market
price of the bond. Only so can the investor take advantage of its
appreciation in value. In order for the improvement in security to be
reflected in market price and thus add to the principal invested, it is
necessary that a bond should possess a fairly active market. For this
reason the industrial bonds which hold out the greatest promise of
appreciation in value are the larger, more speculative issues, which
possess the greatest convertibility. The purchase of such bonds
frequently results in substantial profits.
V. _Stability of Market Price._ The four points above touched
upon--safety, rate of income, convertibility, and likelihood of
improvement in intrinsic value--are all inherent characteristics of
every bond. The likelihood of favorable or unfavorable fluctation in
market price is largely external in its nature and depends upon general
financial and business conditions.
As a class, industrial bonds can not be said to possess much stability
of market price. Some of the smaller issues enjoy a fictitious stability
because of their inactivity, but generally speaking industrial bonds are
subject to wide fluctations in accordance with changes in the business
outlook.
The foregoing is a summary, necessarily brief and imperfect, of the main
points to be considered in judging the value of industrial bonds. The
question remains whether such securities are desirable for the
investment of a business surplus and of private funds.
Except in special cases industrial bonds are not suitable for a business
surplus. It is impossible to find an industrial bond which combines all
the characteristics necessary for that purpose. The requirements are
great safety of principal and interest, a relatively high return, ready
convertibility, and stability of market price. Many industrial bonds can
be found which combine two of these requirements, some even which
combine three, but the full combination, if it exists at all, is unknown
to the writer.
In addition, the principle of distribution of risk should prevent one
industrial company from investing its reserve funds in the securities of
another industrial company.
For private investment the case is somewhat different. A man of good
business judgment, who desires to obtain a high yield for which he is
prepared to sacrifice something in the way of convertibility and
prospect of appreciation in value, may buy the underlying issues of
strong companies with every confidence in the safety of his principal.
Again, the investor who wants a high yield and quick convertibility, who
is prepared to take a business man's risk and to sacrifice stability of
market price, may make a large profit by buying second-grade industrial
bonds. No investor, however, should deceive himself with the idea that
any industrial bond will satisfy all the requirements of the ideal
investment.
VI
PUBLIC-UTILITY BONDS
It was a common saying among bond-dealers a few years ago that the day
of the municipal bond had passed, the day of the railroad bond was
passing, and the day of the public-utility bond was to be. Municipal
bonds were selling at fancy prices in consequence of the low rates for
money which then prevailed, and railroad bonds appeared to be following
in their wake. Public-utility bonds alone afforded a satisfactory yield,
and it was felt that the investing public would be forced to turn to
them.
This prediction, like many others which were based upon the assumption
of continued ease in money, was destined to be unfulfilled. Almost
immediately there appeared an added demand for capital, and in the face
of this demand, supplies of capital which had before seemed ample became
suddenly scarce. Money rates rose rapidly and as a necessary
consequence municipal and railroad bonds fell in price to a point where
their net return was commensurate with that obtained from the loaning of
free capital. The investment situation was thus completely reversed. It
was no longer a question as to what form of security investors must seek
in order to obtain a satisfactory yield, but rather could the highest
grade of municipal and railroad bonds be floated at any price. Under
these circumstances the contemplated necessity of turning to
public-utility bonds never arose, and the general investing public
remains for the most part unfamiliar with their elements of strength and
of weakness.
The term "public-utility company" denotes a private corporation
supplying public needs under authority of a public franchise. The
franchise may be of definite date or perpetual, and may be partial or
exclusive.
Public-utility companies include street-railway, gas, electric-light and
power, and water companies. Properly speaking, telephone companies
should also be included, but they are not usually regarded as belonging
to the class of public-service corporations.
It is impossible, within the limits of a single chapter, to discuss each
kind of company separately. The investment value of street-railway bonds
will be here considered, and it is felt that the general principles
advanced, with slight modifications of detail, will be found equally
applicable to a judgment of other forms of public-service securities.
I. _Safety of Principal and Interest._ In order to determine the safety
of a street-railway company's bonds, the company must be subjected to a
threefold examination, physical, financial, and political.
An examination must be made into the extent and condition of the
physical property in order to ascertain whether the bonded debt is
secured by property having a real market value in excess of the face
amount of bonds issued. The first point to be determined is the extent
and valuation of the company's real estate. If the appraised value of
the land upon which power-houses and car-barns have been erected is
alone greater than the amount of bonds outstanding, the investigation
need go no further, for the bonds, in such a case, would be practically
a real-estate mortgage. In most instances, however, this is very far
from being the case; and after careful appraisal of the real estate it
is then necessary to make a careful valuation of the other physical
property; namely, power-plants, depots, car-sheds, roadway, and
equipment.
It is usually impossible for the average investor to make such an
examination himself, nor is it likely that he would possess sufficient
technical knowledge to render his investigation of much value. For an
accurate estimate of the value of a street-railway's physical property,
it is usually necessary to depend upon the expert opinion of a trained
engineer. It is a matter of regret that the average street-railway
report can not be relied upon to furnish an accurate valuation of the
physical property; and it is accordingly customary for careful
bond-dealers, when they contemplate taking an issue of street-railway
bonds for distribution among their clients, to have the property
examined by a competent engineer, whose report then determines for them
the question of taking the issue.
Disregarding the figures which show the cost of property and equipment
upon the company's books, the engineer proceeds to make a careful
estimate of the replacement value of the property, including real
estate. If the result of the examination shows that the property could
not be duplicated for the amount of the bond issue, the company occupies
an unusually strong position--altho even in such a case some part of the
value of the bonds comes from the strength of the company as a going
concern.
In most cases, however, it is probably found that the bond issue is in
excess of the value of real estate and the replacement value of the
physical property, the balance representing a capitalization of the
franchise.
To determine the real value of the franchise or franchises is a
difficult matter and involves the whole question of the company's
relations with the community which it serves and with the local
lawmaking bodies.
The first question which arises is whether the franchise is perpetual or
for a definite time, and the second whether it is partial or exclusive.
Franchises vary greatly in these respects. Sometimes a franchise,
apparently partial, is practically exclusive, owing to the fact that
all the available space in the streets is already occupied by the
company's own tracks. If the franchises of a company are limited as to
time, it is expedient, if not imperative, that the bonds should mature
before the expiration of the franchises.
If the company whose bonds are under examination satisfactorily passes
this physical test--if it possesses real estate of considerable value,
if the replacement value of the property is as great or nearly as great
as the amount of the bonds, and if the franchises, while perhaps not
perpetual or exclusive, are yet of longer duration than the bonds and
render successful competition unlikely--the next step may then be taken;
that is to say, an examination of the company's financial condition and
earning capacity may be made.
The amount of its gross earnings should be examined and the figures
scrutinized for a number of years back to discover whether its earnings
are increasing or decreasing. The position in which the company stands
for obtaining new traffic must be noted, and some estimate must be made
of the stability of its earning power. In this connection the relations
of the company to the public are of great importance. It must be learned
whether the company follows the policy of conciliating or ignoring
public sentiment.
The net earnings of the company must then be examined. This involves a
criticism of operating expenses. The payments of the road must be
analyzed to determine whether the proper amounts have been expended for
renewal of track, replenishment of rolling stock, and other improvement
sufficient to keep the property in good physical condition. This is the
most intricate subject in the investigation of a street-railway
property. Unless proper allowance be made for depreciation, in addition
to the expenses of direct operation, it is only a question of time
before the strongest company will become bankrupt.
Deterioration of plant and equipment, which goes on constantly, can only
be offset in two ways: one is out of earnings and the other is out of
the security-holders--that is, by decreases in the market value of the
securities. The first takes prosperity or courage; the second leads to
bankruptcy. It is difficult to measure depreciation accurately, but a
safe rule is to write off ten per cent of gross earnings each month for
depreciation. In this way the charge for depreciation will be
proportionate to the traffic, which provides automatic adjustment.
If the net earnings, after making this allowance for depreciation, and
after providing all expenses of operation including ordinary repairs,
amount to as much as twice the interest charges upon the bonds
outstanding, it is probable that the bonds may be taken with safety.
Before finally determining the question, however, certain political
factors must be taken into consideration. The relations of the company
to the leaders of the dominant political party must be investigated. The
likelihood of agitation looking toward a reduction of fares must be
considered and the possibility of increase in taxes (if below the legal
limit) must be weighed. The probable attitude of the legislature on the
question of renewing the franchises when they expire must be considered.
In general, it must be learned whether any real ground of contention
exists between the company on the one hand and the public and its
representatives on the other, because it is inevitable that the company
will weaken its independence of position by too close a connection with
politics, and that the physical property will suffer if there is any
lack of uninterrupted attention to it.
Finally one other thing should be investigated--the amount of the
accident account and its proportion to the net earnings of the company.
On small lines a single case of heavy damages will sometimes make
serious inroads upon the earnings.
The foregoing is a summary, necessarily brief and imperfect, but true in
its essential outlines, of the main points which should be considered in
judging the safety of street-railway bonds. The question remains, how
far does the average street-railway company satisfy these requirements?
Broadly speaking, street-railway bonds are not yet to be classed in the
first rank of investment securities. The troubles which have come to a
head in the financial operations of the traction systems in New York and
Chicago are typical of troubles which are likely to occur elsewhere from
the same general causes--overcapitalization in the first place and
insufficient allowance for depreciation in the second place. In both New
York and Chicago the crisis was hastened by open and obvious
overcapitalization, which is almost inevitable when many independent
lines are merged into one system. The same trouble, however, is apt to
occur in other traction systems where this evil appeared less flagrant
at the outset.
The advantages of electricity over horsepower naturally led to the
multiplication of electric street lines, as the system ten or fifteen
years ago passed beyond the experimental stage. As in all new
enterprises, speculation ran ahead of the reality and financing built
upon oversanguine calculations has too often had difficulty in squaring
accounts when brought face to face with facts. In most of the
calculations insufficient allowance was made for the wear and tear of
service; in other words, for renewal of road and equipment. After a few
years' test of earnings against expenses, it became evident that a
proper allowance for depreciation of plant would show a heavy deficit in
the income account. In most cases therefore no allowance or only a
meager one was made. For a time this method of bookkeeping proved less
disastrous than might have been expected owing to the rapid growth of
population and business in American cities. It was possible in many
cases to consider the enhanced value given to the franchise by growth of
business as an offset to the depreciation of tracks and equipment. In so
far also as the plant was kept up to a high degree of efficiency by
charging the expense of repairs to operating expenses, the absence of a
depreciation account was partially offset.
With the progress of recent years, however, a new factor has been
entering into the problem which promises to make the situation still
more serious for the traction systems. This new factor is the rise in
prices and wages. Temporarily the influence of this factor may be
checked by diminished business activity, but when normal conditions are
restored, it will commence to act again upon the railways with
accumulated effect.
In most cases a proposition to increase the standard street-railway fare
above five cents as an offset to the increased operating expenses would
be so revolutionary a proposal that it could hardly be carried through.
With the line of cost converging upon the line of receipts and with no
proper allowance made for depreciation, the traction systems of the
country seem to be facing a difficult problem. In the long run it can
not be doubted that the problem will be met and solved in a way to
afford justice alike to the public who use the cars and to the
capitalists who have made street traction on a large scale possible, but
in the meantime the investor who desires perfect safety should exercise
great care and discrimination in his purchases of street-railway
obligations.
II. _Rate of Income._ As a general rule, street-railway bonds in common
with the obligations of all public-service corporations sell upon about
the same income basis as high-grade industrial bonds--that is to say,
under normal conditions they return considerably more than railroad or
municipal bonds.
III. _Convertibility._ It is difficult to speak of the convertibility of
public-utility bonds as a class for the reason that they differ widely
from one another in this respect. In general, it is certainly more
difficult to dispose of public-utility bonds than railroad bonds. They
do not possess sufficient convertibility to justify their purchase by
any one who may need to realize quickly on his holdings.
IV. _Prospect of Appreciation in Value._ Public-utility bonds, except
such issues as are convertible into stock, possess little prospect of
appreciation in value. It was pointed out above that depreciation is not
properly allowed for, and it is very difficult for the securities to
advance in the face of this obstacle.
V. _Stability of Market Price._ The bonds of public-service corporations
are relatively more stable than railroad bonds because their earnings
are not subject to the fluctations which occur in railroad properties
between years of prosperity and years of depression. At the same time,
it should be pointed out that their stability of price is largely
fictitious, owing to the comparative inactivity of the issues. In other
words, while the quotation may be maintained, it is usually difficult to
sell any large quantity of a public-service corporation's bonds in a
period of financial disturbance, while railroad bonds are more easily
liquidated even if at a sacrifice.
The question remains, do public-utility bonds afford a desirable
security for the investment of a business surplus and of private funds?
In regard to the former, it may be said at once that public-utility
bonds do not meet the necessary conditions. The security is too
doubtful, the convertibility is too small, and the stability of price
too uncertain.
For private investment the case is somewhat different. Keeping in mind
the desirability of diversifying investments and admitting the
attractiveness of investing in a class of property whose earnings are
comparatively stable, it seems clear that public-utility bonds can not
be dismissed without consideration. When a company is found whose
property is substantially equal in real value to its bonded debt, whose
allowance for depreciation is ample, whose franchises are satisfactory,
whose earning capacity is large, and whose management is capable and
upright, the investor is justified in giving careful consideration to
its issues. Unless all these points are found to be satisfactory,
however, the investor should content himself with some other form of
security. For some years to come it is to be feared that many of our
public-service corporations will suffer from the war of discordant
elements--disregard of the rights of the public on the part of the
management and socialistic agitation for control on the part of the
community. Until these warring factions are reconciled and the questions
at issue adjusted with fairness to the security-holders and the public,
the investor should be most prudent in his purchases of public-utility
obligations.
VII
MUNICIPAL BONDS
The previous chapters have considered, in turn, the investment value of
railroad bonds, real-estate mortgages, industrial bonds, and
public-utility bonds. The desirability of each of these different
classes of security has been judged in accordance with the general
principles laid down in the introductory chapter; that is to say, each
class has been analyzed in relation to safety, rate of income,
convertibility, prospect of appreciation in value and stability of
market price. The same determining factors must now be applied to a
judgment of government, State, and municipal bonds.
Bonds issued by a national government, by a State, or by a municipality
are based primarily on some form of the power of taxation, tho the bonds
are usually tax exempt within the political unit which creates them.