government and the sovereign States, there can be no question as to the
ability of the political unit to meet its obligation, and the question
becomes entirely one of good faith. It is probable that the obligations
of the United States Government, by reason of the fact that the
per-capita debt of the country is so small, the wealth of the country so
great, and the good faith of the American people so clearly established,
represent the highest type of security to be found in the world. It is
quite possible, therefore, that the 2-per-cent United States Consols
would sell in any case at a relatively higher price than the obligations
of any other country, but it can not be denied that the chief reason
which causes them to sell at the remarkably high price which they have
attained is the fact that they are required by national banks as
security for circulation. This fact is doubtless the controlling element
in their market position, and at once accounts for their special
strength and removes them from the field of private investment.
Only less secure than United States bonds are the obligations of the
sovereign States of the Union. State bonds usually sell upon a basis
which may be taken as the equivalent of pure interest, with no element
of risk or speculation involved. The obligations of different States
sell at different prices, in accordance with market conditions and the
relations of supply and demand, but there can be no question of the
equal ability of all States to pay their obligations. Repudiation of
State debts has occurred in our history, but only in cases where an
overwhelming majority of the citizens were opposed to the creation of
the debt at the time of its issue, but lacked the means to control the
situation. Such instances are chiefly to be found in the case of the
so-called carpet-bag governments of the Southern States after the Civil
War.
Municipal bonds--_i.e._, the bonds of cities, counties, and
townships--are indirectly a first lien upon all taxable property in the
municipality, and take precedence of every form of mortgage or judgment
lien. This lien is enforced through a tax levy to meet interest and
principal, and this tax levy the courts will compel in the rare cases in
which a municipality attempts to repudiate a valid bond. This priority
of the tax lien is the foundation of the prime position of municipal
bonds. The case rarely occurs where a bond held valid by the courts
proves uncollectable if sufficient taxing power existed when the bond
was issued to provide for its redemption. It is only when the
municipality itself diminishes in population and taxable property to the
vanishing-point that such a default can occur. An investor can judge for
himself as to the likelihood of such a catastrophe in any particular
community, and can feel sure that his bond, if valid and protected by a
sufficient taxing power, is as secure in its principal and interest as
the municipality which issues it is secure in its continued existence.
The following are the chief points which should be considered in the
investigation of a municipal bond: (1) The proportion which the total
debt of the municipality bears to the assessed valuation of the property
subject to taxation. Usually a maximum rate is fixt by constitutional
provision which rarely exceeds 10 per cent. (2) The purpose of issue.
This must be a proper and suitable one. (3) The proceedings under which
the bonds were issued. These proceedings, the form of bonds, their
execution, and their legal details must be in full compliance with the
law.
If these points are found to be satisfactory, the investor may rest
content that no other form of security is so greatly safeguarded and
that his bond ranks upon a substantial equality with government and
State obligations.
The rate of income to be derived from investment in municipal bonds
varies in accordance with the obligations selected. Like other forms of
security, municipal bonds are controlled by market conditions, and their
price is determined by the relations of supply and demand, and by
adjustment to prevailing money rates. While differing only moderately
from one another in point of safety and income return, municipal bonds
may be divided into two distinct classes in accordance with the degree
of convertibility which they possess. Some municipal bonds possess great
convertibility; others almost none. The feature which chiefly determines
the activity or inactivity of a municipal issue is the size and
importance of the municipality, together with the amount of bonds which
it has outstanding. The bonds of large and important cities, whose
outstanding debt reaches considerable proportions, usually possess great
activity. They are constantly traded in and command a broad market
because dealers are willing to buy or sell them in blocks at prices
within a fraction of 1 per cent apart.
On the other hand, the bonds of counties, townships, and small cities
are usually quite inactive. Transactions rarely occur in them, dealers
do not make a market in them, and they can be sold only to genuine
investors. It is often impossible to have them even quoted.
At first sight, it would appear that active municipal bonds would be
much more desirable, but inactive municipals possess a special advantage
which the active ones do not enjoy. They possess more stability of
market price. It is true that their stability of value is due to the
fact that they are not traded in or quoted and is, therefore, largely
fictitious, but nevertheless it accomplished a useful purpose. It
enables the investor to carry inactive municipals at cost price upon
his books through periods in which active market bonds would require
to be marked down in conformity with prevailing market prices. No
other class of investment except real-estate mortgages possesses to
the same degree this quality of price stability. For many classes of
buyers--savings-banks, for example--stability of price is a consideration
of prime importance. The preservation of the savings-bank's surplus and,
indeed, the continued solvency of the institution depend upon maintaining
the integrity of the principal which it has invested. A savings-bank
requires, also, great safety of principal and interest; _i.e._, the
certainty that principal and interest instalments will be paid at
maturity. It needs only a fair but not high yield, and it does not need
to place emphasis upon convertibility or prospect of appreciation in
value. Comparison of these requirements with the characteristics of
inactive municipal bonds discloses a striking adaptability on their
part to the real needs of the case. As a consequence, it is not
surprizing to discover that inactive municipals are greatly sought
by savings-banks.
The desirability of inactive municipals for savings-bank investment was
never more forcibly illustrated than on the first of last January, when
the savings-banks came to make up their annual statements. Broadly
speaking, there can be no doubt that they were saved by the large
quantity of inactive municipals and real-estate mortgages which they
carried. Had any considerable portion of their assets consisted of
railroad bonds and active municipals, upon which they should have had to
write off a loss of ten to fifteen points, their solvency would almost
certainly have been impaired.
But we are chiefly concerned in these pages with the advantages and
disadvantages of different forms of investment from the point of view of
a business man, both for the investment of his business surplus and of
his private funds. Do municipal bonds, either active or inactive,
conform to the requirements of the business surplus? It can not be said
that they do. Municipal bonds possess either convertibility without
stability of price or stability of price without convertibility. Both
qualities are necessary for a business surplus. The only form of
municipal security which is at all adapted for the investment of a
business surplus is a short-term issue of an active municipal bond. If
it has only a very few years to run, its constant approach to maturity
will invest it with the necessary stability of price. But even in this
case equal safety and equal stability of price combined with a higher
yield can probably be found in some high-grade railroad issue--either a
short-term mortgage or equipment bond.
For private investment the case is somewhat different. Enough has been
said in the preceding chapters to impress upon the reader the importance
of buying securities only in accordance with his real requirements. If
any investor, after careful comparison of the characteristics of
municipal bonds, either active or inactive, with his necessities,
decides that he can more closely satisfy his requirements with
municipals than with any other form of security, he should not hesitate
to purchase them. It is the opinion of the writer, however, that a
thorough survey of the field of investment will generally disclose to
the investor some security in either the railroad or corporation field
which will suit his requirements as well as the municipal bond and at
the same time provide him with a greater income.
VIII
STOCKS
Passing to the consideration of stocks as investments, it is necessary
at the outset that the reader should have clearly in mind the
fundamental difference between stocks and bonds. This distinction was
drawn in the introductory chapter, but it will be well to amplify it
here, even at the risk of carrying the reader over familiar ground.
The distinction between bonds and stocks is that between _promises to
pay_ and _equities_. Bonds, loans on collateral, and real-estate
mortgages represent some one's promise to pay a sum of money at a future
date; and if the promise be valid and the security ample, the holder of
the promise will be paid the money on the date due. Stocks, on the other
hand, represent only a beneficial interest or residuary share in the
assets and profits of a working concern after payment of its obligations
and fixt charges. The value of the residuary share may be large or
small, may increase or diminish, but in no case can the holder of such a
share require any one, least of all the company itself, to take his
share off his hands at the price he paid for it, or, indeed, at any
price. If a man buys a $1,000 railroad bond, he knows that the railroad,
if solvent, will pay him $1,000 in cash when the bond matures, but if he
buys a share of railroad stock his only chance of getting his money
back, if he should wish it, is that some one else will want to buy his
share from him at the price he paid for it or more. If he buys a bond he
becomes a creditor of the company, without voice in its management, but
entitled to receive his principal and interest when due under pain of
forfeiture of the security which the company made over to the trustee to
insure payment. If he buys stock, he becomes a partner in a business
enterprise, exercising his proportionate share in the direction of the
company's affairs, and sharing ratably in its profits and losses. In the
one case he buys a promise to pay and in the other an equity.
This distinction, which appears plainly marked in theory, has been
much obscured in recent years by the influence of two factors. As the
country grew in size, the large corporations--the railroads, for
example--required greater capital in order to provide facilities for the
handling of their growing business. It was impossible to provide this
capital wholly by means of bond issues without destroying the proportion
between bonds and stocks, which alone could give to the bondholders the
protection of a substantial equity. It was therefore necessary to obtain
a large part of the capital required in the form of stock. The
railway-managers were thus confronted with a difficult problem. It was
imperative that they should obtain more capital, and it was impossible
to dispose of sufficient stock on the basis of a speculative risk in a
business venture. It was therefore necessary for the railway-managers to
emphasize, as far as possible, the investment character of their stock,
and various expedients were adopted to accomplish this purpose. In some
cases preferred stocks were created or resulted from reorganizations,
which possest a first lien upon the assets after payment of the
obligations, and which were entitled to a certain stipulated dividend
before the common stock obtained any distribution from the earnings. In
this way the railway-managers created a compromise security which could
be regarded as a stock, and would thus provide equity from the
bondholders' point of view, and, at the same time, one which could be
disposed of to investors. In other cases, which were probably more
numerous, railway-managers attempted to give their stock an investment
value through stability of income return. In good years when the company
earned 10 or 15 per cent on its stock, their policy was to pay only 5 or
6 per cent in dividends, and hold the rest in their surplus fund in
order to have the means of paying the same dividends the next year if
only 2 or 3 per cent should be earned. By giving their stock stability
of income return they hoped and expected to give it some stability of
market price, and thus make it attractive to genuine investors. The
effect of this policy was unquestionably successful, and one after
another the stocks of our more important transportation systems and
other large undertakings passed into the hands of investors.
The successful adoption of this policy on the part of the
railway-managers and other captains of industry has had one curious
effect which was not contemplated by the originators of the movement,
and which brings us to the second influence mentioned above as having
tended to obscure the distinction between bonds and stocks. When a case
has been brought before the courts in which the contention was advanced
that the charges of the railway or public-service corporation were too
high, the courts appear to have taken the ground that stocks and bonds
should be classed together in order to determine the aggregate
capitalization of the company, and that the justice or injustice of the
contention that the charges are too high should be determined by
ascertaining whether if the charges were made lower the net earnings
would still be sufficient to pay a fair return on the total capital
invested. This is the general line of reasoning pursued by the courts,
both in the case of the Consolidated Gas Company in New York and the
Pennsylvania Railroad in Pennsylvania. The effect of this attitude on
the part of the courts has been to obscure still more greatly the real
distinction between bonds and stocks. It is too early as yet to judge
what will be the final outcome of the changed attitude toward stocks,
but it can not be doubted that the present tendency of opinion on the
subject, so far as large corporations are concerned, is to limit the
return on stocks to a strictly investment basis, instead of leaving the
stockholders free to reap all possible profit from their business
venture subject to the restraints of competition.
The adoption of this attitude by the courts should be a matter for
serious consideration on the part of present and prospective
stockholders. If the maximum return on stock is to be limited to 6 per
cent, or any fair investment basis, and charges reduced to consumers so
that they obtain the benefit of any greater earning power, it would
appear that the stockholders occupy an undesirable position. With their
possible profits limited, but with no fixt return insured to them and no
guaranty against possible loss, it can not be held that the purchase of
stock seems attractive.
These questions, however, will doubtless be settled in the long run in
justice both to the public and to the stockholders, and in the meantime
the stocks of our large and successful railway and industrial
corporations, which have attained a certain stability and permanence of
value, are entitled to consideration when investments are contemplated.
It is not worth while to lay down rules for judging the investment value
of such stocks, because the general principles advanced in the preceding
chapters will be found sufficient for a judgment of their values.
One class of stocks, however, deserves special mention. Bank and
trust-company stocks possess one characteristic in higher degree than
other classes of stock. Owing to the general practise of self-regulated
banking institutions to distribute only about one-half their earnings in
dividends and to credit the rest to surplus account, a steady rise is
assured in the book value of the stock. No other class of stock
possesses quite the same promise of appreciation in value. Bank and
trust-company stocks are especially sought by wealthy men, who can
forego something in the way of income return for the sake of increasing
the amount of their principal. The general characteristics of bank
stocks are great safety, a low rate of income, limited convertibility,
and practical certainty of appreciation in value.
With the present chapter the discussion of specific forms of investments
has come to an end. The next and concluding chapter will explain the
general principles which control the market movements of all negotiable
securities, and will endeavor to point out the indications which may be
relied upon in determining whether or not given conditions are favorable
for the purchase of securities.
IX
MARKET MOVEMENTS OF SECURITIES
There is no question connected with the investment of money more
important than the ability to judge whether general market conditions
are favorable for the purchase of securities.
After learning how to judge the value of every form of investment, a man
may still be unsuccessful in the investment of money unless he acquires
also a firm grasp upon the general principles which control the price
movements of securities. By this it is not meant that a man needs to
have an intimate knowledge of technical market conditions whereby to
estimate temporary fluctations of minor importance, but rather that he
should have clearly in mind the causes which operate to produce the
larger swings of prices. If an investor acquires such a knowledge, he is
enabled to take advantage of large price movements in such a way as
materially to increase his income, and, at the same time, avoid
carrying upon his books securities which may have cost much more than
their current market quotations. If he can recognize the indications
which point to the beginning of a pronounced upward swing in securities,
and if he can equally recognize the signs which indicate that the
movement has culminated, he can liquidate the securities which he bought
at the inception of the rise or transfer them to some short-term issues
whose near approach to maturity will render them stable in price,
allowing the downward swing to proceed without disturbing him. It is not
expected, of course, that the average business man will be able to
realize completely this ideal of investment, but it is hoped that the
following analysis will give him a clearer conception of the principles
involved.
Broadly speaking, the market movements of all negotiable securities are
controlled by two influences, sometimes acting in opposition to each
other and sometimes in concert. One of these influences is the loaning
rate of free capital; the other is the general condition of business. A
low rate of interest or the likelihood of low rates has the effect of
stimulating security prices, because banks and other money-lending
institutions are forced into the investment market when they can not
loan money to advantage. Conversely, a high rate of interest or the
prospect of high rates has the effect of depressing prices, because
banking institutions sell their securities in order to lend the money so
released. The automatic working of this process tends to produce a
constant adjustment between the yields upon free and invested capital.
When money rates are low, securities tend to advance to the point where
the return upon them is no greater than that derived from the loaning of
free capital. When rates are high, securities tend to decline to a point
where the return is as great. This explains the influence of the first
factor.
The other factor is the general condition of business. Good business
conditions, or the promise of good conditions, tend to advance security
prices, because they indicate larger earnings and a stronger financial
condition. Poor business conditions, or an unpromising outlook, have the
reverse effect.
The larger movements of security prices are always the resultant of the
interaction of these two forces. When they work together the effect is
irresistible, as when low interest rates and the prospect of good
business conditions occur together, or when high money rates occur in
the face of an indicated falling off in business activity. At such times
all classes of securities swing together. For the most part, however,
money rates and business conditions are opposed in their influence,
rates being low when business is bad and high when business is good.
Usually the worse business conditions become, the easier money grows;
while the more active business becomes, the higher money rates rise. The
effect of this antagonism between the controlling causes is to produce
movements of different proportions and sometimes in different directions
in different classes of securities. High-grade bonds may be declining,
middle-grade bonds remaining stationary, and poor bonds advancing, all
at the same time. This serves to give a very irregular appearance to the
security markets, and appears to justify the widely held opinion that
security prices are a pure matter of guesswork, and that they are
controlled only by manipulation and special influences. A clear
conception of the nature of the influences which are always silently at
work reconciles these apparent inconsistencies and makes it plain that
general price movements are determined by laws as certain in their
operation as the laws of nature.
This may be illustrated by a single example. Let us assume that interest
rates are low and business conditions bad with prospect of still lower
interest rates and still more unpromising business conditions. What will
be the effect upon different classes of securities? High-grade bonds,
such as choice municipals, whose safety can not be impaired by any
extent of depression in business, will advance because their market
price is influenced almost wholly by money rates. If their interest is
certain to be paid, no matter what business conditions may become, they
can not be greatly affected by a reduction of earnings, and consequently
the influence of low money rates is left to act practically alone.
Middle-grade bonds, such as second-class railroad issues, will remain
almost stationary, low money rates tending to advance their price and
the fear of decreased earnings tending to depress them. The lowest grade
of bonds and stocks, whose margin of security even in good times is not
very great, will probably suffer in price because the fear of default in
interest and of reduction in dividends will operate much more strongly
than the mere stimulus of low interest rates. Of course, securities can
not be clearly separated into these three classes, but shade
imperceptibly into one another. The classification is adopted only for
purposes of illustration.
Up to this point we have been concerned merely in showing that the
market movements of negotiable securities are controlled by the
influence of certain factors. A more important question now remains to
be considered, viz.: whether the effect of these two influences is to
produce general swings in prices which may be depended upon with
comparative certainty, and, if so, what indications are afforded to the
investor of the commencement or culmination of such a movement. The
answer must be that the combined effect of the two influences described
is to produce definite and regular swings in prices, and that the
indications which define the movements are not difficult to follow.