Part 8

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.

MARKET MOVEMENTS OF SECURITIES

There is no question connected with the investment of money more important than the ability to judge whether general market conditions are favorable for the purchase of securities.

After learning how to judge the value of every form of investment, a man may still be unsuccessful in the investment of money unless he acquires also a firm grasp upon the general principles which control the price movements of securities. By this it is not meant that a man needs to have an intimate knowledge of technical market conditions whereby to estimate temporary fluctations of minor importance, but rather that he should have clearly in mind the causes which operate to produce the larger swings of prices. If an investor acquires such a knowledge, he is enabled to take advantage of large price movements in such a way as materially to increase his income, and, at the same time, avoid carrying upon his books securities which may have cost much more than their current market quotations. If he can recognize the indications which point to the beginning of a pronounced upward swing in securities, and if he can equally recognize the signs which indicate that the movement has culminated, he can liquidate the securities which he bought at the inception of the rise or transfer them to some short-term issues whose near approach to maturity will render them stable in price, allowing the downward swing to proceed without disturbing him. It is not expected, of course, that the average business man will be able to realize completely this ideal of investment, but it is hoped that the following analysis will give him a clearer conception of the principles involved.

Broadly speaking, the market movements of all negotiable securities are controlled by two influences, sometimes acting in opposition to each other and sometimes in concert. One of these influences is the loaning rate of free capital; the other is the general condition of business. A low rate of interest or the likelihood of low rates has the effect of stimulating security prices, because banks and other money-lending institutions are forced into the investment market when they can not loan money to advantage. Conversely, a high rate of interest or the prospect of high rates has the effect of depressing prices, because banking institutions sell their securities in order to lend the money so released. The automatic working of this process tends to produce a constant adjustment between the yields upon free and invested capital. When money rates are low, securities tend to advance to the point where the return upon them is no greater than that derived from the loaning of free capital. When rates are high, securities tend to decline to a point where the return is as great. This explains the influence of the first factor.

The other factor is the general condition of business. Good business conditions, or the promise of good conditions, tend to advance security prices, because they indicate larger earnings and a stronger financial condition. Poor business conditions, or an unpromising outlook, have the reverse effect.

The larger movements of security prices are always the resultant of the interaction of these two forces. When they work together the effect is irresistible, as when low interest rates and the prospect of good business conditions occur together, or when high money rates occur in the face of an indicated falling off in business activity. At such times all classes of securities swing together. For the most part, however, money rates and business conditions are opposed in their influence, rates being low when business is bad and high when business is good. Usually the worse business conditions become, the easier money grows; while the more active business becomes, the higher money rates rise. The effect of this antagonism between the controlling causes is to produce movements of different proportions and sometimes in different directions in different classes of securities. High-grade bonds may be declining, middle-grade bonds remaining stationary, and poor bonds advancing, all at the same time. This serves to give a very irregular appearance to the security markets, and appears to justify the widely held opinion that security prices are a pure matter of guesswork, and that they are controlled only by manipulation and special influences. A clear conception of the nature of the influences which are always silently at work reconciles these apparent inconsistencies and makes it plain that general price movements are determined by laws as certain in their operation as the laws of nature.

This may be illustrated by a single example. Let us assume that interest rates are low and business conditions bad with prospect of still lower interest rates and still more unpromising business conditions. What will be the effect upon different classes of securities? High-grade bonds, such as choice municipals, whose safety can not be impaired by any extent of depression in business, will advance because their market price is influenced almost wholly by money rates. If their interest is certain to be paid, no matter what business conditions may become, they can not be greatly affected by a reduction of earnings, and consequently the influence of low money rates is left to act practically alone. Middle-grade bonds, such as second-class railroad issues, will remain almost stationary, low money rates tending to advance their price and the fear of decreased earnings tending to depress them. The lowest grade of bonds and stocks, whose margin of security even in good times is not very great, will probably suffer in price because the fear of default in interest and of reduction in dividends will operate much more strongly than the mere stimulus of low interest rates. Of course, securities can not be clearly separated into these three classes, but shade imperceptibly into one another. The classification is adopted only for purposes of illustration.

Up to this point we have been concerned merely in showing that the market movements of negotiable securities are controlled by the influence of certain factors. A more important question now remains to be considered, viz.: whether the effect of these two influences is to produce general swings in prices which may be depended upon with comparative certainty, and, if so, what indications are afforded to the investor of the commencement or culmination of such a movement. The answer must be that the combined effect of the two influences described is to produce definite and regular swings in prices, and that the indications which define the movements are not difficult to follow.

A general survey of the history of every industrial nation reveals the fact that business conditions undergo alternate periods of prosperity and depression extending in clearly defined cycles of substantially uniform length. By tracing the usual course of interest rates and of business conditions throughout one of these cycles, a general idea can be formed of the way in which the joint influences operate to produce price movements. To what extent the course of interest rates is a cause as well as a result of changing business conditions, we shall not attempt here to estimate, but will be content to note carefully the general course which rates for money pursue throughout the cycles. Immediately after a financial crisis, which usually closes an era of great business prosperity, money rates become abnormally easy. Within a few months from the climax of the crisis, money accumulates in enormous volume in financial centers. This is caused by the great diminution of business activity which renders unnecessary a large part of the circulating medium that was formerly required to transact the greater volume of business. To the extent to which this accumulation of money merely reflects a redundancy of currency as distinguished from real liquid capital, it can have little effect in encouraging the resumption of business activity. As time passes, however, and economies in operation commence to make themselves manifest, and especially as waste and extravagance are curtailed, the country as a whole commences to accumulate real liquid capital; that is to say, its total production leaves a surplus over the amount of consumption. In the state of business feeling which has been pictured, the undertaking of new business ventures or additions to existing properties would not be approved, so that the surplus wealth created finds its way into bank deposits as liquid capital. The competitive attempt to loan this capital at a time when borrowers are few produces merely nominal interest rates. This continues for some time. It is only gradually as confidence returns and as the spirit of initiative begins to reassert itself that some part of the liquid capital created each year is diverted into fixt forms. Here and there some enterprising group of men will develop a mine, lay a new piece of railway, or make some addition to an existing undertaking. For some length of time, however, the liquid capital of the country not only remains unimpaired, but is continually increasing. After a time a change comes. The annual surplus of production, tho larger than before, is only sufficient to provide for the new undertakings which the growing optimism demands. Interest rates rise moderately in response to the added demand for capital. A few years further along, as business activity increases and success appears plainly to wait upon new ventures, the demand for new capital with which to develop increased facilities and new enterprises exceeds the annual supply of wealth created. Prosperity having increased, another factor commences to assert itself. The spirit of economy and thrift which had prevailed throughout the years of depression gives place to extravagance, the demand for luxuries, and other unproductive forms of expenditure. While the total production is much greater than in the lean years, the margin of production is not proportionately as great, and this amount is insufficient to meet the demands upon it. The supplies of liquid capital stored up during the years of depression are resorted to, and they serve to provide the new capital for a few additional years. Interest rates at once reflect the encroachment upon stored-up capital, and their rise gives the first real warning of the country's true position. The optimistic business men do not heed the warning. After exhausting all the real capital available in the country, they proceed to borrow extensively from foreigners or from government banks--in this country from the national government through bank deposits. Every step which can be taken to induce foreigners to part with their capital is resorted to. If foreigners will not buy long-term bonds, short-term notes are created. If the foreigners refuse these, they are asked to make loans secured by the new bonds and notes. The rates of interest offered are so attractive that considerable sums are usually obtained, and the pressure of business activity continues further. Finally the day of reckoning arrives when some incident, usually unimportant in itself, first suggests to the lenders of money that their debtors whom they know to be overextended may not be able to pay their loans. The attempt to collect their loans produces a financial crisis which brings to an end the period of prosperity.

The foregoing is a description of the more important stages through which business conditions pass from crisis to crisis. Different cycles vary in particular details, but all agree in essential outlines. Sometimes special influences are at work which operate to shorten or prolong the cycle. The approach of a crisis will be retarded by inflation of the currency, for the excess finds its way into bank vaults and increases the volume of loanable credit. The effect of such inflation, however, is wholly disastrous, because the addition to the supply of capital is fictitious, not real, and only defers the day of reckoning for a greater catastrophe. On the other hand, the approach of a crisis can be greatly hastened by wars, conflagrations, and other agencies which destroy capital, and by attacks upon capital and the conduct of corporate business, for such attacks tend to render capital timid and produce the same effect as a violent curtailment of the supply. These are only some of the many influences which might become operative, but they serve to show the necessity for careful consideration of all the factors at work if a true conception of the condition and tendencies of business is to be formed.

From the general account given above of the successive phases of a credit cycle, it is possible to summarize the course of interest rates and the course of business conditions. Money rates become suddenly easy after a crisis, remain low or grow easier for a period of several years, and then rise continuously until the next crisis, advancing with great rapidity toward the close of the cycle. Business conditions remain poor or grow worse a few years after a crisis. Liquidation is taking place, prices are going down, and the uncertainty of the outlook causes diminished activity. Thereafter, however, conditions improve and activity increases with fair uniformity until it reaches the high tension of the period immediately preceding the crisis. The course of interest rates and the course of business conditions may both be deflected by the operation of special influences, but the general tendencies are substantially as outlined. The result of the operation of these joint factors may be traced in the market movements of any class of security desired. For the sake of simplicity, let us consider their effect in producing the market swings of the highest grade of investment issues and of the lowest grade, those which are affected only by money rates and those which are affected almost wholly by business conditions.

Emerging from the strain of the crisis at their lowest point, high-grade bonds, such as the best municipal and railroad issues, advance rapidly as interest rates decline, continuing their advancing tendency throughout the period of business depression which follows upon the heels of the crisis. As business conditions improve, their position, while perfectly secure before, is further strengthened and an added stimulus is given to their rise. About the middle of the cycle when the business outlook is very promising, and before interest rates have sustained any material advance, the prices of high-grade bonds are usually at their highest point. From that time forward they commence to decline, in spite of the increasing prosperity of the country, under the influence of rising money rates. They make their lowest prices in the midst of the crisis, when the strain upon capital is greatest and the outlook for business most unpromising.

The lowest grade of bonds, on the other hand (whose margin of security is least), do not commence to recover materially in price, in spite of the influence of low money rates during the hard times which follow the crisis, the influence of reduced earnings and the fear of default of interest holding them in check. As the outlook becomes brighter, they advance rapidly and continue to improve in price so long as they yield more than current money rates. At some point, difficult to determine in advance but usually well along toward the end of the cycle, they reach their high point and thereafter decline under the influence of the growing stringency in money.

Between these two extremes, every class of security is to be found. The better ones will tend to resemble, in their market movements, the course pursued by the choicest bonds; the poorer ones will approximate the lowest class. In every case, however, unless special influences operate to produce variations, the market swing of a given security should be easily conjectured by an investor who gives careful attention to the relative weight which is likely to attach to each determining influence.

* * * * *

Transcriber's Note: Spelling remains as in the original except "qualities to be emphasied; for investors" has been changed to "emphasized".