The Art of Investment

THE ART

O F

INVE STM ENT

By

MORRELL W. GAINES

With Brown Brothers and Company

Second Printing

NEW YORK

THE RONALD PRESS COMPANY

1924

COPYRIGHT , 1922 , BY

THE RONALD PRESS COMPANY

All Rights Reserved

PREFACE

The sol id fortunes have been amassed through investment and not made by speculation . They have been bui lt

up by men who have developed character and wi ll-power ,who have created depth and breadth O f mind throughconcentration and experience

,rather than by men of

exceptional native bri lliancy.The serious practice of investment i s a sturdy and

businesslike pursui t. I t i s , in fact, at the root o f everybusiness . As an art, i t depends on no mystery or occultsecret. It consi sts o f learning facts that are within thecommon reach and Of applying principles capable Of beingassimilated .

The purpose o f this book i s to present an outline of

principles ; i t i s not a manual Of facts . The discussion ,moreover , i s confined to the pr inciples governing theinvestment o f personal funds

,excluding the canons of

institutional and trustee investment , which i s concernedwith the funds o f others. Yet even as thus limited , thesubj ect i s vast and the outline presented is not intendedas an exhausti ve treatment but merely as a foundationfor orderly reasoning and inqui ry.Some men come to knowledge o f the key to construe

tive or wealth-upbui lding investment in one way ; somein another. There are men in every line o f business whoarr ive at it early, and forge ahead Of their fellowsf Thewriter , in setting forth principles , pro fesses no readyformula or Open sesame save one—that work bringsmastery. It is his aim to discuss the problem of the

4 0 0

111

PREFACE

individual who invests in bonds and stocks , with suchcomment

,descr iption , and analysi s as may help the in

vestor in working to a solution .

Constructive investment i s not speculation . Neither

i s i t investing solely for income . Constructive investmenti s the middle course between these two extremes whichi s di rected to the purposeful upbuilding of principal while

maintaining the sa feguards o f income. In the faith thatthe individual may have results from his labor and inte lli

gence , and in the conviction that the greatest sa fety comes

from knowledge and application , the writer discusses thi stype o f i nvestment for those who are able and wi lling to

invest work with their money.

MORRELL W. GA I NESNew York Ci ty,December I , 1922

CONTENTS

CHAPTER PAGE

I THE FOUNDATION OF INVESTMENT 3

I I THE BUSINESS OF THE INDUSTRIALS 7

III THE BUSINESS OF THE RAILROADS 24

IV THE BUSINESS OF TRACTIONS AND OTHER UTILITIES 41

V THE RELATION OF BANK CREDIT TO BUSINESS 56

BOOMS AND DEPRESSIONS 70

BUSINESS BAROMETERS 80

VI I I CORPORATION REPORTS 96

IX THE LINES OF DEFENSE AND ATTACK IN INVEST

MENT 1 17

"THE COURSE OF THE STOCK MARKET 140

I THE COURSE OF THE BOND MARKET 152

XII CLASSES AND TYPES OF SECURITIES 165

XI II CATCH PHRASES AND FORMULAE OF INVESTMENT 19 1

XIV TRUSTWORTHY AND UNTRUSTWOR’

I‘

HY DEALERS IN

SECURITIES

THE POSTWAR INFLATION AND DEFLATION

ORGANI"ING ONESELF 0 " 0 0

CHAPTER I

THE FOUNDATION OF INVESTMENT

Se cu ri t i es th e B as i s of Inde pendence

One o f the deeper aspirations , because it i s the basisfor carrying out almost al l other aspirations

,i s to earn

independence . To this purpose stocks and bonds providethe means .Securities , taken straightforwardly, embody the essence

of the struggle to be one’s own master while l iving and,

when dead,to leave one’s family protected from want .

At the present stage O f material civi l i zation they are,i f not

the last,at least the broadest door O f opportunity open

to the public , sti rring viri le minds to action , vivi fyingambition

,and breeding men . The saying of James J .

H i l l i s true that a new force i s borne into the world whena man has saved his first thousand dollars for investment.

Securities are too much neglected as a purposeful pursuit . They are regarded too lightly. Market activities

are rather looked down on by the steady man of business,

as tinged with a Shade of the di srepute that attaches tothe dissipation o f energies in speculation . This i s notaltogether surprising , for there is much dabbling and

inconsequential gambling in stocks , and little study andless O f consecutive effort.I t i s too well known that securities, and especially

stocks, have been and sti l l are abused by professionalgamblers in a tainted struggle for di shonest wealth

.

There is , on the other hand , an insufficiently wide recognition o f the fact that securities

,taken soberly and seri

3

4 THE ART OF INVESTMENT

ously, are the head and center o f sel f-created opportunity,to be followed as every other proper goal o f ambitionwith al l energy and resolution .

Inve s tmen t an Art

Knowledge of how to invest in securities i s not soeasy to impart as knowledge O f law

,medicine

,engineer

ing, accountancy , or the principles of business management . Investment i s an art that must be acquired individually , not a science whose principles have been formulatedand standardized . To the general publ ic , and even perhaps to most bankers and brokers

,the art O f investment

i s not so fully developed as other practical arts , whereexperience

,precedent

,and tradition have been classified ,

summarized,and brought within the range of practical

learning . Success in investments depends upon the manlargely upon his development O f two dissociated i f not

contrary traits of character,instant and force ful initia

tive , and deliberate and cri tical j udgment . He must behot in action , and cold in thought .Investment i s

,besides

,the most difficult art O f busi

ness,because O f the ci rcumstances surrounding it. The

field O f Operation s is moving—in continuous Change . The

action i s d i rected not to the known past but always to anunknown future . There are few O f the ordinary and

definite starting points and landmarks , such as pertain to

professions and businesses of more limited scope . The

investor must there fore grope ; he cannot hope to knowabsolutely. He can hardly hope to escape a Share O f mistakes . It is his problem to resolve the course o f comingevents clearly enough to make use ful decisions upon indi stinct

,uncertain

,and shi fting grounds . This i s true even

i f he takes none but the most conservative investments ;he must sti ll be either looking forward or go ing blindly.

THE FOUNDATION OF INVESTMENT 5

The difficulty is not diminished by the almost universaltemptation , when some understanding of securities hasbeen gained , to speculate and run great chances for greatprofits , instead o f following the minimum risks and seeking the more conservative profits Of investment.

D isc ip l i n e and Tra i n i ngThere i s no clear-charted course in the field O f invest

ments . Nevertheless there is a rational method of disci

pline and conduct to be followed that wi ll serve . I t i s aswith any other art. The mind must first be trained tothink , reason , and react in terms of investment ; thenpractice must bring

,step by step

,the mastery of detai l

and technique, unti l at length learning and reason arecorrelated into decisions that are made instinctively . The

real difficulty a fter al l l ies not in the complexities of thesubj ect but in the arduousness of the eff ort required tounderstand and master its language that speaks in termsof large affairs .Other mental arts face similar problems . In one espe

cially, that of war, the training Of the mind to meet theexigencies of a vast

,unknown

,changeable

,and hosti le en

vironment, seen darkly through inexact information , hasbeen per fected to an extraordinary degree and on a grandscale. No two arts could be farther apart in Obj ect. Butthe methods and maxims O f the one apply with great forceto the other .General Foch

,in the Principles o f War , begins by

answering incis ively those who doubt that an art, espe~

cially one so difficult as that of war , can be taught orlearned save from experience . To those who wouldsti l l doubt and hesitate he says abruptly

,

"O f all mistakes,

one only i s disgraceful,inaction .

"

There follows , scattered through the description o f


battles and campaigns , an i llum inating analysis both o fproblem and of method

The unknown i s a constant factor in war. A l l armies havel ived and marched in the unknown . The best commanded armieshave l ived and marched in the unknown, it was inevitab le ; butth ey have resisted that dangerous condition , th ey have come out

victorious , by depending on p rotection wh ich has enabled them to

l ive w ithout danger in an atmosphere ful l of peri l .The e lements of a war prob lem, to begin w ith , are on ly se ldom

certain ,they are never definite . Everything is in a constant state

o f Change .

One standard alone , that o f reason . We wish to reach the

fie ld w ith a trained power of judgm ent : it on ly needs to have

us begin training it today. Let us for that purpose seek the

reason of th ings ; that w i l l Show us how to use them. Each one

O f us must bui ld up h is faiths , his belie fs , his know ledge , h ismuscles . Results w i l l not Spring f rom any sudden revelation of

light, as by a stroke O f l ightning. We can on ly obtain them

through a continual effort at understanding , at assimi lation . Thus

on ly do minds stretch in accordance w ith the study undertaken ,

principles are absorbed to the extent of becoming the basis o f

decisions taken . You w i l l be asked to become the brains O f an

army : I say unto you today—Learn to think.

These same precepts apply to the investor ; they mightalmost have been wr itten O f his field of action . Hi s victories , too , l ie within . Sel f-restrained be fore hidden dangers , always respecting that which cannot be known , hekeeps guard and maintains de fense . Enlarging hi s knowledge , watching the opportunity, he discovers, also , thepoints of vantage for the attack.

CHAPTER I I

THE BUSINESS OF THE INDUSTRIALS

Sequence of B us iness Changes

It i s within common experience that there are per iodso f activi ty and prosperity, and periods o f inactivity anddepression in business . It i s general knowledge that thecost o f l iving i s higher in good and lower in bad times .Wages simi larly expand and shrink. Incomes and

,to

some degree , salaries , fol low the same universal trend .

These are basic elements of business , aff ecting theprofits of industry even more sharply than the earnings o fthe individual .The course o f business i s far from uni form. I t passes

through a sequence o f changes which, while i t cannot beforecast with precision

,aff ords abundant room for study ,

Observation,and understanding. The cycles o f business ,

and the order and probable duration Of the successive

phases , have Of late years been the subj ect o f much re

search, concerned sti ll with the learned and the abstract ,but already making, i n some quarters , a bri lliant approachto the concrete and the practically helpful . The S impleracqui sition o f a practica l knowledge o f the state o f industry and of i ts progress toward prosperity or depression ,i s not difficult to attain .

Va lue s of Secur i t i e s and Cours e of B us in e ss

In a broad way the prices and values o f al l securi tiesare dependent upon the stage o f the business cycle—uponthe next stage even more than upon the one now actual ly

7


present. The solid , slow-moving bonds swing w ith thecurrent ; the lighter , more volati le, and quick-acting stocksare in perpetual process o f di scounting in advance whatis about to come . Values , no less than prices , surge up ordown according to the prospects o f Change in business

conditions . TO understand , therefore , the basis of investing in securities it i s essential to comprehend the fundamentals of the business that has created them , from whoseearnings interest and dividends are paid

,and by whose

successive phases prices are profoundly aff ected .

K i nds of B us i n e s s

The securities i ssued by corporations are Classifi ed ,among other ways , by the kind O f business they represent .It i s a useful and elementary distinction . The principalkinds of corporations are those engaged in trade ; i n

manu facture ; in mines and Oi l wel ls ; in specialties, suchas bank ing

,shipping

,storage

,moving pictures

,ten-cent

stores,and the like ; and those operating rai lroads , trac

tions , electri c l ight and power systems , gas plants , tele

phones and telegraphs,and other public uti l i ties . TO

these may be added holding companies and companies o fmixed activities .

Stocks and bonds take color and derive character asmuch from the kind O f business pursued by the corpora

tion that i ssues them as from the corporation itsel f .Each business i s d ifferent . The ri sks of security-holders ,thei r normal rate o f return

,and their hope o f profit vary

with the kind O f business .

C l as s e s o f Co rpo ra t i ons

Corporations may again be divided under two greatclassifications Of business , those that sell commodities andthose that sel l services . The former are control led by the

THE BUS INESS OF THE INDUSTRIALS 9

laws o f trade—directly and immediately by the law ofsupply and demand ; the latter are qu ite generally re

stricted by statute and regulated by commissions , whoserespect for the law of supply and demand has beenremote. The price of the product, which may ri se or fallf reely

,i s the dominating factor in the prosperity and de

pression of companies selling commodities . The cost o fthe expenses is the more power ful factor with the servicecorporations

,the rai lroads and public uti lities , since the

regu lated rates for services are too inelastic and in

adaptable . In thi s chapter the main types of commoditycompanies wi ll be reviewed

,with brie f comment on the

relation between thei r business and thei r securities. Inthe next two chapters the service companies wil l beconsidered .

The commodity enterprises are those engaged in trade ,in manu facture , and in the extractive or min ing industries . A l l these companies respond quickly to changes ingeneral conditions . The securities they i ssue are theindustrials , which rise tremendously in prosperity andsink in a disheartening manner on the approach O f depres

sion. As a group the best and strongest o f them havemuch more continuity and solidity now than in earl ieryears . Within the group there are many diff erences

,each

subdivi sion having di stingu i shing characteristics o f itsown .

Trading or Commerc ia l Compan ies

The trading , or commercial , companies probably givethe most abrupt response to Changes in business conditions . Their proportion Of sales to capital is greatest , andthere fore thei r turnover of capital i s most rapid . Tradingcompanies sell quickly what they buy , the rate earned onthe capital depending not so much on large margins o f

I O THE ART OF INVESTMENT

profit as on the number o f times a year the capital i sturned . Thei r Operating results reflect almost at oncechanges in general conditions that aff ect either the currentvolume of trade or the immediate margin O f profit inprices .These companies profit by ri sing prices . They are in

the position of sel ling at a higher level than that at whichthey have bought. In SO far as higher prices imply activitythe companies also do a larger volume o f trade. Thusthe quantity of sales and the margin O f profit per unit areboth increased . The general prosperity strikes them withdouble eff ect.Trading companies are adversely aff ected by declining

prices . In Spite o f every care , prices received tend to belower than prices paid . During depression sales decreaseand the value of inventorie s Shrinks . The turnover of

capital i s retarded both by smal l sales and by slower col

lections. There i s more danger O f loss then from inabi l ityO f debtors to pay

,and when there has been a severe price

decline,f rom cancellations O f orders for which purchases

have already been made .The business O f merchandi sing i s necessari ly specu

lative in some degree , no matter how prudently i t may be

handled . I t i s perhaps O f al l l ines O f business the mostdependent upon management

,requiring not only ski l l

in i ts own special technique , but also alertness in j udgingconditions and sa fe

,conservative financing . I t i s true that

trading companies,involved as they are in the shorter

operations,may have the advantage o f being able to turn

and run before adverse conditions , and that shrewd ,weather-wise management may minimize inventory ri sks

and depression losses . But the broad fact remains that the

condition O f the business , and of the companies also, i ssubj ect to quick change .

THE BUS INESS OF THE INDUSTRIALS 1 1

Se cur i t i e s o f Trad ing Compan ie s

The foundation being changeable , the'

securities of

trading corporations are almost necessari ly somewhatspeculative

,partaking of the same changeable character .

The exceptions are specially limited kinds O f trading com

panies , such, for example, as chain stores and mail—orderdistributors , whose securities have a recognized and insome cases an assured place . But as a whole trade i s bestadapted to private capital , or semiprivate companies , underindividual initiative . I t i s unsuited to the i ssue of bonds .It i s difficult for the public investor to follow Closely theimmediate facts aff ecting the ordinary trading company

,

further than to make a guess from knowledge Of generalconditions.The Claflin fai lure of 19 14, which aff ected banks even

more than individual stockholders , i s perhaps the besti llustration of the difficulty investors may find in maintaining contact with the values of the securities O f trading concerns. In 1920 and 192 1 many, i f not most, trading com

pan ies incurred enormous losses ; j ust previously they had

been making immense profits. Sears-Roebuck, large

and well regarded , fel l into serious difficulties . In fore ign trade Gaston , Williams and Wigmore fel l , whileAmerican International , l ike many private concerns , tookheavy losses in its trading departments . Trade as a wholehad to be carried by the banks . Had traders been requiredto liquidate debts and pay Off loans

,a considerable propor

tion O f them would have been found bankrupt .The l i st of trading companies whose securities are in

the hands.

of the public i s relativel‘y small when compared

with the importance o f trade . Those whose securities

are outstanding compri se leading companies,such as

Woolworth , S . S . Kresge , United Retai l Stores , Mont

gomery Ward , and Sears-Roebuck . Some o f these have


clearly defined obj ects and publi sh prompt and ful l statements Of earn ings and condition

,so that the investor may

form a fai rly intelligent idea o f the progress of their busi

ness . But essentially commerce,as di stingui shed from

industry and transportation,i s in the hands of S ingle pro

prietors , or partners , and not o f stockholders , as indeed it

should be from the nature O f trade itsel f .It i s always to be remembered that whatever i s perma

nent in trading companies lies in intangible assets—intrade-marks

,organ i zation , establi shed trade , and good wi ll .

The capital i s being turned over and over and i s invested ,not in fixed assets

,but mainly in inventories and accounts

receivable,both variable assets

,which it is hardly possible

to follow closely during periods of instabi lity . An investment in trading company securi ties i s to be made morewith reference to improvement in trade conditions thanas an expression of j udgment on the permanent worth O f

the securities . AS to the type o f investment to be made in

thi s case,the common stock has a chance at profits , whi le

preferred, or any other security based on expectation O f

assured and steady future income , i s insufficiently pro

tected. To this general Observation there are a number

O f exceptions,particularly among the large retai l distribu

tors,but with respect to trading companies as a class it

i s a rule of caution sufficiently well buttressed by the ter

rific,general

,and sudden inventory and depression losses

of the recent price declines .

I nd us tr i a l o r Manu f ac tur i ng Compan i es

Manufacturing companies , which form the bulk O f the

industrials known to the securities markets , are also very

responsive to changes in general conditions . Thei r capi

tal i s larger in proportion to sales than in the case o f theordinary trading companies , because i t takes longer to make

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profi ts follow the trend o f business conditions . Steel is byno means the only industrial that i s either "prince or

pauper ." While for most industrials the range of profits

between prosperity and depression i s thus very wide , therei s nevertheless a fai rly numerous class o f industrials whoseearnings are rather steadier .

Cost of manu facture i s an important i tem with industrials . The ri se in expenses during prosperity i s usual ly

compensated for,and more

,by increase in selling price.

But thi s i s not un iversal ly true. I t may sometimes happenthat profits during the last year or two of a period O f

great activity are less than in previous years because o f the

rise in wages and other costs . The first marked slowing

down of profits usual ly appears,in time of excessive pros

perity , when rai lroad congestion and expensive strikes

begin to impede the out- turn o f product . At al l times thedi ff erence in costs between competing companies

,which

make the same article , i s a most important factor forconsideration in estimating the safety and value o f thesecurities .

When depression , with its sudden changes o f prices ,arrives , the extent O f the immediate loss sustained bymanufacturing companies depends on the size O f thei r

inventories and the conditions under which they must beworked off, and upon the outstanding contracts and ac

counts . Operations can be Shut down within a Short timeand further losses can be minimized during the dull periodthat fol lows . Natural ly thi s i s usual ly a per iod of l ittle

or no profits . Possibly the most conspicuous instance O fcrippling loss suff ered in 1920 was that of the GoodyearTi re

,which was overstocked with rubber and cotton fiber

contracts . The Steel Corporation , on the other hand ,which was able to carry through to better times without

sacrificing prices , realized comparatively little inventory

THE BUS INES S OF THE INDUSTRIALS '

15

loss. Depression is eventually fol lowed by recovery , when ,i f the company is normal

,part o f the inventory loss i s

regained .

Se cur i t ie s of Indus tr ial Compan i es

It i s a little difficult to make easy general i zations concerning the industrial securities as a group . In respectto the distribution of thei r securities among the generalpublic the manufacturing companies stand midway between the trading compani es

,sti l l mainly owned by pro

prietors and.

those close to them , and the uti l ities andrai lroads , which are owned by shareholders from the publicmarket place. Most of the large industrials are owned bythe public, while most of the smal l industrials are ownedby single individuals

,by fami lies

, or by friendly interests .

Very large industries have been built up by one man , or agroup O f men

,such as Carnegie Steel , Standard O i l , and

Ford Motor . But the time comes when the death O f aleading proprietor

, or the desi re for cash , or the necessityfor more capital

,turns the securities of these compan ies

into the market. The public i s eventually let in , and ithas now for twenty years owned the largest , best , andstrongest manufacturing units

,with only a few outstand

ing exceptions . The many smaller enterpri ses , which are

very important in the aggregate , must naturally work withprivate or local capital .As to the quality of the industrial securities

,there

are too many types and kinds O f compan ies to permit O f asweeping characteri zation . The compan ies range fromthose always on the verge of trouble to those of splendidefficiency and solidity. The industrial combinations of

the early years of thi s century were quite generally overcapital ized and inadequately financed . Many by wise management and withholding dividends have become strong .


A F ew I n du s tr i a l Compan i es by Way o f I l lu s t rat i on

From the many varying types o f industrial com

pan ies a few may be cited by way of il lustration . United

States S teel Corporation , now capital ized at $508 ,000 ,ooo

common, $360 ,ooo ,ooo preferred , and $572 ,

ooo ,ooo bonds ,has always been noted for the massive bulk of i ts physical

properties . I t has in recent years become notable alsofor the strength O f i ts current assets . Three years a fterits organi zation in 190 1 i t was thought that thi s greataggregation O f mill s must fai l for lack of adequate work

ing capital . The early history O f the Steel Corporation

i s in contrast to that o f another large and wel l-managedindustrial , the Standard O i l Company, whose in itial progress was secured essentially by conspicuous strength in

liquid assets . Among the lesser companies InternationalPaper , organized more than twenty years ago with rather

old plants , inadequate working capital , and large reserves

o f timber lands , worked its way along with considerabledifficulty . F inally the war , creating a great demand for

newsprint and limiting the supply,produced an abundance

o f cash . While part o f thi s was lost in high-cost in

ventories of pulp wood , natural to the length O f the processes of the business , the company , with its new bond

issue,i s in comparatively strong position , although not

paying dividends .American Woolen

,also a company of long processes

O f manufacture,experienced a savage loss in the price

decl ine o f 1920 ,although apparently protected by con

tracts with buyers . Its business , however , returned to i tquickly a fter the decl ine was over . I t financed itsel f bystock , absorbed its losses , and i s forging ahead with unimpaired power . American Sugar , long the synonym o f

steadiness among industrials,incurred large losses in the

scramble for sugar just at the end of the high prices. I t


has put out bonds,and has passed its common dividends .

The leather and ferti lizer companies , and in generalthose industries requiring long processes or the seasonal

accumulation of material in advance of manufacture , wereamong the hardest hit by the price slump of 1920 and

192 1 and the ensuing paralysi s O f trade . The l i st o f in

dustrials i s too long to pass al l O f them in review. At thi smoment they fall into three main categories : ( I ) industries stimulated by the war that kept thei r profits ; (2 )industries stimulated by the war that lost their profits ;and (3 ) sober industries whose activities are increasing inthe postwar epoch

,such as equipment companies .

H ighe r Retu rn on I ndus t r i a ls

As a rule the normal percentage Of profit on the realcapital O f industrials i s greater than with any other typeO f company. But thi s profit i s also variable , according astimes are good or bad . Because of this variabi lity indus

trials must pay more for money than rai lroads and uti l ities .The yield , or income , from thei r securities i s therefore

higher . This general condition i s somewhat accentuatedby the fact that the newer industrial securities are not wellseasoned , the methods O f financing Of the companies notalways settled and conservative , and the memory o f water ,or inflation o f nominal capital beyond the real capital

,

has not yet died out. Industrial securities have gained inpublic confidence but are not yet , and probably neverwi ll be , the equal of rai lroad securities for stabi lity.

Securities i ssued by industrials derive their qualityf rom the high return and the variabi lity o f the earningsupon which they are based . The largest profits are madein these securities when times are propitious

,and the

greatest losses when times are unfavorable. From thenature o f the case the companies are

,l ike the trading


companies , wel l suited to the i ssue of common stock , withhope of profits offsetting risk of loss . The strongeramong them have sufficient stabi lity to i ssue sound preferred stocks , whi le the weaker , and especially those with

the more intermittent earning power,put out unsatis fac

tory and disappointing pre ferred stocks . With the exception of the strongest and most stable compan ies , fortifiedby valuable plants , the business o f manufacturing i s notwel l suited to financing by bonds .

Common S to ck

Investment i s to be made as an expression o f judgment on the permanent worth O f the securities , but also , as

a very general rule,with reference to probable improve

ment in trade conditions . Thi s i s particularly true of common stock

,whose fortunes follow the development of the

company,besides being subj ect to the general

'

ups and

downs O f industry. D ividends and quotations ri se in timeO f prosperity, fal l Off when business recedes , and fo l lowalso the growth of the business . The returns are great

,

under the right conditions,with almost any O f the solvent

and well-managed companies . The ri sk i s also great,

especially during good times,when thi s c lass o f stocks

sel ls far above i ts value.

Pre fe rred S t o ck

Investment in industrial pre ferred stocks i s to be mademore strictly upon the permanent strength O f the com

pany. There is less chance of market appreciation with

the preferred than with the common . Sometimes there

i s more danger , because the situation i s less keenlywatched

,on the assumption that pre ferred dividends wi ll

continue to be paid . This assumption i s not j ustified .

Nothing is to be taken for granted w ithout knowing the

THE BUS INES S OF THE INDUSTRIALS 19

affairs o f the company and understanding its position .

Payment o f pre ferred dividends i s not compulsory, evenwhen they are cumulative . The desideratum for invest~

ment i s a pre ferred stock so strong that dividends willnot be passed and income interrupted in time Of severedepression . Some of the wel l-known industrial preferred

stocks fai l to meet the test in every period o f strain . The

best among them have withstood the crises of twenty

years , and a few are considered to have almost as soundsecurity as investment bonds.

B onds

The investment in industrial bonds i s also to be madeupon the strength O f the Security. At certain stages ofthe business cycle there may be some expectation Of ap

preciation of principal , but as a general rule the Obj ect

of the investment is permanent income and safety. Anearning power subj ect to fluctuations i s not the best foundation upon which to lay fixed charges . Industrial bonds ,except where secured by abundant fixed assets , rarely

rank as prime bonds . There has been at times a tendency

to overdo bond i ssues and make the creditor bear parto f what i s properly the owner ’s burden

,especially in the

case o f consolidations . Bonds are a form o f financing ofwhich industrials should partake sparingly

,both because

of the nature of thei r business and because they shouldhave no prior liens to inter fere with such borrowing atthe bank as may be necessary to carry the expanded activities Of prosperity. Nevertheless , with the great increasein strength experienced by leading industrials in recentyears , there are a very considerable number of sound andstrong industrial bonds whose security i s sufficient regardless O f temporary variations in earnings . Under the federal reserve banking system , which moderates the acute


strain of cri ses and makes cash avai lable in emergencies,

the number and safety of these sound issues should increase . They are , however , to be bought with di scrimina

tion . Thei r average yield i s higher than that O f rai lroad

bonds,and considerably higher than that of municipal or

government bonds .

Pi o te s

Industrial notes must in each case be j udged upon theirmerits . They may be protected by ample security

, or thei r

payment may depend upon the progress o f the business .A fter a peri od of inflation they O ften represent the funding O f heavy bank borrowing, and are to be repaid byliquidation O f inventories and accounts , or more arduously ,by application O f future earn ings . At other times theymay represent borrowing to complete construction

,or to

carry out some other program Of expansion . A note i s ashort-term investment that should be considered fromthe standpoint of safety and not of profit .

I ndus t r i a l C r i s i s an d Re cove ryIndustrials have j ust recently been through a period

O f great strain . The most important point to make sure

of during a crisi s i s the cash position . I f sufficiently

strong in the cash box to ride through adversity , andabsorb inventory losses and dead-season expenses , thecompany can be counted on to reach another period o f

prosperity intact and in position to do business withunimpaired power . I f the company is strong to endure ,its securities can be reli ed upon to rise f rom the basi s

O f urgent l iquidation and O f disappointing earnings to that

of confidence and bright prospects .

The acute strain upon industrials i s a matter o f cur

rent assets that have ceased to be current and o f current



Operating mines and wells . I t can keep pace with demand ,whether in expansion or in Shrinkage , only within limits ,after reaching which there i s a scarcity or a glut O f pro

duct. These companies feel prosperity and depressionalmost immediately

,and at times they feel i t most

acutely.

Anthracite coal securities have been more dependablethan bituminous

,the trade served being steadier and better

organized . The large , well—equipped bituminous mine, withgood rai lroad faci lities

,i s preferable to the smaller , more

remote mine on an in ferior seam . Low -cost tcopper

mines that can make a profit at almost any price for themetal usually present better securities for investment than

the high-cost mines . The latter are more speculative ,rushing up violently in prosperity

,when the metal i s high ,

and descending precipitously when there i s an oversupply

of copper and the price i s low .

A ll extractive company securities are dependent firstof al l upon the value and quantity Of the coal , ores , or Oil ,

as they may be ascertained,and upon the volume of the

i ssues based upon that value . The dividends ari se from

the extraction o f these assets,and cease when they have

finally become exhausted .

A Sharp line i s to be drawn between the legitimatemining enterpri ses , represented by many corporations

thoroughly known and understood,and the numerous ex

ploitations of the imaginative and gullible,whose mines

are pocketbooks worked by stock salesmen . Far too o ftenthe price of a new Oi l or mining stock depends upon ex

parte statements,f raudulent or semi fraudulent marketing

methods , and the public fashion or momentary enthusiasmfor thi s type of investment . Even among the more legiti

mate i ssues there are recurrent manias for mines , as in

1906, and recurrent o i l furors , as the two since the war.


During such periods al l manner of f rauds are swept alongwith the general current and foi sted upon the public.

Va lue of Se cur i t i es and Earn ing Pow e r

With all industrial , as with other corporate securities ,values depend upon earning power and upon the volumeOf the issues resting thereon . The earning power dependson the volume of business for which the organization hascapacity, the cost o f doing the business , and the margin ofprofit in the price received . I t i s the probable future earnings that really constitute earning power and determinevalue. This has been strikingly i l lustrated during the pastyear by the rise in Pacific O i l on the strength O f pros

pective new connections and development o f acreage heldin reserve. Almost all industrials compete. I t is a fairtest to compare the volume of business with the volume ofsecurities

,as between competing companies , and the profits

per unit,and the aggregate profits . From such compari

sons,the eff ect O f the next great activity, or great depres

sion , may be forejudged.

CHAPTER I I I

THE BUS INESS OF THE RA ILROADS

Pub l i c Se rv i c e Co rpo rat i on s

The service companies , while aff ected by the sameprosperity and depression , stand on diff erent ground fromthe commodity companies . They are the compan ies of

great fixed assets , and of small inventories and currentor working assets . They give no credit

, or practically

none , thei r business being done for cash . They are natural monopolies , by force O f location ; and because theyserve the public , which must pay thei r rates , the rates areregu lated by public authori ty. There i s a vast publ ic

investment in railroads and util ities that rests in the finalanalysi s upon public necessity.

E l em en t s Aff ec t ing Ra i l road F i nan c es

Beginning with 1907 there was a long and gradual ri se

in expenses that placed these companies , and particularlythe railroads

,in a condition of chronic debil ity. During

the participation O f the United States in the war , andafter the war , the enormous ri se in rai lroad expenses produced a cri si s . This was met first by governmental operation and subvention

,and later by radical increases in rates .

The period O f artificial support i s not, at this writing ,enti rely ended . For that reason a long—distance viewmust be taken o f rai lroad affai rs— a view that goes beyond

their present environment . At the same time it i s necessary to look rather closely at thei r immediate position .

Rai lroads are clearly in a stage O f transition . I t is not

24

THE BUS INESS OF THE RAILROADS 25

possible to speak conclusively of the outcome , but enoughprogress has been made to permit o f definite comment .Rai lroads have an immense investment in plant in

proportion to business done . Using the Interstate Commerce Commission ’s figures for 19 18 , the funded debtand stock were the operating revenues

5, and the interest and dividends paidThe gross earnings were less than one

quarter of the outstanding securities . The balance appliedas return on those securities

,after taking care Of ex

penses and taxes,was less than 4 per cent O f the aggre

gate volume of the securities . The turnover was slowand the margin O f profit small . While 19 18 i s an i llustration rather than a yardstick , the 5% to 6 per

cent upon the value O f the property,expressed in the

rai lroad law of 1920 as a measure of net earn ings , represents the normal rate Of return in good years , andon properties better than the average . I t i s a rate notreached from Operations in the trying years from 19 17

to 1922 , and the return fel l Short of this rate moreo ften than not in previous years .A low rate Of return i s a consequence o f railroad his

tory and O f the vitally important part played by railroadtransportation in the development O f the national re

sources . The truth of the matter is that investmentin railroads has tended to tread close upon the heel s Ofearning power

,because of their prime credit and the

favorable attitude O f the publ ic towards their securities .I f money could earn the going rate in rai lroads

,i t went

into them . The result i s that the average rai lroad couldearn in normal years no better than the going rate onthe money that had been put into it ; in many cases lessalmost universally less in the recent years o f over-regulation of rates and swollen expenses .


Th e Pe rman en cy an d Pr im e Cred i t o f Ra i l roads

Yet rai lroad credi t and securities have remained on

the whole in prime standing. The reasons are that thebusiness itsel f i s permanent and steady

,that the secur

i ty issues rest upon permanent property , the fiked plantbeing large and the current assets small

,and

,perhaps

most important, that railroad property i s a permanent

public necessi ty that must continue in use .Rai lroad troubles may be severe , but they are essentially

temporary. NO substantial rai l road has ever abandoned

its tracks and given up its business . When financial diffi

culties have brought on receiverships , security-holders

have had Opportunity to recover part or al l of thei r

losses out of the ensuing reorganization and reconstruc

tion . Provided i t was a real rai lroad , with present traffic

and future possibi li ti es,and without too unreasonable a

capitali zation,they have usually fared well in the end .

Rai lroads have accordingly Offered the best corporatefoundation for the i ssue O f both bonds and stock .

Effe c t of P ro s p e r i ty and D ep res s i on

The eff ect o f prosperity and depression upon railroadsi s that the volume of traffic increases moderately whenbusiness i s active

,and decreases quite sharply for a

few months,but on the whole moderately, when business

slackens . The forepart of a period o f prosperity increases

the net earn ings . During the later portion the net begins to be cut into by rising expenses . Upon depressionsetting in there are unavo idable delays in reducing expenses

,and lean earnings result for some months unti l

expenses can be fully got in hand . Net earnings con

tinue to be on a somewhat reduced basis during theperiod o f business and traffic depression .

Except for the fact that transportation i s always a


business o f narrow margins of profit, the railroads arenot so responsive to changes in general conditions asare the industrials . A 25 per cent fal l in traffic duringthe first few months o f depression i s considered a se

vere decline . But thi s moderate fall ing off in volume O fbusiness produces a much greater inroad on net earnings . Because of thei r narrow margins of profit therai lroads are also parti cularly Sensitive to a rise in costsO f operation

,such as was but recently experienced . Con

versely ,the net earnings are fattened by a period of

declining costs, or O f increasing traffic .

There i s always a delay in adjusting rai lroad expenses to meet changed conditions , arising main ly fromthe fact that more than hal f of the expenses are for

upkeep and less than hal f for running trains . In the

event Of depression it naturally takes several monthsto rearrange tie

,ballast, and rai l programs entered upon

for the entire season . I t takes time also to cut downforces Of Operation , agree on new wage scales

,reduce

train schedules to fit altered traffic conditions, use up thehigh-cost coal of prosperity, and substitute the low-price

contracts of adversity. For much the same reason thefirst traffic increases O f returning prosperi ty invariably

produce a marked improvement in net earnings . The

rai lroads enter upon the increases with economies inforce —on short rations as to operating

,and Often as to

maintenance . Later , when traffic i s assured , they mayspend more l iberal ly. There is much in the tendencies o frai lroad earnings that i s determined by the delayed ad

j ustment O f expenses .

E ffe c t of Regu l at ion by Comm iss ions

I f the rai lroads were fully under private control thi sdelay in adjusting expenses would probably mean little


i n the long run . One season would balance another.But under public control of rates i t had , during the longrise in expenses , a most detrimental and even dangerouseff ect. The rate deci s ions of the Interstate CommerceCommissions and the state commissions were always

much too late to cope with current emergencies,and

never in fact caught up with rai lroad needs . These are

deliberative and quasi - j udicial bodies . They must hold

hear ings and accumulate great quanti ties o f evidenceregarding conditions already past. The decisions are

reached sti l l later . While expenses were going up dur

ing the upward trend from 1907 to 19 18 , the rai lroads

suff ered from tardy justice . A t this momentwith expenses down from the peak and traffic increasing

,they are benefited by the immobility Of the rate

making machinery. It is perhaps rather likely that

downward changes in rates , such as the reduction O f July,1922 ,

wil l be made with greater speed than the upwardchanges . Nevertheless there i s a general condition ofimmobil ity in the regu lation exercised by commissions

that wi ll continue to aff ect rai lroad prospects accordingto the di rection of the expenses .

In 1906, almost contemporaneously with the progressive rise in expenses

,the ful l vigor Of rate control be

gan . Prior to the war the rai lroads were being forcedto narrower margins O f income , and were plainly becoming impoverished by degrees . The war , with i ts suddenand overwhelming ri se in expenses , would have ruinedthe rai lroads had it not been for the aid and subventionsgiven by the federal government during the two yearsand eight months beginning January 1 , 19 18 . A fter thetermination Of federal control , with traffic depressed andexpenses inflated

,the rai lroads reached, in 192 1 , thei r

darkest and most cri tical hour .



months the railroads had alarmingly small net earnings.For the three months , January to March , 192 1 , the operating expenses and taxes were not covered . This was the

most searching test Of rai lroad endurance . Trade began

slowly to revive in the fal l , and this , with the crop move

ment,brought the turn of the tide in September and

October . With the advent Of 1922 more active businessrestored the earnings of the larger roads to somethinglike normal—but not yet on a normal rate level . The

roads had experienced distress , and many of them had

borrowed in an unprecedented manner in order to preserve solvency.

W ages unde r Con t ro l o f th e Lab o r B oard

The situation i s at thi s writing sti l l artificial,fi rst

as to wages,and

,second

,in consequence

,as to rates .

The Labor Board in June,1 92 1 , announced a reduc

t ion O f only $4oo ,ooo,ooo in the annual wages, preferr ing

to force the public to continue to bear the burden O f thebulk O f the war- time increases . Later i t adj usted working conditions

,modi fying the union rules that had been

applied to rai lroads SO that an additional reduction inexpenses m ight be made. There i s no doubt that railroad

men had come to be underpaid,with the exception O f

the most skil led and strongly organi zed groups,in the

years of rai lroad economizing that preceded the war . Butthe action o f the board Showed that i t d id not recognizethe existence O f a seri ous crisi s

,and that its l ine of re

s istance would be to meet situations with pal liatives . Itslack O f decisiveness in the shopmen

’

s strikes and in thed i sputes over "seniority

,

"a fter the minor wage reductionso f July, 1922 ,

shows again a lean ing towards expe

diency in dealing with rai lroad employees rather ‘than to

wards principle in dealing with the railroad prob lem as

THE BUS INESS OF THE RAILROADS 3 1

a whole . This is an influence that may and probably willchange

,but is for the time being to be reckoned with

as a factor in rai lroad progress.

Th e At t i tude of th e Pub l i c Towards th e Ra i l roads

The rai lroads, for their part, met the wage and ratecrisi s of 192 1 in a frank and manly fashion. The pressand publicity agents who proclaimed that the000 increase in rates of 1920 simmered down to a questionof a few cents on ly in transporting a suit o f clothes fromNew York to Los Angeles , were relegated to the rear .The ablest of the railroad leaders took the stand , toldthe truth

,and were believed . Public sentiment had al

ready turned in favor o f the corporations , after longyears O f alienation . This had been shown in the passage

o f the rai lroad law Of 1920 ,which proposes to base

rates on a fair return upon the values o f railroad proper

ties,instead O f

, as previously, upon the complaints of

Shippers that the rates paid by them were unreasonable .The public recognizes more clearly that its own great

interests are involved in the rai lroad problem,fears

either political or labor control,and desi res in consequence

the efficiency and enterpri se Of private management.This i s a factor O f immense importance , to be taken intoaccount in surveying the future.

Th e Pa s s i ng o f th e C r i s i s

S ince 192 1 the rai lroads have made rapid progressto a position Of greater strength. The tide O f traffic

,

which brings net ea rnings up , has set in with remarkablepower . Bonds and equipment trusts have been i ssued ,with the revival of the securities market ; much Of the

current indebtedness has been funded , and a beginn ing

has been made toward bringing up the arrears of car


replacements and rai l renewals . While traffic i s thusflowing , the aspect O f the stronger rai lroads i s changed ,quite suddenly, to that of health and vigor . But theresti l l remain certain legacies both from the federal con

tro l and from the great crisi s . In the first place the

rai lroads wi ll not be on the most solid ground unti l highrates , and wages that make rates high , have been in

due course of time reduced to normal . As yet the nettleof wages has not been grasped firmly and the deflation o f

rates has hardly more than commenced . In the second

place the great pool O f rai lroad equipment created by theRai lroad Administration

,that took cars away from their

"home" l ine and from thei r owners’ shops,resulted in

enormous destruction and damage to equipment. I t willcost the rai lroads many hundreds Of millions of dollars

to replace and repai r these cars . While large orders for

equipment have now been placed , there i s a definite pros

pect O f car shortage , impeding the ful l recovery of tra f

fic. In the third place , a cri si s involving so much strain

as that of 192 1 , when rai lroads borrowed heavily at the

bank,let their fuel and supply bi ll s run , economized on

maintenance,reduced forces

,cut Off trains , and withheld

orders for equipment, ties , and rai l s , must needs leavesome o f the companies in a permanently weakened con

dition . Receiverships that were long averted by the most

heroic expedients have materialized in some cases , notably

the A l ton and the Denver . They will undoubtedly fal lupon others of the weaker and less favorably situatedrai lroads before the atmosphere i s cleared .

Ra i l road Se cu r i t i es

Eventually the great war unsettlement , l ike all otherrai l road di sturbances

,will be completely o f the past.

Rai lroad securities , which have already returned to favor


as investments, should finally be establi shed on a betterand more solid basis than for many years past, becauseO f the change in public sentiment . The political hostility to rail roads has had its day and is dead . These

are times o f more constructive temper,during which

the commissions and their regulation may be expected,

more and more , to guard the foundations of business byprotecting the means of transportation. The 5% per centthat has now been set by the Interstate Commerce Com

mission as the fair measure of return on the value o frail road properties is not a promise o f net earnings toany rai lroad nor to al l rai lroads, but i t is a promi se o fj ust and moderate dealings .

Railroad securities stand high because o f the carr iers ’ perpetual and steady business. A stream o f trafficonce establi shed is like a r iver that cannot be divertedand will not dry up. Railroad securities also stand high

because the important facts concerning both maintenanceand finance can always be known . The annual reports ,publi shed under the accounting rules of the InterstateCommerce Commission

,give the fullest of information .

There are,therefore , few sudden and unexpected changes

in condition to be feared which cannot be known be forehand by investigation.

Th e Ra i l road Valuat ion

The valuation O f the rai lroads,uncompleted a fter

these many years and probably destined never to be conclusive ly finished

,has nevertheless progressed far enough

to answer the main question which is involved. The

value to be found should support the existing capital ization o f the average rai lroad

,including both bonds and

stocks . For many roads the value wi ll be far in excess

of the volume of securities outstanding ; the exceptions


may be the newer l ines or those roads well known forthe water included in their non-dividend-paying stocks .In the rate advance proceedings Of 1920 the Interstate

Commerce Commission based i ts findings on a tentativevalue Of nearly for the railroads o f the

enti re country, a figure approximating the actual capitalization o f something over The valuation

was original ly intended as an engine O f decimation o f

rai lroad securities , to el iminate water and abol ish dividends on fictitious capital . For a time the confiscatory

tendency had a threatening aspect,being dangerous be

cause O f the public temper . In the end the valuation ,in so far as it may have any active influence at all

,wi ll

serve as a barrier against un in formed and demagogic attacks on the exi sting securities .

G reat Rai l road Sys tem s—New York Cen t'

ra l , Penn

sy lvan ia, and E r i e

The l i st o f great rail roads may be passed briefly in

review . Each i s an artery O f trade for states and ci ties ;and each has be fore it a future l imited on ly by the devel

opment and prosperity o f vast territories whose future i s

in turn dependent on the rai lroads ’ efficiency and abil ityto carry traffic . New York Central and Pennsylvania arethe largest in tonnage and earnings . O f these two trunklines the former has three-quarters o f a bil lion dollars

o f debt and a quarter O f a bi ll ion in stock ; the latter

has hal f a bi l l ion in debt and hal f a bil l ion in stock .

New York Central came through the war period withoutmuch impai rment of earnings and , as always , recuperatedquickly f rom the ensuing traffic depression . I t has main

rained its 5 per cent d ividend .

1 Pennsylvania was injuredby the war - time dislocation O f coal traffic and the partial

divers ion o f through f reight . Being largely dependent

1 S in ce increased to


upon coal , steel , and iron for freight , it was S lower torecuperate from traffic depression . I ts dividend was cut

for the time being from 6 to 4 per cent. Earnings have,however, now returned and the 6 per cent dividend

has been restored . In the long run this i s a company Of magnificent strength .

Erie has a hal f-bill ion securities outstanding,O f which

something over three hundred mill i ons i s debt. This isheavy in proportion to traffic, the gross revenues beingone-third those o f the Central and less than one - fourth

those O f Pennsylvania , and very heavy in proportion to

net earn ings . That i s the reason Eri e common has neverpaid dividends. By careful improvements , reduction o f

grades , and skilled use O f equipment and power, the management has made Erie a strong railroad , but i t has notyet made it a strong corporation . Baltimore and Ohio,with over hal f a bi ll ion Of debt and two hundred mill ionsof stock

,was seriously disturbed by the reduction in traffic

during the war. A fter the war was over , its first task wasto set about recovering i ts business . In 192 5, $ 1 2o f its bonds

,al l bearing 3% per cent interest, come due.

The property was put through an extensive improvement

and reconstruction program in the ten years before thewar . I t i s a power ful system in point Of traffic, but asa corporation i t i s sti l l in the making. Beginn ing with19 19 it has passed its common dividends .

2

A t ch i son , U n i on Pac ifi c , and Sou th e rn Pac ific

O f the transcontinentals , Atchison and Union Pacifichave wonder ful records . Atchison , as built up by Ripley,i s a striking example O f the results of strong conservative management . He required hi s superintendents tocount every tie i n the track and examine every piece o ftimber twice a year , and to keep their budgets o f needed

2 Dividends recommended in December , 1923.

35THE ART OF INVESTMENT

expenditures made up in detai l for five years ahead . Heheld the dividend rate down to 6 per cent , and ploughedsurplus earnings into the property. Thus the company

was bui lt up f rom the wreck O f the nineties , when it

passed through receivership,into the superb property

O f today. In finance also the management has been ex

ceptionally sound , using convertible bonds , which holders

have later exchanged for stock . The present capitali za

tion consists o f less than $300 ,000 ,

ooo o f bonds , and

o f stock .

Union Pacific i s a striking example o f br i l l iant andpower ful management. Under the leadership Of Harri

man money was poured into the rebui lding Of the prop

erty , after the reorganization of 1897. The Sherman

Pass in Wyoming and the Lucin Cut—O ff across GreatSalt Lake ( belonging to the Central Pacific ) are greatnames in the annals o f engineering. As a result of the

reconstruction , Union Pacific has not only the shortestroute but the lowest gradients across the G reat D ivide .

Harriman also added to the power of the system by in

vestments made on a gigantic scale in the securi ties o fother rai lroads . The company has outstanding a l ittleless than of bonds and sl ightly over $300 ,

O f stock . With the exception of three years,

when slightly lower rates were disbursed,i t has paid I O

per cent on i ts common stock since 1906. This h igh rate

has been due primari ly to the fact that the road i s naturally the best transcontinental route , being the shortest,most direct , and least costly to Operate, and secondari lyto the fact that i t has been made an extremely efficientmachine for transportation .

Southern Pacific , with about bonds and

$344,ooo ,ooo stock , i s not only a transcontinental rai l

road,but one o f extensive mi leage on the Pacific S lope.



better and safer proportion o f stock to net funded debtthan St. Pau l .

O the r Sy s t ems

There are many other Important rai lroad systemswhich are most conveniently studied by groups . The

southwestern group, including Mi ssouri,Kansas and

Texas , St. Louis-San Franci sco , Kansas City Southern ,St. Loui s and Southwestern , and Mi ssouri Pacific , serve agrowing territory. The north-and- south lines

,such as

I l linoi s Central , and Louisvi lle and Nashvi lle , and thel ines of the Southern Rai lway west of the Alleghanies ,are o f importance . The traffic to the Gul f i s participated

in also by Atchison , Kansas City Southern, M i ssouri ,Kansas and Texas

,and the I ron Mountain lines of Mis

sour i Pacific . The southern rai lways proper are theAtlantic Coast Line

,the Seaboard , and the Southern .

The so ft coalers begin with the Clinchfield, the Vi r

ginian,the Nor folk and Western , and the Chesapeake

and Ohio . Coming north they include also the Western

Maryland,the Baltimore and Ohio , and the Pennsyl

vania . The Wheeling and Lake Erie , Wabash , and Chi

cago and Eastern I ll inoi s are other examples o f this

very numerous type o f rai lroad . In fact, most roads

carry sof t coal as a pr incipal i tem o f tonnage . The hard

coalers are the Reading, Jersey Central , Lackawanna,Delaware and Hudson

,Lehigh Valley, and to a less con

spicuous degree , New York , Ontario and Western , Eri e ,and Pennsylvania . The New England group comprisesthe New York

,New Haven and Hartford , the Boston

and Maine , the Maine Central , and other smaller l ines .

This group was the one which was hardest hi t by the

postwar conditions,and the southern group was the next

hardest.


There are also the greater groups,such as the trans

continentals,the t runk l ines

,and the grangers. Essen

tially the trunk line connects New York and Ch i cago ,and the granger connects Chicago with the wheat and cornbelts. But both titles spread over rai lroads that may beincluded under other groupings . The New York Cen

tral might be mentioned as typi fying the trunk l ine and

the Chicago and Northwestern, the Rock Island , and

the Burlington as typi fying the grangers . The CanadianPacific i s both a granger and a transcontinental . It i sone o f the most important rai lroads on the continent ,doing a large business in the Uni ted States as well as in

Canada .

Besides the important rai lroads and groups there arevery numerous local or short l ines , each serving some

particular di strict or traffic . In competitive territory,

such as that between the Ohio and the Lakes,such lines

have usually fared poorly in recent years . Elsewherean occasional l ine has done sufficiently well

,being able

to cover its expenses out of high rates .

Th e Bas i s of Ra i l road I nve s tm en t

Railroad investment i s usually made on the basi s ofpermanent value. In the bonds men seek sa fety ; in the

stocks , except of companies whose position has becomeprecarious and speculative

,they seek the orderly working

out of the rai lroad ’s problem , to develop itsel f and its

section of the country. The great attraction o f rai lroad

investment i s that i t expresses so much of continuity andpurpose , and so l i ttle of blind chance . There are o f

course chances . A railroad must be maintained or i twi ll collapse . A rai l road must have terminals or i t cannot expand . A rai lroad must be well and closely Operated , or i t wi ll lose money. But these are chances that


may be watched and understood as part of the law ofgrowth inherent in the investment.It i s not general ly known that rai lroad traffic doubles

every twelve years on the average . The cost of therailroads as represented by stocks and bonds used to

double about once every fi fteen years , until retarded bytoo zealous commissions . Rai lroad growth to transporta growing commerce i s always a national necessity. To

grow, funds must be raised . To raise funds , securities

must be salable . This necessi ty is the great protectionof rail road securities . The public i tsel f i s bound in theend to guard thei r value

,guiding regulation and control

toward fair moderation and away from confiscation.

CHAPTER IV

THE BUSINESS OF TRACTIONS AND OTHER

UTILITIES

F inan c ial Fac tors of Trac t ion s

In many respects the traction companies face thesame problems as rai lroads . They have large fixed in

vestments and a slow turnover of capital,second only to

the rai lroads. There are nearly miles of track and

an investment of about Traffic on city

lines i s steady to an unusual degree,being hardly af

fected by the course of general business . Rates of fare

within city limits have usually been fixed by franchise .Traction companies having been placed in an impossibleposition by increase o f expenses

,these rates were rai sed

during and just after the war in over 600 cities andtowns . The relie f , however , was far f rom being proportionate to the great ri se in expenses and many tractioncompanies were accordingly brought into serious difficulties .

Tractions are o f two general types, urban and interurban . A s a rule the former aff ord the better basis forsecurities . City traffic i s denser and operating conditionson the whole more favorable in spite of the crowded

streets . The best property o f al l tractions i s the throughline in a large city, placed in a tunnel or on an elevatedstructure , or at least occupying a private r ight o f way.

But no class o f traction has , during the period of highexpenses

,been whol ly out from underneath the general

Cloud .

49 THE ART OF INVESTMENTd

Franch i s e s and O th e r Troub l es

The chie f difficulties with c ity tractions have been ,first , the overcapitalizations that accompanied the originalconsolidations into urban systems

,second

,the undermain

tenance characteri stic of the earlier years o f electric oper

ation,and

,finally

,the pol itical quarrels with local

authorities over expiring franchises and over rates of

fare . The industry is sti l l new ,and has had much to

learn . Among other things, bitter experience has taughtthat a twenty-year f ranchi se cannot be made a sound basi s

for securi ties . The final years o f a term franchise are

usually fi lled with demoralization and trouble . Franchisetroubles o f an acute character had been experienced innearly all o f the large cities , except New York, in theyears prior to the war . In New York franchises wereunl imited

,or perpetual . But during the postwar infla

tion of expenses the 5-cent fare provided in those franchi ses became total ly inadequate , and the city authorities ,making the matter a pol itical i ssue, were able to punishthe companies as severely as though the f ranchises hadexpired .

The hereditary antipathy between municipal ities andtractions i s due

.

largely to the corruption and promoter ’s

profits o f the original era o f electrification and consolidation . The practice of paying high prices in watered

stock for properties to be consol idated was almost univer

sal , and that o f buying franchises from aldermen was by

no means unknown . As a rule the cities of moderate

S ize have been more reasonable in their treatment o ftraction companies than those of large size . But local i

ties diff er. In many of the cities the quarrels have beensettled and the franchise troubles are a thing of the past.Interurbans have also had troubles . Fi fteen to twenty

years ago an exaggerated idea was held o f the efficiency

TRACTION S AND OTHER UTILITIES 43

and economy o f electric transportati on , largely becausethe properties were undermainta ined while they were new.

Lines were bui lt across country that would not yield apaying traffic. The increasing use of automobiles for both

freight and passengers added to the natural embarrass~

ment f rom the un foreseen r i se in expenses . Overmiles o f interurban track have been abandoned in the

last six years . Well—managed interurbans aff ording aconvenient route between populous ci ties as termini and

carrying express as well as passengers have been able to

stand up and pay their way. Some o f these are excellent properties .

E lemen ts of th e B us iness

The main point about tractions is that they are distinctive ly local enterprises . Each must be j udged by itsel f , according to i ts f ranchises and its relations with the

public, as well as by its property and its earnings . The

public relations are perhaps the most important s inglefactor in j udging future prospects . A l l c ities grow ,

and

the question i s whether the traction wil l be encouragedin the investment of capital to keep pace with that growthor will be crippled by municipal hosti l ity and opposition .

On the whole the industry i s establi shing more satisfac

tory public relations,either through franchise protection

or by means of a service-at-cost scheme o f regulation .

Generally speaking, more common sense and less poli ticsis now Shown by cities than formerly. There may stil lbe an earnest effort f rom time to time to dry out

water in the stock or punish past stock j obbing,but there

i s more disposition to protect genuine investment on thepart of the average city .

I t i s difficult to use general izations regarding the business and sti ll more difficult to characterize the securities.


The properties are not interconnected l ike steam rai lroads ,nor are the companies competing like industrials . Tractions are separate enterpri ses . There are , however , two

important and outstanding features o f the business . Onei s the steady growth of passenger travel f rom year toyear. The other i s its f reedom from fluctuation . In the

larger cities the gross receipts may be relied on to in

crease and to maintain their volume through good timesand bad . Tractions also have thi s in common , that thei roperating expenses are composed of S imilar elements ,alike with local variations . H igh expenses , such as ac

companied and followed the war , reduce the net earn

ings . Reduced wage scales and lower costs of fuel , steel,and materials increase the net. A lthough the propertiesare separate

,the income o f the entire industry rises or

fall s with the trend of the expenses.

T rac t i on Se cur i t ie s

Tractions have,accordingly

,been through the same

strain as the railroads . They, however , had no govern

mental aid . Such local aid as was given by increase

o f fares was not usually adequate . In addition the com

panics were less strong to begin with . Many of the

companies went into receivers ’ hands , and others barely

averted receivership . Some were solvent , but few were

prosperous . Traction securities as a class are sti l l some

what di scredited and low in price,having begun to re

cover f rom the great depression of 192 1 later than either

industrial or rai l road securities,and with less confidence .

Expenses being sti ll high , the margins of profit are notlarge and in some cases are entirely lacking . The sub

stantial securities of solvent and well -managed companies ,and underlying bonds o f companies that have defaul ted

on junior i ssues , are therefore sti ll at prices that offer


45 I‘

HE ART OF INVESTMENT

the holding company going, dividends were pa id at ahigh rate upon the Rapid

'

Transit stock,as high as 20

per cent from 19 14 to 19 17, inclusive, 15 per cent in

19 18 , and then 2% per cent in 19 19 , a fter which they

ceased , whereupon the holding company, obligated to pay

bond interest, went into the hands of receivers .The dividends o f the Operating company

,the Inter

borough Rapid Transit , were keyed too high and main

tained too long in the face o f rising expenses . I t has

been obliged to propose an adjustment o f i ts lease o f

the Manhattan , a five years’ interruption o f the sinking

fund on its bonds , an extension o f i ts notes , and a sub

scription from its stockholders , i n order to escape t e

ce iversh ip o f i ts own properties . In the cris is i ts previous

dividend po l icy proved a fatal weakness in its attempts to

negotiate with the city for an increased fare to meetswollen expenses . I t had made itsel f a fit target for attack .

A fter the adjustment , with expenses on a more normal

basis,the company’s bonds wil l be sufficiently well secured

,

resting as they do upon a public necessity whose credi t no

city or state administration can afford to destroy. The

stock,although its dividends are to be l imited under the

plan o f adjustment,i s in l ine to benefi t by increasing

travel . But the eff ect o f the proposed new subways , andthe results o f negotiations with the city over construction

contracts,and o f the control and valuation to be imposed

by the state Rapid Transit Commission , must also beconsidered as they may material ize. The stock is speculative

,dependent upon developments sti l l to come.

Brooklyn Rapid Transi t Company was formerly asystem of sur face and elevated lines in Brooklyn. I t

invaded the subway field and the i sland o f Manhattanin 19 13, and was caught by the high costs of both con

struction and operation . I t went into the hands o f


receivers on December 3 1 , 19 18 . I t has been througha process of partial dismemberment as to its sur face lines ,and i s now gradually approaching the stage of reorgan i

zation . I t has nearly stock, upon whichdividends were paid from 1909 to January , 19 18 , the rate

being 6 per cent for the last five years of thi s period .

The direct debt is about not including the

debt of former subsidiaries .

New Yo rk C i ty Sur face L ines

O f the sur face lines in New York City proper , theThird Avenue has weathered the storm and i s beginningto Show a restoration o f earning power . I ts l ines in theBronx and to the north , the Union Railway, have considerable promise . The New York Rai lways

,a larger system

than Third Avenue , went under . The havoc of high

expenses was complete . I t de faulted down to i ts underlying bonds . O f the three principal i ssues o f thes e underlying bonds that passed through the Metropolitan receiver

ship unscathed,the Lexington Avenue and Pavon ia Ferry

,

and the Columbus and Ninth Avenue , have failed to payinterest, while the Broadway and Seventh Avenue bondsdropped to low receivership prices but continued to payinterest. The New York Rai lways is at this wri ting not

yet far enough through its difficu lties to be in conditionto reorganize.

Ho l d i ng Compan ie s

Traction holding companies are only partly typifiedby the Interboro Consolidated . There are well-managedholding compani es whose capitalization i s not excessive

and whose purpose i s to provide ski lled operation tosmaller

,scattered properties . But most holding companies

are too heavily capi talized , subj ect to the danger o f ex


Cessive dividends and undermaintenance on the part o fthe operating companies whose stock is held . The re

ported earn ings o f the holding company are not a sa feguide . I t i s no stronger than its subsidiaries

,whose

maintenance,earning power , and borrowings are not al

ways easy to ascertain . Some holding companies,l ike

American Light and Traction , were launched early, when

properties were cheap . This company,mainly light and

not traction , paid a high rate o f dividends from 1909 to

1920 S ince then the rate has been more moderate. O therholding companies , which began late , paid too much for

properties that were not first-class . Some of these have

been speculative , others chronically weak , with a high

rate o f mortali ty at times when funds could not be oh

ta ined by borrowing or by sell ing additional securities .

E l e c t r ic L igh t and Pow e r Compan i es

Electric l ight properties have been in more favorable

position than the tractions . The business being newerand the services rendered mainly under contract withprivate consumers , the public regulation has been less

stringent with them than with either rai lroads or streetrai lways . The treatment has been more liberal both as to

rates and as to conditions of service . The machinery and

appliances having been improved rather swi ftly and con

s istently , the companies have been permitted to retain a

considerable part of the profi ts resulting f rom the economies . In eff ect they have forged out in f ront o f theregulation . There was a margin of profit even during

the war era when prices for coal were at thei r peak .

This cris i s did not interrupt the record o f good earnings .The electric l ight business i s steady, with only moderate

changes due to general conditions . On the expense sidefuel i s a leading item , the pay-rol l o f wages being rela


tively less than with tractions or rai lroads . The capitalinvestment

,while large, i s not so large in proportion to

revenues as in the case o f the transportation enterprises .The net earnings upon the real capital invested have been ,as a rule , very good . It i s possible to mismanage anelectric light property

, or to put an installation where

there are too few consumers , or to neglect franchise protection for pole l ines . But the record of the business as

a whole i s excel lent. The securities are in favor in themarket to almost the same extent as the traction securities are in dis favor .In the evolution of the business

,l ighting companies

became f requently yoked with fractions . By use of acommon power house the traction received Cheaper current and the lighting company a steadier load

,

" or demand for current , and therefore cheaper costs o f production . O f recent years thi s un ion has had unexpectedfinancial consequences , the l ighting company carrying, or

attempting to carry, the traction . Occasionally the evolution took a diff erent course

,as in New York Ci ty, where

the New York Edison Company has been a mainstayof Consolidated Gas , and the traction companies havebeen kept out of the lighting field .

The l ighting companies have also,where permitted

to do so by local laws , undertaken to furni sh power toindustries . This i s usually an advantageous arrangement

,

furnishing a low-rate , large-volume market for current at

hours when the machinery would otherwise be idle. The

invested capital i s made to work longer hours,with a

result similar to that sought in supplying current to

tractions . The power load for industries,and conse

quently the earn ings from this end of the operations,

fluctuate somewhat according to general business conditions . But Where the industries served are diversified,


w i th no preponderant block of power going to one con

sumer,the fluctuation i s not great .

An outstanding character istic of the electric light ih

dustry i s that it i s stil l growing . The principal eff ect

o f depression i s a retardation , and of prosperity an ac

ce leration , o f growth . The uses of electricity are in

creasing both in the home and in the factory. The field

for its employment i s by no means saturated .

Gas Compan i e s

Gas i s o f course older than electric l ight. The incan

descent mantle and the new uses o f gas for fuel and heating have rej uvenated an industry that seemed to be threatened by the electric competition . The consumption per

capita i s much larger than in the o ld days,when gas had

a monopoly o f lighting, and the industry i s on a solid

and enduring basi s . Nevertheless gas is the poor man ’s

l ight,and as such its rates and its qual ity have long been,

and sti l l are,a favorite political battle ground . In Ch i

cago the People’s Gas bases its rates upon a fixed return,

recently 7% and now 7 per cent , on the value of i ts

property as ascertained by a local commission . In New

York the rates of the Consolidated Gas and Brooklyn

Union Gas,with other lesser compan ies , have been in

the courts f rom time to time on the issue o f confi scation .

The courts have protected the companies in the right to

earn a fai r return on the legal value of their properties . In many cities the companies have won the right

to make gas o f a heating-power instead o f a candlepower standard . The former i s cheaper gas

,suitable for

cooking or for lighting with mantles . In New York

C i ty the right of the poor to burn a naked light,at higher

fi rst cost , was , unti l 1922 , firmly protected by the candlepower requ i rement.


Gas companies came through the expense cr i sis in

better shape than the tractions, but worse than the electric lighting companies . The expense cri si s for thesecompanies was very Sharp , coal for coal gas and theenriching oil for water gas mounting swi ftly to unheard-ofprices . But the crisi s was also comparatively Short. The

rise in costs began in 19 16 and 19 17, but the worst o fthe peak lasted only from a year to a year and a hal f

,

according to the state o f the existing contracts for coal

and o i l . Rate increases, more or less adequate, weregranted in many cities and towns , or secured through thecourts . In the end the companies came through with fewinsolvencies or maj or embarrassments . The earnings are

again swi ftly improving with the breaking of the pricesof coal and o i l , which are the largest S ingle items o fexpense.The gas business i s extremely steady, the ch ie f eff ect

of prosperity and depression being upon expenses . I t

i s well adapted to the i ssue o f both bonds and stock . In

some districts the business has become more complex because o f natural gas , or because o f the use of by-productcoke-oven gas . Natural gas as a competitor i s ruinous ;as a component part o f the business

,i t i s not a perma

nent asset . The use o f by-product gas cheapens costs

but places the business more under the sway o f generalconditions , as i t i s not always easy to market the coke.

Hyd ro-E le c t r ic Pow er Compan i es

Hydro-electric power companies are characterized byheavy capital outlay and smal l operating expenses . W i tha new enterpri se the problem is to sell power enough totake care of the large ini tial investment . Even large

,

success ful , and expanding companies, such as the PacificGas and Electr ic Company, had for years the problem


o f finding new capital to keep up with the additionalsales o f power . Thi s company finally solved the problem of growth in the most sati s factory way -by sell ing

stock to its own consumers .Hydro-electric properties are large units owing their

inception to the vision of the promoter and engineer .They do not grow from small beginnings . The financingof new properties has been almost necessari ly upon a

construction company basi s,bonds being issued to cover

the cost and stock as bonus or inducement to make the

bonds palatable to the purchasers and to pay the entre

preneur and financier . The cost of construction varies

greatly according to local conditions , such as length o f

dam,nature of river bottom ,

height of fall,and neces

s ity for bui lding an auxi liary steam plant against r isk

o f drought or ice . The value of the securi ties depends,

among other things, on the rate of capital ization per horse

power o f capaci ty,and the quantity and average price o f

the current sold .

The securities o f a seasoned hydro-electric , such asthe Niagara Falls Power Company , are often well protected and regarded as sa fe . Both bonds and stock o f anew or uncompleted proj ect are speculative . There are

compan ies that have been great successes , l ike ShawiniganWater and Power

,and those that have met disaster at

the start , such as the McCall Ferry Power Company andthe Hudson River Power .A sharp distinction i s to be drawn between hydro

electrics producing so-cal led primary power,good 365

days in the year,and those producing secondary power

,

subj ect to reduction or interruption in time of low water .The latter are of in ferior and more doubtful earningpower . Auxiliary steam plants may be used to bol ster upthe secondary power of a hydro-electric plant , and pro



stock s . The main essential for investment i s the estab

l ished market for the current, w ith primary power andcapita l i zation within the l imits of the earnings . The

construction enterprises , or those with markets to develop

or expansions to make , are Speculative.

Te leph on e and Te l egraph Compan i e s

Telephone and telegraph companies are a class o futi l i ties apart from the others . The Postal and the

Western Union stil l compete between the larger cities , and

there are sti ll some local telephone systems. But essen

tially each o f these businesses i s a natural monopoly be

cause of the fact that i t is better and cheaper to be pro

vided with a single channel for talking to everybody thanto have duplicate channels , or, worse , separate channelsthat reach di ff erent people.

The monopoly o f the American Telephone and Telegraph Company has been tacitly assented to instead of

being opposed, with local exceptions and with the except ion of its temporary control of Western Union . Its

public relations have been good . This has been a most

important asset. Commissions have begun to turn their

attention toward telephone rates,but up to the present

time the rates have been sufficient to provide liberal mar

gins for maintenance and for constantly recurring ex

pansion- replacements o f switchboards

,l ines

,and appl i

auces. The business will probably never be subj ected todestructive regulation for two reasons : fi rst

,what cus

tomers are paying for i s service and they would not

tolerate impairment o f service by inadequate rates ; second, in order to keep going and supply new connections ,the company or its subsidiaries have to sel l securities

every year , and i t must keep the confidence of the moneymarket and be able to pay the necessary return.


From its smal l beginnings , which were the source o flarge fortunes

,the business has assumed great proportions .

During the twenty years since 190 1 the net additions

to plant have been Including $ 1 15,ooo

,ooo new stock just subscribed , the stock outstanding

i s The debt o f the parent company ,not counting subsidiaries, i s about In 192 1 ,

at the worst o f the depression in securities,the company

raised its dividend rate f rom 8 to 9 per cent, and sold

of stock to pay for neces sary construction .

With great courage it took the position that i t must giveservice and

,therefore

,must pay the going rate for money.

Co rporate Se cur i t ie s

Corporate securities outstanding in the hands of the

public probably aggregate nearly or quite fi fty bi ll ions

of dollars, excluding those personal i ssues not quoted or

dealt in in the markets . These securities, together withfarms , city real estate , and the assets o f individuals andfirms and o f semiprivate corporations, represent the bulkof the national wealth. Together with government andmunicipal i ssues , which are a debt against that wealth ,and the loans o f foreign countries

,they constitute the

fabric of investment. A l l securities , whether restingupon earnings or upon taxing power , are dependent uponthe course o f business for thei r value

,and in a different

way, as w i l l be shown in succeeding chapters, for theirpr ice.

CHAPTER V

THE RELATION OF BANK CREDIT TO

BUS INESS

Ban k Cred i t a Fundam en tal Fac to r

Bank credit is the most general and fundamental factorcontroll ing the course o f business . A l l o f the forces of

trade,industry

,and finance center upon the banks . Thei r

posi tion is the expression o f a country-wide , or even

world-wide,complex of activities and relationships . The

S ituation of the banks with respect to thei r lending credi tto business i s in constant flux .

It is well known that cred i ts expand when business i sprosperous

,and shrink when it i s depressed . The prices

o f securities are aff ected by the resulting credit conditions .A t times the prices are controlled more force fully by creditthan by business conditions. F inal ly, the business conditions themselves are influenced by the credit conditionswhich prosperity or depression has produced .

The cyclic changes in credit , business , and prices ofsecurities wi l l be touched upon later . To begin , there isneeded direct di scussion o f the bank figures

,the banking

system , and the relation of banking conditions to securities .

Any change in credi t conditions produces changes inthe bank figures . Any great change alters the rates forthe lending of money . The cause o f the changes in the

bank figures and in the rates for money i s not always

immediately clear . But the result is explicit , a definitepoint of departure for the investor , i f rightly read andunderstood . The weekly bank statements , together with

56

RELATION OF BANK CREDIT TO BUS INESS 57

the analyses publi shed in the Federal Reserve Bulletins ,are a comprehensive and prompt index of the course o fcredit. They afford insight also into the prospects forexpansion or contraction of business , as well as a measureof i ts present volume. They furni sh grounds for j udging

the course o f bank rates , the changes in which directly

aff ect the prices of Securities. They reveal what i s actual lygoing on in industry

,trade

,and finance . The best and

most truly inside information an investor can have i s

knowledge o f the credit s ituation drawn from these officialsources .

Th e Nat i onal Bank Sys tem

The old national bank system leaned upon cash re

serves kept by the individual bank. Originally, as a Civi lWar outgrowth

,the national banks were intended to i ssue

bank note currency against the security o f governmentbonds deposited with the federal treasury. They served

the more limited needs of thei r day, but their functionas banks o f i ssue became gradually atrophied and thei rinabi l ity to cope with conditions o f financial strain became

,more and more clearly, an imminent menace. They

were i ll adapted to the larger and more active commercialand industrial l i fe o f later years for two fundamentalreasons : ( 1 ) Thei r note i ssues , based on a cash outlayfor government bonds

,could not be adapted to the alter

nate shrinkage and swelling o f commercial requ i rements ;

(2 ) thei r reserves , kept in the vaults of the bank , werealso inelastic. The requ i rement that the reserves shouldbe kept in vault prevented them from being used . Whi lethe country banks had a lower reserve requ i rement , andcould keep a part of thei r reserves with selected correspondents in reserve C ities , the keystone of the structure ,which was its greatest source of immobility, was the t e


quirement that the strong institutions in the central reservecities Should maintain a cash reserve o f 2 5 per cent of

deposits .The records showed that the combined deposits of

country and reserve city banks together might , under

the most favorable conditions , reach a maximum o f, say ,

seven times the aggregate reserve kept by both . But when

anything happened anywhere , or any bank fel l below its

reserve requirement , credit had to be curtai led in order to

draw in cash and repleni sh the deficient reserve . Thisdrawing in o f cash aff ected other banks and made themlook to their own reserves . The center o f pressure wasnaturally the central reserve citi es. In time of tight

money the reserves in these ci ties hovered close to the 2 5per cent mark . The moment thi s limit was passed by

some of the banks , al l o f the others were put underpressure . Every bank then sought cash.

Mon ey Pan i cs

Under these circumstances , cal l loans were called , asthe quickest recourse

,and the rates on call money rose

to preposterous figures . Then , as the stringency continned , time loans were not renewed at maturity. The 2 5per cent limit against deposi ts , with no way of gettingcash except by taking it away f rom some other bank

,and

no way of reducing deposits except by demanding the

payment o f loans , brought an imperious and universaldemand for payment. In times of cri si s the banks generally found themselves in much the same predicament .They were forced into a competitive scramble for cash .

Just when they Should have extended credi t,they were

obl iged to restrict it ; they were compelled to cease func

tion ing in time of financial difficulties simply because of

the inelasticity of thei r reserves .


"Money panics , which recoi led upon the banks themselves , were the most immediate and violent mani festa

tions o f cri ses . A fter the first burst o f destruction thebanks stayed further wreckage

,in so far as they were

able , by resorting to a credit expedient entirely outside o f

the national banking system,the i ssuance of clearing

house certificates . But in the meantime great havoc had

been wrought. Men in the ful l stride of prosperity had

been brought to ruin. The country had been prostratedby the breaking down of i ts credit mechanism , and had to

bui ld again from the very ground .

Th e Fede ra l Re se rve Sy s tem

The federal reserve system ,which came into opera

tion in 19 14, was designed to obviate these di sastrouspanics by creating a stronger basi s for credi t and permitting a more di scretionary use of i t in time of strain . The

banks were to be of service in time of cri si s , instead of

being crippled and made useless . Under thi s system thebank reserves are no longer held individually in separatevaults

,but are pooled . The reserve requi rement o f the

member banks i s lower and the limit i s not rigid butelastic. The reserve itsel f may be replen i shed otherwisethan by drawing in cash from other banks .Under the Federal Reserve Act the member banks

are required to keep reserves of 13 per cent against demand deposits in the central reserve cities ; I O per cent in

the reserve cities ; and 7 per cent i f located elsewhere .Against time deposits a 3 per cent reserve i s requi red o f

all the banks . These reserves are not kept in the memberbanks’ own vaults , but with the federal reserve banks .The gold and real money of the whole banking systemi s collected in a common reservoi r in these regional banks

,

which are owned by the member banks and do no general


banking business with the publ ic , but function as banks ofi ssue and of redi scount fo r the member banks .These federal reserve banks

,which are the governors

and safety valves o f the combined banking system , are

required to keep gold reserves of 35 per cent against the

deposits made with them by the member banks , and of

40 per cent against their own federal reserve note i ssues .

The 40 per cent reserve against notes i s not mandatory , but

i s an elastic limit . I f a cri si s requires the further i ssue

of notes a fter thi s l imit has been reached,they may sti l l

be i ssued subj ect to a graded tax that makes them expensive and insures thei r early reti rement . In 1920 the

better situated o f the federal reserve banks helped out

those whose reserves had fallen too low ,by making ad

vances against redi scounts and thus keeping all the regionalreserves up to the requi red 40 per cent so far as possible .

But the graded tax on note i ssues was imposed because of

deficient reserves for a brie f space in New York and for

a longer time in southern and western federal reservecenters .

Th e E las t i c i ty of Cre d i t un de r Res erve Sy s t em

The mechani sm of the federal reserve system adaptsi tsel f with great flexibil ity to the expansion and contrac

t ion of the national credit requirements . To procure bank

notes , or to repleni sh reserves that have fallen low ,the

member banks have but to take from thei r port folios commercial paper or paper secured by government bonds , and

redi scount i t with the federal reserve bank . As i t i s

the intention to support commercial in contradistinction

to stock exchange credit,paper secured by bonds and

stocks o f corporations cannot be redi scounted . The

avenue of relie f for low reserves of member banks is ,however , sufficient for all purposes , so long as the bank



war bonds at a low rate o f interest , that allowed theinflation o f that period to acquire such great impetus . The

thi rd remedy for low reserves i s the tax on note i ssues

and the auxi liary coercive powers granted by the law.

Th e Eff ec t o f th e Ra i s i ng o f th e Red i s coun t Rate

O f these three remedies the raising of the redi scount

rate i s the most natural and salutary . I t i s the timehonored method of the Bank of England and the Continental central banks. When the exchanges were normal andthe free international movement o f gold was permitted

,the

increase o f the bank rate in London , or Berlin,or Pari s

would draw money instantaneously f rom neighboring

countries,or even f rom the United States , to the sup

port of the center that needed it . Dealers i n exchangecaught the signal in al l countries , and put thei r funds

where they would earn the highest interest.The free international movement o f gold f rom low

interest money markets to high- interest markets was inter

rupted by the war , and has not yet been restored . Rai sing

o f the redi scount rate in 1920 was not , therefore , so

quickly eff ective as such action would have been before

the war,especial ly in Vi ew of the high rates that ob

tained elsewhere . I t did , however , prove gradually

eff ective. Whi le loans were not reduced in volume for

many months and the federal reserve ratio remained foran uncomfortably long period close to the 40 per cent line ,a definite and power ful di scouragement had been interposed upon further expansion . Business stood sti l l unti l

i t could accompli sh a recession to lower price levels . In

the end there was an orderly deflation of both the swollen

note i ssues and the swollen loans and credits .

Someare i nclined to critici ze the federal reserve banks

for maintaining high rates too long , in thi s fi rst serious


crisi s in their exper ience . The fact i s that the march

downhill , with its sweeping price changes , was accom

plished with a minimum of wreckage—in striking con

trast to the national di sturbances of 1893 and 1907. Bankscarried thei r debtors and gave them help . The bankingsystem stood the test. Even greater stabi lity i s to behoped for in future inflations and overexpansions , upon

which,under conditions o f peace

,a more timely restraint

may be imposed by rai sing redi scount rates be fore condi

tions become acute .

Th e Expans ion of Cre d i t un de r th e Fede ra l Rese rve

Sy s tem

The Installation o f the federal reserve system was

practically contemporaneous with the outbreak of the warin Europe . For a time it seemed that credit wou ld bein unlimited supply. For the fi rst few years the new

machinery o f enlarged credi t faci l ities was hardly used.

In the end the war and postwar demands strained thecapacity of thi s machinery. The discarded national bank

ing system would have been totally inadequate for such

enormous demands and would have broken down. The

reserve banks carried the brunt of the Liberty and Victory Loan financing

,met the governmental borrowing

upon Treasury certificates , took care of the expanded commercial borrowings upon high-priced merchandise during the period of feveri sh activities

,and

,finally

,supported

the so-cal led "frozen credits" upon commodities thatcould not be moved because the market for them had vani shed. Far more quickly than anyone had deemed possible , credit expansion reached the ful l capaci ty of thefederal reserve system .

The financing of the war through the federal reserve

banks was a great achievement . The carryi ng o f the post


war inflation was a much greater and more difficult task .

The inflation gathered force as i t grew. In the four monthsfrom September , 19 19 , to January , 1920 ,

loans to mem

bers and total investments o f the federal reserve banksincreased from $2 ,3 to or over

40 per cent. Beginning shortly before the end o f 19 19

and continuing on into 1920 ,rediscount rates were rai sed

by the reserve banks in successive stages,the Treasury

advi sing the Federal Reserve Board on January 10 ,1920 ,

that war financing had been so far completed that the

Board might feel f ree to exercise i ts statutory powers andregulate the di scount rate without regard to governmentalrequirements . There was then inaugurated the long and

difficult process of bringing the situation back within con

trol . Loans continued to increase a fter the higher rateswere imposed , although more slowly than in the last quar

ter of 19 19 . November , 1920 ,was a month of real money

"pinch . In thi s month loans were practical ly at themaximum . The total deposits o f the member banksaggregated nearly eleven times the $2 ,

in round figures of gold holdings o f the

federal reserve banks and close to the theoretical max

imum of the ratio of deposits to gold which has been

estimated to be twelve to one .

Th e F igu res of I nflat ion and D eflat i on

A detai led relation of the history of thi s notable epochcannot be given within the space o f this volume . The main

features may be told as fol lows : Beginn ing with 19 17

the reserve ratio was lowered f rom 86 per cent in March

of that year to 40% per cent in May , 1920 . It underwent

a Slow recovery to 44% per cent at the beginning of

192 1 , and a more rapid rise to 57 per cent by July o f

thi s year . Finally the beginning o f 1922 saw i t at 71

RELATION OF BANK CRED IT To BUS INESS 65

per cent,from which point there was a rise to 80 per cent.

The note ci rculation was practical ly negligible unti ltoward the end o f 19 17, when i t approached000 . I t reached in December , 1920 . By

February,192 2 , i t was down to a l ittle over

000 . During 1920 ,gold began to pour in f rom abroad

and to accumulate from domestic circulation , and the s ituation was alleviated . By 1922 ,

the gold holdings of the

federal reserve banks were nearly or four

times the amount held by these institutions early in 19 17.

The most significant changes of all,however

,were in

the loans . Loans and investments of reporting memberbanks increased $2 ,

f rom midsummer , 19 19 ,

to October, 1920 ,

and decreased the same amount byJanuary

,1922 . The maximum loans made to member

banks by the federal reserve banks were

on November 5, 1920 ,having risen from about

000 at the beginning of 19 18 . They decl ined early in1922 to the same low point , or lower . These loan figures

and those for deposits show clearly the swelling and subsidence of the inflation . The approaching strain was fully

indicated as it came on . The maximum strain and greate st extension of credit was a fter prices of securities andcommodities had broken and the banks were engaged incarrying the situation through .

Th e No rm al Bank Cred i t in th e Re se rve Sy s tem

It is not yet fully possible to say how much of thevast powers of credi t of the federal reserve system

,which

in its first hours coped with so great an emergency,will

be required for the normal peace-time business o f thecountry. I t i s at present obvious that, with the loansto member banks so nearly cleaned up and the federalreserve ratio approximating 80 per cent , credit wil l be in


abundant supply for some time to come—fully equal tocarrying at low interest rates the recovery o f business thati s now developing .

N0 one can guess or prophecy the exact reserve percentage at which increases of redi scount rates are likelywhen credit has again been drawn upon for future

expansions of business . Ci rcumstances wi l l aff ect the

decision . Exports of gold , a too rapid mounting of

loans,or overindulgence in speculation would lead to

quicker action than a gradual and healthful increase

of business . I t i s altogether probable that the reserve

banks would stiff en the rediscount rates under any Cir

cumstances long before the reserve ratio approached thelegal l imi t of 40 per cent. I t i s certain

,from recent

experience,that the Reserve Board wi l l give warning

,in

advance of action , when the point approaches where

business exuberance must be curtai led .

In the meantime the bank statements are,more than

ever,the primary barometer of the commercial and

financial outlook . Redi scount rates , the interest rates o f

the open market,and the figures of reserve and member

banks Show the trend and mark the final goal . The post

war period that has been used as i llustration was most

unusual . For that very reason it brings out,better than

long years of less strenuous experience, the bearing o f

the banking changes upon business, and their relation

to securities and investment.

Secu r i t i e s an d B us i n e ss as A ffe c t e d by Bank C re d i t

The relation of business and securities to bank crediti s to be seen primari ly through loans . There are three

pr incipal types of loans , of which two are di rectly,and

the third indirectly but intimately,dependent on bank

credit . Short-term loans are made by banks to corpora

RELATION OF BANK CRED IT TO BUS INESS 67

tions and firms for temporary requirements . Long-termloans are obtained by corporations from investors by thesale of bonds through investment bankers . Cal l or time

loans are made by banks to individuals, or thei r brokers,for the purpose o f carrying securities . There are otherimportant forms of loans , such as real estate mortgages ,and of credit

,as

,for example , bank and trade acceptances ,

but the three forms considered embody the main relationships between the banking systems

,business

,and securities .

The three types o f loans have diff erent functions.The first finances trade ; the second finances construc

tion ; and the third finances the purchase of securities .That i s not to say that the proceeds of a loan may notbe turned to other purposes ; but these are the usualpurposes .

Th e B o rrow i ngs of Corpo ra t i ons

Corporations provide thei r permanent endowment of

funds by issue and sale o f stock , and sometimes by longterm borrowing on bonds . With strong compan ies thispermanent provision includes a normal amount of working capital . With weaker companies part o f the work

ing capital may be short- term money borrowed over andover again from the bank . But al l companies , no matter how fully financed

,require additional money when

business expands , especially when wages and costs are

high and trade i s at flood tide . To do the larger volumeof work they must carry increased inventories

,more

accounts receivable,and larger pay-rol ls

,al l demanding

funds from some source unti l the companies are paid for

thei r goods . For these and other temporary purposes ,such as the carrying of costs of construction pendingcompletion and permanent financing

, short-term loans atthe bank are resorted to .


Increased prosperity means,therefore

,increased

bank loans in all di rections , in order to carry the largerbusiness . Depression means a decrease o f bank loans .Banks supply the money to carry the increased quantityo f goods at the higher prices of prosperi ty. In depression , as inventories are sold down and accounts collected ,they are asked to carry less and at lower prices . Business i s always moving

,either expanding or contracting

rarely standing sti l l save in time of profoundest depression . Short-term bank loans supply the power to expand

,the elastic cushion for contraction .

I t follows,therefore , that when bank credit i s stretched

to the point of great strain by abundant prosperity,the

power to enlarge business has disappeared and the nextphase i s certain to be a downward change . On the otherhand

,when in the course o f depression bank credit has

become plenti ful and cheap , the power to enlarge business exists and wi l l at length , in due sequence of time

,

be exerci sed . These are general principles , sometimes

affected by war or other great disturbances , but lying

deeper and consti tuting a more permanent force bearing

on business than the external influences , such as foreigntrade

,the tar iff

,the crops , politics , strikes, the rulings o f

commissions, Sherman Law and Clayton Act decisions ,

or even taxation .

Bank C red i t and S ecur i t i es

Securities precede business in thei r dependence uponthe position o f bank credit . The cal l loan , secured by

stock collateral,i s the most sensitive o f any type of loan .

Its rate of interest varies almost f rom day to day, and

i s the first to ri se when funds become fully loaned . I talso ri ses the most Sharply , the money lent on call being

essentially the surplus , from al l parts of the country, le ft


CHAPTER VI

BOOMS AND DEPRESS IONS

Psy ch o l ogy and S equen ce

I t i s characteri stic of both good and bad times that

people always think them more permanent than they

a fterwards turn out to be . The reasons why business

i s booming or i s depressed are in the foreground . Rea

sons why prosperity should vani sh or depression melt

away are not yet apparent .Thi s general state of mind has much to do with the

overintensification of business activity into booms , and

with the accentuation of depressions . The psychology of

the matter i s that many,thinking the prospects assured ,

take on new business in time of prosperity , j ust when new

activities are in fact most speculative . In depression theyre fuse to enter into new activities because the outlook i s

so black , thus intensi fying the exi sting dullness . No

small part of the business commun ity i s aff ected by thi scontagious mob spi rit . Nearly all construction , whethero f rai l roads , mills , office bui ldings , or houses , i s done in

time of prosperity when wages are high and materials

costly. Very little i s done when business i s dull and con

struction i s cheap . Consolidations and new enterprisesare launched when the tide i s high—not when it i s low.

Liquidations of businesses are conducted when the tide isout, owners lacking cash to carry on ,

or throwing up their

hands in despai r . It i s also‘

true of securities that the

general public have more confidence and buy mofe freelywhen prices are up than when prices are down.

70

BOOMS AND DEPRESS ION S 71

Much has been written o f the so-called cy cles o f

business ,"the sequence of whose phases Governor Hard

ing of the Federal Reserve Board has described as follows : ( 1 ) business activi ty and increasing produetion ;

expansion and speculation , fol lowed underthe old national banking system by panic and forcedliquidation ; (3 ) a long period o f slow liquidation , businessdepression

,and st

‘

a

‘

gfiation; and (4) revival . The peri

odical recurrence o f these cycles as affecting stocks andbonds wil l be di scussed later. Here something will besaid concerning the nature o f booms and depressions ,thei r mechanics and their causes

,with a view to laying

down the basic rules for identi fying them whi le in progress

,in the face o f the mob spi ri t that asserts their

permanency.

Recu rren ce of B ooms and Dep re s s i ons

Thi s country, with its incessant development , i tsabsorption of capital in new enterpri se , and its long con

tinuance of a rigid banking system , has been the home

of both panics and booms . The transition from a wi lderness to a populated , highly industrial ized country,could hardly have been accompli shed without these

phenomena . Much capital had to be ventured . Some

times i t was ventured unwisely, and resources werestrained , with l ittle liquid capital to fall back upon . The

heights and depths were both increased by the sharp upsand downs of bank credit under the national bankingsystem . Nevertheless there are sti ll periods of greatactivity and great depression under the federal reservesystem , and wi ll be under any banking system as longas the country continues to grow and business looks tothe future . The phi losophy of these ebbing and flowing

tides lies deeper than the banks ; i t l ies i n human nature,


the pursuit o f l ivelihood and profit , and the spending o fmoney for whatever i s desi red . Money panics may be

a thing of the past , but to suppose that booms and depressions also are gone i s to imagine that the national

character and the national energies have reached a deadlevel and become quiescent.

Caus es

Much has also been written in explanation o f reasonsfor the alternation of prosperity and depression . I t wouldbe useless to advance a new theory

,and presumptuous

to hold that any existing theory was complete or universally accepted . There are many theories , most of

which are partly true . Most are also too abstract to serve

the investor ’s purpose . To attempt the practical and concrete , in such a case , i s possibly dangerous . Nevertheless

a brie f picture o f the reasons for alternating prosperity

and depression must be attempted , in such terms as may

bear upon investment problems . There are at least land

marks which the investor may use to mark h is course .A chart may be sketched

,without pro fundity or erudi

tion , to trace some o f the salient facts .To leave out of consideration detai l s and collateral

questions such as are scattered through thi s and otherbooks on financial subj ects , the fundamental principleunderlying thi s ebb and flow of business i s so broad andsel f - evident as to seem to be of no di rect significance .The ups and downs of business are due to the law ofdemand and supply. A simple method of analyzing the

demand for the products of business , which ignores complications and refinements

,i s to regard i t as composed of

two elements—that of ordinary and dai ly consumption ,and that o f extraordinary or special consumption . Foodand clothing , for example , are always needed . War, the

BOOMS AND DEPRESS IONS 73

construction o f railroads , canals , public works , or numerous private bui ldings , abnormal exportations o f merchandise

,and the prevalence o f speculative fever , with its

luxuries and waste , create a special demand for tempor

ary purposes. Thi s i s a rudimentary but useful class ifi

cation .

The special demand i s superimposed upon the basicdemand for articles of constant consumption . In addition ,i t stimulates the basic demand by increasing the generalbuying power . The

‘

most'

active period of special demand

w ithir. our hi story wai

sm

fhafw

oi

f the"

Great War, incliidingthe years immediately following. The demand for prod

ucts was insatiate , extending through every corner o findustry and trade . It began with munitions , ships , steel ;passed through wheat , sugar , oi l , and other necessities ;and finished with si lk shi rts , automobi les , housing , andall manner o f luxuries . Th e demand created rising prices

that pr_oduced profi ts . Speculation became rampant andbred new and more artificial demands after the war itsel fwas OVCI‘ .

E ras of Con s truc t ion and Spe cu la t ion

In peace time these periods of great special demandare

"

ITS—q as of cons tructi on . The rai lroad bui lding

of the late eighties i s perhaps the most conspicuous example . The period be fore 1907 was one o f industrial emlargement and of speculation. The cri ses o f the last

century are each marked by the previous outpouring o f

capital into some new field of endeavor outside of the

regular routine . O f the greater cri ses , that o f 1837 waspreceded by canal and railroad bu i lding

,and the first great

development o f the West. It was precipi tated by wildcat banking and the end o f the Uni ted States Bank asa government institution . That o f 1857 fo l lowed the


stimulus of the Cali fornia gold discoveries and the con

struction of rai lroads. That of 1873 was l inked with the

creation o f industries by the Civi l War and,once more

,

the construction o f western rai lroads .These earlier cri ses were connected with the westward

expansion of the people. They were al l consequent upon

wild speculation , not only in stocks but i n commodities ,and

,last and worst , in land . In the course o f the com

modity speculation the increase in consumption usuallyresulted in a great increase of imports

,leading in the end

to payment by shipment of gold abroad and the weakening

of the banking situation . Thi s position in foreign tradewas an internal development. The country has been

shaken more than once by foreign cri ses,through that long

period when it borrowed capital and was a debtor nation ;and i t i s true al so that the contagion o f Specu lation mayaff ect the enti re world and i s not confined to any one

country. Nevertheless the springs o f thi s country’s great

cr i ses have been within i tsel f .Each dollar of capital poured into construction marks

an increase i n the special demands o f the construction

eras . There i s consumption of both labor and commodi

ties that the new permanent enterpri se may be produced .

The l imit of thi s additional demand i s set by the amount

of money that can be raised , by floating securities or bytaxation

,for construction purposes. I t i s an intermittent

demand,dimini shing when the enterpri se has been pro

duced and the labors o f construction recede.Then comes speculation , when additional dollars are

poured,i f not into new enterpri ses , then into old enter

prises—into commodities,securities , and land at higher

prices . The r i sing prices in these periods o f unusualactivity , and the great ease o f launching of expanding

enterpri ses,lead necessari ly to speculative trading,


broadening markets at sti l l higher prices , and to extrava

gant consumption based on prospects . The speculationi s always overdone . The dollars that ci rculate quickly intrading from high to higher prices are not the sound

dollars o f sober commerce. F inally , the construction andspeculati on demands collapse and yield place. Businessfinds itsel f In reduced circumstances , and with that therei s a return to the minimum necessitous demands o fconsumption.

These overactive periods are times o f fictitious income ,when people are really l iving upon capital and not withinthei r incomes . In the ensuing depression , when there i sl ittle spending

,income i s being accumulated to form new

capifii ll' h

Besides the very active and very dul l per iods there

are of course the various shades and degrees of moderateactivity and moderate depression . There i s always some

construction ; always some speculation . The intermittentdemand , ari sing from the diversion of energies into f reshchannels , such as construction or speculation

,i s never

enti rely absent ; but i t varies more than the basic demandsof necessitous consumption , those making up the standardsof l iving in ordinary times . The special demands are

also prone to rather tremendous outbursts,being limited

by nothing but the amount of money avai lable at the time .

Th e D raw ing of Cons e rva t ive Bus i ne s s " i n to a

Specu lat i ve Pos i t i on

Not all of the increased demands of these times i s

consciously speculative or based on construction. Whenprosperity approaches , i t gathers strength as it goes on ,gr ipping the entire population down to the wage-earners .The rising prices make money for traders and manufacturers , as well as create opportuni ties for speculators .


The spi ri t of enterpri se and activity is in the air . To thevery crest of the wave the appearance is that business wil lcontinue good indefinitely , with increasing activity andsti l l higher prices . So i t i s that not only the incautious

keep on wi th forward plans,but the sol id manufacturer

and merchant, faced with the alternative o f closing down

until pr ices moderate, find it most d ifficult to curtai l . Justat the top

,orders for goods are characteristically hard to

place, are subj ect to delay, and require premiums for

prompt del ivery. But business must go on . Orders continue to be placed after the limits of safety have been

passed , in the general expectation that the break wil l be

postponed and that in the meantime sti l l higher pricesare pending.

But the special demands are nevertheless essentiallyspeculative , or connected with new enterprise and con

struction. The moment the price level Is doubted or begins

to sag , the speculative demand disappears . The demand

for constructi on stops almost as quickly , for these enterpri ses , too ,

are undertaken on the promise of future pros

pects . There i s then a very sudden lopping off of the

special demands . A l l branches of business are confrontedwith an oversupply

,instead of the overdemand , which

must be mopped up slowly and pain ful ly by the residua l

basic demands .

S i gns by w h i ch B oom s May b e Re c ogn i z ed

Those interested in the hi story and theory of the ri se

and fal l of business wil l find Mitchell’s "Business Cycles"

an i l luminating book of research . An older book , Sir

Robert Giff en ’

s"Stock Exchange Securities—An Essay

on the General Causes of Fluctuations in thei r Price ,publi shed in 1877 , also gives interesting observations

which bear more di rectly than Mi tchell on the problems



Th e B orrow i ngs o f th e B oom Pe r i ods

The special demands which have been re ferred to rest

upon borrowing . periods are times of

increased borrowmg in every form . F i rst , there i s the

financing of construction by bonds ; or in part by flotation

o f stock . Then the ordinary mercanti le borrowing i s

increased . A s money becomes less easy the long- term

financing o f corporate enterpri se turns naturally to the

temporary expedient of notes . Speculators borrow upon

collateral of al l types . Syndicates borrow upon bond andstock i ssues that have proved slow o f distribution . The

trend i s toward an excess of borrowing from the banks .Final ly

,there are bank loans upon undigested securi ties

,

bank loans to finance the needs o f corporations that can

not sell securities,bank loans on collateral bought and

not yet paid for , cal l loans for speculation , and , by no

means an un important factor,bank loans and credits to

merchants and manu facturers to carry the enhanced costo f inventories and enlarged volume o f accounts rece iv

able .In the end a strain i s put upon the mechani sm of

credi t. Bankers , cogni zant o f inflation , begin to takecounsel of prudence and limit thei r accommodati on . Un

der the federal reserve system the putting on of the brakes

i s an elastic process , which in 1920 resulted in an almostcomplete cessation Of buying unti l prices had accom

plished thei r ful l reduction . Former ly the attempt to

reduce loans produced panics,with an immediate and

general crash . In 1907 the bubble broke with the breathof suspicion , di rected at the Knickerbocker Trust Company on account o f i ts loans on S low construction

enterpri se col lateral , and at thi s and other insti tutionsfor thei r speculative loans to insiders . Loans and bank

credit having been di scussed in the preceding chapter,i t


need be said here only that booms end when doubt beginsm . . M Io -u

"" 6

Renewing the:_break_ in prosperity i s a period o f salesN .

to rai se comes after an era of purchases on

gredit w Formerly thi s took the form of scrapping d"bri sand clearing the decks for rebui lding . Now structures

are preserved , as far as possible , but there i s a moregradual eff ort to pay loans" previously contracted , ti). sel loff goods acqui red at high cost , and to complete hal f""fi ii i

‘

shfi

ei

crc'

on

r

-

iStruction . The banks furni sh the cash to carryon , but nevertheless , in place o f demand crowding supply,supply now towers high above demand unti l the processi s completed .

Dep ress ion and Re cove ryThe stress of the liquidation i s over a fter the current

loans have been provided for , or defaulted on , as the casemay be . Sup ply ceases then to be so insi stently pressing .

There fol lows,

a periodtofdepressed business , of nursinglame ducks along , o f windingm corporations

,

and of col lecting accounts and -cost

inventories . It is a time of litt le or no profiuts, whenenterprise i s sick and buyers are slow and timid . Eventually the beaks find themselves with a surplus ofmoney

and a quiet situation,in wh ich

i i

flie'

ylean lend without fear .Then the underconsumption disappears . The bare shelves

of the merchant , the lean inventory o f the manufacturerthe deferred maintenance of the rai lroad , the worn ward

robe of the householder , give an upward.

impulse towardrecovery and

_activity. Final ly , new security issues and

new construction reappear . The consumption demandsmay be repressed for a space , but cannot long remaindormant . The i r reawakening cleans sitliation,

andM

arouses construction demands."

CHAPTER VII

BUSINESS BAROMETERS

B arome t r i c F igu res and Fac ts

Understanding of credit relations i s fundamental , andknowledge of booms and depressions is elementary . I ti s necessary to have

,in addition

,such barometers as are

avai lable to forewarn o f the great changes,and so far

as possible o f the lesser changes .There i s an infinite variety o f barometric figures and

facts , ranging in scope from the most general indications ,di scerned by the expert while sti ll indistinct and far off

,

to the more definite foreshadowings that bear upon a

particular security or group of securi ties . Safety, the

protection in an atmosphere ful l of peri l , depends in

part upon what i s chosen as barometer and how it i sused ; the rest depends upon the strength of the security .

The greatest and most common mistake i s to be unduly

influenced by what has already happened,especially in

the securities markets,and to assume that i t i s an index

of what wi ll happen next .The prepared stati stical barometers are use fu l in the

sense o f placing before the reader a convenient summaryo f recent financial and industrial facts . But they are too

narrow . Conclusions taken from compilers are weaken

ing and sap the power o f independent j udgment . Onedifficulty i s that the forecasters have to forecast ; that

i s thei r trade . But there are times when no forecastShould be made—when doubt should be f rankly acknow l

edged, precautions taken, and the situation waited out.

80

BUS INESS BAROMETERS 8 1

It i s also true that forecasting opinion , as commonly c i rculated,

i s never more dangerous , or more l ikely to bewrong

,than when it i s unanimous . There may be fore

casters and prepared barometers free f rom the contagion

of general opinion . Nevertheless the true investor learnsto look through his own glasses ; forward at what i scoming more intently than back at what has just hap"

pened .

Sou rce s of I n format ion

Original sources of in formation are pre ferable wheretime suffices to follow them . These are , primari ly, thebank statements

,the daily quotations o f prices o f se

curities and commodities , the rates of interest , rediscountand exchange

,the financial news o f dai ly and weekly

j ournals,the annual reports of corporations , and the

statistics of the investment publications . As secondarysources there may be added the monthly B ulletin of the

Federal Reserve Bank of New York , remarkable for the

clarity and scope of its figures and analyses , the F ederalReserve Bulletins i ssued from Washington , the monthlyreviews o f member banks , the reports of the Secretary o fthe Treasury and Comptroller of the Currency

,and the

summaries of foreign financial news given in suchperiodicals as the two London publications

, The S tatis t

and The Economis t. Probably the most in forming of al l

sources , although not always available , are the official orsemiofficial utterances of the Federal Reserve Board

,put

forth for the purpose of acquainting the entire countrywith the current situation , its progress , and its prospects,f rom a banking viewpoint.From these main sources and from others there i s

drawn a great store of stati stics commonly classed asbarometric . Among these may be mentioned the bank


ing detai ls—the redi scounts , loans , deposits , gold hold~ings , note i ssues , clearings, and reserve ratios—the rai lroad earnings and car loadings , building permits , steeltonnage, crop reports , imports and exports , price indices,volume of securities i ssued and volume of trading andrange of prices , the figures o f savings bank deposits

,

employment , and wages . The Stati stical Abstract of theUn ited States summarizes these and simi lar figures year

by year . Current figures are publi shed covering everyphase and form of commercial , industrial , and financial

activities .O f these stati stics the financial figures are more truly

barometric than those relating to trade and industry,

most o f which re fer to the past instead of the future .By in ference only

,as exhibi ting the most recent phase

,

may they be regarded as reveal ing the probable phase nextto follow

,in its due sequence . But they are quite apt

to be confusing because of the overemphasi s placed on

their value as indices o f existing conditions . It i s difficult to read them with the necessary degree o f imagina

tion .

S t e e l an d Pig I ron

Steel , for example , has been held up as the idealbarometer o f business conditions. I t does Show the riseand fal l of the tide . But steel orders are a result andnot a cause of the financial conditions with which theinvestor i s concerned . The Pittsburgh district i s notori

ously wrong in i ts estimate of the business prospects andthe course of the securities markets , the local speculativeenthusiasms reaching their height on steel operations

rather than on the true outlook . Carnegie made most o fhi s historic fortune by going counter to the view o f those

who dwelt too close to the blast furnaces , buying up

BUS INESS BAROMETERS 83

properties cheap when the fires were dead , and selling

out at a time when all of the stacks were in ful l blast .

It i s true that in a sense , and especially during the firstrevival after depression , the incoming of orders for steel ,and the production o f pig i ron , may be barometric andindicative of a widening circle o f activities elsewhere ,until the steel i s made , fabricated , and erected in new

construction . But the interpretation requires perspective .The construction demands , for which much steel i s used ,are those that stop most abruptly , and often earliest,when financing begins to be impeded by scarcity of capital and high rates for lending. Under the most favorable ci rcumstances the indications of the steel industry donot anticipate either the stock market or the bankingfigures .

C rops and th e Crop Repo r ts

The crop reports , in their proper place, are a moresubstantial and useful barometer . Crops are always atr i sk

,the doubt diminishing as harvest time approaches .

The stock market i s influenced by the appraisal and re

appraisal of the crop prospects, and more strongly as the

season wears on . A fter midsummer there i s a directeff ect both on sentiment and on securities prices . Good

harvests have a sustaining influence on business throughthe next s ix months , and have been known , when conditions were suitable , to turn the tide from depression toactivity. The purchasing power of the farmer

,the largest

single element in the population,i s an important factor

in itsel f. The granger rai lroads,and indeed all railroads

,

expect increased earn ings from a bumper crop tonnage.

Unlike most o f the non-financial figures the crop conditionreports are truly barometric for th e investor

,because they

relate wholly to the future and not to the past.


Sy s t emat i c I nqu i ryIn addition to the general and publ i shed stati stics

much may also be learned by systematic inquiry. The

credi t departments and executives of banks have organized methods of keeping themselves in formed

,being

naturally in touch with a large number o f commercialand industrial companies . The heads of all large busi

nesses use such faci lities as are at thei r disposal forlearning the developments aff ecting thei r trade . In

every direction men are to be found with Special knowledge o f thei r own business and o f experienced judgment

on matters within their own observati on . The investor

can thus establi sh personal contact with the progress ofmatters in which he i s interested . Trade conditions

,

politics,prospects for tari ff and tax legislation , the trend

in foreign countries , the dri ft of sentiment at home , thespecial local situations

,the undercurrents that do not find

thei r way into print,can be ascertained by word of

mouth . The di ligent and di scriminating investor maysupplement what he reads and thinks by what he hears

,

unti l the habit i s fully formed o f keeping en rapport

w i th what i s going on .

Us e and Abu s e o f S tat i s t i c s and F igu res

There is a use and an abuse o f barometric stati sticsand figures . Some minds absorb and remember more

easi ly than others . But i t is better for any mind to knowwhat are the sal ient and important facts , to learn those

few facts , and to reason correctly therefrom , than to

weigh itsel f down with a mass o f uni lluminating details,

especially the dead detai l s of events already past. The

detai l and sharp outlines o f the vital facts are necessary ;the rest Should be background , where detai l s are not onlyuseless but destructive o f perspective . The mental proc



without conscious eff ort, with those considered logicalwhen the moving cause was first discerned . The ln

vestor finds himsel f , in the most natural way, watching

the unrol l ing of the scrol l of financial hi story— eager to

see and learn . He can di scover no better arena to "seekthe reason of things" -no broader opportunity to reach

the field with a trained power of j udgment."

Some are born with the gi ft of turn ing in formation

into action ; others must labor to acquire it. Acting uponinsufficient in formation i s a vice, but not more common

or more aimless than the pursuit of in formation withoutaction . Decisions are to be taken with regard to investments . The figures

,the statistics , the barometers , are

aids to making up one’s mind to buy or to sell . They

may be avai led o f in deciding, first, when to .act,second ,

whether to sell or to buy, third , the general type of se

curity to be bought, and , finally , the more specific choice

of securities—even the actual bond or stock.

P r imary Fun c t i on of Baromete rs

The time when to buy or to sell i s at or near the point

o f change , especial ly of the greater changes . To fore

warn of these i s the primary function of barometers,

and by al l odds thei r most difficult. This, thei r most important use

,has already been touched upon in previous

chapters,and wil l be discussed in more detai l in later

pages . The interpretation of current barometric figures

i s always a matter of j udgment—of balancing knownfactors and adding into the scale a guess at the unknown .

In the past financial men have almost always differed inthei r opinions

,even on the verge of the great crises .

Yet the reading o f the figures o f the past also shows

that these greater changes were clearly indicated before

they came ; that the known factors in plain sight o f


everyone’s eyes generally outweighed the unk nown thatwere guessed at in forming opinion . The interpretation

will never be a per fected science ; but by paying attentionto the maj or indications

,particularly those of credit , and

Shutting out the con fusing countercurrent of the lesser

elements,concrete results should be had .

The type of securities to be bought depends uponthe barometric indications in considerable degree . In

times of expansion stocks wil l go up . In the high moneyperiods to which expansion leads , bonds wil l go down.

In the liquidation that follows , the soundest o f shortterm maturities are needed. In the depression long

term bonds may be depended on to rise. One may thenalso pick and choose among stocks , which as a whole ,excepting the cripples, have the ir pronounced rise on the

eve of the business recovery. While the investor can

not afford, l ike the speculator , to commit al l that he hasto his current hypothesis of the probable course o f busi

ness , i t i s sti l l of obvious advantage to him to knowwhere the times are increasing his ri sks and in whatdirection they favor hi s profits . Even where he maintains

,as he should

,the protection of a solid substratum

of bonds and prime securities , and insures against ri sksby diversification of his investment, nevertheless theselimiting factors of safety wil l not annul freedom ofaction in accordance with the barometric outlook.

Th e Sec ondary Fun c t i on

The narrowing down o f the choice o f securities to beinvested in

,and even the picking out o f the actual bond

or stock , i s the secondary function of barometric figures,

and on the whole much the easier function . I t i s not

altogether a conclusion following the maj or premises o ftime and type

,although dependent on them . But a fter;


the hypothesi s o f general business conditions has beenformed , the hypothesi s o f conditions in any one par

ticular business i s something much sharper and more

distinct. There are always plenty of special data apply

ing to . the one business,as soon as the trend of the

general conditions has been arrived at.Following the financial news creates a composite

barometer of the condition and prospects o f the several

great divi sions of enterpri se . The railroads, public uti li ties, steels, coppers , texti les , equipments , and ferti l i zer ,oil, automobile , coal , and other industries , fal l intoseparate compartments

,envisioned as facing separate

problems . According to the state o f business, the in

vestor will think well of one group and poorly o f an

other . To i l lustrate by the broadest grouping, the r ise

i n commodity prices early in 19 19 spelled prosperity for

most industrials,except munitions factories

,and depres

s ion for al l uti l ities and railroads . The divisional

barometer indicates where improvement i s to be ex

pected, and where retrogression .

Crops , for example , may augur well for the northwestern and central western rai lroads . Settlement of a

coal strike, with increasing steel tonnage , may presageincreased earnings for Pennsylvania and Baltimore andOhio comparable to increases previously secured by

New York Central and the transcontinentals f rom a

revival of general business . Wage and rate deci sionsmay affect the prospects of al l rai l roads

,but f rom the

investor ’s standpoint two classes in particular,the

stronger dividend-paying rai l s and weaker roads whose

bond interest had not been too abundantly covered .

Heavy stocks of refined copper , with slack consumption ,may depress

"the issues of the companies producing and

refining copper , and the gradual absorption of these


stocks may bring recovery long in advance of the re

newal of active production . A period of curtailment atdeclining prices may fall sharply upon automobile , tex

ti le,and compan ies produ

'

cing luxuries , which stand tolose both on thei r business and on their inventories . A

period of extravagant spending may bring prodigal wealthto the same companies . Great local speculations in Japan

and in Cuba may send si lk and sugar soaring , and be fol

lowed by col lapses requiring a long time to mend because

unsound conditions have been produced .

E ff e c t o f Ch ange upon I n dus t r i es and Cho i ce of

Secur i t i es

The ramifications and collateral consequences o f anyconsiderable change are great , o ften affecting not one

industry alone but a Chain o f industries , and in the endmore than one group of securities . The important de

velopments are in the current news , coming before the

reader in time to be used in buying or selling securities ,provided the correct deductions are drawn . Some shrewd

investors in stocks prefer to confine themselves to thespecific indications affecting particular securities

,as be

ing more positive than the barometer of general conditions . They are o ften sufficiently wel l in formed on a

group of chosen industries to be able to pick stockso f the best promise. Their protection against generalchanges is not complete, but i s better than it looks because a correct summing up o f the prospects of any one

stock or group of stocks wi ll probably include maj orfactors aff ecting other stocks .In time of depression it i s useful to be able to judge

which group o f industries will be quickest and surest to

revive. I t i s true in a broad sense that all industries andall securities come up together in the ultimate revival o f


activity. Nevertheless there is precedence among them .

Something is to be gained by avoiding industr ies andcompan ies that have come into a bad and unsound position and choosing the securi ties of those that are soundat bottom but have slowed down . Thus in 1920 and

192 1 the steel industry was slowed down to the point

of demoral ization , but the compan ies were sound and very

strong in quick assets . The ferti l i zer and farm imple

ment businesses,on the other hand , conducted on long

credits to farmers , had so much money owed to them

by poor debtors that thei r resuscitation depended on a

deferred ri se in the value o f agricultural products . In

general the raw material industries are worse hit by de

pression than those making finished products ; the prices

of raw materials begin to recover first but the securit ies

of the fin i shed product companies are a more l ikelychoice for early buoyancy. Industries supplying ordinary

consumption make an approach to normal sooner thanthose serving construction . The vigorous ri se in stocks

rests,however , with the awakening o f the latter class o f

industries .I t i s sti l l more use ful to pick out companies that are

in position to resume active business with full power andare in an industrial group considered to be sound . The

large companies publ i sh complete annual reports,and

the prominent bonds and stocks are well known . The

principal i ssues may be compared one with another as toprice, ri sk , and the possibi l ities o f profit . From a general analysi s o f the business Si tuation one may proceed

,

then , to groups o f i ndustry , and from groups to the par

ticular bond or stock . In a similar manner , when pros

perity has been experienced , the runn ing barometer shouldguide the relinqu i shment of securi ties and the avoidance

of r isk.

BUS INESS BAROMETERS 9 1

In selecting securities,by whatever method , the first

and foremost precaution is to make sure that the company itsel f

,into which funds are put , i s solvent and sa fe .

The well-known and standard companies, which followcareful financial policies

,aff ord the investor a wide scope

for decisions and action . The lesser compan ies"

, with

small means o f tiding themselves over difficulties , eitherby bank borrowing or i ssue of securities , are much more

apt to develop individual weaknesses , and when they do,holdings o f their stocks or bonds are unmarketable except at great sacr ifice . "uestions o f dividends or o fabil i ty to pay interest are wont to become suddenly im

minent upon an unfavorable change in business condi

tions,and it i s a sound rule to give these questions a wide

berth.

S tat i s t i ca l S tudy of Ph as es of B us i n e ss

The Harvard University Committee on EconomicResearch i s making a genuine and serious attempt to

apply stati stical methods to the successive phases o f busi

ness progress . By collecting data o f business activities,

and plotting and comparing curves , i t has made a starttoward analyzing the sequence o f events . While sti l l

somewhat occupied with technicalities and preliminaries,

such studies Should ultimately give a clearer insight intothe causes o f change in business and securities .Interesting tentative conclusions have been reached for

the sequence o f events in the cri ses of the period 190 319 14. Securities reached maximum prices "when the ratefor capital was at a minimum"—bonds first and thenstocks . Building permits and New York bank c learingsreached their maxima four months later . Two monthslater pig i ron , outside bank clearings , imports , and orders

o f the United States Steel Corporation reached the top,

9 9 THE ART OF INVESTMENTfl

whi le business fai lures were at a m inimum . Two monthslater rai lroad earnings and commodity prices were at the

peak,bank reserves were at the low , interest rates were

up,and security prices at bottom . Four months later

loans and deposits touched bottom , and bank rates were

at the highest point . The period under review included

the panic o f 1907 , the liquidation of 1903 , and the lesser

reaction o f 19 10 .

The data are incomplete , being for a short period only.

The observations , and the curves that accompany them ,

are o f interest but not intended to be accepted as givingthe exact time and order of precedence . The two impor

tant facts are,first

,that bonds and stocks precede , and ,

second,that the trend of the bank interest rates , it s r i se

or fal l , precedes the other phenomena with regularity ,although its peak or lowest dip may follow them.

Legacy o f t h e W ar

The war and i ts sequel have le ft a legacy of figures

that are barometric in the deepest and widest sense . For

long years they wi ll result f rom time to time in greatchanges in values

,both those of slow evolution and

probably also those of sudden di sturbance. They consti

tute fundamentals o f a new era , i n that great cycle extending f rom war to war that overshadows the norm of

prosperities and depressions . To these basic facts thebarometers of lesser change must be adjusted with duesense o f proportion . While the fi rst years of peace are

replete with unusual opportun ities , i t is also a period demanding alertness , courage , and constructive conservati sm .

Th e Un i t e d S tat es

As for the Uni ted States , the war has le ft , in 1922 ,

a l ittle more than of federal reserve notes



Europe

In Europe the postwar picture i s less favorable . Iti s not only that man-power and wealth have been de

stroyed , that currencies have been debased , that budgetshave not been balanced , and that taxation i s crushing ;there are left unsettled questions o f vital importance—thedi sputes over which may produce cr i ses and the settlemento f which may cause an upli f t that wi ll be felt everywhere.These i ssues , l ike the German reparations , the world loan

to Germany, the collection or remission of debts from our

associates in the war, and the arrangement o f a modusvivendi _w ith Russia or Turkey, loom up f rom a far , become acute , and finally exert a force fu l impact upon thestate of business here as wel l as abroad .

England has recovered her position in international

trade and finance with amazing strength and ski l l . France ,pending the reparations

,has fallen into the error o f spend

ing and not balancing her budget , of taxing too l ightly,

and o f giving too small energy to rebu i lding trade . Itis a people o f strength and endurance , whose test i s sti l lto come. Holland and the Scandinavian countries , which

have passed through rather deep waters i n both industryand banking

,have balanced their budgets and are in posi

tion to work ahead . Germany , with i ts bi l li ons of marks ,and Russia

,with its tr il l ions of rubles , have passed from

budget to printing press . International agreements for

reconstruction may be reached with Germany , and possibly placed in the way of beginning with Russia ; or theymay be postponed . O f the struggl ing new nations inCentral Europe and the Near East i t i s too early to speak .

Some , l ike the Czecho-S lovaks , are working ; others have

hardly done with quarrel s . More certainly even than the

news,the current rates of exchange on these various coun

tries will be barometric of changes present and to come .


The world figures of debt , taxation , governmentalexpenditures

,expansion of bank credits , and inflation o f

currency,evidence the most noteworthy financial upheaval

of history. The readjustments wi ll aff ect our trade andindustry. The loans that have been and wi ll be in sti l l

larger measure called for wi l l affect our finance,draw

down the excess of gold now in reserve here,and tie our

prosperity in with the well-being of European , SouthAmerican , and other countries . We Shall not live entirelyto ourselves . The barometer of affairs here must be read

in terms of the greater civi l and financial changes abroad,

and must sense disturbance , as well as recuperation , fromall quarters o f the globe.

CHAPTER VIII

CORPORATION REPORTS

Known Compan i es and Secur i t i es

The real opportun ities to choose and buy securitiesare non—spectacular

,being among the famil iar and well

tried companies . The surest profits l ie with the upbui lding

and growth of establi shed industries , and the greatest

gain f rom following the incoming and outgoing tides o f

business i s in the old, worn channels . The occasionalinstances o f great profi t from venturing into new anduntried enterprises are the exception . The lure o f

financial adventure is followed at the risk o f loss .

The doctrine of caveat enzptor has been di storted out

of recogn iti on,but covers the seed of a useful truth . The

man who makes money out of his purchases , whether he

buys horses , houses , merchandi se , or securities , i s one who

knows all about what he i s buying . The man who does

not know ends by buying something he does not want‘

and

cannot get rid of . I t i s easy to know a few standardsecurities , whi le i t takes time and work to know a large

l i st of securities ; and i t i s impossible to know the pros

pects and ventures that are j ust being hatched by adver

tis ing and flotation . The error that leads people to buythe unknown is that they have not taken the trouble todiscover that profi ts li e

,also

,in the known .

U nknow n Compan i e s and S e cu r i t i es

Skeptici sm i s not only j ustified but is imperative when

unusual profits are promised in return for a cash payment .

96



devoting energy and prudence to bui lding up thei r busi

ness . I t i s not necessary to j ump into investmentshasti ly. Excitement and artificial pri ces are to beshunned . The temporary movements up and down do

not matter . What i s needed i s buying on values,at a

price where one i s sure he has hi s money’s worth. The

quick turn may be against or with the buyer ; i t cannotbe foretold . But the long pull , i f the securi ty has thevalue

,and the price it i s sell ing at i s moderate

,will be in

his favor .In order to apprai se the value of securities the investor

must be able to analyze annual reports , understand theproblems con fronting corporations

,grasp the progress

made in meeting them,compare the i ssues of one com

pany with those of others,and choose the greater value

for the lesser price . The true reading of the statements

o f account publi shed by companies is the foundation of

corporate investment.

Th re e Ma i n F eatu res o f a Co rpo ra t i on Re por t

A corporation report contains three main features with

the accompanying explanatory matter a balance

sheet, ( 2 ) an income account , and (3 ) a profit and loss

statement.The balance sheet i s a schedule o f assets and l iabil i

ties . The income account i s a record of earnings of the

fi scal year . Profit and loss i s a summary of debits and

credits of special character , pertaining to prior years or

otherwi se di ssociated from actual operations . It includes

occasional ly current items,such as dividends , that are not

stated in the income account .

The fi rst two o f these statements are the more im

portant . The balance sheet shows the company’s engage

ments and the resources i t has to meet them . By com

CORPORATION REPORTS 99

pari son with previous balance sheets i t reveals whetherthe company i s becoming stronger or weaker , what themoneys earned are going into

,and what other money than

earnings has been received from borrowings , i ssue of

stock,reduction of inventories and accounts , or sale of

property. The balance sheet shows whether the company

i s strong or weak in quick assets, clean or clogged in

current liabi l ities,heavi ly or l ightly burdened with funded

debt,and moderately capitali zed with stock , or over

capitalized,i n proportion to i ts business .

The income account , the most widely publi shed of the

statements,shows the results of operations—how much

was earned and how much was paid in dividends on thestock. I t furnishes a very important hal f of the story ,but does not tel l what the earnings have gone into , except

as to interest,dividends

,and appropriations. The earn

ings may be in disposable cash, or may have been applied

to inventories , receivables , or debt , or may be locked up

in new construction . To find what the company i s doingwith its money, balance sheets also must be consulted .

The most useful application of the income account i s in

determining the amount earned that i s applicable to in

tere st and other fixed charges i n proportion to the pay

ments , and the amount earned that i s applicable todividends .The profit and loss account i s in forming chiefly as a

check on income accounts , setting forth the correctionsand alterations made in incomes of previous years . A

substantial surplus in the profit and loss account i s some

times indicative of stock dividends,or some other form

of di sbursement . But more usually the figuring of book

values , or prospects , from the accrued surplus i s o f li ttleor no value. Surplus represents bookkeeping hi story.What is divisible among stockholders stands i n the cur


rent accounts and cash o f the balance sheet ; what maybe given them without divi sion , by means of the stock

dividend,i s to be deduced from the ea rning power Shown

in the income account more di rectly than from the

accrued surplus .

Th e Analy s i s o f Co rpo rate Repor ts

The story of the analysi s o f corporation statementshas been told and retold . Works on accounting andauditing discuss to a certain extent what figures mean .

There are other books of analysi s bearing more broadly

and directly on finances and securities . Among these

Woodlock’

s"Anatomy of a Rai lroad Report" and

Greene ’s "Corporation Finance may be mentioned ' as

short and to the point . To be able to analyze the important facts of a corporation report quickly and surely

,and

to understand thoroughly the significance of figures,i s

basic to knowledge of the values o f securities . No ex

tended exposi tion of method can be given in these pages .In accordance with the general purpose of the book the

discussion wi l l be limited to an outl ine and summary of

the Simplest type of analysi s .

Th e Balan c e Shee t

The balance sheet marshals assets on one side andliabi li ties on the other . Each of these two categories i sdivided into two principal classes

,current and permanent

,

or fixed. While balance sheets diff er in form there are

certain conventional arrangements now generally used

which can be easi ly fol lowed and understood ; rai l roadsand public uti l ities use forms of balance sheets prescribed

by the supervi sory commi ssions . The order o f the assets

i s usually—permanent , current , and deferred . The orderof the l iabi lities is—stock , funded debt , current and de



developed by the earnings . The p roperty may be overvalued or i t may be undervalued . Nowhere in bookkeep

ing i s more latitude permi tted than in the figure set up

for the property account . I t usually represents cost as

measured in terms of the securities i ssued for the acqui

s ition of the plant,together with the cost of subsequent

additions , and does not represent an apprai sed or sale

value . One needs to know the hi story of a company to

understand what the book figures mean—the earnings tounderstand the going-concern value , and the amount of

the physical properties,as compared with similar units

o f other plants,to determine whether there i s inflation .

RE"U IREM ENTS OF THE PROPERTY .—The property

account i s not cash in hand or l iquid assets . Instead , i t

consumes money for additions and equipment , or , i f run

down,for extraordinary replacements and repairs . The

earnings of the property reported as avai lable for thestock must always be viewed in the light o f the requirements of the property i tsel f . Nominal profits and di s

posable cash are not the same .Among the requirements o f the property are the addi

tions to property account. These may be shown separately

on the balance sheet ; or i f not , they can be computed fromprevious balance sheets . They show the consumption o f

cash,f rom whatever source derived

,i n the increment of

the plant. In England additions are capital ized . In theUn ited States a considerable part o f them i s paid f romearnings . Sound practice i s exemplified in the motto o f

the Pennsylvania ,"A dollar for improvements

,a dollar

for dividends." No other course has been safe in a country of rapid growth and severe depressions . Companies

may be ranked,as to both safety and prospects

,by thei r

policy toward ploughing earnings into additions and expenses into maintenance.


I NVESTMEN TS . —The next item of assets i s usuallyinvestments . Some are salable, some not. Investments

range from quick assets to extremely slow assets , and

from the most liquid and positive values to worthless

paper . They may be Liberty Loan bonds or Treasury

notes,available for instant realization , bonds of the cor

poration i tsel f held for a market , or permanent holdings

o f stocks and bonds of subsidiaries , representing the

amount o f cash that has gone into these outside properties .

Losses o f subsidiaries may be concealed in this account ,as wel l as in the "advances to subsidiaries account , asproved to be the case in the historic frauds o f the Atchisonbookkeeping thi rty years ago . The value and nature of

the investments should be looked at . The question shouldbe answered whether they are a cash resource , a permanent asset held for the production of income , or a cashconsuming drain .

RECEIVABLEs .—Accounts and bi lls receivable should

,of

course,represent collectible items

,in volume proportioned

to the amount and kind o f business done . Excessivereceivables , or unexplained increase , bring suspicion of

inabil ity to collect . Failure to write off for slow and baddebts hides losses and piles up a dead asset . The proportion between earnings

, or sales , and receivables Shouldindicate an active turnover of collections , according to theterms and nature of the business .

INVENTORI Es .—Inventories should be priced at cost or

market , whichever is lower . NO profi t should be takenunti l i t i s earned . NO loss should be unrecognized .

Volume depends on the times and upon the kind o f business done , usually bearing a rough , normal ratio to the

annual sales . The inventory o f product has all to be sold,

and sometimes an idea can be formed o f what i s going to

happen to the company by seeing how big i t i s . Railroads


and uti l ities ca rry relatively small inventori es—consumption inventori es O f materials

,supplies

,and fuel .

Manu factu ring and trading companies carry larger inventories , mostly production inventor i es of raw materials

,

semifin ished, and finished goods .Industrials with seasonal purchase o f raw material

,or

sale o f fini shed product, of wh ich there are many , carry

heavier inventories at one time of year than at another .The annual report may be so timed as to Show the low

po int o f inventories and of borrowings . Industrials o f

l ong manu facturing processes naturally keep larger in

ventories than those o f short processes . Much the same

distinction should be drawn as with the accounts receiv

able,where some industries sel l for cash or on short

date whi le others,as in the farm implement trade

,cus

tomarily allow very long credits . What i s normal to thebusiness Should be considered . I f the management i s to

earn money it should keep its investment in inventories ,as in everything else, fai rly active and tu rning over

reasonably well .Where there have been great downward changes in

the general price level,one should make sure that the

inventory has been thoroughly written down . I f there

has been an upward change , i t i s equally important toknow that the inventory has not been written up andpaper profits credi ted to income—to make su re that theexpectation of profits f rom bettered conditions i s aheadand not behind . Industrials suff ered inventory losses inamounts running into the millions o f dollars in 1920 ; some

recovered part of thi s loss in the subsequent sales,but

with most the question reduced itsel f to sell ing inventori es at pr ices less than cost . There is always a price

risk in the producer’s and trader’s inventory . That is a

leading reason why the condition of industrial and trading



patterns , hand tools , j igs , dies , and the like as permanentassets ; more conservative companies charge these special

appl iances to the close o f the fi rst operations in which they

are employed .

TRU E STATEM ENTS—Increases and decreases in theseveral classes o f assets are always in forming . Analysisusual ly discloses the character o f the management . The

most important thing about the statement o f assets,and

in fact about the balance Sheet in general,i s to know that

i t tel ls the truth . The statements o f the larger companies

are certified to by independent auditors . The th ing nextin importance i s that the statement Should be clear andunderstandable . I tems o f doubt ful meaning are also

i tems o f doubt fu l value . I tems of concealment,such as

occur in the complicated statements o f a certain type o fholding companies

,are items o f suspicion .

L iab i l i t i es

STOCK , BONDS, AND NOTES .—On the l iabi l ities side

o f the balance sheet the fi rst i tem is stock,divided into i ts

classes,and the second item is funded debt

,or bonds .

These,together with note issues

,are the securities of in

vestment . Being o f the fi rst importance,they require a

separate chapter. In discussing them as balance sheeti tems it should again be observed that the stock i s not a

debt , has no due date , and does not requi re to be paid off

unless the company is dissolved . The bonds are longterm debts with due dates

,and unti l they mature nothing

is due but the interest , and , i f so nominated in the bond ,3 sinking fund .

Notes and bi l ls payable are Short-term liabi l ities withan early due date . The outstanding fact i s that they mustbe paid . They may also be

,and o ften are

,renewed or

re funded . Sometimes , as between affil iated companies ,


they are to be construed as standing and permanent loans .

In the ordinary course o f business , companies should

clean up thei r loans from time to time ; i f the type o f

business i s one that is customari ly carried by the banks on

secured loans,the companies should at least preserve an

ample ratio of quick assets to quick liabi l i ties .PAYABLEs .

—Pay- rol ls and accounts payable representthe ordinary bi lls of the business . No company , however

wealthy,i s ever quite f ree of them . Pay-rolls accrue be

tween pay-days,and accounts payable be fore vouchers

can be audited and paid . Strong companies are promptpay with thei r accounts . They take advantage o f cashdiscounts . Compan ies running behind show it first in theslowness with which they pay bills . When the accountspayable have run up too high

,there is a note or bond

issue,or perhaps insolvency . The i tem i s especially

symptomatic o f weakness,s ince an excessive amount o f

current bills i s expensive because cash discounts are nottaken

,and therefore indicates poor credit at the bank .

Nevertheless there is no universal gauge o f the prope r

volume of the accounts payable . I t varies with the busi

ness and with conditions .Rai lroads and util ities may make seasonal purchases o f

ties or rai ls for the spring and summer replacements,or

they may be buying material for a major improvement or

extension ; otherwise thei r accounts for fuel , lumber , andother supplies are fai rly regu lar and cover the needs o fa month or two at the most . Pay-rolls cannot be al lowed

to run , unless the company is in desperate straits , and thenormal figure i s approximately a two weeks ’ accrual o fwages . Open accounts payable

,i f larger than usual

,are

usual ly reflected in the inventory on the opposite s ide o f

the balance sheet , unless the company has been running behind or has incurred capital expenditures not yet financed .


With the industrials and trading companies the ac

counts payable are on a diff erent basi s . Every trade hasits own usage in extending time on purchases . Com

panie s that extend credi ts to their customers and thus

carry large accounts receivable may,i n turn

,lean on

thei r own sources o f supply for credit and have cor

respondingly large accounts payable . Thus,the cotton

factors are o ften,in eff ect

,financed by their mill s . Cer

tain other lines of business rely upon bank loans . But

the strongest and best industries provide themselves with

sufficient working capital to pay up the bulk of the normalrequi rements .

TRUE AND CERT IF IED STATEM ENTS—Liabi lities areto be regarded f rom a diff erent viewpoint from assets .

With the assets the question i s what are they worth .

They are good only to the extent they are realizable and

available . The l iabi l ities , on the other hand , are good , as

against the business,for 100 cents on the dollar . The

question i s not what they are worth,but whether any

have been omitted,including contingent l iabi l ities . Here

again the auditor ’s certificate is helpful . The analysisof liabil ities should reach far into financial condition ,policies , and manner of payment , while that of assets

should go into values .NET CU RREN T ASSETS .

—By net current assets i s

meant the excess of current assets over current l iabi l ities .The figure i s not so important with rai lroads and public

uti lities , possessed o f great fixed assets and with nothing

on the shelves to sell,although even thi s class o f com

panics should have enough net current assets to do business with . But the industrials and trading companiescarry in thi s figure a main essential of their business . I trepresents working capital

,the margin o f sa fety for bank

borrowing , and the available resource for protection of


1 10 THE ART OF INVESTMENT

ing o f a book surp lus of magnificent size upon the divi~

dend pol icy i s a question of what i t means ; it may have

arisen from mere bookkeeping in marking up the plant

account,or i t may have been bui lt up out of current

earnings . A watered surplus i s o f no especial value. An

earned surplus means something. I t at least shows the

ploughing of earnings into the business . In the end i t

may mean a stock dividend to compensate stockholdersfor the ploughed- in earnings . The payment o f stock

dividends i s,nevertheless , more a matter of current earn

ing power than o f accrued su rplus , the declaration o f such

dividends being designed primari ly to increase the annual

cash disbursement to stockholders without increasing the

rate,and at the same time to cut a melon"without sub

j ecting the beneficiaries to punitive taxes . The methodhas been fol lowed , legit imately, by companies whose pros

perity has proved excessive in proportion to their capi

talization . I t has been followed more questionably by

companies interested in sell ing thei r temporary pros

perity to the stock market . Most strong companies arecontent to keep a substantial surplus and to confine divi

dends to regular cash payments .

I n come Acc oun t

The second of the corporate statements , the income

account,shows sales or revenues, the operating expenses

or costs o f doing business , the taxes , and the balance of

net earnings remaining after these deductions . I t shows,

then,the interest Charges, dividends , appropr iations , and

surplus . Thus the income account gives first the results

of the business , and second the use made o f those resultsby the company. I t i s becoming increasingly customary

to publish detai led periodical statements o f income .

A l l income accounts were d istorted during the war

CORPORATION REPORTS I I I

period . Vo lume was inflated during the four years 19 16

1920 ,became subnormal in 1920

- 192 1 , and i s recoveringto normal in 1922 . Price and cost level s were fan

tastically high unti l the co l lapse, and are sti l l passing

through long processes of readjustment. Many industrial

concerns made money out of high prices on business ex

traneous to their regu lar field , created by the specialdemands of war and speculation ; afterwards they lost

money on lack o f business, low prices , and inventories

of high cost, and have now returned to the endeavor to

make money on their normal business . Rai lroads lost

money on expenses during the inflation and are now re

covering lost ground because rates were not reducedviolently when prices collapsed and because traffic hasreturned .

I t i s thus a time o f more than usual difficulty inj udging values from the recent record o f earnings .There was an upheaval

,with after-effects . In order to

or ient one’s V i ew ,the pre-war earn ings must be taken

into account as evidence o f the establi shed basis of the

business , and the net current assets as evidence o f thepresent abi l ity o f the company to do its customary busi

ness . W i th any company the figures for a period of five

to ten years should be taken and the record observed asa whole with respect to progress

,continuity and fluctua

t ions , the amount kept in the business , and the amounts

paid to security-holders. I t should be especially noted

whether the war exigencies have forced a company toenlarge i ts capitalization , or to i ssue bonds or notes . Newi ssues were o ften made for war expansions or to paydebts in order to keep afloat

,and not for the purpose o f

producing new earnings . The carrying charges of thenew securities are in these ca ses to be considered as aprobable deduction from the o ld earnings .


SALES OR GRoss REVENUES—Turning to the detail so f the income account , the sales or gross revenues represent the money volume of the business done . A healthybusiness grows ; a business lacking in vigor stands sti ll ,or shrinks . I t i s so difficult to cut down expenses to fi t

a reduced business that the usual result of a minor fal l

ing away in gross i s a maj or fal ling away in net. Fal ling

behind competitors ends in a struggle to keep al ive. The

records of the last few years are abnormal both as toquanti ties and prices . To determine whether a business

i s going ahead or fall ing back one should look at othercompan ies and longer records .EXPEN SES .

—Expenses include two main classesthose o f doing the business and those o f maintaining the

plant. Good management is economical in the first and

l iberal in the second . Success ful companies spend money

for what they do carefully, methodical ly, and without

waste . These are also the compani es that keep toolssharp for work

,replace old machinery and equipment

with what is efficient , economical , and modern , and setmaintenance be fore dividends . Companies on the road

to fai lure yield to the temptation to make a showing by

undermaintaining their plants . In the end the costs o f

doing business run up according as the plants have run

down . When the situation i s faced , there are arrears ofmaintenance to be made up , money to be provided forimprovements and rehabi l itation , and , i f not outright dis

aster,there is at least an era o f struggle and no profi ts .

The culmination of neglect of plant i s usually sudden

a Shock to unobservant fol lowers of dividends .

Units of compari son for Operating expenses have beenevolved for rai l roads , uti li ties , and some of the larger in

dustrials . The stati stics of operation publi shed in the annual reports o f the former are very fu ll , showing work



up in reserve , but only later when the reserve is used .

Thus there i s considerable paper depreciation both with

rai lroads and industrials in the shape of unexpended

credits to reserve . I t i s the cash that counts in the phys

ical condition .

TAXEs .—Next a fter the expenses come the taxes.

The present federal tax law has done away with the"invested capital"that was the x of the former tax equa

tion. A fai r guess can be made whether the provi sionfor current taxes i s sufficient. The government tax audit

being four years behind, there are sti l l Occasional sur

prises from time to time on back taxes,as in the case o f

Crucible Steel and Kansas City Southern. I t i s impossible to determine f rom the annual reports whether man

agements actual ly set up , and paid , for the war period the

ful l taxes that the government wi ll require o f them . Butthere is l ittle danger with a reputable management and

reliable auditors . What danger may exist l ies with com

pan ies of boom earnings from 19 18 to 1920 , which earned

a high percentage upon thei r stock . A s a rule taxes are

truly and care ful ly stated . Increases in local taxation

are a menace to some railroads, and are an i tem to bewatched . The federal taxation has been too heavy and

is sti l l a burden upon the vitali ty o f business. Taxation

has become one o f the larger factors in estimating thefuture of both companies and securities .

NET INCOME—The net income after the expensesand taxes are paid belongs to the company and i s ap

plicable to the securities and the interest payments,and

to the bu i lding up o f the business . The financial strengthand the policies o f management are revealed in the disposition made of thi s income . F i rst , the interest payments on both funded and un funded debt shou ld be easilycarried

,with enough le ft over for protection in bad years.

CORPORATION REPORTS 1 I 5

Second , the dividend payments shou ld be wel l within thecompany’s means . Third , there should be a substantial

margin above these two payments , applied to the growth

of the business . The main point in running over income

accounts,and a very essential matter with balance sheets ,

i s to determine whether the company i s getting stronger

or weaker . Useful decis ions as to the safety of interest

and the probabi l ities with respect to dividends must bemade long in advance

,before the market has made its

final appraisal .D ividend payments are voluntary, whi le interest pay

ments,once the debt has been incurred, are compulsory.

Companies heavi ly laden with charges, or too rashly

weakened by dividends,lack buoyancy against storms .

The future,the chie f consideration with al l foresighted

management,i s then insufficiently provided for , and

danger i s courted . I t is also a fact o f importance to the

investor that the stock of a company that de fers dividends

and devotes earnings to bu i lding up i s fai rly certain toappreciate in market price , while no stocks are moreproductive o f losses and dangerous than those payingsteady dividends on too narrow margins.

Resource s and Th e i r D i spos i t ion

A simple statement of "Resources and Their Di spo

s ition may be prepared f rom the balance sheets o f the

beginning and end of a period to Show where the money

has come from and where i t has gone . At- the le ft of the

statement , under"Resources ,

"are li sted the increases in

liabi l ities and decreases in assets . At the right, under"D i sposition of Resources

,

"are tabu lated the decreases in

liabi li ties and increases in assets . Thi s statement may be

use fully amplified by making an inset o f the aggregateincome and profit and loss accounts for the years covered ,


to show how the increase or"

decrease in surplus and re

serves was derived .

The table of"Resources and Thei r D i sposition i s a

searching analysi s— elementary but of great power . One

side of it presents the picture of the proceeds of opera

tion , merchandi sing , and financing ; the other exhibits the

uses to which these proceeds have been put . The table

wi ll Show companies of apparently ample earnings be

coming reduced and in debt because conditions of growth ,for example

,have not been met with financial common

sense and clear vi sion ; or wi ll show thri ft , the clearing

up o f encumbrances , and preparation for better days bycompanies of reduced incomes in hard times . I t demon

strates what problems have been met and how .

S to ry To ld by F igures

The story told by figures i s interesting , fascinating ,when dug out in the concrete case to reveal the truth . It

i s infinitely broadening,not only because i t tells more than

gets into print,but because i t i s a first point of entry for

the continual eff ort at understanding , at assimi lation"by

which "minds stretch in accordance with the study undertaken

,principles are absorbed to the extent o f becoming

the basi s of deci sions ." Figures in the abstract , or with

out i l lumination , are h eavy , dead , and stupefying. En

l ivened by application,they become the best aid to

developing brains and learning to think .



processes may be consecutive and increment cumulative .

NO investment i s absolutely free from risk . There i s

always the unknown . It i s only a short time since the

Great War shook the foundations of the civi li zed world

and government bonds themselves rested on victory for

security. But there are degrees of r i sk that a prudent

man considers , and there are ways of guarding against the

ri sk that exi sts . "The best commanded armies have l ived

and marched in the unknown,i t was inevitable ; but they

have resi sted that dangerous condition , they have comeout victori ous

,by depending on protection which has

enabled them to l ive without danger in an atmosphere fullo f peri l .

Va lues , and th e U s e s of th e Marke t

In defense and in attack the art of i nvestment impl iesthe employment O f elementary principles based on values

rather than upon the technique of the market . The mar

ket cannot, to be sure , be ignored . I t i s there that prices

are made,and securities are bought and sold . To know

a great deal about the market is useful , especially i f one

knows the most important matter , and that is to regardi t from far off and not become enmeshed in trying to

solve i ts problems . To follow the market by active trading almost invariably results in small profits interspersed

with losses , and in missing the large profits that comefrom holding on to securi ties for the ultimate value ."Beating the market"i s hard , a task attractive to men of

bri ll iant abi li ties because i t i s hard , but also a task thathas sucked in and wasted many use ful careers . The in

vestor who buys on values for the long pul l does not

need to "beat" the market. Sooner or later the market

wi ll help him .

What the investor needs to know about the market i s

THE LINES OF DEFEN SE AND ATTACK 1 19

not what the speculator needs to know . The maxims of

specu lation,such as to let a profit run and cut a loss , are

o ften revealing and informing , but do not general ly fi t

into the investor’s longer View . The l ines o f accumu lation and distribution that serve as indices to many speculators may be casually interesting to the investor but are

not hi s mainstay. The rate at which stocks are lending

for short sales , the double tops , the gossip o f who i s sel ling and who buying

,the rumors and tips that are digni fied

by the name o f"inside in formation,

"are not his stock-in

trade.

In the abstract the investor needs to know only twothings—the value o f hi s security and the price at which i ti s selling. In the concrete he needs to know more , but sti l lalong S imple l ines . Value i s a fter al l an expression o fj udgment based upon past prices and upon the compara

tive prices o f similar things . The investor Should bethoroughly posted on quotations and market levels . HeShould understand the hi story o f prices , know the meaning o f the price presently put upon hi s securities by the

market , and be able to j udge for himsel f whether thatprice i s high or i s low. He should have respect for themarket and not fight i t. But he Should also have respectfor hi s own sense o f values

,acting on it when in hi s j udg

ment the market prices have swung too high or too low .

Thi s i s reasonably simple i f he but refuses to concernhimsel f with what the market i s going to do next. It i s

the endeavor to call the turns and follow the short swings

that nullifies i nvestment processes and turns them intothose o f speculation .

P r in c i p les of Inve s tm en t B ased on Va lues

I t i s not easy to formulate the principles of investment

that are based on values. The exper ienced investors have


each thei r own creed or set o f pr inciples in which theybelieve. The most effective o f these practically are o ften

the most deficient theoretical ly, because based on the vividimpress of some personal experience, l imited but never

the less workable because clung to and worked out. But

principles may be set down which are based on the belie fthat consecutiveness of increment i s not to be secured

solely by taking interest on prime mortgage bonds,but

may also be obtained,and with more profit

,by a di scern

ing shi fting of investment f rom time to time , and bystudying the opportunities. There i s an i rregular rotation ,or cycle of investment values, diff erent from the busi

ness cycle although dependent on i t , that may be employedto secure consecutiveness o f increment

,including at times

an appreciation of principal that i s as certain as the

interest on a bond . The appreciation i s not perhaps as

certain for everyone. Anyone can read the p lain English

on a bond ; but not everyone can read the plainest facts

of business and of the market . These principles are based

upon the rotation o f values and upon investment for thelong pull .

1 . The fi rst principle i s that business wi ll come back .

It wi ll neither remain depressed nor exalted .

2 . The second principle i s that security prices are

finally governed by the course of business and the relatedchanges in credits . The extremes o f high and low in

stocks are di splays internal to the market , and are i ronedout after a time by stronger external forces . It is only

in a limited sense that the stock market forecasts business .The beginnings of stock market movements are much more

o ften due to the real trend o f future business than toany design or eff ort to l i f t prices . The ends o f market

movements, the height and depth o f speculation , almost

invar iably over-run the real trend of business and go



able very cheap,on the simple i f daring theory that the

rai lroads had the value o f a necessity and that they wouldeither come back to normal earnings of themselves , or

else the government would have to take them over . During the formative period o f the country a well-knownpractice of Engli sh investors

,versed in American rai ls ,

was to buy ten or twelve diff erent kinds of rai lroad stocks

selling for a few dollars a share a fter a panic . A thirdor a hal f of the roads might go into the hands of receivers ,but the profit on the rest would more than pay for those

that dropped out . Thi s i l lustration of insuring against

ri sk by diversification i s not intended as advice , because

buying "cats and dogs" i s always dangerous and specu

lative. But i t serves to bring out the point in question .

There are times of greater and times o f less ri sks , and

there are ways of analyzing and appraising ri sks and of

protecting against them . For most people , and at most

times , the simple principle o f sticking to investment in

solid , progressive companies and first-class securities i s by

far the best ; and of avoiding the dangerous attempt toincrease income by purchasing securities o f extra high

yield . I t i s quite common for investors to run a dispro

portionate ri sk as to principal , which i s all that they have

for the sake o f an inconsequential increase i n income ,f rom holding in ferior bonds and stocks .

.4. The fourth principle of investment i s that that typeof securities shou ld be chosen which best suits the purposeof the investor . He Should have a defin i te obj ect in m ind

and choose a fi t security of a fi t company. The investor

has to run hi s investments l ike any business undertaking .

I f he has al l of his money in stocks , which are a proper

investment in their place and time , he has subj ected himsel f unreservedly to the maj or ri sks of the unexpected

Changes in markets and conditions . Like the speculator,

THE LINES OF DEFEN SE AND ATTACK 123

he wi ll go on wel l enough as long as the market is ri sing ;but when it becomes depressed he is , at the very best ,reduced to quiescence and Inactivity. The i nvestor should

have a cash reserve , so that i f there i s a slump in securityprices he can go into action and buy cheap , instead o f

being put out o f action by being loaded up with securitiesthat have depreciated . He also should have a solid substratum of bonds or notes

,long bonds i f bonds are cheap ,

short bonds or notes i f bonds are high . T hese securities

should be diversified and strong , so that they may bringhim assured income through any depression and be avai lable for realizing cash at need

,or to buy other securities

at low prices.Men vary in thei r investment requirements . The

striking fact about the estates of the great investors of

recent years i s the high proportion of stocks they held .

Under the sur face is usually the equally important fact

that these men had the ski l l and forethought to provide

themselves with cash for buying these stocks in growing

companies when stocks were down . For the ordinary

investor the main point i s that he should not ti e up hi s

cash so that he cannot seize opportunities . He shouldalso not put hi s income at ri sk . I f he goes into stocks ,the investment should be within hi s means and should bemade when the stocks are cheap and the ri sk i s smaller .But i f he i s paying attention to the business of investment ,he may at times properly put a certain -proportion of histotal capital into stocks

,bearing in mind thei r higher ri sks

and greater chances of profit.

5. The fi fth principle of investment i s that the value

and the price o f a security are to be weighed and the ri sko f loss set over against the chance o f profit. At the pricepaid the ri sk should be less than the Chance of profit . I ti s no uncommon mistake to take maj or r isks for minor


profits both with bonds and with stocks . The real ski lland discernment o f investment exhibit themselves nowheremore than in appraising ri sks . I f i t can be discovered

when and where ri sks have been exaggerated in the lowness o f price

,the maj or profit fo llows as a natural

coro l lary .

To cite two i l lustrations , the bond markets of early1908 and late 192 1 aff orded very sa fe opportunities for

great profits to those who had cash or credi t and understood the bond business . They could buy prime gi lt-edged

bonds at the lowest prices for years , bearing coupons that

would more than pay bank interest on loans to cover the

cost. Thus they had,in the first place

,a prime gi lt-edged

investment that more than carried itsel f,an unusual de

s ideratum, and , in the second place , i f the precedents o fsimi lar occasions in the past were to be relied on

,they

had an investment that would Shortly appreciate in price .Bonds were strong all through the year 1908 ,

ri sing nearly10 points on the average . The uprush o f 15 to 18 points

in standard bonds,beginning with the autumn o f 192 1 ,

i s too recent to need recall ing to mind . Bonds were low

on these two occasions for many reasons but perhaps most

o f al l because r i sks were exaggerated in the mind of the

general investing public . There i s a depressing mental

paralysi s after the occurrence of calamity, high interest

rates,lack of funds

,and long months o f liquidating sales

,

so that fears remain after thei r cause has been swept

away.

As hopes revived in 1922 there came also the oppor

tunities for profits in stocks , which had likewise beenextremely depressed . The first-grade bonds recovered the

bulk of thei r gain fi rst,the second-grade bonds next , and

the stocks took a longer time. For some time a fter the

great bond r ise it was evident that the best investment



take opportunities as he sees them,governing himsel f by

the long-distance viewH i s methods are simpler and surer than those o f the

speculator who holds on for the top of the r ise, en

deavors to buy at the bottom , fol lows stocks booked for

immediate and quick action in the market, or tries to getin on the ground floor or lower stories of some excep

tional enterpri se. The business of investment does notdepend on any of such money-making accidents

,the

search for which i s rather to be avoided . Instead it fol

lows rational and understandable lines o f thought and

action .

7. The seventh principle of investment, the most genera"and underlying all others , i s that the investor mustknow all the elements of his investment—the company

,

the security,the stage of business and o f market prices

,

and the outlook for credit and banking . He must under

stand . Where he knows, he can invest . Where he does

not know, he i s only speculating. I t i s not the function

of this book to impart a detailed knowledge of securities .The main sources o f in formation have been indicated .

Real ly to know any security requ i res solid work ; to havewide knowledge of securi ties requires a great deal of

work—simple but abundant work . Such knowledge i s the

basi s o f sound investment .

Th e Tren d o f th e T imes

These are , and wi ll be , unusual times . The first and

most difficult deflation of bank credits and commodity

prices f rom the recent dangerous , speculative inflation

has been wel l accompli shed almost everywhere around theworld . I t was a pain ful process . Commodity prices

are now resting at the hal f -way mark—something over

50 per cent above the pre—war level , but incomes, except


wages , have not on the average moved up to the same level .

Some elements of inflation sti l l remain—the waste and extravagance of governments , the tremendous borrowingthat has been going on ,

the high wages in favored in

dustries , the high retail prices , and the heavy taxes we

are requi red to pay.

Besides these elements there i s in many quarters ,short-sighted but political ly power fu l , a desire to re inflate .

Farmers want their burdens l i fted by great liberal ity of

the federal reserve banks—to carry their crops and putgrain prices up—as wel l as by loans f rom the Farm LoanBoard and aid f rom the War F inance Corporation .

Labor, on rai lroads and in the coal mines, wants govern

ment backing in keeping its wages up . Manufacturers

desire a tari ff ; rai lroads need supported rates . This i s

natural . Deflation means , in general , gradually reducedexpenses ; inflation means , for many, increased

'

income . I t

i s not altogether selfishness that aligns many groups on the

side of fiat money , or flat credit , or fiat wages . There i s a

real pinch o f hard times and insufficient income during

the maladjusted business that follows deflation,while

costs of l iving are sti l l high . There i s ignorance of

economic laws which has , for nearly fi fty years,kept the

fiat i ssue to the forefront in pol itics as a cure-al l for

poverty and lack of money. But more than all else,and

this i s the poison in the pot, there i s the widespread feel

ing that those who have made money by war- time speculation , by the longer processes of investment

, or bycontroll ing banks or other large business enterpri ses

,have

not been honest or scrupulous .This feeling i s due largely to misunderstanding of

the part played by brains and work in making money ;but it exists . I t i s at no time devoid of political influence .I t has , i f not kept down by common sense, the power


to start the country on a wrong course. Inflation theor ieshave appeared

,and have been fol lowed to a conclus i on In

the countries suff ering under the strain of defeat . Forthis one cannot blame men so much as the political pres

sure to al leviate misery and meet necess ities by i ssue of

paper : One or two of the hardest pressed among the

Victorious nations in Europe have yielded to a l imiteddegree to the same pressure . In thi s country there will

be attempts at special,or class

,re inflations

,the force of

which wil l depend a great deal upon ci rcumstances—thecourse o f business and the degree o f discontent.

I rregu lar Adj us tmen ts

Speaking generally,i t i s bel ieved that we are in a

peri od of i rregu larly decl ining prices and wages . From

the precedents of former great wars thi s may endure for

a period o f years . But even i f undisturbed by re infla

tion,the decline i s and wi l l be i rregular . Prices o f some

commodities have already been down to pre-war figures .

Others have not moved . Retai l prices , rents , and cost of

fuel have yielded only moderately. The general decline

i s now stayed by resumption of business activity , and wi l l

be resumed when business becomes poor again . During

al l such periods business may recover vigorously for atime

,but i ts permanent solidity is conditioned upon a

natural , and not artificial , level o f prices having beenfinally reached .

There i s thus , along with the general improvementalready experienced

,a period o f many currents and cross

currents . There may be points of transition—sharp anddifficult . The expenses of business and the prices receivedfor product wil l change from time to time and makerather more diff erence than usual in the annual returns

o f corporations . There will be ups and downs in vo lume



as being high enough . I t may be quite a wait be fore pricesbegin to come back . I t requi res patience . I f stead fast

,

one will get better than interest for the period o f waiting.

2 . The second line o f defense i s to have seasoned and

well-distributed securiti es , with a broad market and capa

ble o f instant sale . A mistake admits then of quick re

treat . Sudden news , altering the outlook , Can be metimmediately.

The unli sted or specialty stocks, especial ly those i n

control o f one dominant interest , and bonds quoted only

by thei r sponsors , which are not standard i ssues over every

bond counter,have no such market . These i ssues are

tempting because of thei r higher yield , but they deprive

investors o f initiative,when conditions change , because o f

the difficulty O f sel ling them . The holder finds himsel f

locked into the s ituation of the compan ies that i ssued

them . He cannot raise cash upon these securities in time

of unsettlement , except at great sacrifice . Thus hi s re

sources are rendered immobile,whether for defense or

attack . By pre ferring income to marketabi l ity he has

made himsel f the prey of circumstance .3 . The thi rd l ine o f defense i s to have , so far as pos

sible,only such securities as are worth holding through

a decl ine . Enough of these‘

to assure a fai r return

through good times and bad should be income-bearing . I t

i s not always possible to avoid being caught in a decl ine.The investor who has securities that will wear through ,wi th income coming in , may feel discomfiture at lowprices but does not need to worry.

Some investors indeed , who have bought cheap the securitie s o f companies they believe in , pre fer to hold on

through declines and take no chances of being faced

with a higher price when they come to buy the securities

back . Th i s is, w i thin its sphere , a sound method of in


vestment,productive o f results over a period of years .

I t i s an inactive method but, at that , pre ferable to too

great activity.

4. The fourth line of defense i s to buy outright, or

i f borrowing,to borrow so moderately upon strong col

lateral that the loan can under no circumstances wipe out

the equity .

As in all l ines of business more speed can be madewith borrowing than without . But the ri sk i s increased .

Borrowing i s safer at some times than at others . Those

who borrow wisely lighten ship or lade it according

to Ci rcumstances . One difficulty with borrowing is that

the j ettisoning o f cargo to save the ship i s pain ful , and

quite apt to be postponed instead of being faced . Aloan eats up the owner ’s equity in declining markets just

as rapidly as it increases the equity when markets areri sing . Another difficulty with loans i s that i t i s notalways possible to arrange with the lender to maintain the

loan for more than a fixed period, say , of s ix months . In

case money gets tight so that the loan is not renewed,

that is preci sely the most inconvenient time for the borrower to pay. A call loan is sti ll more dangerous because the payment may be asked at any time, and is l ikely

to be when a slump appears in the market .No phase o f investment activity demands more judg

ment and prudence than borrowing . A sound plan i snot to borrow at al l unti l assured experience has been

gained , and then to borrow only at long intervals , when

investment issues are to be had below values and bankmoney is relaxing.

L in es o f At tack

1 . The fi rst l ine of attack in investments i s accrual

of income . Money doubles in fourteen years at 5 per


cent , i n twelve years at 6'

per cent , and in ten years at

7 per cent, assuming the income to be reinvested at thesame rate . A thousand dollars a year for forty years invested at 6 per cent wil l amount to Income is

a primary force working in the investor ’s favor . In these

days of high investment yields it i s a very potent force .I f

,as usual ly happens when bonds are cheap

,and

sometimes when they are high , the lending rate on money

i s less than the interest yield of the security, income

may be increased by borrowing. Thus i f one—hal f o f thecost o f a bond yielding 6 per cent be borrowed at 4per cent

,the rate o f return on the other hal f

,the actual

investment, i s increased to 8 per cent . One can be confident, also , that i f the carrying rate stays low, and the

bond is sound , the pr ice o f the bond wil l eventually r i se,adding profi t to income .

2 . The second l ine o f attack i s appreciation o f pr in

cipal through knowledge o f corporations and their se

curities . Thus a forty-year 5 per cent bond bought on a6 per cent basi s at 85 might be resold in five years on a

4% per cent basis at 109 , i f i ts position had improvedin the meantime by its becoming an underlying issue

,

or i ts strength had improved because of earnings . In

this instance the appreciation wou ld be practically equalto the interest . The wise investor i s always looking forchances o f appreciation in hi s solid bonds, but is usually

content with a much smaller swing than that ci ted in

the i llustration . The best opportunities are with the new

bonds o f well- reorganized companies , with convertibles ,and more broadly

,with bonds of companies of increasing

financial strength .

With stocks the buying for appreciation i s perhapsmore generally known . Stock of a sound company,with dividend prospects , may be bought cheap in



strengthening receiverships and drastic reorganizations .The only difficu lty then lies in '

having the faith , vision ,and patience required to hold securities through a period

o f dri ft and doubt unti l the brighter day of assured earn

ings and market recognition i s at hand . These Oppor

tunities come from time to time. Many see them,and

pass them by for the few that take advantage of thembecause they are already fully invested . The Opportunity

knocks for those who have cash, or can sell securities

that have not depreciated .

3. The thi rd line o f attack i s appreciation of prin

cipal through knowledge of general financial conditions .In part this blends with the appreciation through knowl

edge Of corporations and thei r securi ties ; in part' i t i s

di stinct . In every cycle f rom depression to prosperity

there i s a sweeping change upwards in stock prices . There

i s an advance in bond prices that begins a fter the wave

o f prosperity has broken and carries through the phase

o f depression and cheap money . To carry over from

the time when stocks and bonds are palpably high to the

point where sa fe bonds are Obviously cheap, there are

Treasury notes and other secure short- term investmentsto put funds in , which produce income and avert the depreciation o f principal

,to which al l other securities are

subj ect .This cycle of security values , con forming to the cur

rents Of the cycle of business , may be fol lowed for the

purpose O f securing continuous income and a sufficiently

consecutive appreciation Of principal without incurring

the greater r i sks . I t i s not, perhaps , so simple to followthe cycle as might appear . In the long space of the

greater cycle o f business securities,prices have move

ments not directly related to the business cycle . I t i s

also a matter o f j udgment to gauge the business cycle

THE LINES OF DEFENSE AND ATTACK 135

i tsel f . The shi fting values Of the di fferent type s ofsecurities may be followed nevertheless, not closely, to besure

,but sti ll positively and productively.

Even with one-class investment , stocks excepted because of their natural ri sks , much may be done by the

shi ft from long-term to short-term bonds , and vice versa.

The usual fate O f investments in bonds is to dri f t inertly

with the current. Over the space of the last twentyyears thi s meant going down with the current. For a

time,beginning with 192 1 , i t meant going up with the

stream ; but as soon as the excessive borrowings and

business revival bring fi rmer money rates there will again

be a turn in bond prices . Bond swings are long. The

turning points and the factors upon which j udgment may

be based wil l be di scussed in a separate chapter . A s always the trends o f long swings are not hard to see

,but

the point of change i s much harder . I t is easier and surerto work from very simple considerations o f high pricesand low prices for bonds

,and in fact for al l securities

,

with Observation o f banking conditions and o f the em

ployment o f money in new flotations, i n stock marketactivities, and in business .

Appre c iat i on of P r in c i pal

Appreciation Of principal , to such extent as the investor may safely seek it, tends to double the compoundinterest that ari ses f rom reinvested income . Apprecia

tion sharpens and strengthens the weapon O f attack . I fit were not difficu lt to follow without constant eff ort the

strong tides of affairs , the pi l ing up o f large fortunes

through investment wou ld be a commonplace . Such ac

cumulation of wealth i s not inf requent . The bu i lding upof independence , through thri ft

‘

and the knowledge of

one or another form of investment , is to be found in


every community. Some few know what things areworth , and consequent ly accumulate money .

Barga i ns

The war and the waste fol lowing consumed the sur

plus capital O f the world and lef t an outlook ful l o fdangers and uncertainties . Investments were eaten up

by taxes, impaired by the maladjustments a fter so great

an upheaval , and subj ected to risks that were basic andgrave . There were , therefore, exceptional bargains to behad ; there have been most unusual opportuni ties , the

extreme low price of sol id investments having been an

outstanding feature of the times . A s in every era o fdistress and widespread losses , those who had cultivated

the trading and investing instinct laid the foundation for

their greatest profits , whi le those who had fol lowed specu

lative proclivities during the preceding fictitious and arti

ficial prosperity , were fortunate i f they escaped the net ofgeneral ruin . Such conditions of di stress and doubt arewel l recognized as the mother of great fortunes .The fi rst Rothschi ld bought Briti sh consols be fore the

Battle o f Water loo,not knowing how the battle would

go,but knowing that consols were cheap, and cheap be

cause neither he nor anyone else knew the outcome ofthe battle . The same courage to set one

’

s course against

the prevai l ing despair has within the past two years

resulted in substantial additions to investment , in someinstances doubl ing

,trebl ing

,or multiplying the value .

While the fi rst forceful recovery o f investment valuesi s now past

,there sti l l remain opportunities . The ‘

up

swing due to renewed ease of money is not , at this

writing,yet complete . Later there wi ll be pauses and

recessions due to i rregulari ties o f business , and there w i l l

be new opportunities to buy .



the faith that both the business o f the company and themarket for the securities wil l return to normal . With

reorgan i zations brought out in time of improving busi

ness conditions,the recovery may be surpris ingly prompt .

I f general conditions are poor , there may be a period

o f dragging at low levels, or even of decline below the

reorganization prices,because the new securities are

orphan i ssues,forced upon Old holders who have neither

money nor enthusiasm . But eventual ly,a fter the dri ft

toward selling has exhausted itsel f , business has turned ,and the reorganized company has demonstrated that i t i s

clean and sound,the securities take thei r right ful place .

The fruit ful experience O f the railroad reorganiza

tion era O f the C lose o f the last century i s in process o fbeing repeated . I t i s not on the same scale because lead

ing companies have not gone under ; but where there i s

a real business to be reorganized , i t follows the same

course . There i s the same buying of salvage after the

wreck—the same purchasing of sound investments at

prices below value. I f anything, the opportunities go to

the public more than in former days , because leading men

of wealth have been forced by taxation to confine them

selves largely to tax-exempt government, municipal , andstate Obligations . The corporation i ssues must seek a

wider and more scattered market , thei r higher yields andgreater possibil ities going now to men of lesser wealth

and lower surtaxes .

R i sks and Lo ss es

The lines o f attack are not more important than those

of defense . Much has been said of potential profits , andi t should be repeated that there are potential ri sks andlosses that must be guarded against . Not too much should

be ventured on any single investment, or on any positive

THE LINES OF DEFEN SE AND ATTACK 139

theory of the course o f business and o f pr ices . Ri sks

may be reduced by dissemination , and by being moderate

and not too active .But mere diversification of investment, so Often advo

cated, i s not a panacea against ri sk . An English book

wr i tten some years ago urging geographical diversification

showed greater safety and larger profi t from investmenti n government bonds around the wor ld than in British

home securi ties,over the period 1896 to 1908, but since

then one-thi rd of the foreign l i st i s in defaul t andlargely worthless

,another third is depreciated and doubt

ful,and the final third is not to be compared in qual ity

with the solid Briti sh securities . D iversification shouldnot go further than knowledge and understanding o f the

securi ty itsel f . While one cannot perhaps go as far asCarnegie’s dictum to "put all your eggs in one basketand then watch that basket ,

"i t i s evident that there i s no

common sense in spreading investment over diff erentthings just because they are diff erent . A l l true invest‘

ment rests upon values and upon abili ty to foresee risksas well as profi ts . The writer’s leaning

,especially in

these times , i s toward nearby baskets that can be watched

with unrelenting vigi lance—such diversification as the investor can afford and considers wise to Off set individualr isks . The real and greater ri sks are those o f unsoundpr inciples , o f taking improper chances for a possibleprofit, rather than those of unforeseen contingencies suddenly altering the character o f a standard investment.

CHAPTER X

THE COURSE OF THE STOCK MARKET

Th e Th re e Movemen ts

The stock market i s l ike the sea—always in motion,

with waves,ground-swells, and tides . The bond market

i s l ike sheltered waters , with smaller waves and moderated

tides .

Stocks have maj or , or primary , movements , lasting,say, f rom

‘

One to four years , secondary movements running for a few weeks , or possIbly months , and day—today fluctuations . These movements proceed concurrently

,

and each i s subj ect to change. In addition , prices o f

individual stocks are subj ect to movements o f their own .

As a consequence,the real direction o f the market , posi

tive and simple enough in retrospect , appears at any one

time complex and confused .

The primary movement i s the most important ; the

secondary i s of much lesser importance ; and the day- today fluctuations are incidental and of sign ificance only tospeculators . The largest of the primary movements are,

inter- related with the great cycle f rom depression to pros

perity and from prosperity to depression .

Maj o r Movem en t D ependen t on th e B us i n e s s Cy c l e

In pre-war days the striking feature O f the business

cycle was the banking cri si s that broke the tide of

prosperity. Under a banking system o f inelastic creditsuch crises recurred periodically, although at no exact

intervals , but fo l lowing the typical strain of prosperity

140



intermediate fluctuations. The successive ri ses and dec lines were not continuous between the points taken . The

table shows the reaction o f the stock market to the great

sweep o f the business cycle. I t also shows that the swin’

gS

o f the market are shorter than the cycle. In fact , they

12 INDUSTRIALSTOct. 12 ,

’

96

Sept. 19 ,’

02

Nov. 9 ,’

03

Jan . 19 ,’

06Nov. 15,

’

07Nov. 19 ,

’

09July 30 ,

’

I4Dec. 24,

’14

Nov. 2 1,’16

Dec. 19 ,’I 7

Nov. 3 ,’19

Aug . 24,’

2 1

Sept. 1 1 ,’

22

These dates do not represent top or bottom of swings. The fi rst i s forth e clos ing of the stock exchange on the outbreak of th e war , and th e othermerely i s g iven to br ing the table substant ia l ly down to date.

1The S tock Exchange was c losed from Ju ly to the midd le of December , 301 9 14. Upon resumpt ion of trading th e pr ice record for industr ia l stocks wascont inued with twen ty instead of twelve i ssues.

usually last much less than hal f the time of the cycle,

theW

p

’

eriOd‘

s

"

o f"

deci sive movement centering on

' f

the

moments o f overstimu lation and the crises o f depression,

much o f the time between being consumed in indecisivefluctuations .

Se condary Movemen ts

The secondary movements are sometimes o f consid

crable si ze, so that they con fuse for a t ime the trend o fthe major movement . They are of very minor importance

for the investor , who can i l l aff ord to waste time or

r i sk money in trying to guess the turn . They are notstages Of the great primary movement , but independent

20 RAILROADSOct. 12

,

’

96Sept. 9 ,

’

02

Sept. 28,

’

03

Jan . 22,

’

06Nov. 2 1 ,

’

07Aug. 14,

’

09Ju ly 30,

’

14Dec. 24,

’

14Oct. 4,

’

16

Dec. 19 ,’

17Nov. 9 ,

’

18June 20

,

’

2 1

Sept. 1 1,

’

22

THE COURSE OF THE STOCK MARKET 143

swings within that movement , except that, of Course, theusual rally a fter a drop in a bear market and the reactiona fter a towering rise in a bull market are corollaries o f

what has gone before . A i ypical secondary swing i s usu

ally short—a month toW eeks at the outside , and o ften

less . It runs from 5 to 10 points, 535 311135? more. A

rally in a bear market i s o ften from one-third to one

hal f o f the preceding sharp decline.There i s no fixed schedule of periodicity for the sec

ondary movements . They come and go . But secondary

rises have occurred twice a year , suffi ciently o ften to beremarked in January or early spring , and again in

late summer or early fall . The points of greatest ease inbank credits come after the turn of the year and in the

dull season o f midsummer . The greatest strain on banks

i s in the late fall and the fi rst winter months , when the

crops are being moved and interior cities withdraw fundsle ft on cal l in New York . Funds avai lable for investment f rom the dividends and coupons O f January 1 and

July 1 have a tendency to strengthen the market. The

crop prospects become an important factor f rom Auguston . Thus from the yearly cycle of crops , money condi

tions, and funds for reinvestment, there is a condition

tending to promote or favor a certain degree of periodicity for the secondary movements .Nevertheless the movements.

are i rregular and uncer

tain . They cannot be counted on . The y occur every

year in almost ceaseless succession . They come at othei'

fimes than those mentioned above and for other reasons .The minor swings are Often faint, and are sometimesobliterated when in progress by a stronger mani festationof an active maj or movement . They may sometimes be

guessed at , from crops or other indications , but as a rule

they should be Observed only to be passed by.


Da i ly F luc tuat i ons

The dai ly fluctuations , the l ittle waves that are thethi rd movement of the market, are of interest to tradersscalping eighths on the floor . The alert mind that skims

these small quick profi ts from the sur face i s not sui tedto the slower , more thoughtful processes o f investment.Usual ly the traders do not know the value or the meri ts

of the stocks they are in and out of they do not need

to know . They do not have to have their feet on the

ground in order to swim in a sea o f quotations . The

dai ly fluctuations, which often move with considerableforce , represent the eddies o f speculation and the ephem

eral eff ects of i tems of news . For al l investment pur

poses they are to be disregarded . To pay attention to

them is fatal . The investor who sel ls for trifl ing imme

diate profits wi ll get nowhere .

Th eo ry o f S to ck P r i ces

I t i s , o f course , not the function of a book deal ingwith investments to set forth the theory of stock prices ,a subj ect most efficiently handled by Charles H . Dow

twenty years ago . Nevertheless it i s necessary to de

scribe briefly what takes place in the speculative markets.

While investors must by no means let themselves be

drawn into the trap of f ollowing the market instead of

values,i t i s most essential for them to have a clear con

cept of the cold,dispassionate way in which the market ,

at i ts best,appraises values ; and it i s of interest and

profit for them to know the surest o f the maj or signs

given by the market—those most widely accepted by theinitiated .

The great movements of the market, and to some

extent the lesser movements , conform to cycles o f buSI

ness and credit. But there i s always visible, even in



more intermittent in attacks than the bul l , the general

result i s the same—the movement in either di rectiongathers momentum from its own inner forces , as well

as f rom the fact that i t attracts followers .

There i s a thi rd principle of speculation , very gen

eral in principle although usually given exaggerated im

portance . This is that pro fessional speculators , in pools

or singly as Operators , will endeavor to s it in the driver ’s

seat,f rom time to time , and direct the mechani sm . It i s

a simple mechani sm,capable of manipulation in detai l

,as

in the case O f the famous Amalgamated Copper episode ,the notorious Stutz corner , and numberless pools ; but too

massive to be moved as a whole . Manipulation in the

Open market is l imited in scope and extent. I t cannot go

against the main stream . I t may anticipate and stimulate

movements , but cannot cause them . Nevertheless it

exi sts .

B u l l and B ear Marke ts

The bull market begins slowly,creeps gradual ly up

,

and gathers headway a fter i t has risen 5 or 10 po ints .I t swings on into days of large trading and higher prices .Eventually i t passes into a realm of fevered unreality

,

of excited dealings , and fictitious appraisals of value . I t

sinks then with great swi ftness , rebounds part way fromthe first fal l , and Sinks again to sti l l lower levels .The bear market , the long swing downward that i s

thus ushered In , 15 often characteri zed by a series of

slumps , with partial rallies , and intervening periods o f

comparative quiescence or of gently r ising prices . The

slumps are sudden and apparently without reason . At theend there are usually days of tremendous activity and of

slaughtered prices . I t i s typical that sore spots that have

produced the acute trouble shou ld come to l ight at this


juncture,in the shape of failures , or the taking over

by bankers o f the holdings o f embarrassed plungers .A fter a sharp rebound from the bottom , the speculative

force becomes exhausted and passive . There i s then dull,

quiet trading and general depression .

Thus both bull and bear markets go to extremesto posi tions beyond the discounting of values . In the

end,however

,they produce their own correctives . I t i s

impossible that speculation on margin should continue tocarry prices in one direction without meeting a fter a

time a more power ful counter speculation in the oppositedirection . In spite O f the momentum of stock movements

there i s a sel f-created weakness that becomes most imminent at the very po int o f the greatest d isplay o f

strength .

Th e L im i ts

Bull markets are dependent on loans . These havethei r l imit. When prices become unsafely high , or money

tightens, lenders di scriminate between collateral and ask

for wider margins . More real money i s required to keep

the market going. Manipulation appears in order to eu

courage public buying and conceal private sel l ing . Bear

drives are attempted . To maintain prices requ i res more

cash from bulls who can no longer borrow on increasedmargins . In this situation the wiser and stronger have

already sold . The crowd that remains has become

overextended—long o f stocks and short o f cash .

Bear raids break prices . The machinery o f decl inecomes into operation with great power . Additional margins are called for to protect loans . Some speculators

respond and some do not . Loans are therefore calledand stock i s sold ; frightened bulls sel l to prevent margins from crumbling and loans f rom being called . The


selling induces new decl ines, a repetition of the demand

for margin,and fresh sales . In place of having more and

more cash to work with , the bulls have less and less . The

position slides into collapse .

The bear market reaches its l imit and finds itsel f pow

erle ss in a somewhat different way. There i s the same

machinery of margins but not the same curtai lment of

excessive bank loans . I t i s usual ly felt also that whenstocks have dropped far below values , the investment

absorption and the buying by bargain hunters , capitali sts ,and bankers have a more potent influence than the selling of investments at or near the top of the ri se . A fter

a time bear movements meet genuine buying on values .But the most important fact is that the bears themselves

must buy in order to close their trades . TOO much com

pany on the Short side means , there fore , that the positionby being overdone has become exposed to and ripe for abull attack . Bears are j ustly a fraid of their fellows

,

knowing that there are certain to be purchases that wil lusurp the place of sales . When prices harden

,the cov

ering o f shorts i s wont to assume the form of a panicky

rush,which ral l ies the whole market sharply and sud

denly .

Bear operations succeed when they make other people

sell . A fter this phase i s past , they not only fai l to

depress prices but are a recognized protection against

further decline . While "long"stock i s being sold,prices

swing downward , below true values . When thi s i s ove r

and it proves to be "short ,"

or borrowed , stock that i sbeing sold , i t i s the bears themselves who are due to beharried . The wary take cover . The stubborn

,fewer in

proportion than the bulls when the market i s at the top,

O ften back thei r pride of opinion by a futi le and costly

attempt to hammer prices that are already down.



see that the most specu lative stocks are a buzz-saw , dan

gerous to trifle with . Money has been made out of thesestocks

,but those who have made and kept it have not

endeavored to follow the fluctuati ons. Money has also

been lost in these stocks . In a general way what i s true

o f these extreme cases i s also true Of all speculation .

I t is a dangerous business . The ski ll o f the expert specu

lator directs i tsel f to making mistakes cost less than theprofit of being right, i f that is possible ; i t rests also to

some extent on values and conditions . He has no fore

knowledge .

S imp l e Ob s e rva t i on and Deduc t i on

For the investor the simplest Observations and deductions regarding market movements are most effective .He should know when speculation has become intense and

active , and when it has died away . He shou ld know whenprices are high and when they are low . To perceive the

psychology of the market , to Observe i ts trend , and to

understand the reasons for its overappreciations and

underdepreciations of value, will stand him in good stead .

In so far as he uses the market he should take counselof patience , wait out the declines , and not try for the

very top Of the rises . There will be occasional bargain

days . But in general , to paraphrase an old saying, he

shou ld buy a little late and sell a l ittle early . Valueschange . They have no determined level . That is what

makes speculation and requires , equally , a watch ful alert

ness in investment. When,for example

,values have

moved up on easy money a fter a depression , but are not

yet resting on fully restored business activity, there i s an

obvious uncertainty . There have been instances o f a false

start a fter a depression cri si s,when business sinks back

into dullness and the permanent values of everything but


fixed interest investments do not mater ialize for a year ortwo longer . But in general , the market prices follow

values—move with and not against conditions . Theyswing too far, but swing back towards

’

normal .

The beginn ings Of market movements are nearly a l

ways right in thei r trend , giving advance notice o f pros

perity or adversity before general business is aff ected .

The cu lminations o f market movements are always wrong ,in the sense that they are , f rom the very nature of thespeculative mechanism,

too extreme.The investor may learn much from the market. To

be sober and clear about the market level is an invaluableasset . The appraisal of values under changing conditionsmust be cultivated . The habit must be formed Of sitting

as a court Of independent review on prices,aloof f rom the

enthusiasms and pe ssimisms o f the market place itsel f .

CHAPTER XI

THE COURSE OF THE BOND MARKET

P r i ce Movemen ts

Bonds are aff ected by the great cycle o f prosperity. and

depressIon , but less sharply than stocks and in a,some

what diff erent manner. They are also aff ected moderately

by the minor movements of business , especial ly when these

represent change in credit conditi ons . Bonds have also

theIr'

Own slow fluctuations , and occasional_ly _fairly bri sk

movements ; but they~

are practically immune from the

dai ly ups and downs o f stocks, except , of course , bonds

that happen for one reason or another to have assumed a

Speculative character .There are many diff erences between bonds and stocks.

In the market the great diff erence i s that the former are

owned outright,as permanent investments

,while the lat

ter are carried on margin as a speculation . There are im

portant exceptions . An increasingly large amount o f

stocks is held for investment . There are bond i ssues that

are speculated in. But the diff erentiation i s essentially

correct .It fol lows that bond prices are not subj ect to the power

ful influences of margin speculation that produce the ex

tremes in stock prices . They are more di rectly subj ectto fundamentals o f the business cycle , o f credit , interest

rates , of commodity price levels , and o f the supply Of

investment money as compared with the volume Of newi ssues Off ered for sale .There is no schedule o f bond pr ices qu ite comparable

152



This table gives the main turning points in ful l-faced

type ; al so , as bond prices are not so well known as stock

prices,some of the minor changes and fluctuations in

years O f hesitation . The price changes , whi le not incon

siderable , are much less than i n stocks .The influence of the Baring fai lure i s Shown in 1890 .

Low prices continue unti l the S lump of August,1893 , at

the height of the panic of that year . There i s an im

mediate recovery by Apri l , 1894, to better than the pre

pan i c level . From this point bonds pass on through thesemipanic conditions of 1896 with little recession , and

f rom time to time through higher prices . Beginning withthe latter part of that year , and all through 1897 , they

Show consistent strength . Each year i s upward , withminor fluctuations

,unti l 1902 , the point of maximum

prices .Beginn ing wi th Apri l , 1902 , Six months in advance

of any deci s ive turn in stocks , bonds begin a steady march

THE COURSE OF THE BOND MARKET 155

down to the low point Of August , 1903 , where they turnupwards two months be fore stocks . The move to a newhigh in August

,1905, i s unbroken . The downward march

begins again the latter part o f that year (before thehighest prices are reached by stocks ) , and is un inter

rupted all through 1906 and unti l November , 1907. Re

covery begins with December , and there i s an advance eachmonth unti l February , 1909 . A fter staying at the high

levels for a few months,bonds sell OE moderately in 19 10 ,

after which they di splay no marked tendencies unti l 19 13,when lower levels are ushered in . These continued with

moderate ups and downs , unti l the entrance o f the United

States into the war in 19 17, when there was an immediate

and severe decl ine .The forty-bond table

,running from 19 15 to 1922 ,

rests

upon ten highest grade rai ls , ten second-grade rai ls , tenindustrials , and ten public uti li tie s . The movements o f thecombined average are as fol lows :

40 BONDS , PRICED ON 4 PER CENT BASIS19 19 June

Dec.

1920 Jan .

May

192 1 Jan.

1922 July

A concurrence with the preceding table would be mostnearly shown in the prices of the ten highest grade rai l

road bonds alone , which start at in Apri l, 19 15, are

at in December , 19 18 ,drop to in May , 1920 ,

and again drop to in June, 192 1 , and rise to

in July, 1922 .


RANGE OF PRICES OF STANDARDPrev ious

Bond H igh Price1 51: Liberty Loan 3 } Aug. 1 9 1 83 rd Liberty Loan 4 4 Issued at par4th Liberty Loan 4 } Issued at parVictory Loan Issued at parNew York C ity 4 '

s 1 9 59 . . Apr. 1 909

Atch ison Genera l 4 3 , Jan . 1 9 06

New York Central Ref.

Imp . 45's , 20 13 Jan . 1 9 1 7

Penn sy lv an i a C on so l idat ed4

’

s 1 948 Oct . 1 9 08

C . B . ". Nebraska Ext .

4'

,s 1 9 27 . Feb . 1 906

Un ited States Stee l Sin kingFund 5 '

s , 1 963 . Aug . 1 909

Like the previously cited tables o f averages thi s tableof specific prices Shows the trend ; but with exceptions .Only three of the bonds were outstanding as long agoas 1906, when highest prices were reached . O f these

three the Steel sinkers"reached thei r high price in 1909 ,

due to the improving position O f the corporation . For the

same reason , and also because the sinking fund , for which

they are drawn at 1 10,came into Operation since 1907,

these bonds were 10 points lower in the cri si s of 1907 than

during 1920 - 192 1 . But the story i s the same as that o f the

averages . Bonds sank beginn ing with the entrance o f

the Un i ted States into the war , recovered briefly at thearmi stice

,sank practically al l through the inflation o f

19 19 ,and then sti l l more profoundly when in 1920 the

deflationary consequences commenced to materiali ze inthe Shape o f higher federal reserve redi scount rates . The

great recovery began before the reduction of the federal

reserve rates,but started after the open-market rates for

loans had gone down and a fter the ri se of the reserve

ratio f rom 40 per cent o f notes and deposits to 60 percent had made it plainly apparent that the redi scount rate

would follow suit .The striking features o f the war period in these three

tables are the extent of the decline f rom 19 17 to the lows

BOND INVESTMENTS

0

PriceLow Price July 2 5 , 19 22

Jun e 1 9 2 1Dec. 1 9 20

May 1 9 20May 1 9 20June 1 9 2 1May 1 9 20

May 1 9 20

Ju ly 1 9 20 9 3 5 0

May 1 9 20Dec. 1 9 20



into the teeth o f high money, supporting for some time

formidable rates on ca l l loans . On the other hand,bond

prices r i se forcefully, without much regard for the business outlook, when interest rates are low ,

money i s easy,

and there i s absence of borrowing for enterpri se. Within

the Space o f the two tables given above , such ri se has occurred in the latter part of 1893 and early part o f 1894,

from August , 1896, through 1897 , i n the latter part of

1903 , in 1908 , and in the second hal f o f 192 1 , runninginto 1922 . I t has been rightly sa id that as low com

modity prices are a concomitant of depression and of the

pi ling up o f money in the banks , one could tel l howlow a nation’s commodities had sunk by seeing how high

its bonds had risen . Thi s i s a graphic way of expressing

the apparent antithesi s between bond prices and business

conditions . The fact i s , however , that bond prices areamong the most rel iable indices of business conditions .But the conditions they indicate are some distance ahead

a shorter di stance on the fal l and a longer distance on

the r i se .

W h a t Make s th e P r i ce—Pas t H is t o ryBonds are a class of security paying a uni form and

determined rate of income regardless o f business conditions. The ruling rate of interest on long-term money

and the element of chance or ri sk attaching to the bond

itsel f are the main factors determining i ts price .

F i fteen to twenty years ago the ruling rate o f interest

fel l to 4 and even to 3% per cent. Rai lroad bonds of

savings bank class sold at par , or better , bearing these

rates of interest. A few i ssues were even put out at 3per cent . I t was thought at that time that rates would

go sti l l lower,a fter the classic example of the Bri tish

consols .

THE COURSE OF THE BOND MARKET 1 59

For a generation , practically since the h i stori c

sale made by Jay Cooke in the Civi l War o f United

States government bonds bearing per cent interest ,the rate commanded by bond money had been gradually

declining.

But the event proved that these extreme low rateswere but the sequel o f the long business depress ion o f thenineties . As activity revived again , i t produced a cumulative demand for capital . For this reason , mainly, the

rate o f interest on investment money began to r ise and the

price of bonds to decline . Other auxi liary reasons havebeen urged , such as the inflation of gold by the productionof the Transvaal

,the consumption of capital in the South

A frican War , and the destruction o f capital in the SanFranci sco earthquake. But the first reason given i s themore weighty. A heavy shrinkage from the high prices

of 190 1- 1905 followed in the subsequent period , with all

investments paying a fixed or settled rate of return .

While the decline was not rapid enough to off set the enti reinterest , there were nevertheless severely felt market losses

in long-term bonds in the decade preceding the Great War .Such bondho lders as had to reali ze thei r investments ex

perienced a depreciation .

Th e Eff ec t o f th e W ar on B on d P r i ces

The Great War produced in accentuated degree theinvestment conditions of other wars . The English experience in thi s respect i s summari zed in H i rst’s "PoliticalEconomy of War ." There were inflations , destructionsof capital

,and new flotations of loans , beyond all previous

measure. While the peoples o f the entire world weredrawn into bond investment as never be fore

,the supply

of new bonds outstripped the absorbing power . The bor

rowings continued after the war , and , as is usual , the most


pro found eff ect upon investments and upon banking con

ditions came a fter the war activities were over . The

activities sustain enterpri se and common stocks that rest on

enterpri se. A fterwards , when other means have fai led ,i nvestments must be used to rai se desperately needed

cash . Bonds , pre ferred stocks , and common stocks payingestabli shed rates of dividends , were plunged to lower andsti l l lower levels of price. The war and its sequel exhibited

in greatly intensified form the same phases of the progress

through overactivity to depression as are Shown in the

peace-time cycle .The ruling rate of interest on seasoned and well

secured corporate bonds rose during the postwar strain

to 5, 6, and 7 per cent. Tax- f ree Liberty Loans yieldedbetter than 4% per cent and Liberty Loan bonds partlyexempt from taxes f rom 5 to nearly 6 per cent . A l l newfinancing required a high rate

,f rom 7 per cent for the

most conservative up to 8 and even 9 per cent for theless conservative i ssues . The second-grade rai lroad bondsand some industrial i ssues returned yields of more than

I O per cent .Bond yields in July, 1922 ,

were,using very general

terms , substantially 2 per cent lower than in July,192 1 ,

and the prices of the longer maturi ties were, say ,

1 5to 18 per cent higher . While following the analogy o f

former recoveries , i t may be that yields wi l l become even

lower and prices somewhat higher , i t i s al so evident that

the fi rst great uprush has carried the standard bonds

through the maj or part of the total ri se f rom depression .

I t was a violent uprush,fol lowed by great flotations , by

excessive construction of dwellings and other bui ldingsat home

,and by harassing uncertainties abroad . At the

moment of writing bonds o f the fi rst grade have receded

moderately from the levels of the initial recovery.



are claiming their day in the market , passing through thefami liar cycle by which they become too high . Finally

the questions of cash and of confidence wi l l reappear .

Val u e o f B ond F igures

Figures for bonds have been given quite f reely, not

with the idea of setting the framework o f a chart or patentindicator , but because they are sign ificant and much less

generally known than they should be . The writer i s not

in favor of applying too much mathematics , or stati s

tical method,to facts whose real analysis depends upon

common sense . The artificially manufactured barometers

re ferred to in a previous chapter ‘are,to use a simi le ,

playing chess with a poker deck . The uncertainties of

business are due,first to one new factor , and then to

another becoming imminent and dominating . The best

forecasting i s done by watching the changes and trends ,selecting the one or two most important factors , and e limi

nating the rest . Among these factors the trend of bonds ,the trend of bank reserves , the trend of redi scounts andrates on S ix months ’ paper

,have been most f requently

and continuously the essentials .

B ond Inve s tmen t—Th e I n s t i tu t i on sThe relative ri sks o f seasoned bonds are always closely

appraised in the market . The strongest and most conservative i ssues may be recogn i zed from the price . The red

flag of danger i s vi sible in a price so low that the yieldi s excessively high .

Bonds are graded and classified by thei r quotations .Underlying , or prior mortgage , bonds sell higher than

junior bonds o f the same rai l road bearing the same rateof interest . The bonds o f a strong rai lroad are on a

different basis f rom those of a weaker system . Indus

THE COURSE OF THE BOND MARKET 163

trial bonds sell on a separate scale o f prices and foreign

bonds on sti ll another .

The heavy investors in bonds are the savings banks ,the insurance compan ies

,numberless estates , and individ

nals of wealth . The institutions , and the underwriters

and bond houses that supply them , have a most discrimi

nating j udgment as to the relative ri sks . They make the

price,determine the yield

,and establi sh the character of

the market for bonds suitable for institutional or trustee

investment .I t i s the business of the savings banks and insurance

companies to buy bOndS . They must invest funds

safely to yield income . The stream of thei r investmentcontinues

,even in time of uncertainty or when the prices

o f all bonds are due to go down . The institutions may not ,perhaps , buy as actively , but from their very size and im

mobi li ty they cannot sel l en bloc when con fronted with a

bad situation . Savings banks,for example

,were permit

ted by law to carry depreciated rai lroad bonds at cost ,and even to buy additional rai lroad bonds that had fai ledto keep within the original savings bank requ i rements

because o f lapsed dividends . It i s outside o f the canonsof trust fund investment to buy for appreci ation , and i t i slargely outside of insti tutional practice to sell in order

to avert depreciation . The institutions pick and choosewith great ski l l , and at times exchange one i ssue for another . But they must

,to a large extent

,stay in bond

investments from force o f ci rcumstances .

B ond Inves tmen t for th e Indiv idual

There i s also much that is heavy and inert in the bondinvestments of individuals . Like the traditional Bostonand Maine , and New Haven stocks for the fami ly funds o f

New England , an investment i s o ften followed through


force of habit by others than trustees . Bonds are notwatched after being bought. The income i s considered

secure and no attempt is made to gain appreciation or to

avert depreciation o f principal . This i s unsound invest

ment because it i s asleep—and o ften doubly unsoundbecause it seeks high income . I f investment for appreciat ion results in safeguarding income and watching all the

chances aff ecting principal , i t i s sa fer than the lethargic

investment for income only. It has the great advantage

o f being ful ly awake .The active investor has the advantage of mobility

o f buying or re fraining from buying when or where he

will . H i s field o f action i s o f the broadest. He may

establ i sh hi s own standards of sa fety, and not only exer

cise the highest di scrimination between bonds , but also

an independent judgment as to fundamentals . The real

sa fety of the investor in bonds lies in constantly knowing

the facts,watching governments , corporations , and the

possibi li ties o f the bond market,and running away from

risks as they appea r . I t i s far f rom enough to buy safe"

bonds . They must be kept sa fe . Effort and intelligencemust be exerci sed . I f bonds are so bought and held

, ap

preciation o f principal Should fol low , in due course , as anatural consequence o f the care and attention given them .

The safety of the income should be increased rather than

lessened by seeking , along proper and reasonable lines ,sa fety. and appreciation in market price .Investment in bonds depends upon j udgment of values

as affected by the strongest and deepest currents of finance .No form of investment offers more scope for the "con

tinual effort at understanding , at assimilation ,"or for the

absorption o f principles . I f ful ly understood and fully

labored with , no form o f investment offers a surer profit .



specia l knowledge or investigation can naturally not becovered .

The omi tted li st includes the i ssues o f lumber andi rrigation companies , o f al l smal l companies , of specialtyand holding companies , of companies not publi shing full

annual reports , of construction enterpri ses , o f patent pro

motions and other speculative undertakings , o f all -o i l well s ,gold mines , and exploration proj ects . Even real estate ,whose investment principles have been most clearly presented in Ri chard M. Hurd ’s book , i s excluded—becausewhoever buys or takes a mortgage must first look at the

property in person or by agents . Real estate bonds as a

class , except where guaranteed by a strong and conserva

tive institution , rest too much on faith and are subj ect to

the danger of over lending upon unknown securi ty. Many

foreign bonds are also considered to be beyond the line ,as i t i s impossible for most investors to follow the ci rcumstance s , solvency , politics , or moral s o f the i ssuinggovernments . Thi s l ine o f cleavage fol lows that broad

investment principle—the investor must know his security.

D i s t i n c t i on b e tw e en B onds and S t o cks

Among the securities here treated o f which rest on public knowledge and a publ ic market , the most fundamental

di stinction lies between bonds , representing credit , and

stock,representing capital . The bondholder i s a lender ,

protected more or less fully against r i sks ; the stockholder

i s the propri etor,subj ect to the ri sks and enti tled to the

profits o f the business. No very extended catalogue o f

attributes can fit both classes of securities , or in fact cover

very much of either class . The differences are as impor

tant as the simi lari ties . Both types o f investment , and

the subordinate types as well , have thei r use , i f the

investor knows and understands the nature o f the secur i ty.

CLASSES AND TYPES OF SECURITIES 167

In practice bonds may carry some r i sks , and the riskso f stock are sometimes partially protected . There aremany grades and qualities of securities. There are gi ltedged bonds

,whose fixed interest i s so fortified that they

are free of concern in the profits and losses of the business . There are bonds that have a distinct ri sk in theirdependence upon management or the continuation o fprosperous conditi ons . There are also bonds that havebeen un fai rly sold to the publ ic , carrying unsuspectedri sks

,or ri sks that Should have belonged to the stock

holder . As to stocks , there are some so sound and strong

that thei r risk is less than that of many bonds . t i s quite

general practice also to modi fy the risk o f stocks by classi

fying them into pre ferred , ca rrying less risk and a fixed

rate of dividend , and common , carrying the full brunt o fthe risk and dividends according to earnings .

C las s ifi ca t ion of Se cur i t i es to Me et Inves tmen t

Needs

The obj ect o f subdividing securities into classes i sgenuine and usefu l . Each class appeals to a di fferenttype o f investor and i s suited to different investment pur

poses . Bonds could not be made sa fe for institutions i f

they were not followed by stock . Stock would not be

attractive to the active and ambitious individual i f i t car

ried the enti re weight o f the business and bore a fixed, or

approximately fixed , rate o f return . Except the com

panie s suited only to stock and not to bonds , more moneymay be rai sed , there fore , for the enterpri se by classi fying

securities and appealing to Several groups of investors ,than by appealing to one only. In every business o f settled earning power and large capital requirements i t i s

necessary and customary to rai se part of the money on

bonds at stated rates o f interest,and to concentrate the


profits,as they may be earned , upon a correspondingly

smaller i ssue, or i ssues , o f stock.

There are many types o f investment secur ities,and

there are as many kinds of investment as of securities .The securities cou ld not be sold i f they did not seem to

fi l l an investment requirement , to fit some particular niche

in investment demands . Thus , for example , what thesavings bank laws of Massachusetts and New York real ly

imply when they require be fore bonds are legal for savings banks that rai lroads Shall have paid dividends o f not

less than 4 per cent for ten years on an amount o f stock

not less than one-thi rd of the outstanding bonds,i s that

individuals Shall make a solid j un ior investment of definite

type and proporti ons to protect the senior investment ofthe Savings banks . In every legitimate enterpri se the investment in stock or junior bond issues is

,and always

has been,a large part of the whole . A l l types

,with

thei r various qualities , constitute securities o f investment ,serving a purpose and capable of being purchased inte lli

gently. They are to be characteri zed and defined separately to Show thei r purpose and the degree o f their r i sk .

Evo lu t i on of Co rpo rat e F i nan ce

Corporate finance is the result of evo lution . Be forethere were corporations , merchants and fi rms carried on

business with personal capital , and borrowed at the bank

on the strength of that capital as they do today . The

efl ect in England o f the South Sea Bubble o f 1720 was

that stock companies , designed to draw capital f rom a

wider public,were requ i red to be formed on the l ines o f

partnerships,with an unlimited l iabi li ty against each

stockholder for the debts o f the corporation , except inthose special cases where Parl iament granted chartersconveying the privi lege o f l imited liabi l i ty . But the



where the former absence o f regulation was too loose .The methods o f the English Companies Act , which per

mits corporations to issue stock for what i t may be worth

but requires sworn statements to be fi led a fterwards,

allow o f a more salutary f reedom .

Not to go too much into hi story , the fi rst simple stockand bond issues have been supplemented as occasion has

requi red by all manner of devices and forms of raising

money by promise to pay or by promise to divide profits .The industrials have o f recent years been less restricted

than the rai lroads , but the latter because o f their age andexperience have a more complex financial structure. In

both cases i t i s a rational financial structure,devised to

meet the requ i rements o f investors . Through i t the publ ic

has bui lt and equipped and now owns the rai l roads andthe other so-called private enterpr i ses o f great magnitude .

Ty pes o f Se cu r i t i e s

The principal types o f corporate securities , stated inthe order of thei r protection against ri sk , are mortgage

bonds, debentures or plain bonds , pre ferred stock , andcommon stock. Notes secured by mortgage collateral rank

with mortgage bonds , and unsecured notes with deben

tures.

Ra i l road B on ds

Mortgage bonds , especial ly of rai lroads,have become

subdivided . Purchase money, prior lien , and other under

lying issues come "next to the rai ls ." These are usual lythe old bonds , not o ften on the market. There are alsothe first mortgages

,which may or may not be actually

first,the Baltimore and Ohio , among other companies ,

having stretched the name more than i s reasonable. Sec

ond mortgages were more frequent i n former days. The

CLAS SES AND TYPES OF SECURITIES 171

idea of giv mg a bond a good name and at the sametime o f providing that i t ultimately become a first mortgageupon the maturity of prior i ssues , so that the holders

might look forward to increased security and appreciati ono f principal

,has been in vogue in recent yea rs . The gen

eral,refunding

,consolidated , improvement , first consol i

dated,fi rst and re funding

,general first , refunding and

improvement,general and re funding , and similar mort

gages,are of thi s blanket type as a rule. The names

are not indicative of qual ity. Rock Island put out a fi rstand refunding mortgage that matures more than fi fty

years be fore the underlying general mortgage , which

i t might be supposed to refund , will mature . On the otherhand the general mortgage of that company has now be

come a genuine first mortgage , a metamorphosi s that

i s in gradual process everywhere .Divi sional and extension mortgages are more usual ly

but not always the type that rests on part o f the propertyand not on the property as a who le. Specific or localnames are o ften given to such mortgages. The col lateraltrust mortgages are not secured upon real property butby pledge of collateral . Equipment being good security ,chattel mortgages and leaseholds on cars and locomotives are used as a basi s for a very important classof serial obligations known as "equipment trusts." These

various types of debt , and others , are a result o f the

growth of properties and the necessary creation of newvehicles o f borrowing.

Convertible bonds may be secured by mortgage, or

they may be i ssued as plain promises to pay. Guaranteed

mortgages are usually i ssued as a mortgage by the sub

s idiary and guaranteed with the force o f a plain bondor debenture by the parent company. Joint mortgages arethose in which two or more companies j oin by mortgage


upon property of each. A typical terminal bond is securedby mortgage upon the terminal , Supported by rentals

from the lessee roads and by a j oint and several guaranty

of the tenant-proprietors .

G en e ra l P ro te c t i on o f Mo r tgage B onds

The last-ditch protection o f the mortgage bond , a fterdefault has taken place , i s , first , the value o f the mortgaged

property i f sold under the hammer , and second , the earn

ing power o f that property i f taken possession o f by

the bondholders. The rate per mi le of the bonded debt

i s of significance only when compared with the probablevalue of the property , which varies greatly as between di f

ferent rai l roads and between diff erent sect ions o f thecountry. What i s important i s that the property shouldbe a unit, o f sufficient extent to be capable of separate

operation , and at the same time necessary to the system of

which it i s a part. Recent rai lroad reorganizations havetreated branch- l ine i ssues harshly because the bondholders

could nei ther operate thei r property nor sell it as a rai lroad , and hence were not in position to fight.To avert de fau lt the general protection of al l bonds

l ies in these three important factors o f safety—the generalearning power of the company , the weight of i ts bonded

debt and charges as compared with that earning power,

and the volume of stock and j unior bonds that must see

to i t that senior i ssues are taken care of in time o f trouble

or lose thei r equities . Something depends also uponwhether the i ssue i s a closed mortgage or i s the company’s

medium o f future financing . In the latter case new sales

of bonds are to be expected from time to time,and possibly

with a resulting depression o f price . I f the provi sion for

future i ssue i s too l iberal , there i s also the possibi l ity

that the security may be di luted , the r isks of construction



cept w ith the Pennsylvania Conso lidated and a few otherissues

,to a fixed matu rity date , did not completely solve

thi s problem. I t proved impossible to look far enough

ahead and the same problem had to be faced again and

again,resulting in inconvenient three and fou r-story bond

structures and costly piecemeal financing outside o f the

general structure. Accordingly a number of the stronger

rai lroads have now created open-end mortgages,with no

fixed limit upon the authori zed amount o f bonds outstand

ing except that they must not exceed three times the

amount of the stock . These are intended to be a perpetual

means o f finance,the bonds being issued in series matur

ing at diff erent dates and bear ing such rates o f interestand ca rrying such provisions as to conversion and sinking

fund as may be necessary at the time o f i ssue . In general

they serve thei r purpose,although the unexpected condi

tions o f the war resulted . in departures and the i ssue

o f a stronger form o f short-term bonds secured bymortgage col lateral . The open-end mortgage i s adaptedonly to the strongest companies , with legitimate expecta

tions o f remaining strong .

P rov i s ions of Mor tgage I nden tures

Mortgage indentures reci te the purposes for which

bonds may be i ssued , the amounts, and the conditions .

They set forth the r ight o f the bondho lder to possession ,operation

,foreclosure

,and sale in case o f default. Unti l

default the bondholder has no control over the property

or voice in i ts operation . The manner in which the

privi leges o f the co rporation and the remedies o f the

bondho lders are establ ished in the indenture bears on

the sol idity and value o f the bond . The principalf eatures are avai lable in th e standard descr iptions o fbonds

,including those prepared by reliable investment


bankers . As a general rule the more recent indenturesare more care fully and precisely drawn than the earlier

ones . The defect most to be watched i s too great f ree

dom of i ssue,especially for expansion or against col

lateral . But the earlier bonds have as a rule the betterphysical security and are more seasoned i ssues . In addi

tion,underlying mortgages are usually, but not always ,

closed by the creation o f the newer blanket mortgage.

Conve r t ib l e and Co l late ra l Trus t B onds

Many convertible bonds have turned out well , the

conversion privi lege being u ltimately cashed in at a profit .

Sometimes the conversion privi lege has been o f no benefit ,lapsing and becoming ineff ective because the stock didnot rise to the convers ion figure within the time allotted .

Obviously the call on the stock i s given as an inducement

to buy, and the bond itsel f i s not usually of the first orderof strength. There are exceptions , good convertible bondshaving been i ssued

,for example , by Atchison , Nor folk

and Western, Southern Pacific , Union Pacific, and al

though a distinctly junior securi ty,preceded by a large

volume of mortgage bonds , by the New York Central .Examples o f weak convertibles are furnished by the oldMi ssour i Pacific before reorganization

,by Erie

,and

, un

der present circumstances,by Chicago , Mi lwaukee and

St. Pau l . Conversion i s a top-dressing that does notwork on poor soi l .

Col lateral trust bonds secured by stock alone sometimescarry the ri sks o f a stock with the limited return of abond . In eras o f consol idations such bonds are a favoritedevice for securing contro l at a minimum cash expenditure .O f these the Rock I sland Collateral Trust 4

’

s of 2002 ,

that were foreclosed , are an example . The Chicago and

Eastern I l linoi s stock trust certificates of the old St. Louis


and San Francisco were practica l ly the same thing. The

Interborough-Metropoli tan 4V2’

S, although not strictlyrai lroad bonds , are a case in point. On the other hand

,

there have been strong bonds secured only by stock,such

as the Northern Pacific-Great Northern Burlington Joint

4’

s recently paid off, New York Central

’s Lake Shore

Collateral 3V2’

s , now become a mortgage on the railroaditsel f , the Atlantic Coast Line

’s Loui svi lle and Nashvi lleCol lateral Trust 4

’

s,and Reading’s Jersey Central Col

lateral 4’

s .

Collateral trust bonds secured by deposit o f other

bonds are essential ly stronger than those secured by stock,

the strength depending , however , upon what is pledged .

In time of high money and poor credit i t i s quite common

to i ssue notes or short-term bonds secured by pledge of

mortgage col lateral in an amount in excess o f the par

o f the obligation issued . I t i s the customary method of

administering oxygen to S ick companies , and in such cases

a danger Sign . I t i s also the method followed by strong

companies to Shorten the term during which they must

pay high interest rates on money borrowed during hardtimes

,and to avoid sel ling thei r regular bonds at a heavy

discount . Among the railroads avai l ing themselves o fthis type of collateral trust bond during the last four

years are the Pennsylvania , New York Central , I l l inoi s

Central , Union Pacific , Chicago and Northwestern , At

lantic Coast Line , and Baltimore and Ohio . Their bondsare not of equal strength , but the form of the bond i s thestrongest known . Many other companies fi l led the need

for short-term money by borrowing o f the government.

Co l l at e ra l In c l ud ed un d e r B lanke t Mo r tgages

There is a proportion of collateral included in the

secur ity of a large number o f the blanket mortgages.



trial,the old American Tobacco Company . This i s a

weak type of bond which can only be i ssued with pro

priety by a strong company.

Equ i pmen t Trus ts

Equipment trusts have been among the sa fest o fbonds . Equipment i s necessary to operation , and a re

ce iver usually finds he i s short of it and not in position

to dispense with any. The instalment payments outstrip

the normal depreciation in the equipment, so that the

security improves with age. But under present conditions

o f excess "bad-order"cars and extremely high prices j ust

recently paid for both cars and locomotives,the newer

trusts should be regarded as based partly on the strength

of the i ssuing company, whatever that may be , and on the

fact that equipment is universally in scant supply. In

the event o f a fall ing off in business and S lack traffic the

equipment would hardly bring what i t was pledged for .Equipment trusts are a very strong form o f obligation

,

and yet burdensome to the i ssuing company because o fthe instalment payments running off within a compara

tive ly short term . New York Central has done a great

deal with 15-year equipment trusts , having

outstanding,besides borrowed through the

Rai lroad Admini stration . But as a rule excessive resort

to equipment trusts i s indicative o f a weak company, or

one lacking suitable means of permanent financing .

Ii otes

Notes are o f various types and o f varying significance.They are a j ustifiable expedient to postpone high cost

,

long-term financing , provided they are secure and can bepaid off . But i f notes are to be paid only by issue and

rei ssue of more notes , the company is already in trouble.


A t the same time there i s , even in such case , a moderatepresumption in favor o f thei r being paid off , because

they are usually in strong hands and because i t is against

the interest of other and longer term securities to let them

default. The M i ssouri Pacific notes, which finally brought

the company to receivership,were paid off in the reor

ganization ,although hardly as well secured as bonds that

were readjusted . There are many note issues , however ,that have failed of payment, and it i s a general rule that

no obligation ri ses higher than its source—the securitythat backs it. There can be li ttle appreciation in the price

of notes , because o f the short maturi ty. Thei r use fulnessin investment is against uncertainties . I t i s

,therefore ,

essential that no r i sks whatever Should be taken in purchasing them . A strong note Shou ld be bought or none,money in bank being pre ferable to a weak note .

I n c om e B onds

Income bonds have more o ften been unsati sfactorythan not . An occasional i ssue put out in reorgan ization,l ike the Atchi son Adjustment 4

’

s, has turned out well andbecome actually , or practically , a fixed interest obligation .

Occasionally , as with the Central o f Georgia , bondho ldershave enforced their rights . General ly speaking , the di fficulty has been so to define income that di rectors would

be obliged to pay interest i f any was actual ly earned . I fthe interest i s cumulative

,bondholders have a fair chance

,

but i f non-cumulative , they have insufficient hold . Prog

ress has , however , been made in defining the terms inwhich income is to be measured

,as

,for instance

,with the

New York City Rai lways Adjustment 5’

s,now unhappily

sunk beyond hope o f payment . The income bond,both

cumulative and non-cumulative , i s being used extensively

in such reorgan izations as those o f Missouri , Kansas and


Texas and St. Lou i s-San Francisco, and with apparentlygood results . As a class, income bonds have been really

a stock in the form of a bond , with the risks of stock

but without its voting power . The passing of the interest

payments,as has happened with the Seaboard Ai r Line

Cumulative Adjustment 5’

s,does not constitute an en

forcible de fau lt on the bonds .

P ropo r t ion o f Ra i l road B onds t o S to ck

O f late years rai lroad financing has tended to grow

topheavy with debt because o f inabil ity to sell stock . The

proportion of bonds to stock has r i sen from an approxi

mate equal ity twenty years ago to something over one and

one-hal f times . The present ratio i s recognized as unsafe

in the sense of imposing too great a burden on weaker

companies . The debt exceeds the hypothetical danger line

of 60 per cent of total capital ization . While . no exact

ratio of sa fety for funded debt exi sts , all credi t ratings

being subj ect to almost more exceptions than rules,i t i s

evident on looking over the field that although a maj ority

o f rai lroad bonds are sound , the rai lroad structure as awhole i s not . I t needs more stock financing . Preferred

stock financing has recently been in itiated by I ll inois Central and Chesapeake and Ohio . Sufficiently good earnings ,with prospects o f fair rates and treatment, would result

in an era of sales of both preferred and common stocks .For nearly fi fteen years

,since the Great Northern , North

ern Pacific,and St. Paul brought out thei r large issues ,

rai lroad earnings and prospects have not been brightenough to permit floating stocks at par or better

,with few

exceptions . As the law and the commissions f rownupon the sale of stock for less than par , the rai lroadshave been involuntari ly thrown back upon bonds and notesas the sole way of rais ing funds for capital expenditures .



restrictive provisions prevent the weakening o f the bond

i ssue . Too many restrictions are , however , an unfai ling

S ign of a second-rate property forced to borrow on di f

ficult terms . The essential thing i s the real value o f the

security. There are good bonds,especially among the

older i ssues, and even, also , with the discredited tractions .The newer i ssues used as medium o f financing by theutil ity holding company are more speculative . Recent

years have been as severe a test of uti lities as could be

conceived , and any closed or properly restricted i ssue that

came through unimpaired has a strong prima facie pre

sumption of safety.

Mun i c ipa ls

Municipal bonds are a class apart . Being tax exempt

under present laws they sel l higher than corporation bonds

of equal security. Municipals are essentially an inactive

type o f investment— suitable for r ich men,trustees

,and

institutions . State i ssues and the F i rst Libe rty Loan

3V2’

s , together with some of the series o f Treasury notes

and certificates , are also tax exempt and appeal primari ly

to the same class. The other Liberty Loan issues have a

l imited and temporary exemption,ending in 1923 and

1926, and are more suitable for general investment . The

presence o f so large a body o f securities,the income from

which is non- taxable,has had an important influence on

all investment. Holders with high surtaxes have shi f ted

at their conven ience into such i ssues,releasing to the

general publ ic corporate bonds and stock o f higher yield .

A l l governmental i ssues are supported by the taxing

power . With the municipals proper there are certain

govern ing considerations . A debt limit i s customarily

prescribed by the state legi slature beyond which bondscannot be issued by c ities . This l imit does not include


the sel f-sustaining bonds , such as those i ssued for rapid

transit or docks . I t i s sometimes of interest to note

whether or not this additional debt is actual ly sel f-sustain ing. The l imit i s also breached , especial ly in the West

and South, by the creation o f drainage or school dis

tricts,practical ly coterminous with the city

,to issue bonds

as a separate un it. There are also special assessment, or

improvement bonds,that are a levy against individual tax

payers and not against the city as a whole . The vice of

municipal ities i s extravagance , and the tendency to swol

len debts,now stimulated by the ease of selling tax- free

bonds, or the conservatism in creating obligations , are the

important factors . While states have been S lower , fornatural and constitutional reasons, to pi le up debt, therehave been instances of careless bonding for highways

,

which wear out quickly and which may be subj ect to gra ft

in the construction,or of issues on the grand scale for

other publ ic works such as canals and for bonuses . The

repudiations of former years are fortunately not now a

factor with states or with any important city.The laws governing investment by savings banks and

trustees in municipal and state bonds contain provi sions

as to population, observance o f past obl igations , and percentage of debt to assessed valuation

,by which the best

o f the city i ssues are to be identified . Beyond this themarket makes i ts own diff erentiation . But the most important fact with respect to each new i ssue

,whether i t

was put out in accordance with law by duly constituted

authority, can only be known through painstaking legal

examination o f the steps taken by the municipality. I f

a board of directors makes a mistake in the formalities o fa bond issue the bonds are nevertheless a debt of the

corporation ; but i f a board of aldermen o f a city makesa m i stake in authori zing a bond issue the obligation may


be totally i llegal and invalid- a debt o f no one—whichcannot be assumed by the city. Hence the purchase ofmunicipal bonds i s usually done through bond housesequipped for that purpose and able to furnish the opinion

o f counsel as to thei r val idi ty . The future o f mun icipals

i s largely concerned with federal surtaxes and,possibly

,

tax legislation . This i s a Special , although important ,type o f investment , the detai ls o f which scarcely belong

in thi s volume .

Fo re ign Gove rnmen t B onds

The bonds o f foreign governments have expressed,

most prominently, the necessities of the borrower . Theyhave borne most attractive rates o f interest . These bonds

,

practically a new division of the bond market,are be

ginn ing to be sorted out as to values . The United K ing

dom issues are up to a prime- security,low-yield basi s .

The Canadian , Swedish, and Swiss i ssues are ranking as

fair securi ties , of moderate yield . But most other i ssues

are on a high-yield level,speculative basis . Generally

speaking,the external loans o f European countries that

have both commerce and a sense of honor are regarded

as reasonably sa fe . The internal loans are more specu

lative,besides carrying a gamble in exchange . In the

fi rst rush o f foreign investment the business of lending

has been in some direction qu ite overdone . Nations at

war have so mu ltipl ied their debts that a nation not atwar which has merely doubled its debt appears conserva

tive—an appearance , however , that in the case o f South

American countries improves neither the morals nor the

financial abi l ity of thei r governments . With the creation

of new countries constituted out o f discordant elements,

such as Jugo-Slavia , bonds o f extreme high yield have ap

peared that are a specu lation in pol itical stabil ity and in



sional ly gets into the cou rts , parti cularly as to the relative rights o f non-cumulative preferred and common . In

the Union Pacific case it was held that the preferred hadno cause to stop the payment o f a large extra d ividend

to common out o f accrued surplus . In the case o f the

Chicago , St. Paul , M inneapoli s and Omaha , now in liti

gation ,the court o f fi rst instance held that although the

dividend on the preferred was reduced to 2 per cent out of

current earnings the company could sti l l pay 2 per cent onthe common out of the surplus o f previous years . In

general the non-cumulative pre ferred is interested onlyin the earnings of the current year

,which may be good

or poor , whi le the cumulative preferred i s entitled to divi

dends out of any surplus that the company may have

past, present, or future.A l l dividends are payable when and as declared by the

board o f directors , whose j udgment as to whether or notthe company needs the money for something else i s final .

They are not compu lsory like bond interest. The remedy

of the stockholders against unfai r treatment l ies in thei r

control over the board at the annual elections . I t i s some

times use ful to note which class o f stock has the voting

contro l ; i t i s vital , when a working control i s held by an

other company or by some one dominant interest , to knowthe dividend policy of that control . Chesapeake and Ohio ,for example

,under the tutelage of Pennsylvania and New

York Central , paid 1 per cent dividends for ten years ,while the property was being strengthened . When Hawley bought in in 1909 ,

he raised the rate to 4 and then to

5 per cent , cashing in the conservatism of hi s predecessors .

Covenan ts of I n dus t r i a l P re ferred S to cks

Many industrial preferred stock i ssues of recent years

are supported by protective covenants , such as to main


tai n properties , to redeem a percentage of the stock an

nually , to keep net current assets equal to or greater thanthe amount of the pre ferred

,and not to issue other pre

ferred , a prior obligation , or mortgage , without the con

sent o f three- fourths thereof . Sometimes also con

trol is given to the pre ferred i f dividends are passed , a

maj ority or all o f the di rectors being elected by this class

of stock. These covenants do not, and cannot, create the

strength of a bond . In so far as they may limit the

dividends paid out on common they may strengthen the

preferred . But in so far as they may limit, or reduce ,the borrowing power in time of trouble , whether at the

bank, by notes, or on mortgage , they may be weakeningto both classes of stock , and inconveniently dangerous .

Pre fe rred S toc ks as Inves tm en ts

There are sound and strong pre ferred stocks, mostly

o f the older type—plain and without the protective innovations that inter fere with management . S tandard O i lpre ferred i s better than most bonds . United States Steel

pre ferred is an investment security o f great strength .

The strongest industrials and many o f the standard rai l

roads have preferred stocks—some cumulative,others non

cumulative—ranking high in this class o f security. Stil l

preferred stock investment is not to be made withoutwatching the business . I f things go wrong

,there is l ittle

equity , as debts must be paid first . I f things go poorly,

the lapse o f dividends is apt to be longer than expected .

Preferred stocks rightly carry higher yields than bonds

because the risks are greater . It i s therefore a type ofinvestment to be made ci rcumspectly

,and primari ly with

an eye to possibi lities of profit . Improving conditions

and the approach o f dividends are usually reflected earlierin the price o f the pre ferred than in that of the common .


Comm on S to ck as an I nve s tm en t

Common stock has the larger r isks and the greaterchances of profit . The investment is to be made with

eyes open in both di rections. Even when a regular dividend has been paid for years , i t i s but blind plunging,and quite too common

,to assume that i t wi ll for that

reason continue to be paid . In time of crisi s dividendreductions may aff ect several hundred large corporations

,

including in the difficult years j ust passed such stable

compan ies as Pennsylvania,Chicago and Northwestern

,

and American Sugar . I t is necessary to know the facts

o f the corporation , the trend of the business and of thenet current assets

,and of earn ings and debt

,the main

tenance , the financial requirements , the weight o f the fixedcharges

,and the proportions and aggregate amount of

the capitalization,including bonds . A sa fe and service

able rule i s to compare the company with i ts own past

and with other companies in the same line o f business ,avoid al l capital izations that are heavy in proportion to

earn ing power , and then invest on the basi s of generalconditions.

D i v i dend an d F i n an c ia l Po l i c i es

Industrial dividends are more changeable than those

o f rai lroads . Industrials are more likely to adapt them

selves to conditions,paying in years o f good earnings and

passing or reducing in bad years . Rai lroads are Slower to

change and endeavor to follow a steadier course . While

industrial stocks ri se and fall with dividend prospects , the

changes in rai lroad dividends,when these take place , are

of more serious nature and may herald an alteration o f

the enti re character o f the investment . Not every rai lroad management has the courage of the Pennsylvania

to reduce dividends on an investment stock in a temporary



and running down hi l l in its maintenance and business , has

100 per cent r i sk , with no chance of investment profit .

The war, with the subsequent inflation , was the hey

day of the common stockholder , as i s every period o f in

tense activity. Few foresaw,nor did many participate in ,

the ful l extent of the rise in such stocks as Bethlehem

Steel , Electr ic Boat and Submar ine Boat , and Interna

tional Mercantile Marine. War i s too in frequent to be

familiar,and its power ful forces are not a part of the

knowledge and equipment o f peace-time investment. The

war, with its taste of extraordinary profits and unusual

losses , was unsettl ing to investment habits . Neverthe

less it was most instructive from the investment standpoint . I t multiplied the reactions and impulses that may

be observed in the milder transitions of peace .During the feverish period during and after the war

stocks went up and bonds went down . The course of

safety itsel f was reversed,the worst securities becoming

the best and the best securities giving rise to apprehensionsand causing difficulties. But afterwards , for those who

were not aware that stocks should be sold when earn~

ings are at the peak and prospects most resplendent,

profi ts were turned of a sudden into losses . The con~

traction o f business brought out al l at once al l of the in s

herent r isks of stocks , and brought also salvation to bond

holders who had clung to thei r investments . I t revealedthe inherent safety of bonds .Much i s to be learned from the eff ects of the war .

In lesser degree these same effects recur in the cycles ofpeace . The war has displayed with startl ing Sharpnessthe uses o f different types o f investments to meet changing conditions.

CHAPTER XI I I

CATCH PHRASES AND FORMULAE OFINVESTMENT

Fo rm s and th e Rea l i t ies

These pages contain few rules and no catch phrases .

The ready formula i s absent . There i s even a deficiency

in those sati s fying measurements of such matters as over

capitali zation,bonded debt per mi le of rai lroads , under

maintenance,proper ratios o f fixed charges to net reve

nues,safe and desi rable yields of income , and the due

proportions o f bonds,pre ferred and common stock . I t

i s not that these matters are unimportant in the concrete

case ; but they are not subj ect to uni formity o f measure

ment, so that generalization without particulari zation

becomes dangerous . What must be a imed at in a brie f

survey o f principl es i s , therefore, the substance and not

the form . The advice that may be saf ely given by printed

page is strictly l imited . There can be no counsel to invest

here or sel l there . There Shoul d , then , be no formulaeby which superficial processes of investment without

research and reflection , or the purchase and sale of thi sor that security according to purely formal indications

,

are directed . The purpose of the book i s to initiatethought and work on realities .

Appre c ia t i on and th e Cat ch Ph rase

One of the wel l-worn catch phrases is that whichsettles on the convenient di stinction between income and

appreciation , and aligns investment on the one side and

191


speculation on the other . The definition has thi s measure

of sanction , first , that Speculation is naturally for diff er

ences in price , and , second , that appreciation at any given

moment i s a most uncertain quantity , so that the recommendation o f bankers must necessari ly limit i tsel f to the

quality of the investment and the sureness of the income .

The intimation from responsible quarters that this securi ty or that should appreciate would necessari ly give ri se

to speculation on margin , to abuse by overinvestment , and

to the incurring o f undue r i sk on the part of those who

could not afford it . But thi s S i lence does not mean thatinvestors themselves Should be blind to the fact that securi ties are now cheap , and now dear . I t i s the privi lege

o f the individual , who knows what he is about , to seek

hi s own appreciation .

Adv i ce t o I nves to rs—I ts O b j ec t and I ts R i skThere i s in these pages no thought of persuading safely

anchored investors,dependent on income and following

customary safeguards , to drag thei r moorings , slip their

cables,and seek uncharted seas . But there i s set forth

fi rmly,as strong meat for the strong , the counsel of seek

ing for appreciation through the methods of the long

pull ; j ust as there i s recommendation , in thei r place , ofthe stocks and junior equiti es that pertain to the sphere

of enterprise . The subj ect of the book is investment,

serious,fully considered , and as far removed as possible

from the play for stakes that constitutes speculation . A l lintelligent and experienced investors do aim at appreciation . I t i s generally true of bonds . I t i s almost un iversally true of stocks , where those who buy to keep lookahead as best they can , consider the risk of the dividend

and of the market , and weigh the chance of better things .Those who buy merely on the dividend rate , for income



T ips

The channel s of superficial investment , skimming the

sur face by generali zati on and a priori prescr iption , aremany . Market services spring up with the revival o f inferest in advancing prices , and die away when the mar

ket declines . Tipsters’

letters appear,sometimes from

brokers,sometimes f rom those who make a living by

sell ing them , sometimes for the brazen purpose o f un

loading worthless i ssues on the public,as

,for example

,

a notori ous series on copper stocks . Tips may be inter

e sted or disinterested . They are always floating in count

less number and as a very general rule catch on ly the

novice . Investment does not rest on secrets,and i f i t

did,insiders could hardly be expected to whisper them

to outsiders . There are many methods besides tips Of ar

r iving at hasty general i zations on the course of prices ,quick and simple

,positive and unsound . No formula or

chart provides a rule without exception or one that i s

permanently true . Conditions and ci rcumstances are everin change , and must be seen as they really are . Superficial investment , based upon hal f—knowledge and restingupon what i s told , is always dangerous .

Ph rase s

Phrases are in f requent use . Take for example

business man ’s investment ." It appears to have a sati s

fying meaning , but is i ncapable of logical defini tion . The

thought undoubtedly i s that investments with a vaguelylimited degree o f risk are suited to the man who , beingin business

,understands the ri sks o f al l business and i s

watch ful o f general conditions . In short , i t re fers to apartly speculative investment , of some substance , thatneeds watching . Business man ’s investment" i s a sel fcontradictory term . I f there be any typical investment

CATCH PHRASES AND FORMULAE 193

for men in business other than a mere investor’s investment

,

" i t i s that made to insure against the ri sks of thebusiness

,sound and not speculative . I f there be any

typical investment for the funds o f the business itsel f ,when times are dull and the capital seeks use ful employ

ment,i t i s such as wil l surely produce cash when the

business comes to need the money. Both o f these forms

o f sure investment are the opposite of that denoted by the

phrase . And i f i t i s "business man’s speculation that

i s meant,there i s no use in defin ing it further than to say

i t i s something diff erent . The outside ventures of busi

ness men are too broad a subj ect . I t does not matter somuch that the term lacks definition , or i s used to cover

investments o f al l assorted degrees o f ri sk below the highgrade standards . What would matter , under so broada characterization , would be to know definitely the ri sk o f

the investment and to be able to determine whether or

not i t was worth incurring and under what conditions .

Maxims

AS an i llustration of generali zati on in investment takethe five -year maxim , which i s in substance that prices areto be considered high or low as they compare with the

average price of the five years j ust past . It i s , of course ,most useful to look at the hi story of prices . Thi s rule

does good to a certain class of people by making them lookback . But consider i t as a rule o f investment . Observethe diff erence in rates for money during the five years19 16 to 192 1 and during the years immediately precedingor the year that has followed . Can fixed interest investments , then , with prices dependent on money rates

,be

j udged by a five-year rule ? And as to stocks a companywill quite ordinari ly change for the better or the worsewithin the span of five years . Its earning power may


have altered and its prospects wi l l certainly be diff erent .The danger of thi s rule may be seen in the fact that it

would operate , automatically , to put investors into the

securi ties of companies that are becoming defunct,as

being cheaper than the five-year average . I t would tendto keep them out of companies that are growing stronger

,

because the prices of thei r securities are proportionately

high as compared with the same average . The maxim

presents a val id exhibit of the fallacy o f quick generalizations .

Ru l es

To pass f rom the superficial to that which i s deep andsolid

,look for a moment at the savings bank rules ,

thoughtfully worked out, embodying not only ski l l but

long and responsible experience . They are of immense

value as a bulwark o f the integrity o f savings . But they

are of l ittle value as rules of investment for the individual .In the fi rst place thei r prescribed investments always

include questionable bonds . When the local New Englandrai lroads sink into a morass of difficulties , the Massachu

setts l i st contains bad and dangerous investments . In

New York a complai sant legi slature places Chicago andA lton bonds on the li st . Manhattan E levated struggles

through real and harassing difficulties whi le sti l l complying with the requi rements . St. Paul , strained by expan

sion and pi ling up debt , continues to have its bondsretained on the New York li st even when a yield o f f rom

9 to 1 2 per cent has Shown , for the time being , a clearsignal o f ri sk . Rock Island and Mi ssouri Pacific bonds

are taken from the li st only after the financial embarrassments have begun . During the war and federal controlrai lroads in general are hard hit , and the requirement thatthey must pay dividends , in order to keep thei r bonds



tion i s agreed that it i s going higher , that he doe s nothingwhen there i s a divis ion of opinion , and avoids any at

tempt to use intermediate fluctuations , has apprai sed muchthat i s permanent in human nature .

Dange r in Supe rfic ia l i ty

Phrases and formulae , general i zations and rules , tooreadi ly applied

,blunt and cloud the sight. Investment i s

a business of close and care ful vi si on , and not of yard

sticks measuring the sur face . What lies beneath must be

thoroughly understood . The values must be studied . The

in formation must be genuine and deep .

There i s great danger in the easy , hal f- in formed

methods of investment. In 19 13 some miles of

rai lroads were in the hands of receivers . In the periodicdepressi ons the weaker systems go under . In 192 1 more

than 2 50 large corporations passed or reduced dividends .There were many defaults , collapses , and receiverships .But perhaps the most dangerous time of al l i s that o f

prosperity,when security prices are too high . The seeds

o f corporate downfall are planted in the optimistic expan

siveness of these peri ods . The investor must know ,really

and genuinely, the character of his investment , and be ableto watch encroachment f rom changing conditions , from

weak management, or f rom deceit . The ri sk con f ronting

the hal f- in formed is not academic . I t i s a condition of

i nvestment to be guarded against with every care .

CHAPTER XIV

TRUSTVVORTHY AND UNTRUSTWORTHYDEALERS IN SECURITIES

W h om to Tru s t

There comes for every class of investor the need o fski l led advice . The more he knows the more keenly hereal izes that he falls Short o f what he should know . Hemay go far in searching out by h is own study what to

believe about securities ; and it cannot be too much or tooo ften emphasized that his progress in investment rests on

h i s own knowledge o f values and upon his own deci sions ,and that the profi t to the purse , as well as the broadening

and strengthening of the mind , cannot be surely attainedexcept by personal effort. But in the end there arises also

the question of whom to trust and bel ieve about securities ; where to repose confidence . I t i s o f the utmost im

portance to choose a banker whose sense of honor i s abovereproach , o f whom there are many . It i s o f great im

portance to choose a banker o f sound business sense ando f high pro fessional Skill in investments . N0 loss i s more

i rretrievable than that which comes from fol lowing fal seor mistaken guides . No error i s more utterly hopelessthan that of bel ieving a lie .A l l of what may wel l be termed quack banking

might be passed over in s ilence except for the surpri s ingnumber of dupes among those who Should know better .This class o f security-sel ling i s based either upon del iberate fraud or upon un fai r profits

,beyond what i s legiti

I99


mate . In some forms i t is practiced by men who are ,possibly

,honest but sel f-deceived .

B u cket Sh ops

The bucket shops are the conspicuous instance of

criminal pretense at dealings in securities . The New

York Stock Exchange , long engaged in purging trading

of un fair pra ctices , has j oined vigorous battle with thesecrooks outside of i ts walls to the extent o f its abi li ty

,the

real seat of trouble being with inactive prosecuting at

torneys . These Shops off er to customers inducements

that legitimate brokers cannot—lower margins,less in

terest charges , and reduced commissi ons— for the reasonthat thei r transactions are not genuine ; they themselves

have no margin to maintain at the bank,no interest to

pay on loans , and no commissions to other brokers or costs

of handling securities . Their business consi sts o f bettingagainst the customer by book entries

,instead of executing

hi s orders as broker . A maj ority of the inexperienced,

get—rich-quick type o f speculators are bulls,so that in a

long declining market the bucket shops win the bet, swal

low customers ’ money as profits , and thrive and multiply

l ike weeds . But when the market turns and goes up, thebucket shops lose the bet and , as has happened recently,close by scores ; Whichever the outcome , the customers

lose . The profi t these criminals are a fter i s not a com

mission but the cash of thei r cli entele . The f rauds com

mitted in thi s manner have been colossal in extent andmarvelous in recurrence . They rest upon credulity andaff ect

,primari ly

,margin speculators and not investors .

Ja i l B i rds

A t times o f ardent Speculation the true jai l-bird crim

inals, like the Burr Brothers and Ponzi , also come for



of thi s type o f offering fai l to ci te the highest profits madeby legitimate enterpri ses in the same field . I t i s common

practice to intersperse recommendations of substantial

investments along with the newly incorporated,unknown

,

and valueless ventures , to give the latter the ai r o f sol idity

and at the same time to create an impression o f breadthand substance . Which kind of investment the un

fortunate inquirer will be steered into i s a foregone con

clus ion . The worst of such frauds is that they take

money from the poor and ignorant . They ru in helplesspeople . The most despicable and wide-spread o f these

larcenies,in recent years

,was the procur ing of the ex

change of Liberty Loan bonds,asserted to be depreciated

and of small worth,for oil and mining stocks , mere bits

o f paper,gli ttering with promise of affluence . The ven

dors act as the true f r iends of the buyer , honestly aidinghim to avoid and outwit the unscrupulous powers of Wall

Street, with whom he cannot deal sa fely and who must ,unhappi ly

,look on i n utter contempt .

Promo t e rs

In promotions of new enterprises i t i s the money o fthe purchaser that i s the obj ect . Cash i s being rai sed

by direct action,without bankers or brokers as middle

men . The amount that the seller may take as compensa

tion,legitimately and without f raud , may be matter o f

opin ion . I t i s customary to construe the compensationliberally and the balance that goes to the enterprise nar

row ly . In fact thi s i s necessary, as floating securities

through non-banking channels i s expensive . I t results

that the promoter Class of vendors , ignorant o f corporation finance and optimistic , sel l stocks of more promisethan substance

,upon large commissions , with nothing to

lose, not even reputation. I t is essentially high-profit

DEALERS IN SECURITIES 203

peddling,sweetened with a side profit of bonus stock that

waters down the value o f what i s sold . More often than

not the last thing looked to i s the giving of value for cashreceived

,the seeing to i t that the enterpr i se i s soundly

conceived and organized,with enough real money paid in

so that returns can be earned on the volume of stock

i ssued. Worse , in conducting subscription campaigns o f

thi s nature i t i s impossible for the promoters to knowwhether the intended amount o f money wil l be raised at

al l, or whether the enterpri se wil l be lef t stranded , as

o ften happens,before it i s started . Whatever their in

tentions,there fore

,they may be sel ling what has no pos

s ible substantive value . The di fference between the

optimistic promoter—salesman and the out-and-out crooki s that the latter knows what he i s really doing .

G rada t i on s o f Un t ru s tw o r th in e s s

Cr iminals and promoters are engaged in piti less rob~

bery by selling securities for more than they are worth .

The bucket Shops are robbing by pretending to sell securities . There is no doubt of these facts. But in other

more nearly legitimate cases, where the degree and shade

o f exaggeration of the quality of the wares is less, there

may be doubt . Where brokers or bankers are weakenedand becoming insolvent , there may also be doubt. There

i s less patent fraud . There i s carelessness , though less

flagrant. There i s less obvious and less conscious shouldering of the ri sks o f vendors and dealers upon the customer and his securities . The gradations of’ untrust

worthiness extend into the outer borders o f recognizedbrokerage and banking. Someone is always found tounderwrite and sel l securities of whatever qual ity ormerit, provided they be o f a sort the public wishes to buy.

The distinction between specu lative and assured securities

204 THE ART O F INVESTMENT

may not be care ful ly marked . The banker ’s position oftrust has not seldom been translated into the position

of purveyor , as though he were merely a broker actingat the volition and on the responsibi l ity of his client . Andas for margin brokers , whose strength and solvency i s o f

the essence of al l transactions because they borrow at the

bank on their Cl i ents ’ collateral , there have been fai lures ,and some even among stock exchange houses

,because o f

which evi l the New York Stock Exchange , exerting itsel f

against mani festations of unrel iabi l ity , has recently initiated an audit and examination of accounts of i ts mem

bers . One Should,in buying securities , learn to draw an

absolute line between trustworthiness and untrustworthi

ness,and be, fi rst o f al l , well advised where he shall deal .

The business of dealing in investments should be lookedinto , and also the proper re lation o f the banker .

I n ve s tmen t B an ke r’s Po s i t i on o f Tru st

The investment banker ’s position with hi s client i s in

the first place,that of trust . In the second place i t i s a

position of profit,the commissions on securities and the

underwritings carrying their Share o f the expenses o f thebanking house and contributing to its income . I t i s a

high call ing in the world of affairs,resting on service and

Consideration for others even more than on money re

ward .

The true banker holds to his trust first , regardless

of profits . The"business-getter"who may have arrived

at the banker ’s Chair gives the greater attention to profits ,emphasizing the sel l ing o f securities and the organization

o f salesmanship , and is , i f not forgetful , inattentive andcareless in the relation o f trust . The criminal betrays hi s

trust and sel ls to hi s own profi t, dealing treacherously

w ith h is c l ient .



or Germany lapses into lethargy , or becomes gal vanizedinto forward effort

,as ways of working at a profit may

be found . The resi lient strength of America lies in theenergy bred by profit , everywhere so near and tangible

that the mind of the people i s awake. Profi t produces

every useful thing . It makes use ful things grow andmultiply

,to the common use

,carrying on freely in infinite

progression where the conscious co-operative advance

ments of Chari ty or taxation stop and cease with thei r

first obj ectives . Profit also furnishes the criterion of

usefulness by extinction o f the unprofitable . A world

with a profit motive i s at least a l iving world and a world

of men . So i t i s with the profits in the banker ’s business .I f there were none , we should have few and poor se

curities , nascent industries , and incipient rai lroads i f any

at all , and no investing class participating greatly in thepublic development. The profits of the investment bank

ers are the channel for the organization and use of savings and investment.

Temp tat i on s Avo i d ed by B anke r

From the investment banker ’s profit come the powerto do good and the temptation to do evi l . Out of i t

ar i se the relation of trust and the occas ion for breaches

o f trust. A primary question, there fore, when securi ti es

are off ered for sale, i s as to the nature of the banker ’s

profi t ; i s i t fair or unfair , honest or dishonest ? Enough

has been said of dishonesty. I t remains to review in

bri e f survey the temptations that may lead to unfai rness ,and to outline the code o f ethics and of practice of the

banker loyal to hi s trust .The temptations that the sound banker avoids are con

nected with profi ts . They come in three main directions .overactivity in selling , a dual interest with re ference to

DEALERS IN SECURITIES 2 07

the sa le, and weakness in taking participations or underwritings in unsound issues . These are not usually conscious temptations to unfairness . To resist them requires

abil ity and character . The yielding i s through inexperi

ence or bad j udgment much more frequently than because

of low standards . But looking back over banking historyfor years past , i t i s written plainly that they are real

temptations . Not a few names once prominent have

fallen from their high place because of yielding to these

mistakes .

Ove rac t i v i ty in Se l l i ng S ecur i t i e s

To resi st the tendency to overactivity in sell ing i s notalways simple . The overhead expenses o f a large organization for dealing in securities , the rent, the adverti sing,the salaries o f the force , are a heavy outgo in times ofdull business . I f the temperament of the salesman is in

control o f policies,aggressiveness in sell ing may sweep

from the saddle conservatism in buying . The temptation

is to cover expenses , and not to be timid about in feriori ssues . The best of the large organizations have resisted

this temptation in season and out,o ften at heavy cost .

The maintenance of a high standard o f qual ity can be

j udged by looking over the list of past off erings,to see

whether they have proved to be good securities whose

quotations have stood up , or have turned out to be speenlative or unsound . Publi shed manuals supply this test bygiving the names of the underwriting bankers and thei ssue prices for the various securities .

Dual I n tere s t i n Sale s

The second temptation that may bias the banker’sj udgment i s a dual interest with reference to the securities sold . This commonly arises from his owning the


i ssu ing property, or a large stock interest therein , or fromhaving made bank loans to it. D i scussion o f the financing

o f their own properties by banking houses, a necessary

practice in former times and one that sapped the strength

of strong and promi sing institutions , i s out o f place except as it bears on the marketing of securities . The fact

i s that men identified with a property and its management,

engrossed heart and soul in making a success of the busi

ness,are not suited to be disinterested and critical j udges

o f values . They will be influenced by the connection,and

cannot appraise the ri sks o f the securities as they would

the property o f another . It has not been unknown,also

,

that a banking house too deeply loaded with securi ties o f

properties requiring assistance, has endeavored to sel l

them to the public and keep things going,after receiver

ship and reorganization should have been squarely faced .

Independence of j udgment i s particularly difficult with

specialty houses , interested in one kind of property, be

cause when conditions are un favorable i t involves tell ingcl ients to leave that l ine of investment alone and trade

elsewhere in something else . Among the businesses o f

thi s type,which work only one way, may be mentioned

the irrigation bonds that were so adverti sed some years

ago,certain real estate bonds of the present day

,and the

inferior section of the public uti l i ty holding companies .An element of the same dual interest may, i f not

guarded against,attach to the handling o f inactive i ssues

o f smal l companies , to the dealing in speculative bonds ,to the fol lowing of syndicates during boom periods of

flotations , and to al l securities transactions where theprofit i s more tempting than the ordinary commission .

The enthusiasm for the profi t may assume undue importance . Restraint must be exercised i f trust i s to bekept . The avoidance of bias i s essential . Some very



tionsh ips , i s entanglement in one or another form o f spec

ulative banking , o f the overeager pursuit of great profits .It i s a fail ing to which generous abi lities may yield

,men

consc ious of power attempting to gain by bri l liancy what

they should seek by patience and industry. During boom

or speculative eras aggressiveness i s wont to be morehighly regarded than conservati sm

,as with the Barings in

the Argentine thi rty years ago, and with names that

might be cited here before 1907. This was also a very

prevalent banking condition during the postwar exalta

tion . These periods are particularly a time for restraintand caution . But at al l t imes the banker ’s eye must be

farsighted and single to sa fety, moderation , and permanency .

I nves tmen t B anke rs th e I n t erm ed i a r i es B e tw een

Sav ings and En t erp r i se

Investment bankers are intermediaries through Whomsavings are put to work . In the earlier years enterprisewas a dominant factor , with a new West, new rai lroads ,new industr ies

,and new consol idations as the field . In

these maturer years the emphasi s passes more to security,

in the enlargement o f rai lroads and industries already

in production , the lending to cities already large and

ful ly establi shed , the financing of the war needs of a

strong and wealthy nation . The new field of the present

i s the foreign loans . Sti l l , even at home , the spir it o f

enterpri se l ives in investment and i s sometimes i l l judged

and sometimes becomes impetuous and torrential . The

investment banker worthy o f the name regards the sav

ings of h is cl i ents as the first of al l considerations , weigh

ing every risk and harnessing enterpri se to conservati sm .

He can best succeed in preserving a'

care ful , detached , andindependent point o f vi ew i f he finances other people

’

s

DEALERS IN SECURITIES 2 1 1

enterpri ses and enthusiasms, not hi s own , keeps his ex

penses and his underwri tings within bounds , and has thefinancial strength to remain quiescent in bonds and se

curitie s f rom time to time , at will .

Banke r’s Repu ta t ion

Perhaps the best criterion o f the investment banker’s

standing i s hi s reputation among fellow bankers . The

local banker who carries the deposi t account knows what

institutions are sa fe and strong for the investor to trust

which are active and in good repute. The most satisfac

tory source of investment advice and of investments i s ,natural ly

,a house steadily engaged in the di stribution of

standard securiti es,which i s , because of a general and

high-grade business,keenly al ive to conditions , prices , and

values . The great names of investment banking firms

endure and are known . On ly seldom, as with Verm ilye

and Company , do they disappear . I t i s not because o fdollars

, or because o f massive offices of stone and mortar ,but because these names stand for something more permanent —character , energy , square deal ing, and a senseof honor .As a whole, investment bankers are the most t e

sponsible class in the communi ty. N0 other pro fessionbrings a more pro found sati s faction than the knowledge

that the material wel fare o f those who have come,in trust

,

has been safeguarded and upbuilded. No pro fession carr ies an equal opportunity o f creating comfort and hap

piness . I t tests both brain and conscience,and develops

leaders of great strength . W ith keen minds,understand

ing motives and forces , habituated to the business o f securitie s , they work beyond the hours o f ordinary industryin

"

watching and comprehending that in which they deal .Investment banking is an exacting profession

,with high


standards oi trustworthiness and abili ty , growing higher

as the years pass .

Ru les of th e In ves tm en t B an ke r’s B us in es s

There are three qu i te general , but not universal , rulesapplicable to the business of the investment banker . The

first i s that the bond house buys for its own account,a fter

thorough investigation , securities o f corporations in which

it has no financial interest, or of municipali ties , and off ers

them for resale to investors . In buying the house takes

the ri sk of the value because i t i s not trading with itsel f

or sel ling for a commission upon consignment . The pre

sumption i s that i t has got value for its money, to the

best of i ts judgment. The second rule i s that the dealing

in securities should not be mere merchandi sing,but con

ducted wisely and with conservatism , as befits a business

of intermittent activi ty which to be truly successfu l must

be carried forward through long years . Securities have

long l i fe . Prestige and reputation must be maintained

even longer. The thi rd rule i s that the investment banker

wi ll not ask or allow others to risk thei r money on his

opinion of the course o f the market . He will advi se asto values . He wi ll maintain a service to apprise cus

tomers o f developments . He may express hi s Opinion

as to conditions and the outlook . But his training in the

sale o f securities is to be meticu lously careful to statefacts and not make representations , and his responsibi l ityfor prices ends with the sale. The course of the market

rests with the buyer .It i s not the beginner who may profit most by the

banker ’s guidance . The deeper the study o f securities andthe greater the energy devoted to investment , the higher the

value set upon trustworthy counsel . As in other matters

the imparting of real know ledge by the professional de


CHAPTER XV

THE POSTWAR INFLATION AND DEFLATION

Ty p i ca l P e r i od

Even so brie f and general a survey as the present

work must needs carry into its texture the color of theimmediate financial envi ronment . The phenomena of a

most significant period are touched upon here and there

as passing events ; i ts incidents are used freely. It was

a Sharply typical period,which wi l l recur again in kind

i f not in degree of intensity. A llusion to problems and

events of the hour has value in that i t i llustrates the

processes of investment i tsel f —of groping forward intothe unknown and of foreseeing , dimly but sti l l foreseeing ,possible avenues o f sa fety and increase . More than that

,

there has seldom been in thi s country a short peri od that

has so well i l lustrated the principles governing the values

o f securi ties . From abroad more absolute demonstra

tions could no doubt be drawn , as , for example , f rom

Germany,where bonds have become worthless and stocks

have carr ied speculators to positions of unparalleled

power,because of extreme inflation . But the lessons of

the American experience are more useful , i f less pos it ive ,because they are more nearly reconci lable with the elements o f our own future .

The three years 19 19 , 1920 ,and 192 1 sum up a swi ft ,

vivid , and complete financial cycle . Starting from the

hesitant pause a fter the armistice , business reached itsgreatest heights , fell to its lowest depths , and afterdesperate losses and stagnation recovered poise sufficiently

2 14

POSTWAR INFLATION AND DEFLATION 2 15

to proceed : The recovery of 1922 belongs to a new e ra

that proceeds under different influences .

Se cur i t ies in 19 19

The stock market speculation that reached its heightin the summer and fal l of 19 19 was centered upon theindustr ial s. These were the companies making the fabulous profits out of high prices and extraordinari ly activebusiness . The rai lroad stocks rose but little . The prop

erties were under federal control , with constantly growing

pay-rol ls and other expenses,and the companies were

living upon the temporary bounty of the government .

Bonds were under artificial conditions . The federalreserve system was supporting the war loans , o f whichmore than par were at one po int carriedby the banks . The rediscount rates were kept low

throughout the year because o f these loans and becauseo f the current borrowings o f the Treasury. But in

general bonds sank through the year beginning almostwith the armistice . Toward the end of the summer the

higher rates for money in the open market and the pressure o i undigested Liberties and Victories sold to meetthe exigencies o f overloaded owners undermined thesupport that the banking system had placed under themost important corner of the bond market. By autumnbonds had fallen heavi ly

,renewing thei r general de

Cl ine .

I ndus t r ia l S to cks f rom 19 19 to 1921

H igh prices for industrial stocks were reached , generally speaking , in July , 19 19 , w i th a renewed advance toeven higher prices in October and early November . Somestocks , however , reached their high points in Apri l , 1920 .

The first great slump took place in August , 19 19 , the


second in November , the thi rd , a fter a typica l hal f-wayrecovery in December and early January

,ran through

the rest o f January , February , and the first few days o fMarch. A fter a sharp recovery o f a few weeks the

heavy decl ine began again in the middle of Apri l,fol

lowed by other intermi ttent declines unti l at the end of

1920 the industrial average stood 50 points below that ofNovember , 19 19 . The first four months of 192 1 were

deceptive , with gently ri sing prices . Then came the culmination o f the bear market in May

,June

,July

,and

August , with days o f tremendous sel ling and prices sink

ing to less than hal f o f the 19 19 prices and 10 points

below the low o f 1920 . After the outburst of sales the

market ral l ied somewhat,and a l ittle later began , slug

gishly and almost imperceptibly , to creep up from the

depths . By October,192 1 , recovery of prices , quite

against the general di sbel ie f that business could be on the

mend , had definitely set ' in .

The movement o f prices within the diff erent industrial groups i s instructive . The bear market o f 19 19 - 192 1

was typical,being o f unusual length and severity , and

striking hardest at those stocks which had ri sen farthestin the previous speculation for the ri se. It wiped out

not only the advance of the earlier months o f 19 19 but

also the residuum of the preceding advances made during

the activities of the war .

S t e e l S to cks

To begin with the steel group , United States Steelcommon had reached its highest price o f in 19 17

before the government control of the steel market andwhi le the stock was paying 16% per cent dividends . Atthe armi stice it was about par , and from there dropped

to 88% in February , 19 19 . Then the postwar bul l mar



Coppe rs

The coppers , whose heyday had also been in 19 16

and 19 17 , rose to the first high point in June and July ,19 19 ,

but were more sluggish than the steel stocks in

responding to the recoveries o f October , 19 19 , and Apri l ,1920 . Starting f rom less exalted heights than the steels ,Anaconda

,Utah , and Kennecott each lost , roughly, 60

per cent of thei r 19 19 high in their 192 1 low. The influ

ence of surplus copper metal and part- time operations i s

also seen in the laggard participation o f these stocks i n

the general recovery of 192 2 . At thi s writing they havenot yet reached thei r Armistice Day levels

,and have by

no means reinvaded the advanced ground o f 19 19 .

F e r t i l i z e rs

The ferti l i zer companies reached , generally speaking ,thei r very highest recorded prices in 19 19 . The leaders ,American Agricultura l Chemical , and Vi rginia Carolina

Chemical , lost more than 75 per cent of the 19 19 price

by 192 1 . D ividends having been passed,the recovery

to date i s slow and small .

Equ i pm en ts

For the e quipment companies the story i s enti rely

different . American Car and Foundry starting atin February

,19 19 , rose to 1 2 1% by July , to in

October,and to 147% in Apri l , 1920 . The low point

was 1 1 1 i n December , 1920 . In June and August,192 1 ,

when other kinds of stocks were so depressed,Car and

Foundry cl ipped to 1 15% and prices practi cally

up to the high point o f the summer of 19 19 . By Septem

ber,1922 , i t had crossed 190 . The swimming against the

tide during the depression i s not due SO much to divi

dends , which were increased from 8 to 12 per cent in

POSTWAR INFLATION AND DEFLATION 2 19

19 19 , or to the strong earnings , as i t i s to thebad-order"cars on the rai lroads , the wastage o f equipment during the period o f railroad contro l , and the scantyrepleni shment and construction while the rai lroads werepoor. Rai lroad necessities prophesy for the car-builder

an unprecedented volume of business to come. The otherequipment companies experienced declines in 192 1 , but

not o f severe proportions . The fall varied with the

strength o f the company. The manufacture of equip

ment,both cars and locomotives , was clearly in a position

of increasing demand .

Ra i l road S to cks—19 19 to 1921Rai lroad stocks reached thei r high pr ices o f 19 19 at

the same points as industrials . But thei r low prices camein 1920 even more than in 192 1 . The 19 19 ri se was small

and the subsequent depression was much less sharp than

in the case of the industrial stocks . Prices were indeed

low enough , and the rai lroad di stress was acute . But,

there having been little speculation,the more violent

phenomena o f the bear market were absent. The l i ftgiven by the rai lroad law in 1920 moderated the later

phases o f extreme depression . The swing of leading rai lroad stocks through thi s period was :

H IGH , 19 19 Low, 1920 AND 192 1

Atch ison 76Un ion Pacific 1 10

Great Northern 96% 60Northern Pacific 97% 61New York Central 83Pennsylvania par ) 46% 32%I l linois Central 103V3 8o7"gErie 20 9%Southern 32

The subsequent recovery of the dividend-paying rai l ‘

road stocks has already carried them into new ground,


above the high of 19 19 . They have been bought as investments , and have also come back into speculative favor .Stocks whose dividends have been reduced , or with regardto which doubt has been rai sed

,are at thi s wr iting well

up towards the 19 19 best. Non-dividend-paying stocks

are in various position,there having been sufficient re

ce iversh ips to cast shadows over the position o f thedi stinctly weak companies .

Except for the compari son with the industr ials, 19 19

is a poor year by which to measure the prices o f rai lroadstocks . They were already depressed . The ri se o f that

year was most moderate. Past levels had been muchhigher .

B ond P r i ces

The initial s lumps in the stock market of August andNovember

,19 19 , were weighty indications of what was

to fo l low. Yet the recoveries o f October , 19 19 , and

Apri l , 1920 ,tended to conceal the fact that a great liqui

dation movement had set in . Stock prices did not defi

n itely and clearly start downhi l l with i rresi stible powerunti l the latter part of Apri l , 1920 . Bond prices gave ,on the whole , an earlier and clearer indication . Disre

garding the temporary fluctuations , the trend o f bondprices was deeply significant , especially when taken in

conj unction with the previous severe decline of 19 17, f rom

which there had been no substantial recovery.

A previous chapter has given the movement of bond

averages from limited and imper fect tables . The real

course of bonds i s shown as truly and perhaps even more

di stinctly in the price range of almost any active and

typical bond . Take , for example , Atchi son General 4’

s .

Starting at 97 in January , 19 17 , these bonds went to 79i n September , 19 18 , rose to 90 in November , with the



stocks were at their worst , and in the short space to theend o f the year both i ssues had ri sen above 98 .

Thus the bond market , with its strongest gilt-edged

securities selling at di stress prices,gave early indications

of the presence o f a great l iquidation. I t also gave early

indications of a great and force ful recovery, extendingto stocks and to general business .

Commod i ty P r i ces

During the periods of excitement and strain com

modities presented characteri stic reactions . S i lk was

a pound in January,19 13 , was about at the

armi stice , started to ri se i n May , 19 19 ,and reached

in February,1920 . In March the market became panicky ,

and by June the price was down to Sugar ( raw ,

duty paid,New York ) rose during the war from 3%

cents a pound to cents , at which price i t was stabi

l ized unti l January , 1920 . The control was then taken off

and the pr ice soared to 2 2 cents in May . F rom July toNovember

,1920 ,

i t dropped to 6% cents , f rom which

po int i t slid gradually to cents in December , 192 1 .

Wool (Ohio fine delaine, Boston ) was pegged atduring the war

,two and one-hal f to three times its 19 13

price. In March , 19 19 , i t went down to but then

started to ri se and ruled at about during the earlymonths of 1920 . The price began to break in June , was

by the end of 1920 ,and 80 cents by August , 192 1 .

The ri se o f hides lasted unti l July,19 19 . By the end of

1920 they sold at less than hal f thei r former price . InApri l

,192 1 , they sold for one - sixth o f the 19 19 prices ,

and one -hal f o f the peace-time prices o f 19 13 . Coal

reached its highest prices in July and August , 1920 ,

slumping terrifically at the end o f the year . Much the

same story runs through other industries , the price

POSTWAR INFLATION AND DEFLATION 223

changes varying and the time of recession coming latefor some and earlier for others . In general the crest o fcommodity prices was reached in May , 1920 , after liqui

dation had begun with both bonds and stocks .

Each industry went up to the brink of i ts own preci

pice and fell over. No general price index , mingling

ups and downs, can tell the story of havoc and loss

so well as the figures of any one single industry. The

commercial paralysi s was felt throughout the world ;even the caravans o f darkest A frica gave up theircustomary annual j ourneys f rom the interior to the

sea . The real recovery o f trade and industry began w ith

the clearing up of the banking situation,with the creation

of a broad bond market where new activities could befinanced and old bank borrowings wiped off i n secur ity

i ssues , and with the unlocking of the frozen resources of

purchasers . So far as commodity prices are concernedperhaps the most influential changes were the ri se i n

cotton in September , 192 1 , and in hogs and corn andwheat in February

,192 2 ,

which reopened our largestmarket, the domestic trade with the farmer .

Bank i ng S i tuat i on

Figures showing the advent o f strain upon the banking system and its subsequent passing away have been

given in a preceding Chapter . The salient points are the

decline in the reserve ratio from 64 per cent January 1 ,

19 18 , to 5 1 per cent January I, 19 19 , to 44 per cent

January 1,1920 , then to barely above 40 per cent by

midsummer , with a heavy drag back to 45 per cent byJanuary, 192 1 , and the subsequent ri se to 7 1 per cent

January 1 , 1922 , and later in that year to 80 per cent .The most rapid inflation o f loans took place during thelast quarter of 19 19 , although they continued to expand ,


more gradually, unti l a year later. Redi scount rates werefirst rai sed by the federal reserve banks on November 3 ,19 19 ,

and then raised repeatedly and more forceful ly

beginning with 1920 . The open-market rates were high

through the second hal f of 19 19 , and reached thei r maxi

mum in 1920 . The progress of the banking system dur ing

192 1 to a thoroughly l iqu id posi tion was uninterruptedand was very plain f rom the figures o f the banks .

The fluctuations of bond and stock prices,and the

fantastic ups and downs o f commodities , are linked with

the banking situation . The course of events could almost

be read in advance from the mere progress o f the reserveratio . Whi le business does not always press so y ehe

mently upon the banks that i t encounters , with shatter ingforce

,the final limit o f expansion , the bank figures are

always a condition within which business l ives and moves .The striking lessons of thi s period are not to be forgotten . When business moves easi ly, without pressure ,within the metes and bounds of normal credit faci l i ties

,

i t may seem to be dominated by other influences . But

sooner or later business itsel f raises the question of creditin one or another form.



i t up into wider knowledge . To all except the professionalthe business of securities seems remote

,intangible

,and

incapable o f profitable comprehension . The wonder ful

array of in formation that is avai lable passes id ly beforeinert minds . I t is thought o f momentar i ly

,perhaps

,in

terms of speculation , but is not reduced to order by thedi sentangling logic of investment principles .

Acqu i r i ng Kn ow l e dge o f Secur i t i es

A book on the problem of thinking in terms o f in

vestment has limits . The subj ect i s too vast . The ground

covered cannot be dug deep,and much ground must be

le ft untouched . Worse , that portion traversed can hardlyever, under shi fting conditions , be precisely what thereader at any given moment wishes to cultivate . A book

may give useful i l lustrations of the digging process at

great length and in great variety,but they cannot be

followed by the average investor except at a large expen

diture o f t ime . Yet on his Specific problems he needsmuch more . H i s great requ i site i s a simple manner ofgathering and co-ordinating knowledge that bears on what

l ies before him .

In corporate investment there i s abundant in formation

on prices,stati stics

,and general conditions . I t comes

f rom every side in great pro fusion . But i t i s almost

a lways about the waves and not about the tide ; the tem

porary fluctuations overshadow the permanent changes o f

values . Values and thei r trend are not on the sur face ;they need study and orderly assembling o f facts . A basisfor connected observation and thought must be provided .

C las s ifica t i on an d Compar i son o f P r i c es

Pr ices of securities are publ i shed from day to daythe mass o f figures i s con fusing . Changes from the day

ORGANI"ING ONESELF 227

be fore are given for stocks , and sometimes the changessince the first o f the month or year ; but the longer changesand the co llateral relationships are given much less fre

quently. To give meaning to a mass o f figures requ iresclass ification and comparison . The beginning o f under

standing comes when the most simple comparison i s made

by setting like beside l ike . The first step with stocks i sto group them into classes ; as rai ls ( subdivided intodividend-paying and non-dividend-paying

,trunk lines ,

transcontinentals , coalers , and by geographical location ) ,steels , equipments , coppers , automobi le stocks , electr icmanu facturing

,fertil izer compan ies

,and the specialty

groupings . Bonds may be classified into governments ,municipals

,savings bank rai ls

,second-grade rails

,low

grade rai ls,gas

,traction

,l ight and other util i ties

,indus

trials,and foreign issues . The primary comparison may

be , and often is , carried to great lengths , unti l the s imilarities and unlikenesses are sorted out and the groundwork for careful discrimination in securities i s laid .

Security prices are also to be compared with the past .This i s the second comparison . For this a record is neces

sary , such as is given in the monthly booklets distributedby most banking houses

,and in the ""uotation Record

of bond prices . N0 one has ever compassed the enormous

task o f absorbing and understanding all prices,although

the dealer in secur ities derives much o f his intu i tive Skill

f rom his inbred familiarity with quotations . But i t i s asimple matter to compare present with past prices inwhatever group the investor may be interested

,i f he wil l

but equip himsel f with a record running over a period o fyears . Compar i son , for example , o f the price o f Atchisonstock and bonds with those o f Southern Pacific

,the

prices o f Northern Pacific with those o f Great Northernor o f St. Paul , Westinghouse with General Electri c ,


Western Union with Mackay Companies,Amer ican Car

and Foundry with Pressed Steel Car, or United StatesSteel with one or more o f the independent steels

,cannot

fai l to be i l luminating i f carried over a period o f years .A l ready , f rom these two most elementary compar isons o fprice , l ike against l ike and time against time , the investor

will begin to see the reason for the individual prices,to

know whether pri ces are high or low,and to make an

intelligent decision as to the possibi l ities o f the stock orbond he i s starting with .

Compar i son and Ana lys is of F inan c ial and Oper

at i ng S tat i s t i cs

F inancial and operating statistics o f companies , l ikeprices , come with crowding detai l and without standardsof compari son . The monthly booklets give the importantfeatures o f past records except the balance sheet ; themanuals give more details

,and the annual reports o f the

companies give a more complete story . There should be

the same compar i son in these statistics with the past andwith other l ike companies as in prices . But in order todo this some s imple method must be adopted . The

statistics must be reduced to thei r most important elements . I f a brie f memorandum note be made o f earnings

,debt

,capitalization

,dividends

,surplus above

dividends,and working capital o f a company , i t wi l l serve

for purposes o f comparing it with another company .

The increases or decreases in these several i tems wil lShow the trend of aff ai rs within the company over aseries o f years

,which can be compared with what is hap

pening in competing or analogous companies . A strikingcompari son can be made by bringing in pr ices , especiallywhere new stock has been issued , as in General Motors

and Crucible Steel , or where there has been a reorgani



orderly pursuit and development o f the common knowledge o i what are , after all , the most permanent and

largest influences bearing on securities and thei r prices .In the fi rst place , those who possess special knowledge and

power began with the common in formation,sorted out its

confusing mu l tipl ici ty, bui lt up what was o f value and

permanence , acqui red abil ity o f discrimination , and so

passed almost imperceptibly into the possession of special

knowledge . In the second place,s ince the "i f"is in every

si tuation , the tendency is to exaggerate the unknown ,waiting unti l i ts effect becomes fully patent

,when it i s

too late . The use ful deci sions are made by appraisingcorrectly that which i s known

,and thinking ahead .

The best way to develop a sense o f judgment i s to

make judgments and see how they come out . These , i f

the factors are noted,lend themselves to comparison with

other people’s judgments,with one’s previous j udgments ,

and with financial history generally . An investor who

analyzes and class ifies what he knows about general con

ditions cannot fai l to develop powers of judgment on

the progress of these conditions . He wi ll at least know

the status o f affai rs , and have an opinion as to the eventual

trend—the most use fu l cornerstone of his investment .I t may be

,and it has not been unknown to happen , that

he will so strengthen his powers o f j udgment as to be

able to approximate independently the times o f gre-.t

change .

Th e Progress of O rgan i zat ion

Organization progresses f rom simple beginnings to

far-reaching results . I t i s especially true i f a man is

organiz ing himsel f,developing and per fecting his own

latent powers . To go back to the beginn ing , this i s like

any other art . The title and the obj ect o f these pages i s

ORGANI"ING ONESELF 231

inves tment . The subj ect is the man—how he may trainhimsel f and organize what is around him for material

success . Investment off ers no easy, lucky career for the

indolent . I t proffers work and discipline . I t brings to

reality over and again that proverb i llumined with modern

spi ri t : "Seest thou a man dil igent in h is business ; heShall stand before kings ."

Circumstances do not matter . A man can make himsel f i f he be wise in investment

,sturdy in saving . The

s truggle is with money,but the striving is of the Spi rit .

This book bears the message o f resoluteness and steadfastness , of keeping aflame the torch o f ambition and

courage , o f dr iving forward to a sel f-reliant goal .

Documents

The Art of Investment