Investment is the process by which we hand over money to somebody else expecting to receive an income, as a fee for the use of it, and to be able to get it back, if and when we want to do so. Whenever we invest we run a risk, which is infinitesimal if we are careful enough, but very real if we are rash or careless, of getting no income on our money and never seeing a farthing of it again. We are thus parting with funds which we could spend pleasantly in a hundred ways that our inclinations will suggest, and we do so because we decide that the pleasure of immediate spending is less important than the benefit of increased income in future and the possession of a store of wealth to be used in time of need or left to our dependents. To secure this benefit we take the risk that has been mentioned, and the ideal to be aimed at by the judicious investor is to make the risk as small as possible while getting from his investment the largest and most rapidly expanding income that he can, and being able to get his money back with the greatest possible addition to it.
Incidentally, whenever we invest we are increasing the world's capital fund, and so making economic progress possible. We may not act with that intention, but the fact remains that if everybody spent all that they earn or receive, there would, as the world is at present organized, be no fund out of which industry, commerce and transport could be maintained and expanded, and the rising tide of production, into which we all have to dip for life and comfort and luxury, would grow stagnant and then begin to ebb. The "functionless" shareholder, as he is called by Socialists who find it easier to beg questions than to answer them, in fact provides industry with the sinews of toil without which it would wither into impotence, and in doing so risks the loss of money that he might have spent comfortably on satisfying self-indulgence.
This he does, whether he takes up new securities as offered, or whether he adopts the usually safer system of buying existing securities in the market. If he subscribes to new issues he evidently hands over money to be invested in industry; if he buys old ones he lets a holder out who wants cash, and he helps to provide that market for securities without which the present system of financing industry could not be maintained.
So much had to be said concerning the benefit that the investor unwittingly works for the rest of mankind, because many people still believe that there is something mean and unsocial about the act of saving and investing, that the nicest and most generous thing to do with money is to spend it, and that thereby they "give employment" and quicken the wheels of trade. Undoubtedly we give employment when we spend money, but no more than when we invest it, and when we invest we give employment in a way that increases the world's equipment for production and so goes on giving more and more employment, and increasing the stock of goods on which we live. It is certainly possible for any given man or woman to spend too little and save too much, from the point of view of his or her own benefit, but from that of the benefit of the community we are very far from the peak at which over-saving is in sight.
By investing then we are certain to benefit other people (though if we are careless about it the other people may be the last whom we should desire to oblige), and with this comforting thought we may go on to consider the question how by means of it we can best benefit ourselves. In other words how can we most easily secure the investor's ideal as described above?
It aims at the least possible risk, the largest and most quickly growing income, and the greatest capital appreciation that can be had with due regard to safety. One form of investment, however, and one which should be the first consideration of those who would leave dependents in poverty if they died, does not yield an income but demands periodical payments. Life insurance has to be secured by most of us before we think of putting money into anything else, and it is a process by which we invest little by little, year by year, and receive nothing by way of income until we have reached a certain age or until the receiving is done for us by our executors.
A question was begged and perhaps a heresy was uttered when part of the investor's ideal was said to be expanding income and capital appreciation; it is also possible that the use of this latter term may puzzle the uninstructed. As usually carried out, investment is done through the purchase of securities on a Stock Exchange; there are other methods which will be mentioned later, but this is the kind of investment which will be chiefly considered in this inquiry; and when we speak of "capital appreciation" as part of the investor's ideal, all that is meant is that he wants, if he has to sell the securities that he has bought, to be able to sell them at a higher price than he paid, or if he does not need or want to sell, to have the satisfaction of seeing them stand at higher prices and so feeling richer.
This desire for expansion in income and a rise in value of his securities brings the investor to the borderline which divides him from the speculator and, according to the most austere investment doctrine, takes him over it. The Straitest sect maintains that all that the real investor as such should desire is a safe income, and that as soon as he begins to hanker for either an increasing income or a rise in the price of his holding he becomes a speculator. A safe and sufficient income is better, according to this doctrine, than one which may grow but may also dwindle, and it is not possible to aim at growth without running the risk of dwindling; and there is no need, as long as income is secure, for the investor to bother himself about the price at which he could sell out; in fact, a fall in the prices of his securities may cheer his dying moments with the thought that the Inland Revenue harpies will get so much the less out of him in Estate Duties.
This short and simple creed relieves the business of investment of most of its difficulties and robs it of all of its interest. An ideal which confines itself to amassing a holding of British Government securities or other unimpeachable investments is very wise and safe, and those who follow it will sleep soundly o' nights; but they will have renounced all possibility of adding to their income by intelligent selection of securities, they will have foregone the joys of adventure which the pursuit of wealth through investment affords, and they will have freed themselves as far as possible from the risks which earn and justify its handsomest rewards. In doing so they will have followed the counsels of the safest prudence, and for those who hate to be bothered about money matters this course is undoubtedly the wisest.
Nevertheless the fact remains that if everybody did so the progress of industry and enterprise would be very severely checked. The more sporting ideal that I have set up gives a chance for the introduction into investment of that spice of adventure which is an almost universal craving of the normal human mind, it makes calls on the intelligence and so creates interest in an otherwise very dull business, and it enables those who follow it to feel that they are in chase of a quarry which they will only catch if they have helped to produce something which the demand of consumers has sealed as desirable. It is true that consumers often demand things which make the fastidious shudder, but that is another question. Viewed in this light investment may become a quite interesting hobby, and as I hope to show before I have done, the cultivation of this hobby by a sufficient number of intelligent people might do much to clean out the gutters which bad investment and stupid investors fill with unsavoury refuse.
At the same time the ideal of safety has constantly to be kept before us, and it must never be forgotten that as little risk as possible was put first among the objects that we wish to achieve. Anyone who is investing for his old age and for dependents who rely on his earning power has no right to tread the primrose path of dalliance with speculative risks until he has secured himself and them against all chance of penury. It has been well said that it is man's first duty to be healthy, and his second to be solvent; if he fails in either of these duties he is not pulling his weight in the economic boat but is only a cumbersome passenger, carried by the exertions of others on whom he is a burden. Until the point has been reached at which risk can be afforded, the more austere ideal, which puts safety of income first, second, third and last and renounces all craving after expansion of income and growth in capital value, is unquestionably the one to be cultivated.
After that the spice of adventure and the judicious selection with a view to growing yield may be allowed to come into the picture. But this book will have been written in vain if it has not convinced those of its readers who arrive at the end of it that judicious selection is so difficult a business, owing to the scanty information about securities that is available, that the ordinary individual will be most unwise if he trusts his own knowledge and experience in trying to practise it. He will be well advised if he, by his purchase of securities, hands on the problem of investment to professionals who devote themselves to this business and have access to information which is not to be got at by the general public. By this system, the details of which will be explained later, he will reduce risk and at the same time have an excellent chance of partaking of the joys of expanding income and capital appreciation. And finally, if he finds this system of vicarious investment too humdrum, he can begin when he can really afford it to make a collection of hopeful securities for himself, always remembering that there is no hope without risk, and that anyone is an ass who invests in possibilities, while forgetting that one of the possibilities is loss.
By this method the investor begins with the safety pedal hard down, and keeps it so until he is sure that he is able to afford adventure, after which the pressure on it may gradually be relaxed until, when his financial buckler is stout enough to blunt the edge of fortune's arrows, he can transfer the emphasis to adventure and indulge in the luxury of investing in enterprises of "great pith and moment" which, while full of glittering lure, must frankly be recognized as quite likely to disappoint their supporters.
In order that this method may be pursued the investor must grasp firmly the difference between the position of a creditor and that of a proprietor. Investment was described at the outset as the process by which we hand over money to somebody else, but the terms on which we hand it over make a great deal of difference. When we insure our lives we hand over money periodically in return for a promise to pay an agreed sum, with or without additions by way of bonus, on our death or at a certain date. When we invest in the more usual sense of the word, we buy securities by the ownership of which we become either creditors or proprietors; or if we prefer to eschew the pitfalls of the Stock Exchange and venture among the much more terrifying man-traps (as they seem to me) of investments in house property and "real estate," we can either lend money on mortgage or go straight into property ownership.
In the case of houses the distinction between creditor and proprietor is clear. The creditor lends so much to the owner, the so much being a proportion—usually two-thirds—of the alleged value of the property, and the owner engages to pay him a definite rate of interest and to return his money either at a certain date or, more usually, whenever it is demanded, after due notice. Here there is no chance of increase in income or in capital value; it is creditorship pure and simple, and the creditor is protected by the right to seize the property if the debtor fails to carry out his part of the bargain by the punctual payment of interest.
If the property investment takes the form of ownership the investor buys land or houses, gets what rent from them he can, and receives as income whatever is over after he has met the expenses of maintaining the property. If the land or houses are in an "improving neighbourhood" the increase in value and in income from rents is his; if otherwise, he pockets the loss. It is evident at once that in this class of investment, comparative safety is on the side of the creditor, while risk and the chance of the profit are the salt and sugar that savour the dish of the proprietor.
The same distinction, but with an important difference, is to be found in the securities that are dealt in on the stock exchanges. They also confer rights of creditorship, or rights of ownership on those who buy them. Creditorship is enjoyed by holders of Government and municipal securities and of the bonds and debenture stocks of companies engaged in all kinds of industry—including primary production (such as the enterprise of land, plantation and mining companies), manufacture, transport and commerce; holders of these securities are promised a fixed rate of interest, and generally payment at par, or perhaps at a slight premium, at a definite date. Failure to meet the interest charge, or the capital sum at the due date, means an act of bankruptcy which the debtor has many urgent reasons for wishing to avoid; and investment in these creditor securities is thus as safe, when they are obligations issued by solvent and honest Governments and companies, as human ingenuity can make it. The bonds and debenture debts of many industrial companies are fortified by mortgage rights giving power of foreclosure to the holders in case of default. How much these rights are worth will be discussed when we come to consider in detail the various kinds of securities.
Proprietorship is acquired by the buyer of ordinary or common shares or stocks, which represent the capital of the concern, the bonds or debentures being its debt, or part of it. Holders of the ordinary rank last for a slice of the profits, but they are entitled to all that is left after the expenses of the business, including wages, salaries, directors' fees, taxation, interest on debt, sinking fund for its redemption, depreciation, provision for bad debts and all other outgoings and charges have been met. The "functionless" shareholder puts down the money that starts the business and waits until all other claimants have been satisfied in full before he sees any return on it; and whatever is over, if anything, is his. His position is thus necessarily speculative, so much so that some people say that he is not an investor at all but a speculator pure and simple. But the degree of uncertainty involved concerning the income that he is likely to receive varies so greatly with the record and standing of the company in which he is interested that he may be either as safe as, or perhaps even safer than, if he held gilt-edged Government debt, or be quaking on the quicksands of an investment in an untried patent or a mine that is still searching for its reef.
But the point which distinguishes the income of the ordinary shareholder—the proprietor—from that of the debt holder—the creditor—is that it may grow, and, with it, the value of the holding. This power of growth necessarily carries with it the power of diminution even to the point of being wiped out. But this power to grow less is also inherent in the income from all forms of debt; in the case of some of them the risk of decrease is negligible; but even the impossible happens sometimes. Ten years ago a German holder of Prussian bonds or of a Hamburg municipal loan would have laughed to scorn the suggestion that in any circumstances the interest would not be met. And he would have been right, but there came a time when, owing to the manner in which Germany multiplied her currency, the interest was paid in money the value of which had been divided by so many millions that it was not worth while to cash the coupons.
Creditor and proprietor thus both face the risk of diminution to the point of extinction in their income and consequently in the selling value of their holding, though the risk falls first on the proprietor and wipes him out before the creditor is touched. But the compensating chance of increase which comforts the proprietor never cheers the heart of the creditor. He ranks before the proprietor, though after the wage-earner, the tax-gatherer, the office boy and other expenses essential to the maintenance of the business, but he only ranks before the proprietor for a fixed amount, and if the net income of the enterprise is multiplied by ten, he gets no more interest, though he may see an increase in the selling price of his security.
It thus begins to look as if the prudence of those who will on no account be deluded into the purchase of anything so speculative as an ordinary stock or share may sometimes mislead them. They minimize their risk, but they do not, as the Prussian-Hamburg example shows, eliminate it altogether, and they eliminate altogether all chance of expansion in income.
And this chance of expansion in income from ordinary shares in concerns that are well established, well financed and well and successfully conducted on the business side, is not only a chance but a probability. An American writer, whose work[1] and investigations will be more closely examined in a later chapter, made the interesting discovery, from a series of tests that he applied to a large number of securities, that over a long period the investor in a diversified selection of common stocks, would have fared better in the matter of income than if he bought, instead of common stocks, such high grade bonds as were available at the time of purchase. And he gave the reason, which is beautifully simple and obvious when once it is pointed out.
Everyone who considers these matters has always known that ordinary shares, if one gets the right ones—a considerable "if"—are the pleasantest of all securities to hold because they grow in income and value. But Mr. Smith has first shown us the logic of the matter and why there is a probability that they should do so.
The reason why this increase is probable in the case of well-financed and well-conducted industrial concerns is not only the natural tendency of a good business to grow in activity and profit—which is likely to be checked by competition stimulated by its example, and is subject to the inevitable risks which all forms of industry involve in varying degrees—but by the fact that it is a canon of sound company finance never, except in times of acute depression or exceptional misfortune that is not likely to recur, to distribute to the shareholders in dividend all the profit that has been earned for them. It is the usual practice for part of the profit earned to be held back by the directors and either put to reserve fund or added to the amount carried forward, or used to redeem debt. Redemption of debt evidently, by reducing the amount of interest that has to be met increases the future net income of the company; additions to reserves, or to the amount kept in hand and carried forward, mean that the company has larger funds at its disposal, to be invested either in the expansion of the business, and thereby of the profit, or in the acquisition of interests outside of it, that are thought likely to be profitable.
The consequence of this reserve fund policy, which is normal in well-conducted companies whose business is subject to fluctuation, is that the ordinary shareholder continually has part of his income saved for him, because the directors keep it and reinvest it for him. He is thus not only an investor, but also—generally without being aware of the fact—a chronic reinvestor. Very often he growls at the policy of the Board and considers that it is robbing him of money which might have been paid to him in dividends; in fact the Board is not robbing him at all, but keeping part of his money, which he would have spent, wisely or unwisely, if he had got it, and using it to increase the value of his holding and the probability of a larger income from it in future years. If it is used to pay off debt then a larger part of the company's assets—its land, buildings, machinery, stock-in-trade and so forth—is the unencumbered property of the shareholders, and more of the income derived from them will be theirs; if it is added to reserve or to carry forward it is still owned by the shareholders and is put into assets that will earn more for them. Shareholders are too apt to set up an imaginary distinction between themselves and the company, and to fancy that what the directors keep back is not theirs but the company's. In fact, they are the company, and every increase in its property and income is theirs in proportion to their holdings.
The important difference, referred to on page 10, between proprietorship represented by an investment in real property and proprietorship represented by a holding of stock exchange securities has thus emerged. The investor in house property, who manages his investment personally or through an agent, takes the whole income that comes in after meeting charges, and after, perhaps, making a somewhat sketchy allowance for depreciation. If he is wise enough to adhere steadily to the practice adopted by directors of well-financed companies, and reinvest regularly part of this income that he receives, then he makes his holding, if he reinvests successfully, into a gilt-edged real-property investment, steadily expanding in earning power and value. But human nature being what it is, it is evidently much more difficult for the ordinary investor to carry out this policy for himself, faced as he always must be by manifold and clamorous reasons why any money that he receives should be spent, than to submit to the beneficent despotism of the directors who manage the finances of the companies in which he is interested, and reinvest for him, subject to his confirmation in general meeting which he is too wise or too lazy to withhold.
Why, then, it will naturally be asked, are not industrial companies more uniformly successful, and why is it that financial concerns such as insurance companies, banks and trust companies do not invest a much larger proportion of their funds in the ordinary shares of industrial enter prises which have been shown to have this probability of growth in income and in value on their side? And why should the investor whose ideal involves expansion of income and value in his investments, still be advised to seek the comparative safety granted by creditorship up to the point at which he is secured against the chance of penury; and only then be advised to seek the ampler joys that are provided, through a holding of ordinary shares, by ownership? Why should he not go straight to ordinary shares and ownership if probability of increase is involved by their possession?
All these questions are answered if we look back at the sentence on page 14, where the conditions of probability are set forth. It was there stated that the chance of increase is a probability in the case of concerns that are well established, well financed and successfully conducted on the business side. The industrial risk is always there, and can only be met by unceasing energy and vigilance in management and adaptability to every change in conditions that may be brought by the progress of scientific discovery or the variations of demand. Industry of all kinds is necessarily a venture, and the strictest observation of sound finance and the policy of ever-expanding reseryes cannot protect an industrial concern from the consequences of loss in profit-earning due to competition by rivals who are better equipped on the technical side. It will help by placing at the disposal of the management ample funds for making the necessary adjustments, but technical skill is the finally deciding factor; and anyone who invests in industry has to be sure that the companies which he chooses not only possess it now, but are going to possess it as long as he is interested in them.
Moreover, investment in industrials, unless so large a number of them is taken that the average investor's holding would be inconveniently split up, gives the possessor not enough of that distribution of risk which is so essential to safety. The professional man, saving a small amount every year, who began to make a collection of attractive-looking industrial ordinary shares and stocks, might easily be faced by misfortune from his early acquisitions before he had accumulated a sufficient number to secure that average success which is all that can be hoped for from an investment of this kind. It is true that some Boards of industrial directors try to reduce the risk of their shareholders by investing reserve funds outside the business, but there is not much real safeguard in this. It is the business of industrial concerns to engage in their own industry and not to turn themselves into investment companies; and if anything goes wrong on the industrial side it is natural and right that the non-industrial investments should be sold and the proceeds used for the purpose of remedying it.
But it has already been suggested on page 8 that the investor may find a half-way house in which he may enjoy the advantages of ownership while minimizing the risks that are attached to it when he pursues it with the assistance of no better guide than his own knowledge and judgment. These risks are chiefly due first to the mistakes that he is likely to make in the selection of ordinary shares and stocks to be bought, and secondly to the narrow field of distribution to which individual holdings are necessarily subject.
These risks can be avoided by choosing investments in the ordinary shares of concerns whose business it is to select investments over a wide field. By so doing the investor at once secures the services of a body of professionals specially trained in the art and science of selection, and participation in ownership of a mass of assets distributed over a much wider field than he could possibly hope to cover even if he went on investing all his life and split his investments up to the point of inconyenient minuteness.
Such concerns are banks and discount houses, insurance companies and trust companies. It may be objected that banks hold a small proportion of their assets in investments of the kind that are usually described by the name. This is quite true, as will be shown for the benefit of those who are not already aware of the fact, when the question of bank shares as investments is discussed in detail in a later chapter. But the fact that the banks put the greater part of the funds which they handle at the disposal of industry and finance in the form of discounts and adyances does not make their shares any less a doorway through which the possessor may enter straight into the position of ownership, with a body of highly trained experts constantly at work to see that the assets of which he owns a fraction are carefully selected and well distributed, over the immense field that is covered by those whom it is the pride and the profit of the banks to serve.
By taking refuge in this hospitable half-way house the investor will not, by any means, have put away all his risk, and in buying the shares of banks, discount companies and insurance companies he will have to give serious consideration to the question of the heavy liability that is generally carried by them; but the automatic and unconscious saving and reinvestment that we found to be carried out for the shareholder by the directors of well-financed industrial companies will here, especially through investments in insurance companies, be very strongly on his side, while the important position that the trust companies have secured for themselves as part of our financial machinery will give him access to a share in profits and security that are the privilege of first-hand information.
By means of a holding of this kind the investor, who has first through insurance policies and a well-chosen selection of creditor securities protected himself and his dependents against the risk of penury, may seek the ideal of expanding income and rising capital value that may be got from judicious ownership. But he must not by any means suppose that the shares of any and every bank, insurance society or trust company will open this door for him and that he can shut his eyes and buy, or even that he can buy, unassisted by professional advice, after the most patient study of all the information concerning the position of such companies that is produced for the benefit of the public. We shall see as we go on how little real knowledge is conveyed by the balance-sheets and reports that set forth the achievements of all kinds of public companies, and that real understanding of their position and prospects is only vouchsafed to those who can read between the lines and know something about the facts that are behind the figures. To have a good professional adviser and to follow his advice is the best way to safety and satisfaction in investment for the ordinary citizen; but he can help his adviser considerably by applying intelligence himself and knowing something about the difficulties of the problem to be solved.
- ↑ Common Stocks as Long Term Investments. By Edgar Lawrence Smith. Macmillan, New York.