"And so," as Bottom the weaver says, "grow on to a point." What are the practical conclusions reached, for the guidance of the investor, in the chapters that have gone before?
We have seen that it is difficult, to the point of impossibility, for the ordinary citizen, with no financial experience and education, to judge for himself concerning the merits of securities. The solvency of Governments and other public bodies depends on factors that he cannot measure, and their financial position is set forth, if at all, in statements that he cannot understand. The balance-sheets of industrial companies—using "industrial" to cover all kinds of enterprise, agricultural, mining, manufacturing, transport, commercial and retail—are composed largely, on the assets side, of figures that are most unlikely to be correct as an indication of the real value of the company's property, because they depend on opinions; when directors are honest and prudent and able these doubtful assets are likely to be set forth at understated values; when directors are of the other kind the values will be overstated; they could only be right by a miracle, because nobody knows what the real figure is, and even the appraisement of an expert valuer is only a guess.
We have seen also that in all securities there is an element of risk. The example of Germany and Prussia has shown us that the obligations even of a populous, wealthy country, humming with prosperous industry, may be made worthless by bad politics and worse finance; while all industrial securities depend on the successful management of an enterprise that may be hit or even ruined by a new discovery or a change in the consuming habits of the community. Railways, that looked so solid an investment to our Victorian ancestors, made the roads of England into lines of desert; and now the roads are busy winning back traffic from the railways; and Mr. H. G. Wells, a prophet with a large number of bull's eyes to his credit, has ventured to predict that the latter may be scrapped, and "probably will be scrapped within another half century, as slow and wasteful."[1]
Hence it follows that "safety first" is a principle that all judicious investors will cherish. And, in spite of the German example, a sound Government security has the signal merit of being based on the wealth and tax-paying capacity of a whole nation. As long as the service of the debt, plus the essential expenditure of administration (which is really the first charge of every nation's revenue) appears, from such guesses as one can make, to be well within the tax-payers' shearing capacity, the securities of a Government that has always been honest, as Governments go, and has little or no foreign debt, are the safest investment, in the matter of certainty of income, that an investor can have.
To an Englishman the securities of his own Government undoubtedly possess these qualities, and an English investor will therefore construct, with British Government securities, that solid foundation of security which is the basis on which a well-considered collection of investments ought to stand, except for those who are rich enough to afford to hold nothing but venturesome investments.
When that foundation has been well and truly laid, so that all risk of penury, for himself and his dependents, has been fenced off as well as human foresight can fence, then the investor can spread his wings for more ambitious flights, and seek for a higher yield by means of judicious mixtures of less gilt-edged securities, and may aim at a probability of increase in income and in capital value as a set-off to the greater degree of risk that he now intends to run.
Increase in income joined with increase in capital value can only be secured for the investor by the purchase of ordinary (which may be called deferred) stocks and shares. Increase in capital value may be got by judicious jobbing in and out of fixed income securities, but that is the business of the speculator. Increase in capital value, that comes from increased taxing or earning power behind it, can be got, to a limited extent, from the debts of public bodies and companies that are bought at low prices because the taxable area or company is poor and unfortunate, and then rise in value because revenue and earning power improve; but increased capital value, such as is most refreshing to the investor, proceeds from a larger earning power which is his to receive in dividends or to see added to reserves to increase his future dividends; and this is only to be had from ordinary shares which make their holder a part proprietor and owner of the assets of the company, in so far as they exceed its debts, to the extent of his holding.
It was shown that the great majority of successful companies habitually distribute in dividend less than they earn in revenue, so that as long as they are technically successful their ordinary stocks and shares, having compound interest in their favour, can be relied on to enjoy an expanding income and consequently to show a growing capital value.
But in all industrial ventures that question of technical success is a more or less dangerous risk, and the difficulty of selection is greatly increased by the impossibility, so often insisted on above, of drawing any valid inference from the balance-sheet and accounts presented by industrial companies. The technical risk applies, in varying degrees, to the debts—bonds and debentures—and preference issues and is not monopolized by the ordinary stockholder. Holders of debt and preference issues take less risks but get no increase in income (except in rare cases when participating rights are attached) from increased prosperity; and in view of the expansive possibilities attached to ordinary shares, there seems to be some ground for the argument that the greater security attached to debts has caused them to be somewhat over-valued as compared with ordinary shares.
But between the monotonous safety of the best Government securities and the venturous possibilities of industrial ordinary shares we found a class of ordinary shares in what may be called financing companies, whose assets consist almost entirely of cash, quoted securities and debts, and are thus much more easily and accurately valued than those of industrial concerns; these widespread securities and debts provide for any investor, who has a holding of their shares, a diversification of risk such as he could never hope to acquire, unless he were many times a millionaire, by making investments for himself in different climes and different industries. These companies depend for success on unceasing prudence and energy in management; but the service which is supplied by banks, discount companies and insurance companies is so constantly needed, in good times and bad, that they are much less affected by turns in the wheel of industrial fortune than companies which are engaged in manufacture, production and commerce. Trust companies, the other class of venture which provides diversification for investors in their shares, are purely holding companies which carry out for their shareholders the business of choosing risks and taking advantage of market movements. They are affected by industrial risks through the industrial securities that they hold, but it is their business to protect their shareholders against them by wise diversification and selection; and the success of some of the best shows that this business can be done under wise management. After laying his foundation with British Government securities and perhaps very cautiously adding a layer or two of Dominion and foreign public debts, with a careful eye to political risk, and well-chosen industrial and trust company debts, the investor might then be well advised to build his ground floor with shares in banks, discount companies, insurance companies and trust companies, always applying the test of the persistence with which they pursue the reserve fund policy.
One drawback attached to these securities is that the market in them is far from free, and in the case of trust companies is almost non-existent; and there is also a liability on the majority of bank, discount and insurance shares. Of late, however, issues of fully paid shares, of small denomination, have been made by companies of this class, and since the liability of shareholders is now almost a negligible sum in comparison with the gigantic figures of their business, it may be expected that future issues may take this form.
With regard to the banks, it may be suggested that their capitals might with advantage be increased. The paid-up capital and reserves of the English joint stock banks in 1890 were 18.4 per cent. of their deposits. The percentage was 5.7 in 1919 and 7.3 in 1924.[2] It is evident that the banks, in so far as they are trading with funds placed with them by shareholders and consequently not, like depositors' money, repayable at a minute's notice, can afford to "lock themselves up" by granting longer credits; and one still hears the cry that British industry suffers in foreign competition from the long credits that its Continental rivals can get from their banks and pass on to their customers. In the big struggle for world trade that is coming, it is not fitting that our banking system, of which we are so justly proud, should be open to any such accusation, and it may be hoped that in the near future fully paid bank shares, of small denomination, may be more plentiful and consequently more marketable and more popular as an investment.
Trust companies have lately shown a tendency both to increase their capital and to multiply their number, and there is certainly room for great development in this field.
By investing in all the companies of this financing class, the investor may be certain that he is doing a most useful service to all kinds of industry. Without banking, discounting and insurance, industry, as now organized, would be impossible; and trust companies, which take their shareholders' money and invest it, put it directly at the disposal of industrial and official borrowers. If we all insisted on buying nothing but trust company stocks, the whole work of investment would be done by trust companies, and though it is likely that some bad ones would come into being to meet the public's incurable craving for questionable securities, the business of investment would probably be done, on the whole, much better than it is now. Industries which wanted capital would have to get it from trained experts.
When the investor has built his ground floor he can, if he wants a house of many storeys, go on to industrial ventures and to public debts which he believes to be "promising," because new leaves are going to be turned, and sinners are going to forswear sack and live cleanly.
In making this excursion into the speculative he will, I think, be less likely to bark his financial shins if he follows the following simple rules:—
1. Diversify (which goes without saying).
2. Prefer securities which have a fair round amount outstanding, say at least a million sterling. Some of the little fellows are very sound and comfortable, but a big concern is, on the whole, more likely to be well fathered, well held, and well looked after.
3. Prefer securities of companies and debtors that have a record and a past, so that you may have something to work on in guessing at their future. Leave new creations to those who know all about them, and to professional investors, whose business it is to nurse them through their infant ailments. I know that I can be floored by examples to the contrary. But how many of us would be richer if we had always followed this rule!
4. When you invest abroad never buy the ordinary stocks, and only very cautiously the preference stocks and bonds or debentures, of any railway or public utility company—such as tramways, lighting, electric power, etc.—unless the great majority of the shares is held by local investors. Here again there are brilliant examples to prove that I am wrong. But a public utility company, owned by alien shareholders, is exceedingly likely to be unfairly treated by the local authorities in the matter of taxation imposed on it and the price that it is allowed to charge for its services.
5. Invest only in companies which have in the past ten years distributed in dividends, on the average, not more than three-quarters of the amount of profit available (not including the amount brought forward) after meeting all expenses, depreciation, and debenture interest and preference dividend, and have shown no tendency to abandon or reduce their allocations to reserve or other forms of surplus. This rule holds whether you are buying debentures, preferences or ordinary.
6. When investing in debts, whether of Governments, public bodies or companies, prefer those that are not only redeemable at a definite date, but are provided, under the contract of issue, with a sinking fund to provide for their redemption.
7. As a general rule prefer securities which have a real quotation and are freely dealt in. This attribute can easily be tested by a study of the "business done" marks in the Stock Exchange official list, which are given in full in The Times, Morning Post and other papers. Some very interesting and profitable bargain hunting may be done in the by-ways of markets among securities that are rarely dealt in, and are sometimes very much undervalued. But this kind of quest can only be followed with the assistance of the very best professional advice.
8. When, as lately happened in the rubber industry, the price of an article falls below cost of production, it is fairly safe to buy and put away shares in the best companies engaged in producing it; because this is a state of things that cannot last, if the article is one that is really wanted.
9. If a security ought to be sold, never be deterred by its having cost more than you will get for it. People say "I can't sell so and so because I should lose so much." But the loss is there already and you only risk more loss if you wait. The price that you once paid has nothing whatever to do with the present prospects.
- ↑ In an article in the American Magazine, February, 1924.
- ↑ These figures are taken from the Economist banking numbers.