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{{ph|class=half|Hints About Investments}}
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{{border2|style=max-width: 25em;|
{{c|{{larger|{{sc|Works by}} {{uc|[[Author:Hartley Withers|Hartley Withers]]}}}}}}
{{fb|"Numerous instances of the Wisdom of Withers, culled from a ripe experience and put into literary shape by a trenchant, and occasionally caustic pen."—
{{right|''[[The Financial News]].''}}
}}
{{uc|[[War-time Financial Problems]]}}
{{right|{{smaller|''Second Impression.''}}}}
{{uc|[[The Business of Finance]]}}
{{right|{{smaller|''Second Impression.''}}}}
{{uc|[[The Meaning of Money]]}}
{{right|{{smaller|''Twentieth Impression.''}}}}
{{uc|[[Stocks and Shares]]}}
{{right|{{smaller|''Sixth Impression.''}}}}
{{uc|[[Money Changing]]}}
{{right|{{smaller|''Second Impression.''}}}}
{{uc|[[War and Lombard Street]]}}
{{right|{{smaller|''Fourth Impression.''}}}}
{{uc|[[International Finance]]}}
{{right|{{smaller|''Third Impression.''}}}}
{{uc|[[Poverty and Waste]]}}
{{right|{{smaller|''Third Impression.''}}}}
{{uc|[[The Case for Capitalism]]}}
{{right|{{smaller|''Third Impression.''}}}}
{{uc|[[Our Money and the State]]}}
{{right|{{smaller|''Second Impression.''}}}}
{{uc|[[Bankers and Credit]]}}
{{right|{{smaller|''Second Impression.''}}}}
}}
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/title/
{{c|
{{xxxx-larger|{{uc|Hints About Investments}}}}
{{dhr|3}}
{{smaller|{{uc|By}}}}<br />
{{uc|[[Author:Hartley Withers|Hartley Withers]]}}<br />
{{smaller|{{asc|Author of "[[The Meaning of Money]]," "[[Stocks and Shares]]," etc. etc.}}}}
{{dhr|5}}
{{asc|Second impression}}
{{dhr|5}}
{{uc|London}}<br />{{larger|{{uc|Eveleigh Nash & Grayson}}}}<br />{{smaller|{{uc|Limited}}}}
}}
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{{c|{{smaller|''First Published in 1926''}}
{{dhr|10}}
{{smaller|{{asc|Printed in Great Britain by<br />Northumberland Press Limited, Newcastle-Upon-Tyne}}}}
}}
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{{c|{{larger|{{uc|Contents}}}}}}
<div class="toc-block">
{{c|{{uc|CHAPTER I}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 1|The Investor's Ideal]]}}|i||positionoffset=20}}
{{fine block|Investment—The Risk Involved—The Ideal to be Aimed at—Minimum Risk, Maximum Growth of Income and Capital—The Borderline of Investment and Speculation—Investment purely for Certainty of Income—Safety First—Risk for those who can afford it—Handing on the Problem—Creditor or Proprietor—The Ordinary Shareholder—His Chance of Growing Income—The Reserve Fund Policy—The Industrial Risk—A Half-way House.}}
{{c|{{uc|CHAPTER II}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 2|Investment in Life Insurance]]}}|25||positionoffset=20}}
{{fine block|The First Charge on Surplus Income—The Forms of Life Policies—Their Pros and Cons—Survivors Pay for the Casualties.}}
{{c|{{uc|CHAPTER III}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 3|Trade Cycles and Price Fluctuations]]}}|31||positionoffset=20}}
{{fine block|Investing for Income—Registered and Bearer Securities—Jobbing in Long Dated and Short Securities—Trade and the Rate of Interest—The Trade Cycle—A Dangerous Game for the Ordinary Investor—Its Expensiveness—The Risk of Depreciated Buying Power through a Rise in Prices—The Investor's Defence against it—Need he now consider it?—The Probability of Comparative Stability in Prices.}}
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</div>
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<div class="toc-block">
//head/
{{c|{{uc|CHAPTER IV}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 4|Public Debts]]}}|44||positionoffset=20}}
{{fine block|Government Debts—The Prestige of British Government Securities—What is behind it?—The Limits on Taxation—What we Know or Think about British Credit—The Varieties of Securities Offered—Saving Certificates—Victory Bonds—Conversion Loan—The Qualities Desirable in Creditor Securities—Terms of Redemption—Sinking Fund—Municipal Debts—The System of Local Taxation—Its Defects and Dangers—The Assets behind Municipal Debts.}}
{{c|{{uc|CHAPTER V}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 5|Trustee Securities]]}}|62||positionoffset=20}}
{{fine block|The Investment Powers of Trustees—Confined to Consols before 1889—The Extensions of the 1893 Act—The Colonial Stock Act, 1900—Other Additions—A Delusion concerning Trustee Securities—No Guarantee of Safety—Revision Desirable—Restriction to British Government Securities—The Advantages to be Secured.}}
{{c|{{uc|CHAPTER VI}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 6|Public Debts Abroad]]}}|72||positionoffset=20}}
{{fine block|Difficulty of Estimating Taxable Capacity—The War Risk—Tangible Assets—Bad Borrowing and Lending—Why Governments Borrow—For War—For Public Purposes—Foreign Money an Expensive Luxury—Borrowing to meet Deficits—High Credit and Low Foreign Debt—Points to be Examined in considering Oversea Debt Investments—Impression and Instinct—The Question of Exchange—Liens and Pledges—State Debts—Municipal Debts Abroad.}}
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</div>
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/head//
<div class="toc-block">
//head/
{{c|{{uc|CHAPTER VII}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 7|Mortgages and Real Estate]]}}|97||positionoffset=20}}
{{fine block|"Don't"—No Facility for Watching the Investment—The Hard Position of the Landlord—Length of Contract makes him vulnerable by Rising Prices—Injustice inflicted by Government—Right of Foreclosure—The Terms of Mortgages—Their Popularity with Insurance Companies—Their Disadvantages to Private Investors—Violent Fluctuations in Land and House Property Values.}}
{{c|{{uc|CHAPTER VIII}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 8|A Company Balance-sheet]]}}|106||positionoffset=20}}
{{fine block|Sir J. Stamp's Josiad—The Bass Example—A Jaundiced Critic—What is a Balance-sheet meant to Show?—Guesswork Involved—The Opinion of the Directors—Consequent Importance of an Honest and Prudent Board.}}
{{c|{{uc|CHAPTER IX}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 9|The Profit and Loss Account]]}}|130||positionoffset=20}}
{{fine block|What it Shows—Earnings and Expenses—Inevitable and Optional Charges—The Judgment of the Board—Book Values and Real Values—The Auditors' Limitations—The Directors' Record.}}
{{c|{{uc|CHAPTER X}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 10|The Allocation of Profit]]}}|147||positionoffset=20}}
{{fine block|Back to the Bass Example—The Proportion Placed to Reserve—The Reserve Fund Policy—Capitalizing Reserves—The Test of Profit Division—As a Guide to Investors.}}
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<div class="toc-block">
//head/
{{c|{{uc|CHAPTER XI}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 11|The Forms of Company Securities]]}}|157||positionoffset=20}}
{{fine block|Creditorship or Ownership—Company Debts—Right of Foreclosure—The First Floating Charge—Trustees for Debenture Holders—Railroad Mortgages—Investigation of Labels on Securities—The Preference Compromise—Its Weaknesses and Comforts—Participating Preferences—"Guaranteed"—Ordinary, Deferred and Founders' Shares.}}
{{c|{{uc|CHAPTER XII}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 12|The Strength of the Ordinary Share]]}}|172||positionoffset=20}}
{{fine block|Falling Prices and Ordinary Shareholders' Profits—Mr. E. L. Smith's Investigation—Common Stocks ''v.'' High Grade Bonds—The Victory of Common Stocks—The Reason. Why—Some Exceptional Factors in their Favour—Caution in Drawing Conclusions—A Test of the Reserve Fund Policy.}}
{{c|{{uc|CHAPTER XIII}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 13|Financial Investments]]}}|192||positionoffset=20}}
{{fine block|Ownership with Reduced Industrial Risk—Banks, Discount Companies and Insurance Companies—Their Widespread Service—The Inevitable Demand for it—The Liability on the Shares.}}
{{c|{{uc|CHAPTER XIV}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 14|Investments in Banks and Discount Companies]]}}|199||positionoffset=20}}
{{fine block/s}}
The Westminster Balance-sheet—Comparison with an Industrial—Smaller Proportion of "Doubtful" Assets—The Big Reserve Fund—The Profit and Loss Account—Its Reticences—Fallacious Inferences. Therefrom—The Nationalization Risk{{upe}}
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/head//
<div class="toc-block">
{{fine block/s}}
//head/
—The Dividend Question—The Union Discount Figures—The Discount Companies' Function—Their Advantages.
{{fine block/e}}
{{c|{{uc|CHAPTER XV}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 15|Investments in Insurance Shares]]}}|219||positionoffset=20}}
{{fine block|Their Attractions—A World-embracing Business—Its Complications—"Doubtful" Assets Scarce—The Investments—The ''Economist's'' Summary for 1924—High Prices of the Shares.}}
{{c|{{uc|CHAPTER XVI}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 16|Trust Companies' Securities]]}}|233||positionoffset=20}}
{{fine block|The Trust Company Principle—Wide Diversification—Their Attractions—The Edinburgh Trust's Career—Mr. Harman's Criticism of Trust Company Finance—Low Expenses—The Industrial's Full List of Investments.}}
{{c|{{uc|CHAPTER XVII}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 17|Some Conclusions]]}}|244||positionoffset=20}}
{{fine block|Safety First—British Government Securities as Foundation—The Next Layer—The Ground Floor of Financial Ordinary Shares—The Upper Storeys—"Promising" Securities—Some Simple Rules.}}
{{c|{{uc|CHAPTER XVIII}}}}
{{TOC page listing|{{sc|[[Hints About Investments/Chapter 18|The Ignorant Investor]]}}|256||positionoffset=20}}
{{fine block|A Serious Problem—Social Danger and Bad Investment—What Can be Done?}}
/foot//
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{{ph|class=chapter num|Chapter I}}
{{ph|class=chapter title|The Investor's Ideal|level=2}}
{{sc|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/begin/
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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
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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
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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
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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
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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
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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
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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
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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
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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 neighbour-
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hood" 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
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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
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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
-14
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<ref>''[[Common Stocks as Long Term Investments]].'' By [[Author:Edgar Lawrence Smith|Edgar Lawrence Smith]]. Macmillan, New York.</ref> and investigations will be more closely examined in a later chapter, made
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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
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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
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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 [[Hints About Investments/Chapter 1#10|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
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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 creditor-
-19
ship 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 [[Hints About Investments/Chapter 1#14|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
-20
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.
{{nop}}
-21
But it has already been suggested on [[Hints About Investments/Chapter 1#8|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
-22
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
-23
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
-24
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.
-25
{{ph|class=chapter num|Chapter II}}
{{ph|class=chapter title|Investment in Life Insurance|level=2}}
{{sc|Investment}} is usually undertaken because we want to provide an income for ourselves and our dependents when we have left off earning one by our work, and to have a sum ready in the hands of our executors to pay the cost of burying us and proving our wills and filling the rapacious claw which the Chancellor of the Exchequer holds out whenever an estate passes by inheritance.
Investment for all these purposes can be done by means of a policy, or policies, of life insurance, with the additional and very important advantage that if we happen to die the sum assured is immediately available for those we leave behind.
It therefore follows that anyone who has wife or child or others dependent on him should make his insurance premium the first charge on his income after the barest necessities of life
-26
have been paid for. This duty is so obvious that even the Revenue authorities encourage us to perform it, by remitting income tax, within limits, on sums invested in this form of thrift.
Insurance policies are infinite in variety, and it is no part of the purpose of this book to examine their varieties in detail. Their broad divisions are into:—
{{bc|
(1) With-profit and non-profit, and
(2) Endowment and whole life.
}}
A with-profit policy carries the right to share in the surplus shown by the company after providing for claims. The share received by the assured is usually called a bonus, and may be taken in the form of a reduction of future premiums, or of an addition to the sum payable when the policy becomes a claim, by death or maturity. One can have a with-profit or a non-profit endowment policy and likewise with whole life.
The advantages of these different kinds of policy have strong advocates. It seems to me that a man who lives by his work and has to face the possibility of a "Saturday afternoon" to his life in which he will be inclined, and probably obliged, to live without working, is well advised to choose the form of an endow-
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ment policy or policies, payable at the age of sixty or sixty-five.
One argument against the endowment form of policy is the likelihood that the assured, on collecting his policy money, will proceed to dissipate it. If this be really probable it is certainly better to deliver ourselves from temptation by having a whole life policy payable to our executors. But I should have thought that most people who have the sense to insure will be more likely, by the time that they come to the age when the policy matures, to have the sense to take care of the money if it is necessary for them to do so.
An advantage about collecting one's insurance policy oneself is that it saves one from the feeling, which must, I imagine, be unpleasant as one becomes old and a useless consumer, that one's dependents will be better off when one is buried. In the case of a whole life policy-holder this is true. When one is old and helpless, there will be a certain satisfaction in feeling that one is still an earning asset, and this satisfaction one can secure by the acquisition of an annuity which will rather more than cover one's cost of living. This at least wil! give one a material justification for going on living after one has ceased to be an active worker.
{{nop}}
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This may be a selfish, perhaps a morbid, point of view, and of course no one has any right to sink capital in an annuity unless he has already made full provision for anyone that he leaves behind, and preferably, in my view, handed that provision over to them, so that no one may be waiting for monetary advantage from his demise.
As to the non-profit or with-profit division, very shrewd advisers have pointed out to me the disadvantage of paying the higher premium that a with-profit policy requires, when there is a risk that one's company may have no surplus to divide in bonuses. But it seems to me that in normal times this risk is negligible. The companies must work on a margin, and that margin becomes surplus. My feeling is that good insurance companies can invest better than I can—for one, among many other reasons, because they handle much larger funds—and in my youth I took out two with-profit endowment policies, and I see no reason to regret having done so.
But if insurance has all these advantages why should one bother about any other form of investment? Why not put all that one can save into life policies? For those who are going to die young, this would certainly, from the point of view of their heirs, be the far, far
-29
better course. But for those who are going to live a normal span, moderation in insurance is counselled by the fact that those who live pay for those who make brilliant insurance investments by dying.
The chairman of the Clerical Medical and General Life Assurance Society cautioned the shareholders at the meeting held last October against inferring, from its fortunate mortality experience, that every claim represents a profit to the society. "This," he said, "is indeed, far from being the case, and the protection afforded by life assurance against the risk of early death is a very real one. The actuary informs me that of the 241 deaths which took place during the year, two—one of which, I may mention, involved a very large amount—occurred in the first year of assurance. Two deaths occurred in the second year of assurance, and five in the third; while over 40 per cent. of the total number of deaths resulted in a financial loss to the society—a tribute to the value of life assurance to the community." This financial loss, of course, was met out of profits made at the expense of the long-lived policy holders.
As we do not know, when we insure, whether we shall be a financial loss or profit to our society, but naturally expect to be a source of
-30
profit by surviving, the natural course is evidently to limit our purchase of insurance to the point which makes full and, if possible, generous provision for those whom we shall leave dependent if we die young; and having made this duty the first charge on our saving capacity, to devote the balance of it to investing for ourselves.
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{{ph|class=chapter num|Chapter III}}
{{ph|class=chapter title|Trade Cycles and Price Fluctuations|level=2}}
{{sc|After}} he has protected his old age and his dependents by adequate insurance, the investor according to the scheme that has been sketched out for him proceeds to accumulate a holding of securities that will give him an income if he happens to be afflicted by loss of earning power, by ill-health or any other cause.
In England we generally prefer to deal in stocks and shares that are registered or inscribed, while securities to bearer are usually preferred abroad. Under the English system the buyer of a security has his name enrolled by the debtor (or by the company in which he is part proprietor in the case of ownership securities) and his interest or dividends are sent by post either to him or to his bank, as he may direct. If the security is "registered" he receives a certificate stating that he is the registered owner, but this certificate has no
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value as title to ownership, which is transferred by means of a deed of transfer signed by the seller and the purchaser. In the case of "inscribed" stock there is no certificate and ownership is transferred by the attendance, in person or by attorney, of the seller. Bearer securities, as their name implies, are represented by a document which is in itself evidence of ownership—a bond or share certificate—and interest or dividends are paid against the delivery of coupons—pieces of the bond or share—that are cut off it and presented. Safe custody of bearer securities is thus essential and they are generally left by their owners in the charge of their bankers, who cut off and present the coupons. Victory Bonds are an example of bearer securities issued by the British Government, but the greater part of the British debt is in the form of inscribed and registered stocks.
It was agreed that in laying his foundations he is to consider safety first, second, third and last with no thought of increase in income except by addition to his investments and little hankering after a rise in the prices of his securities. Naturally he will not want to see them fall, and he may endeavour to secure himself against this contingency by selecting obligations that are redeemable at a definite
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date ahead. But steadiness of income is the first and last consideration, and to the continuous investor who is saving and investing periodically, a fall in the prices of well-secured stocks enables him to invest to greater advantage. If the stocks that he has chosen fall for some special reason that has made them less safe, that will be a reason for getting out of them, but if the fall only reflects a rise in the general rate of interest and affects all high-class investments alike and is not significant of any weakening in real security, it is an accident that may be ignored by the genuine investor who is first concerned to provide himself with an income that he may feel sure of receiving.
There is, however, a school of investment doctrine which tells us that we ought to watch the fluctuations in the rate of interest and anticipate them, and make a profit from them by changing over from long-dated or perpetual securities to those which are due for redemption at an early date, and back again; and the possibility of engaging in this interesting system may appeal to some investors.
The idea, as far as I understand it, is something like this. Changes in the rate of interest on investments—that is in their yield to the investor at current prices—are due in normal times chiefly to the quickening or slackening of
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the tide of trade. When trade is active and prices of goods are rising, money is wanted by manufacturers for financing enterprise, and there is thus less available for investment and for financing speculation in securities. When Manchester, Huddersfield, Sheffield, Glasgow, and the other great centres of industry and commerce are so busy that they want every penny that they can raise to pay for materials and other current expenses, they are then likely in the first place to sell securities and so depress their prices and, further, by their clamorous demands on their banks for assistance, to reduce the amount that the banks can lend to the financial firms which use it in carrying the floating mass of securities which is the stock-in-trade of the investment market; and so some of it has to be sold and prices are further depressed. As they say on the Stock Exchange, trade and securities cannot boom together.
When money thus becomes scarce and dear, the securities that are most severely affected in price are the fixed rate creditor securities that are perpetual, or are not redeemable until a remote date. Those that have to be redeemed comparatively soon are naturally kept steady by that fact. Evidently a stock representing the obligation of a solvent debtor
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to pay 5 per cent. interest and £100 per cent. in capital in two years' time is less likely to fall far below par than the obligation of the same debtor to pay 5 per cent. interest with no obligation to pay the principal ever, or before, say, 1965.
And vice versa, when money is plentiful and cheap because trade is slack and commodities are low in price, and consequently need less money to finance those that have not yet found their final purchaser, then securities rise because the spare money is invested in them; and the long-dated or perpetual variety will rise faster than those which must, or may, be redeemed shortly.
Consequently, those who can make accurate forecasts concerning the future movements of trade, which expands and contracts, or has hitherto done so, in more or less regular cycles, can make profits by jobbing in and out of fixed-rate investments, from the long-debts to the short ones; or from fixed-rate investments which rise in time of slack trade, to industrial shares and other owner-securities which rise in time of active trade owing to the larger profits that their holders then expect to earn.
For the ordinary investor it is very doubtful whether it is advisable to take part in this form of speculation, for it is nothing else. It is
-36
simply backing one's view concerning the probable course of trade, a matter which requires an amount of study and information that the average citizen can rarely bring to bear on it. The expense of changing from one investment to another is considerable by the time that brokers, jobbers and tax-gatherers have all taken their toll of the process. If you work out the commissions, transfer stamps and fees, contract stamps and jobbers' "turns" on a sale and repurchase of registered stocks or shares, you will find that they may come to something like a half year's income on the securities. In this way a large part of the profit, if any, is gone before it is garnered; and the loss is ''pro tanto'' increased, if calculations concerning the course of the trade cycle should happen to be upset by some prank of Nature's in the shape of good or bad harvests, earthquakes or pestilence, or by some human aberration, such as war or revolution or widespread industrial unrest.
This being so it seems much better for the ordinary investor to choose for the foundation of his holding good creditor securities that can be relied on not to fall because of any special deterioration affecting the probability of the interest on them being paid; and, having got them, to keep them as long as they remain
-37
within that class, unless some special reason arises for changing them.
As long as he has a sufficient holding of such securities he is sure of an income payable in the legal tender money of his own country, or in some other country's which can be relied on (a point which will have to be discussed more fully later) not to vary widely in value when it is converted into sterling. But so much has been said lately—and with good reason—concerning the violent changes that have taken place in the last twelve years in the power of English and other monies to give their holders command over the goods that they want to buy and the need for a careful investor to protect himself against depreciation of the money in which his interest is paid, that this subject cannot be left out of any manual of investment. We have to ask ourselves, is it enough to secure an income in money, or ought we to remember the case quoted in [[Hints About Investments/Chapter 1|Chapter I]] of the holder of gilt-edged German securities whose money income was secure, but was worthless, having been divided by a thousand millions or so by depreciation due to the pace at which the marks in which it was paid were multiplied?
The same thing happened, on a much smaller scale, in England and everywhere else.
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According to the calculations on which the ''[[Economist]]'' "Index Number" is based—an Index Number is an attempt to arrive at the aggregate wholesale price of important representative commodities—prices in July 1925 were just double their average level in the first five years of the present century, having been in the meantime, in March 1920 when the zenith of the after-war rise was reached, nearly four times as high.<ref>The exact figures are: 1901-5, 2,200; March, 1920, 8,352; July, 1925, 4,446.</ref> So that anyone who bought Consols in the early years of the century and hoped to receive a steady income from them, got the income but found that when he turned it into goods its power to purchase them was not much more than a quarter, in March 1920, of what it had been when he bought; and finds now that it is only about half as potent in supplying him with the good things of life.
He feels, probably, that he has been somehow infernally swindled, but that it was all owing to the war and could not be helped, as to which he may or may not be right. But we are not concerned with his feelings, but only with the fact that the same depreciation of money by over-issue, which has applied those "abhorred shears" to the real value of his income, has had
/foot//
{{smallrefs}}
//foot/
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the same effect on all fixed incomes from securities, annuities, pensions, or any other source; and we have to grope our way to a decision as to whether the investor is bound, for his own safety, to consider the risk of further depreciation on anything like the scale that has lately been witnessed.
If he is, then he should eschew creditor securities altogether, because they are only promises to pay so much in money, and confine himself, in so far as he invests at all on the stock exchange, to ordinary shares and stocks which carry with them ownership of the assets of the companies selected, which will rise in price as the currency depreciates and will return a larger money income owing to the higher prices of the products that are sold. Moreover, he will be tempted to invest less and to spend more upon real property and goods such as can be held as a reserve fund. He will be careful to own his own house, and if he foresees extreme depreciation, a piece of ground on which he can grow as much as possible of his family's food, vegetable and animal; and he will learn to do many things for himself, so as to meet the rising cost of service; also he will be tempted to spend freely on imperishable articles, such as jewellery, which will rise in price if currency depreciates; they are also desirable, as a
-40
disgusted super-tax payer once observed to me, because "things like pearls can always be sold easily and are a good liquid reserve, and in the meantime they don't bring in any income for the Chancellor of the Exchequer to rob you of."
But is this sort of thing worth doing in present circumstances? It does not seem to me to be so, though now that currency matters are once more the subject matter of politics, no one has any right to feel certain about them. For many centuries the tendency has been in favour of gradual currency depreciation, or a gradual rise in the prices of commodities, with occasional reactions. In the days of King Henry the Fourth, as Master Silence tells us, "a score of good ewes may be worth ten pounds." This rise in prices has been one of the methods by which Fortune has carried out a "Seisachtheia," or relief of burdens, such as was deliberately introduced by Solon at Athens,<ref>Grote's, ''[[History of Greece]],'' Part II, Chapter XI.</ref> and has loosened the grip of the creditor on the productive power of the world. But it has been so gradual that the creditor has not been afflicted by it to the point of giving up the habit of being a creditor and an investor. During the nineteenth century something approaching stability was achieved. The output of commodities was enormously
/foot//
{{smallrefs}}
//foot/
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quickened, but so also was that of money by discoveries of gold and the development and expansion of the use of credit instruments in the shape of bank notes, bills of exchange and cheques. During the first quarter of the nineteenth century, as Mr. Keynes tells us,<ref>''Monetary Reform,'' p. 11.</ref> "The very high prices of the Napoleonic Wars were followed by somewhat rapid improvement in the value of money. For the next seventy years, with some temporary fluctuations, the tendency of prices continued to be downwards, the lowest point being reached in 1896. While this was the tendency as regards direction, the remarkable feature of this long period was the relative ''stability'' of the price level. Approximately the ''same'' level of price ruled in or about the years 1826, 1841, 1855, 1862, 1867, 1871 and 1915. Prices were also level in the years 1844, 1881 and 1914. If we call the Index Number of these latter years 100, we find that, for the period of close on a century, from 1826 to the outbreak of war, the maximum fluctuation in either direction was 30 points, the Index Number never rising above 130 and never falling below 70. No wonder that we came to believe in the stability of money contracts over a long period. The metal gold might not possess all the theoretical advantages
/foot//
{{smallrefs}}
//foot/
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of an artificially regulated standard, but it could not be tampered with and had proved reliable in practice."
Since his tract on ''Monetary Reform'' was published by Mr. Keynes, England, against his advice, has gone back to the gold standard under which, on his showing, so near an approach to price stability was secured in the century before the war. The reasons that he brought forward for proposing to establish what he calls an artificially regulated standard are highly interesting and ingenious, but did not convince the great body of banking and business opinion. Nevertheless the work that he and many others have done in calling attention to the evil effects of violent price fluctuations on our economic and social life has by no means been without effect. The working of the gold standard will be watched from this point of view in a new spirit of criticism by the public and will be guided with the help of a revised chart by the authorities of the central banks. It is thus fairly safe to assume that the era of wide fluctuations in the prices of goods is over for the time being and perhaps even to hope that it may never return. If this be so, then the task of the careful investor need not be complicated by the effort to provide against reduction in real income by a rise in prices
-43
sufficiently marked to defeat the steadiness of the money income that he receives from a holding of creditor securities, and we can go on to consider the principles on which he should guide his selection.
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{{ph|class=chapter num|Chapter IV}}
{{ph|class=chapter title|Public Debts|level=2}}
{{sc|Among Creditor}} Securities the best known and most popular are the debts of Governments, States and municipalities, the first named of which enjoy a prestige that has only been slightly dimmed by experience of the political risk attached to them, as proved by the war. In some countries, among which England stands pre-eminent, it may be doubted whether the prestige of Government stocks has been dimmed at all. The pre-war holder of Consols who has seen about 45 per cent. knocked off the capital value of his holding and the real value of his income divided by something like two, may still feel sore and surprised, but he is none the less convinced that he cannot be wrong if he buys British Government securities to-day, for safety of capital and certainty of income. The determined rapidity with which England teturned to the task of redeeming debt and meeting expenditure out of revenue, at a time
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when all kinds of specious arguments could be and were put forward for a policy more comfortable to the tax-payer, has raised her financial reputation higher than it ever was before; and it is interesting to note that when a Labour Government was in office, its Chancellor of the Exchequer, Mr. Philip Snowden, talked with all the earnestness of a bank chairman about the importance of maintaining British credit, and brought in a sound Whig Budget which might have been opened by Mr. Gladstone. It is, however, also important to remember that the Labour Government was in office but not in power, since it had not a majority of the House of Commons behind it.
When we come to look at British or any other Government debt or any other security, with that coldly sceptical eye that should be turned upon it by the investor, the real question that we have to ask about it is what is the income behind it, out of which we can rely on the debtor's being able to meet the interest and pay the debt when and if due for redemption. And it is rather disconcerting to find how much uncertainty there always is, though the degree of uncertainty varies, in answering this question.
Concerning the British Government, for example, we know that during the last com-
-46
pleted financial year it collected a revenue of £799½ millions, and paid in expenditure £795¾ millions, of which £312 millions went in interest on debt and £45 millions in debt redemption. But if we want to know what is the real margin of security—how many times over our interest is covered, as an industrial prospectus would put it—we very soon find ourselves in the region of {{hinc|guess-work}}.
Statisticians are most ready to oblige with estimates of the aggregate income of the citizens of the country, the whole of which, according to the principle of jurisprudence laid down by Austin, the Government has the right to appropriate for the public purse. But we know very well that there are limits beyond which no Government can go in taxation, and we also know that nobody can say with any approach to exactitude what those limits really are, because they vary according to the mood of the tax-payer and his willingness to part with his income to meet a national emergency.
All that we know or think that we know on this point about England is that:—
1. Owing to a certain blind commonsense which is the priceless asset of her public finance, there never, unless the whole character of the nation changes, will come a time when her statesmen will lay on her back a debt that she
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cannot face, or when they, or the public opinion of the nation, would begin to think about considering the question of doing anything else but meeting the interest punctually and in full.
2. If the proposal for a levy on capital should ever be revived, we may be sure that the Government, in order to maintain its own credit and borrowing power, will see that holders of Government debt will not be worse, but if anything better, treated than owners of any other kind of property.
3. England has shown and still shows that she possesses stores of economic strength that escape calculation and only appear when an emergency arises.
4. In the summer of 1925, when our trade had been suffering from severe depression and we were supporting over a million and a quarter of unemployed and their families, and when we were repeatedly told that the country was groaning under the weight of taxation, the spending power of all classes of the community appeared to be quite unaffected; sleeping-cars to Scotland for the opening of the grouse season were booked in advance by the railways to an unprecedented extent; and Lancashire operatives, after years of depression and short time in the cotton trade, spent more than twice
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as much (though in depreciated currency) as in 1913 on the August "wakes," or holidays, for which they save all through the year.
5. The present industrial difficulties, of which the state of the coal trade is the extreme example, will be settled, whether amicably or after deplorable conflict, by a recognition of the fact that British trade can only live if it can compete abroad, and that all concerned in it have to work together to that end.
And on these facts and beliefs we think that British Government security is just as good as it can be. But we have to admit that the data on which we base this sentiment are far from being capable of exact calculation, and that the sentiment may be coloured by the popular prejudice known as patriotism.
Having arrived at this conclusion concerning the solvency of the debtor we go on to decide what sort of a contract we are prepared to conclude with him, that is, which of the varieties of the British Government stocks now in the market, or on continuous offer, we think most suitable to the ordinary investor.
There is one rather serious objection to them all, which is that they are a "fancy article "with a special demand for them, because to many important financial institutions they are as necessary as office furniture, since custom
-49
and the exigencies of financial respectability make a holding of them essential; and when a security or any other article is one that has to be bought by a certain number of people, the consequence is that the price is to a certain extent artificial, and that it should, as a general rule, be avoided for that reason by those who are not obliged to have it. This principle also applies to all the other stocks that are known as "trustee securities," as to which more will have to be said later.
Nevertheless, there are certain British Government securities with special privileges attached to them, which outweigh the objection above noted. Apart from safety of income, the pleasantest feature about a security is the power of its holder to demand his money back in full and at once, and the National Savings Certificates that are on continuous sale at our banks and post offices confer this privilege on the holder, and the still more important one—to those whose incomes are large enough to be taxed and supertaxed—that the interest from them, which is not paid but accumulates to the holder's credit, need not be included in any statement of income made for purposes of taxation. The interest on these certificates has been drastically reduced, and to those who buy the Third Series and hold them for ten
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years, the yield works out at about 4⅛ per cent; but their freedom from income tax makes them, to those liable to it, the highest yielding Government security, and a very solid foundation for every investor's collection. The fact that they yield no present income but accumulate at compound interest is not altogether a disadvantage since it means that they are not only an investment but a form of continual saving. The drawback to them is that no one can hold more than five hundred one pound certificates, now to be bought at sixteen shillings, and growing to their face value in five years' time. They are an ideal form of saving, in safety, rate of interest, freedom from taxation and prompt convertibility into cash with accrued interest, if need for cash should arise.
Another British Government security with a special privilege attached is Victory Bonds, which are accepted at their face value in payment of Estate Duties. As long as they can be bought at a considerable discount they thus make death a profitable transaction to the holder to the extent of his liability for Estate Duties, which are the toll that the State takes of his possessions on their transfer to his heirs. Moreover, bonds that are handed to the State in payment of Estate Duties are held by the
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National Debt Commissioners, so that what may be described as a special Sinking Fund is continually in operation to reduce the amount, and raise the price of those that are left in the market. These advantages, however, that are attached to Victory Bonds are, to a certain extent, "in the price." At the present moment the yield from them is less than that to be got from the 3½ per cent. Conversion Loan, now the most popular of British Government Securities, and perhaps the most suitable, after Savings Certificates, for the investor who wants one with no probability of early redemption.
Consideration of the beauties of these securities has revealed to us the qualities that we need in a desirable investment of the creditor class. By far the most important point is certainty of income out of which interest can be paid, and certainty of getting back our money if we want it is a pleasant and convenient addition. In the case of Savings Certificates, return of our money on demand with interest accrued is part of the contract with the debtor, and is an almost unique feature shared only by Savings Bank deposits which carry a much lower rate of interest. In that of Victory Bonds we get our money back plus a considerable premium, as long as they have been bought
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below par, when our executors pay Estate Duty, and they thus only carry this special advantage when held by investors whose estate is large enough to be taxed. In the case of all other securities dealt in in the stock markets, the investor can only get his money back by waiting for the date of redemption, if any, or for the chance of having his bond drawn for repayment, if the security is redeemed by a sinking fund operating in this manner, or by selling in the market at the current price.
And so we arrive at the terms of debt redemption, which are the next question to be considered, after the certainty of the interest payment. Those investors whose circumstances are such that a need to turn their holdings into cash is a highly improbable contingency and only want a collection of stocks that they can sleep on soundly, can take securities with a very remote date of redemption or perpetual securities which are definitely labelled as irredeemable. To such an investor, however, it is very important to be sure that the debtor has not got an option of redeeming if it suits him to do so. For example, the 5 per cent. War Loan can be paid off at par at any time after 1929, so that after that date its holders will be in danger of having their money, or the face value of their stock, returned to them
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if the Government is at any time able to borrow at a rate of interest lower than the one which it is paying on the stock. The fact that it is able so to borrow necessarily means that stock prices are relatively high and the yield to the buyer is consequently low, so that the investor will have his money thrown back at him at a time when it is difficult for him to reinvest to his own satisfaction.
A large number of creditor securities has lately been issued with this option in favour of the borrower—stocks with a life of thirty years or so with an option to the debtor to redeem at any time {{SIC|aften|after}} ten years from the date of issue. Obviously such stocks are not so pleasant to hold as those which are definitely redeemable either at the end of thirty years or at the end of ten years. In the first case the investor has the certainty of a comfortable rate of interest for a long time; in the second the short life of the security helps to keep its price steady. With a ten-thirty year stock the borrower is made comfortable at the expense of the investor, who stands to lose whether the ruling rate of interest rises or falls.
With regard to all creditor securities that are redeemable at a date it is important that the debtor should not only engage to repay but to make annual provision during the life of the
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loan for its extinction on or by that date. Debtors with very high credit have been able in times past to dispense with this obligation, but the financial exigencies of the war and after-war period have obliged the Governments of the highest standing to spread the jam thick on securities that they offer to the public, and the British 5 per cent. War Loan carries with it an obligation on the part of the Government, wheneven the market price of the stock is below 95 to set aside one-eighth per cent. of the outstanding amount of the loan each month to be used in the purchase of stock in the market; with the result that if the stock stood below 95 for a year there would be in effect a 1½ per cent. Sinking Fund, operating by purchase in the market. It is now some time since this provision has been effective, but it was at one time a valuable prop to the price of the stock. The 3½ per cent. Conversion Loan has a still more effective Sinking Fund clause in its contract which obliges the Government whenever the stock is below 90 to redeem each year 2 per cent. of its outstanding amount. Owing to the low rate of interest and consequent low price of the stock in the market, the effectiveness of this Sinking Fund, which is calculated, of course, on the face value of the stock, is all the greater. When the stock can be bought at
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75 a nominally 2 per cent. Sinking Fund actually buys 2⅔ per cent. of the outstanding issue.
For investment in Home Public Debts the buyer's range is practically confined to the obligations of the British Government and those of the municipalities and counties. We saw, when we considered our reasons for the belief that our Government securities are as safe and sound as any securities can be, that these reasons are to a great extent based on considerations which are not capable of exact calculation, that there is a good deal of sentiment behind them, and that this sentiment may be prejudiced by patriotism. When we come to investigate the security behind municipal and county debts, we find the same thing only rather more so, with, however, one advantage in their favour, that they are not debts that have been raised purely for the purpose of waging war.
With them, as with all securities, the most important consideration for the buyer is the income out of which the debtor can meet interest and provide for repayment. This income is derived from the power of the municipal and county authorities to levy and collect the local taxes known as rates from the inhabitants of the area; and any attempt to arrive at an exact estimate of the extent of this power is at least
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as difficult, if not more so, in the case of a local body than in that of the Government.
It is unthinkable, in the belief of most of us, that the British Government would ever incur debts that the nation could not meet; but one does not feel quite so certain about the local authorities, especially as the basis on which they assess their sheep for the shearing process is not nearly so sound. The Government, as we all know, taxes us on our incomes, on our purchases of certain goods, such as drink, tobacco and tea, and on the value of our estates when we die. The local authorities tax us according to the alleged value of the houses that we inhabit or the premises that we occupy for business purposes.
The difference between the two systems of assessment, and the advantage in favour of that which is employed by the Government is at once evident. Anyone who is receiving an income, spending money on articles which are not—though we may have come to regard them as such—necessaries of life, or leaving an estate, evidently has money out of which he can pay taxes. But the mere fact of living in a house or occupying premises for business by no means necessarily implies capacity to pay rates; on the contrary, if misfortune falls on the rate-payer his house or factory is a source of
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expense. A man whose income is a minus quantity and lives in a house on which he pays a rent of £100 a year is not a satisfactory subject of taxation.
You may say that he ought not to be living in such a house, and he will quite agree, but will point out that when he signed a contract by which he became its tenant for seven years he was making a good income which he did not expect to disappear; that he would be delighted to sub-let if he could find someone who would take the house, but that owing to bad times and the fact of the high rates charged by the municipality it is impossible for him to do so. A big shop or a great factory employing large numbers of workers and having to pay rates based on the value of the premises, whether it is earning nothing, little or a fortune in the way of net profit, is also evidently being taxed on a wholly unscientific basis, which lays a devastating burden, in bad times, on production and commerce.
It may be said, as a rough generalization not to be examined too critically, that the Government taxes us according to our assets, and the local authorities according to our liabilities. From such a system there is danger of evil consequences for the rate-payer and for the municipality and so ultimately for the investor who
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buys the municipality's debts. If rates rise too high—and every rate-payer is inclined to regard his rates as too high—they tend to cause a lowering of rents and consequently of valuations for rates, and so the municipality has to impose a still higher rate on a lower valuation, and so increase the evil, or else reduce its expenditure which, like most public bodies that spend other people's money, it finds a very difficult task and highly unpopular with those on whom the expenditure is spent. If the evil becomes too acute, it may drive the inhabitants, residential, commercial and industrial, out of the area. Short of that it stops growth and makes anyone, who can do so, live or work anywhere else. Witness the tendency, already evident, of factories to be built outside urban areas in England; a tendency that may be a good deal quickened if and when any practical result comes from the schemes of electrical power distribution, about which much has lately been said.
Nevertheless, most of us believe that there never can be a question of the solvency of any of the great English towns, and have no hesitation in regarding their debts as almost as gilt-edged as those of the British Government. The fact remains, however, that the much narrower area of taxable capacity that they
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cover, the power of that taxable capacity to shift from one centre to another owing to changes of trade conditions, and the unsound basis on which local rates are collected are disadvantages that cannot be altogether forgotten by the prudent investor.
On the other hand, there is this to be said of municipal debts, that they usually represent something more solid than the long series of wars more or less successfully waged, which are by far the largest asset that we can find to put into the balance-sheet against the seven thousand millions of British debt. But assets are of little advantage to the creditor if from their nature they are unsaleable and if they are not producers of net revenue. And the kind of assets that municipalities own—public parks, tramway systems, sewers, water supply and so forth—are not the sort of article that can be put up to auction and sold if the municipal area has fallen on such evil days that the municipality's power to meet its debt charges is doubtful. They are revenue producing, if at all, only as part of a going concern, and their "old iron" value is practically nil, if extravagance and bad finance on the part of the local authority should result in a level of local rates, high enough to check and reverse the progress of the area covered. We come back to revenue, as we
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always shall in looking at all kinds of securities, as the real test on which the desirability of municipal debts is based, and though comparisons may be made of the rates in the pound charged by the different municipalities, they have little meaning unless the investor who studies them is fully informed concerning local conditions and the prosperity and prospects of the industries and trades of the place.
In considering individual securities offered by the local authorities, we have to make sure of the same points that were indicated as essential with regard to Home Government stocks. That is, we want to be sure that the stock is either definitely redeemable at a date or definitely irredeemable, and that redeemable means that it must be paid off, and not that the debtor has the right to redeem if it suits him. Also that there is no option in his favour of redemption if it suits him, at any time after such and such a date. And that the debtor is bound under the terms of the issue to set aside each year a sum that will suffice to provide for redemption of the debt on maturity. Rateable value has been shown to be a not wholly impregnable foundation on which to raise a skyscraping erection of debt; and there is all the more reason for preferring the debts of a municipality whose total debt is small as com-
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pared with the estimated rateable value of its area. But most investors are content with the fact that the debts of municipalities with a certain population are "trustee securities" and may, therefore, be assumed to be immaculate. It is high time to deal with this assumption.
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{{ph|class=chapter num|Chapter V}}
{{ph|class=chapter title|Trustee Securities|level=2}}
{{sc|Before}} 1889 the only stock that a trustee might buy, unless otherwise instructed by the Trust Deed, was Consols. By the [[Trustee Act, 1893]] (which did not extend to Scotland), his choice was extended to:
1. Other British Government securities.
2. Real or heritable securities in Great Britain or Ireland.
3. Stock of the Banks of England or Ireland.
4. India Government stocks.
5. Any securities with interest guaranteed by Parliament.
6. Metropolitan Board of Works or London County stocks, or Debenture stock created by the Receiver for the London Police District.
7. Debenture Guaranteed and Preference stocks of any railway company in Great Britain or Ireland that has paid 3 per cent. on its ordinary stock in each of the ten years before the investment.
{{nop}}
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8. The stocks of railways and canals in Great Britain or Ireland leased for not less than two hundred years at a fixed rental to any railway included under 7, g. Debenture stocks of Indian Railways sterling paid or guaranteed by the Secretary of State in Council of India.
9. Debenture stocks of Indian Railways sterling paid or guaranteed by the Secretary of State in Council of India.
10. Certain Indian Railway Annuities.
11. Indian Railway ordinary stocks with a dividend guaranteed by the Government.
12. Debenture guaranteed or preference stocks of British water companies which have paid 5 per cent. during each of the ten years before the investment.
13. The stocks of municipal boroughs with a population exceeding 50,000 or of any County Council.
14. Stocks issued by Commissioners incorporated by Parliament to supply water and having compulsory power to levy rates over an area with a population of 50,000, provided that during the previous ten years the rates levied have not exceeded 80 per cent. of the rates authorized.
15. Any securities authorized for the investment of cash under the control or subject to the order of the High Court. Its list includes mortgages of freehold and copyhold estates in England and Wales and debenture guaranteed
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rent-charge preference stocks of railways in Great Britain or Northern Ireland that have in ten previous years paid a dividend on ordinary.
By the [[Colonial Stock Act, 1900]], the Act of 1893 was made to include Colonial Stocks, if the colony:
{{bc|
(''a'') Provide for payment out of its revenue of any sums payable to stockholders under any judgment decree rule or order of a Court in the United Kingdom;
(''b'') Satisfies the Treasury that adequate funds will be made available for this purpose, and
(''c'') Formally expresses its opinion that any legislation injuring the stockholder or involving departure from the original contract with him would properly be disallowed.
}}
The [[Metropolis Water Act, 1902]], made Metropolitan Water Stock a trustee security, under the 1893 Act.
The [[Housing Act, 1919]], included local bonds under that Act and mortgages of rates granted by local authorities authorized to issue local bonds under it.
The rough summary given above is a shortened version of the particulars given by
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the Stock Exchange Official Intelligence. It is not, of course, intended as a complete guide to trustees, who will always be well advised to invest, as such, only with the assistance of legal instruction. The [[Trustee Act of 1925]] has consolidated previous legislation on the subject, but as far as a layman can understand its meaning, has made only two important alterations. It has restricted investments in Indian loans and guarantees to those that have interest payable in sterling and it has permitted investments in (otherwise suitable) bearer securities as long as they are deposited for safe custody and collection in the hands of a banker. Changes made with regard to investments in real property do not concern us here.
The principles on which the securities permitted as investments to trustees were selected under the Act of 1893 are evident and reasonable. They aimed at including debts of the British Government or of bodies which were subject to its control or at least could be watched by it at close quarters. Even so, the inclusion of the ordinary stocks of the Banks of England and Ireland was a curious anomaly, since one would have expected that Parliament would have aimed above all at securing a certain income for beneficiaries
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under trusts, and the stocks of these great banks have been liable to fluctuation in dividend.
The inclusion of colonial stocks merely with the condition that the borrowing colonies should go through certain formalities that (inevitably) imply no Imperial control over their finances, was a departure which sent British trust funds over seas to countries of abounding economic promise, with a tendency to experiment, that might develop along lines which would not be in accordance with the canons of British financial statesmanship. It was a departure dictated by political sentiment, which, as French holders of Russian debt have discovered to their cost, is an untrustworthy guide in the selection of securities as investments. The sequel was an enormously rapid expansion in the debts of the Dominions quoted on the London Stock Exchange.
Any Act of Parliament which says that certain securities may be taken is bound to produce anomalies because it at once becomes possible to point to investments which are left out but are quite as good as some which are officially approved. In such matters it is impossible to draw a line which will not lay the drawer open to criticism of this kind. The wealth that was poured into the laps of the
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Dominions by the high prices at which they sold, during and after the war, the food and materials that are their staple products has done something to put solid assets behind the debts that they built up so fast, but the pace of debt creation, especially by the Australasian States, has nevertheless hardly slackened. And political developments in India and the measure of self-government accorded to her population has given a different aspect to the obligations issued in its name.
These considerations make it very important for investors not to be misled by a belief that because a stock is a trustee security it is, therefore, absolutely safe. As far as a trustee is concerned it is safe, from the point of view of his own pocket—if the debtor should default, the beneficiaries under the trust would: have no case against the trustee, who had invested according to the Act. But the trustee is the only party to the transaction to whom safety is secured. He is fully entitled to this safety, for he performs a difficult, responsible, and generally thankless task, and is apt to be looked on by the beneficiaries, whose interests he protects, as a tiresome nuisance.
It is often argued, sometimes even by stockbrokers who ought to know what security means, that "the British Government could
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never let a debtor default whose debts were included among trustee investments." But what if the debtor could not or would not pay? The contingency may be, and is, most remote, but if it happened, does it seem probable that the Treasury would take over the liability? Trustee securities ought to be judged as severely, on their own merits, as if the Trustee Acts did not exist, by anyone except trustees who considers an investment in any of them. A trustee, seeing that the Acts have been specially passed for his guidance, may well consider that his conscience is as safe as his pocket in following their instructions, but for anyone else to think that he cannot go wrong with a trustee security is a very unsafe assumption.
Nevertheless this assumption is so general that there is a strong argument for the abolition of the dangerous delusion on which it is based by a revision of the Trustee Acts and a return to the old restriction to British Government securities. If people will insist on believing that the Government hall-marks a security as unimpeachable by including it among trustee investments, it is only reasonable for the Government to confine this hall-mark to the only debts over which it has real control, namely its own.
{{nop}}
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There is another very good reason for doing so, which is the imperative need for reducing the burden of taxation by conversion of the British debt on to a lower interest basis. If investments by trustees were confined in future to British debt, this restriction would evidently tend to raise the prices of the securities in which British debt is expressed and so would hasten the process by which the largest item in our national expenditure, and the only one which cannot be touched by any ordinary measures of economy, can be brought down by a rise in the market value of British credit.
It need hardly be said that the restriction could not be made retrospective, obliging all trustees who held securities other than those of the British Government to dispose of them. It is only suggested that future investments by trustees should be confined to the stocks which really give the assurance which is now so often assumed where it does not in fact exist. If this were done it would be very many years before any real difficulty would be experienced by trustees in supplying themselves with stock. In 1889 when they were confined to Consols, the, whole amount of Consols in existence was £552 millions. The British debt, other than Treasury bills and
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other forms of "floating" debt, amounted on December 31, 1925, to £7,016 millions.
It is true that beneficiaries under trusts would receive a slightly smaller income than their trustees would otherwise have been able to earn for them; but this is no great hardship to inflict on them, in view of the greater security that would be given to them, the privileged position that they enjoy in having their property taken care of for them under the eye of State regulation and the great advantage to the nation as a whole that would be secured by a reduction of the debt charge. Moreover, it would always be in the power of anyone who was leaving funds in trust and disliked the limitation on trustees' power of investment, to confer greater freedom on them by the terms of the trust deed. At the time when trustee securities were so dear—in the middle nineties—that it was difficult to get a yield of 2½ per cent. on them, a fashion was introduced of drawing trust deeds with wide investment powers, and there is no reason why this tendency should not be extended.
India and the Dominions would have no legitimate cause to feel aggrieved, in view of the much greater burden of war debt and after-war depression that the British tax-payer has had to shoulder; and the fact that the
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Australian Commonwealth and one of the Australian States have lately borrowed in New York has weakened still further the already weak power of supervision that was exercised over Dominion borrowing by the London market. Moreover, our Dominions have a very definite advantage over all other oversea borrowers, which will be made clear when we come to consider the question of Public Debts Abroad.
In the meantime, trustee securities have a certain prestige as such, and consequently are, like British Government stocks, a "fancy article" which many investors must have and many others think that they ought to have, because of the halo of sanctity which is believed to surround them. To the practical investor who wants to buy securities for intrinsic value only, the fact that a fancy price is put on an article by a law or convention which does not add one half-pennyworth to their security, is a reason for not buying trustee securities, unless overwhelming arguments can be produced in favour of doing so, in any particular case.
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{{ph|class=chapter num|Chapter VI}}
{{ph|class=chapter title|Public Debts Abroad|level=2}}
{{sc|Public}} debts as investments are very much the same problem whatever be the country from which they are issued. All over the world the income that is behind them, on which the soundness and value of the security ultimately depend, comes from the taxable capacity of the inhabitants of the area involved, whether the borrower be a Government or a State or a municipality. The only difference is that the difficulty of arriving at anything like an exact estimate of the extent of that taxable capacity—which we found to be considerable at hone—becomes much greater when we have to send our minds on a sea voyage, and try to imagine how the average Pole or Brazilian or Chinaman regards the question of the sanctity of financial contracts entered into by his Government or his municipality. The war showed us that a nation which is ready to pay taxes for a cause that it thinks to be worth the sacrifice can draw on its resources to an extent which would have
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been thought to be incredible until it was tried. But we are still in the dark as to whether any body of tax-payers would make sacrifices in order to preserve its country's solvency, to anything like the same extent as for securing victory in war; and it is upon the temper of the tax-payer that taxable capacity in the last resort depends. We are also profoundly ignorant about political conditions in other countries. There was a time when Mexican securities were thought to be first rate, of their class. But they depended on the maintenance of the dictatorship established by President Diaz. When he went the country fell back into anarchy and bankruptcy.
Though the basis of security be the same, however, a very important difference between home and foreign investments has been introduced by the war, and the ungentlemanly manner in which it was waged. Some of us are old enough to remember the confidence that used, in the remote Victorian age, to be felt by British investors in Russian Government securities because of a tradition which told them that all through the Crimean War British investors in Russian bonds punctually received the interest due to them. But in the late war the Governments fought with every possible weapon, and among them the financial one was
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perhaps the most important, after the naval and military. They not only did not pay their own debts to belligerents, but did not allow their citizens to do so; and under modern conditions they were evidently quite right. And so anyone who buys the securities of any foreign Government or public body does so with the certainty that if we should go to war with the debtor he would not pay us a shilling's worth of interest as long as the war lasted. The "war risk" attached to all foreign investments is thus a very real factor, as long as the possibility of war lasts; and it is obviously one which is extremely difficult to calculate.
This is the consideration which gives to investments in our own Dominions an advantage over those in all other countries, though the degree of war risk varies very greatly between one foreign country and another.
Apart from it, we have a feeling that the countries of our own race and language are likely to think and act more or less as we should in making sacrifices if necessary to defend their Government and public authorities against default. And the fact that they, nearly all of them, use currencies identical with ours, not only eliminates an element of possible difficulty in making payments, but makes it easier for the conscientious investor to study with intelligence
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any official statements that may be published concerning the financial position of the borrower.
Debts of some Dominion and Foreign Governments have one advantage over that of ours, in the shape of tangible assets, some of which produce a revenue and some even a revenue that more than suffices to meet the interest on the money spent on them. This is the retort that is always, and most rightly, hurled by the Australians at anyone who hints that Australia has borrowed rather rapidly in London. Nearly the whole of the British debt, as was shown above, represents money shot away in the course of wars, some of which have only happened because, as subsequent statesmen have told us, we "put our money on the wrong horse." Australia's debt is offset by the possession of a railway system, and national ownership of railways may be said to be the general rule, except in the United States, England and Argentina. So it happens by a curious paradox that the two countries whose credit stands highest have least to show as revenue producing assets to set off against their debts.
This fact seems to indicate that it is easy to attach too much importance to the possession of such assets, and it is clear that a creditor, who
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relied on them to come to his rescue if the general revenue of a country failed to supply his interest, might be uncomfortably disappointed, even if the railways or State forests or whatever the asset might be were definitely pledged to the service of the loan. State management of railways is often extravagant and bad, but even if the Government were willing to sell or lease its transport system to a body representing foreign creditors, and give it power to carry out reforms in order to produce a larger revenue, it would be extremely difficult to make such reforms effective.
The real advantage, from the point of view of the investor, of Government debts is the fact that behind them is the whole wealth of all the inhabitants of the country, in so far as the said inhabitants can be induced to part with it for public purposes; and the existence of particular assets and sources of revenue, even if definitely pledged and assigned to the service of debt, is a certain protection to the investor and makes a loan look safer, and may even sometimes make the borrower more careful in expenditure; but if the worst happens, Government has to be carried on, or thinks so, and the first charge on every item in every country's revenue, whatever arrangements may be made to the contrary, is ultimately the amount that, in its opinion, is
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essential to the conduct of the administration in accordance with its idea of the services which that administration ought to render to the inhabitants.
Whether Governments should raise debts at all is a question that might very easily be argued were it not that they have so long and so vigorously done so that the argument would be futile. They do so in order to carry on war, to finance public services such as transport systems, and to make good a gap between revenue and ordinary expenditure. In the bad old past, loans have been much too freely granted by the lending centres, especially London and Paris, to irresponsible Governments without sufficient inquiry as to how the money was to be spent, or even as to how much of it was ever going to reach the Treasury of the borrower, after all the cormorants on both sides of the water had been satisfied, who thought that they had claims to pickings out of the transaction. The consequence has been a series of defaults for which the citizens of the defaulting country have little real responsibility, and a very ugly blot on the history of International Finance, in its first century. Such things could hardly happen again, and in the present dearth of capital for investment there is no need to fear that weak borrowers
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will be allowed to have funds of which they are going to make bad use. But as the present dearth is not going to last for ever, it is well that issuing houses and investors should make up their minds about the principles on which money should be lent to Governments, and determine to stick to them.
Lending for war purposes is evidently not a matter to which any economic rules can be applied. One lends to one's own Government when it is at war, because one wants to do everything to help it to win; it chooses to get money from its citizens by loans, and so one subscribes if one can even though one may be convinced that less loans and more taxes would be a sounder and much cheaper way of financing war and that the notion that we can make posterity pay is a pure delusion, even if it were right or wise to do so.<ref>See ''[[Our Money and the State]],'' by H. Withers, Chapter II.</ref> If we lend to other Governments when they are at war, we do so because we want to help them to win, and at the same time believe that they will at any rate end the war not too much impoverished to meet the service of the debt. None of these sentiments are amenable to financial reasoning since they depend almost entirely on patriotism or political fancy.
{{nop}}
/foot//
{{smallrefs}}
//foot/
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Lending to foreign Governments for public purposes requires the most careful scrutiny. It is really only desirable when the public purpose is a railway or a harbour or an irrigation scheme which can be shown to be as certain as is humanly possible to bring in a revenue that will fully cover the service of any loan that is to be spent on it; and even then there is always the doubt whether the scheme would not be likely to be more successfully handled, from every point of view, by a judicious combination of local and foreign capital working under a concession that is fairly drawn and fairly administered in the interests of the concessionaires and of the community.
Moreover, the scheme must not only produce a revenue big enough to meet the service of the loan, it must also, by means of improved transport facilities or production of some article that is in demand abroad, increase the export trade of the borrowing country and so enable it to meet the "invisible import" of demands for interest and redemption. A foreign loan that merely enables the citizens of a country to take in one another's washing with greater ease and mutual profit will be a burden on its exchange each half year as remittances have to be made to New York and London to meet interest and sinking fund, and there is no increase in goods
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going abroad to be turned into dollars and pounds. It may be that schemes, such as road making, may be shown to be going to produce, indirectly, a great increase in revenue and in exports without actually themselves putting any money into the hands of the local Finance Minister, and it would be absurd to deny that these beneficent results might follow in some instances. Nevertheless, very exacting scepticism on such a point is certainly to be encouraged because foreign money is such an expensive luxury for a borrower and the ease with which it is sometimes raised is so great a temptation to slack and wasteful administrators that it is much safer to confine its use to public works in which it will pay for itself.
Foreign money is an expensive luxury to the borrower because its effect is essentially different from that of money borrowed at home. Domestic loans redistribute the income of the citizens, by transferring interest from the pockets of the tax-payers to those of the {{hinc|debt-holders}}, but do not reduce the income of the nation as a whole. They have awkward economic and social effects because the charge for them is to a great extent taken from industry and enterprise and handed over to {{hinc|debt-holders}} who may be mere idlers; but when taxation is soundly imposed and only falls on
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industry when it earns profits (as in the example of a well-administered income tax) the burden of a home debt, if it is not too big, is easily borne and the pages of our historians are full of prophecies of England's ruin made by distinguished statesmen and economists after great additions to her debt by wars, followed by the triumphant refusal of England to be anything but more prosperous than ever.<ref>[[Author:Thomas Babington Macaulay|Macaulay]], ''[[The History of England from the Accession of James II|History of England]],'' [[The History of England from the Accession of James II/Chapter XIX|Chapter XIX]].</ref> Foreign loans, on the other hand, pour a flood of money, that has not been earned in the country, into the pockets of its citizens as they are spent by the borrowing Government and so produce a short-lived spell of artificial and unwholesome prosperity, and then are followed by a half-yearly drain (unless, as often happens, the drain is met by "another dose of the same") which means that the inhabitants as a whole have to consume so much less, because a sufficient value in their goods has to be sent abroad and so provide the foreign currency in which the debt charge has to be met.
Borrowing to meet Budget deficits, caused because the Government has spent too much and taxed too little, is evidently unsound finance and especially so when loans are raised abroad. When it is done at home, occasionally and on a small scale, there is no great harm in
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it; and it may go on for years without damaging a country's credit, as was shown by France before the war. But if the Government of a foreign state borrows in London instead of making its citizens pay for the normal expenses of administration, the result is a serious check on the vigilance with which its expenditure is watched, and the natural tendency to official extravagance is encouraged, and in all subsequent years the check on home consumption and the adverse effect on the exchange that are involved by foreign debt are penalties for the extravagance.
It may be contended that all these considerations are the concern of the borrower rather than of the lender and that if the investor thinks that a foreign security is good enough to hold he need not bother his head about the purpose for which it was raised or the way in which the money was originally spent. Within limits this is true, but bad financial habits are so easy to contract and so hard to reform that when a country's foreign debt has been chiefly raised for purposes that have not helped to increase its revenue and its export trade, it is likely to find the service of it increasingly difficult to meet.
We find then that the real security behind a Government debt is an extremely elusive
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article. It cannot be a matter of real assets owned by the debtor because we have already seen that the United States and England, whose credit stands highest, have practically none; but then the United States owe nothing abroad and the British Government likewise, until during the war it borrowed abroad in order to finance its Allies; it is even now possible that out of Reparations and payments of interest and debt by Allies the British Government may be able to cover the service of its debt to America; and if nothing should be received from these sources, the net income from the foreign investments of British citizens is now estimated at £250 millions, or nearly eight times as great as the yearly sum required for the service of their Government's debt to the United States. It thus appears that countries which have no foreign debt, which is only another way of saying countries that have wealthy inhabitants, are those which enjoy the highest credit, which is a dismally platitudinous conclusion to reach, and not very helpful; because the wealth of a country is nearly as difficult a matter to estimate as the readiness of its citizens to pay taxes rather than allow its Government to default.
The mere fact, however, that a country has to borrow abroad may be taken as an indication
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of poverty for the time being, though it may be compatible with the possession of great potential resources. The latter condition has evidently been present in our Dominions and in countries such as Brazil, Argentina and Chile. It should be noted, however, that the United States, though still a borrowing country up to the time of the war, held all its own Government debt and only did its borrowing by issues of railroad and industrial bonds and stocks. Evidently the financial position of the Governments of our Dominions and of the foreign countries that are chronic borrowers abroad would have been much stronger if the funds necessary for development purposes had been raised by private enterprise, according to the American pattern.
The comparatively severe burden imposed on a country by a debt raised abroad has already been shown, and it is clear that the debts of those countries which are continually adding to this burden become increasingly unattractive to the prudent investor. For the time being repeated issues of external debt relieve the burden because the interest on the existing loans is paid not by a reduction of the consumption of the inhabitants but out of the pockets of investors in some other country who find the fresh money. But there comes a time
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when the process of meeting external interest charges by external borrowing has to stop, and then the full weight of the burden is suddenly laid on the shoulders of those who are really responsible for carrying it, and unless their wealth has in the meantime grown as rapidly as the debt, the process is very unpleasant. But this is unlikely, since otherwise why should additions to external debt have continued?
Nevertheless there have been examples of countries with a considerable external debt, which have been able, through the industry and thrift of their inhabitants, to bring the debt home and so relieve themselves of the burden of external debt charge. France borrowed heavily abroad to pay the German War Indemnity after 1871, but quickly took the debt home, and it is likely that we shall see Germany do the same with the loan issued for her in 1924. It will be remembered also that italy in the years before the war was able to take home most of the italian Rentes that were once freely dealt in in Paris and London, being enabled to do so largely by the wealth that was poured into her by her citizens who went abroad and worked and saved, especially in North and South America, and sent their savings to italy.
France's rapid recovery after 1871, and
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Italy's growing wealth, which improved the credit of both of them so rapidly, were thus accompanied and marked by a reduction of external Government debt, the absence of which has already been noted as a feature of the financial position of the wealthiest countries with the highest credit. And it thus seems safe to conclude that one test of the soundness of overseas debts, as investments, is the pace at which the debtors have been increasing external liabilities America's example has shown that it is possible for a country to expand its resources and development with amazing speed and with the help of foreign capital, without any necessity for its Government to issue loans abroad, and for a country to be using this form of financing its development is clearly an indication of financial weakness—one might almost say moral weakness, were not the word so overworked.
Exception has evidently to be made in the case of dependent countries with an alien administration and a backward population, such as India and the Dutch East Indies. With them there is clearly much more reason for development by means of Government debts, but for' self-governing countries with a number of rich inhabitants, continuous borrowing abroad is a symptom that needs explanation.
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Those then who are considering an investment in any oversea public debt have to decide or make guesses about:—
1. The risk of war with the debtor, because in war there is no interest and the security is probably unsaleable.
2. The extent of the debtor's external debt and the rapidity of its growth as compared with
{{bc|
(''a'') its wealth,
(''b'') its trade balance,
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and, since (a) and (4) are largely a matter of estimate.
{{bc|
(''c'') its internal debt, and
(''d'') its total expenditure.
}}
3. The proportion that its total debt charge bears to its total expenditure.
4. Its habits with regard to balancing its budget.
5. The stability of its currency.
The risk of war is evidently guesswork, and so also to an extent that will surprise any conscientious investor who tries also to be an investigator, are the facts, or what ought to be the facts, included under 2 and 3. Even the matter of the amount and growth of the external debt is by no means always made clear from official statements, because at times when
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monetary conditions are unfavourable to a new loan in the open market it is possible that temporary credits may be arranged in a foreign centre and included under some heading such as floating debt, which does not give the information needed.
Whether any country balances its Budget—or rather, in most cases, the extent to which it fails to do so—is a matter that is as difficult to guess as we shall find it on later pages difficult to know what is the real profit or loss that an industrial company has made. We believe in England that our Government balances its Budget and we hope that we are right because a sum of £45 to £50 millions, yearly devoted to debt redemption, gives us a handsome margin on which to come and go. But if we tried to be exact, how much do we know about the arrears of taxation carried over each year? The sum of these arrears must be enormous, and variations in it might make a substantial difference to a year's accounts.
On the subject of 4 there is a definite record that tells one the actual facts about the exchange value of a country's currency not furnished by its official documents but by the dealings in it on the exchange markets of the world. We can really find out exactly what the rupee or the franc or the milreis has been
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worth in sterling yesterday or a year ago or ten or fifty years ago. And these facts are sometimes really some guide as to what the probable value of any country's currency may be in a year's time; though the extent to which shrewd people may be misled about exchange movements was shown by the readiness with which they went on buying German marks until the value of the mark went out of sight.
In the midst of this mirage of doubts and possibilities those who invest in oversea Government debts work largely on impression and instinct, a hazy knowledge of the financial past of the debtor and the summary of the shrewd judgment of the Stock Exchange which is supplied to them by their brokers. They think and feel and find that Capel Court agrees that "Argentina (or whatever the country may be) is all right" and there you are. In this example there is at least a record to work on, but how can anyone make a guess concerning the probable performance of the frisky European three-year-olds who have lately made their appearance? Of them, however, it can at least be said that they were introduced at a time of great difficulty and under august auspices. The need for care was so evident that we may be certain that as much
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as possible was exercised by the issuing houses which fathered them. Probably investors follow a trusting faith in the issuing house and perhaps after all this is the safest guide with foreign issues, for those who really know the records of the issuing houses. Still I must confess a preference for a mature vintage not only in foreign debt but in industrials. A debtor who has paid and a company that has earned for half a century or even for twenty years, and has stood the shock of 1907 and the cataclysms of 1914 and 1921 has an aroma, like a bottle that is whiskered with honourable cobwebs.
When we come to the detailed points to be desired in any particular form of oversea public debt that we may be considering they will evidently be the same as those mentioned in discussing Home Public Debts, with one important addition. We shall want either a definite date of repayment or regular redemption by drawings or purchase, so that so much of the loan is definitely cancelled every year, or else possibly, in the case of a highly favoured borrower, a perpetual debt. What we do not want is a loan which carries an option in favour of the debtor, so that it may be repaid, after a certain date, if and when it suits his convenience, which it will only
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do at a time when it will be inconvenient to the investor to be repaid.
Besides these obvious requirements we shall want the interest, drawn bonds and bonds due on maturity to be paid in sterling money or else in American dollars, or some currency in the stability of which we have the most complete confidence. It may be asked why, if this proviso is to be insisted on, the stability of the debtor's currency was, a few pages ago, put down as a matter to be investigated—why does it concern the investor if he is to be paid in sterling or dollars? Because if the currency is unstable in which most of the debtor's revenue is collected, the debtor Government will evidently have more difficulty in providing the dollars or pounds in which the debt charge has to be paid; and in so far as its revenue is collected "in gold," the tax-payer will have the more difficulty in paying it. When the Brazilian milreis fell from 1s. 4d. to 5d. in exchange value, the Brazilian tax-payer had to produce more than three times as much in local currency in order to put down pounds in London for the service of the English loans, which thus involved a greater effort on the part of the debtor country and impaired the creditor's security without increasing his income.
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In fact the danger that is run by those who lend to foreign debtors who are cursed with an unstable currency is so great that ingenious efforts are made by issuing houses to secure, as a collateral pledge, some asset which is sure of a market abroad and so is equivalent to so much foreign currency. This device has been successfully carried out in the case of loans to the State of San Paulo and to the Brazilian Government secured on holdings of coffee which had been taken over from the growers in order to prevent its price being wrecked by sales at a time when the market was gorged. The coffee was gradually sold as consumption overtook supply and the proceeds were used to meet interest and redeem the loans. But the circumstances under which any foreign debtor is in a position to pledge such a "sterling asset" are evidently rare, and a system by which Governments undertake such wholesale purchases of commodities is not one to be encouraged, even though it provides a convenient form of collateral, if the operation is well and successfully thought out and concluded.
As to other forms of liens and pledges, such as special assignations of the Customs duties, or the profit of a tobacco monopoly or the revenues of railways, the limitations on their
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value have already been noted. But they are a popular feature with the Stock Exchange and with the investing public which it educates, especially when the assigned revenues are periodically paid over to the agents of the bankers to the loan; and loans so fortified are likely to be more tenderly treated by a Finance Minister than those which have no special security attached. The mere fact of their being given, however, is a symptom of financial weakness.
In some cases, when the borrower is a weak or backward Government, they are a very real advantage. The Chinese loans secured on the Maritime Customs duties paid at the treaty ports and handled only by the foreign officials of the Customs Board are certainly made safer by the fact that the funds needed for their service are collected on the seashore and do no go inland at all. But such an arrangement as this is obviously exceptional.
State debts—that is to say the debts of the provinces that make up the Federated nations, such as the German Empire, Argentina, Brazil, etc.—should be tasted by the investor with a very long spoon indeed. The German States in pre-war days enjoyed, and with good reason, first-rate credit, which was only smashed by the cataclysm inflicted on
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them by the madness of the Imperial Government assisted by that of its neighbours; but when a State's credit is not first-rate—and if it is it seldom needs to borrow abroad—it is likely to be a dangerous debtor because of its limited powers of taxation. The Australian States, of course, having been in existence before the Federation, are in a class by themselves.
Municipal debts abroad and such issues as the Port and Harbour Trust securities produced by India and the Dominions often have a more solid appearance than the debts of the Central Governments, because less subject to the shifting gusts of politics and free from the economic waste of expenditure on armaments which eats into the financial strength of all Central Treasuries. It is easy to persuade oneself that whatever may happen to the Government of a country its principal cities must go on and its great ports must be thronged with ships, which will pay harbour dues.
I still lie awake o' nights sometimes because many years ago a City of Moscow loan came out and friends of mine who had a little money to invest asked me what I thought of it and I answered very much in the terms of the above paragraph. Experience has now
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taught us that, if a central Government falls altogether to pieces and is succeeded by one that repudiates its obligations, or even if (as in the German example) a central Government divides the value of the currency by a sufficient number of millions, the most attractive-looking municipal loan will be found to have no health in it. Nevertheless, their finances being on a smaller scale and covering a smaller area, can be more closely watched by the citizens who suffer if they are ill administered; on the other hand, municipal extravagance is often a source of profit to local contractors and land jobbers and where politics are corrupt, the street corner corruption of local politics is likely to be especially corrosive and disgusting. And the judicious investor, before he handles such securities on his own judgment, ought to know a good deal more than he is likely to find out about the system of taxation from which foreign or even colonial municipalities collect their revenues, and whether it suffers from the defects which we found in the rating system in England.
But, as has already been hinted, perhaps the really judicious investor in Foreign Public Debts is he who makes no attempt to investigate all the incalculable and elusive details that make up a sound security of this
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class, but relies on his faith in the issuing house, which is much more easily able to arrive at something like truth on the subject. But how many private investors know much about the facts which ought to guide them to confidence in an issuing house?
And perhaps, after all, the chronic inability of weak Governments to make both ends meet is the soundest reason for expecting that they will meet their debt obligations, if they possibly can. They know that they are always wanting to borrow, and that they cannot borrow unless they pay.
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{{ph|class=chapter num|Chapter VII}}
{{ph|class=chapter title|Mortgages and Real Estate|level=2}}
{{sc|For}} the ordinary investor this chapter might be put into one word, "Don't." We have seen in [[Hints About Investments/Chapter 5|Chapter V]] that investments in "real or heritable securities," by which I understand that real property and mortgages thereon are meant, are permitted under the Trustee Act; but such investments have been in the past a fruitful source of loss to beneficiaries under trust deeds, when trustees, on their own responsibility or under the advice of solicitors, have put funds into mortgages on house property that has declined in value, as house property is liable to do without the process being evident to anybody but the keenest observer.
This is the essential difference between real property and Stock Exchange securities, that the latter have a quotation—sometimes more or less nominal it is true, but at least a quotation and a record indicating business done in them,
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that can be studied in the daily papers. With house property there is no such facility for watching the value of the investment, and this lack, among other things, makes it quite unsuitable for an investor, unless he is confident that his interests are being guarded, with unceasing vigilance, by a solicitor or other agent, who gives close attention, and brings real knowledge, to the matter. Investments in Building Societies suffer from the same disadvantage, and an investment that cannot be watched is not one to be looked at.
Even ground rents, which rank as a gilt-edged security—and with good reason when they are good—inevitably suffer from the same lack of a free public market, and can only be indulged in on the most competent technical advice.
Anyone who buys houses outright and hopes to receive from them an income, after he has collected the rents and paid all outgoings, is indulging in a frankly speculative form of investment.
It may come right just as a purchase of shares in an oil-field that has not yet sruck oil may come right, but it requires so much technical knowledge or so much good luck, that it is outside the range of the present inquiry, which seeks to light a candle by which the ordinary
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citizen may invest his money with reasonable safety and with a reasonable chance of increasing it. The owner of house property—the "{{hinc|bloodsucking}} landlord" as he is so often described—is very lucky if he gets an average net yield from it which is better than what he could have secured on the Stock Exchange with much less anxiety and trouble; and, owing to his general unpopularity and the subservience of modern Governments to the prejudices of the multitude, he is likely to be treated with the gravest injustice at times when the service that he provides for the public is most essential and costs most to increase or reproduce.
The man who buys a house to live in is evidently in a quite different position. He has a good tenant, who will not be exacting about repairs—in fact the owner-tenant is likely to go wrong in the other direction and forget that houses wear out. If he has chosen a good neighbourhood and paid a reasonable price, he may do well by his investment.
But landlords are at all times especially hard hit by a general rise in prices because of the comparatively long terms for which they dispose of the use of their property. An owner who lets a house on a seven years' lease may have the greater part of his net income wiped out by a rise in prices which adds 10 per cent. or 20
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per cent. to the cost of structural repairs, and to the prices of all the commodities which he has to buy out of the income from the lease. This is a risk that he has to take, and in normal times it is balanced by the consequent addition to the money value of his property. But by the [[Rent Restriction Act of 1915]] the Government, having first made the position of landlords difficult and unprofitable by debasing the currency (which perhaps it could not avoid), proceeded to forbid them to raise rents, so inflicting serious injustice on a class of investors who provide the public with the essential service of shelter, at a time when providers of and dealers in food and coal and munitions were earning peerages by making fortunes out of the nation's need. And at the expense of the unfortunate landlord a very comfortable benefit was conferred on the tenant, who was probably earning a larger money income than ever before and made hay while the sun shone by taking in lodgers. A class that is faced by great difficulties and anxieties in normal times, and in abnormal times is sacrificed to the prejudices of its customers and the opportunism of Governments, is not one that any prudent investor will join unless he knows the ropes so well that he is absolutely certain that he is not making a mistake.
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An investor who confines himself to mortgages on real property is in a stronger position, being, or hoping that he is going to be, not an owner but a creditor, with all the advantages that we have seen to be attached to that position, with the addition that in the matter of real property the right of foreclosure that goes with a watertight mortgage is more practical and valuable than we shall find it to be when we come to consider the question of industrial debts.
Foreclosure means the right, if the debtor does not pay interest or repay the debt if it be demanded, to sell the property over his head and repay oneself out of the proceeds, the balance, if any, going to the debtor. This right is more practical and valuable with regard to houses and land, because they are articles that are wanted to a certain extent on their own account and have some sort of a price whatever be the circumstances of those who live in or on them, whereas a factory or the building in which a great multiple shop is carried on, or a railway station, might, if the enterprise that uses it is a failure, be quite unsaleable and a mere encumbrance to anybody that seized it for the payment of a debt, who would have to begin by spending money on rebuilding it before it could be sold.
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This advantage, however, is only one of degree, because even houses that are too elaborate for a declining neighbourhood often have to be converted into flats or "maisonettes" before they can produce a revenue; and in spite of it, mortgages on house property seem to me to be nearly as unsuitable for the private investor as outright ownership.
If he indulges in mortgages he lends money to the owner of house property or to the owner of a lease, usually up to what is believed to be two-thirds of the value of the freehold or the lease. The owner pays him interest, half-yearly or quarterly as may be arranged, and is usually bound to repay the amount of the loan at any time, on receipt of such notice as is provided by the contract. The lender can at any time transfer the mortgage to any buyer to whom he chooses to sell, and in case of default by the debtor can exercise the right of foreclosure already described.
At first sight one might well ask, What more by way of security could Shylock or Master Dumbleton require than property which is worth half as much again as the amount lent, with a right to demand repayment at any time, and seize the property if the debtor fails to pay? And in fact those wise and wary investors, the insurance companies, habitually place enormous
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sums in mortgages on freehold and leasehold property. Why should you and I fear to tread where these angels rush in? Because the insurance companies, making these investments on a magnificent scale, and deriving from them a princely revenue, can afford to expend upon them the funds necessary to secure the professional vigilance that is necessary in the case of property whose value has to be constantly watched, and watched by an eye that can detect symptoms of decay, because there is no market quotation. With this safeguard, the application of highly qualified expert knowledge, mortgages are a very pleasant form of debt to an investor who can afford it.
Without it, you and I would be in danger of lending £1,000 on property valued at £1,500—or not only valued but known to have changed hands yesterday at that figure—and then finding in ten years' time, either because we ask the debtor to repay it and he cannot do so, or because we cannot get him to pay the interest, that our attempt to get our money back by foreclosure is a dismal failure, because the property is not worth £500. If we are very ignorant and unjust we may call the valuer bad names and threaten him with proceedings; he will say, with perfect justice, that all he said was that the property was worth £1,500 ten
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years ago, not that it was going to stay there till the crack of doom.
And even if all goes well and the debtor is solvent and the property keeps its value, the irregularity with which the interest on mortgages is habitually paid, makes them compare very unfavourably, for an investor who wants to receive his income on certain dates, with Stock Exchange securities. The great majority of public debts and company debts and preferences pay, if at all, on the due date as punctually as the sun rises. The mortgagor pays after such interval as suits his convenience, and usually after having his memory jogged by the mortgagee or his agent.
Land and houses, in spite of the fact that they are real and solid and "cannot run away," and their owners and the owners' creditors can go and look at them and see that they are there, are liable to enormous fluctuations in value both upwards and downwards.
And land and houses are nearly always what the Stock Exchange calls an "all one way market"—either all buyers or all sellers—and consequently difficult and awkward to deal in. A few years ago industrious agents were plastering England with titles to urban freehold plots in the neighbourhood of Canadian cities that were going to rival the growth of Los Angeles
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and New York, and some of the buyers, who were quick enough in turning round and selling, made mouth-watering plums out of the gamble. Those who did not are still waiting for the growth of those modern El Dorados, and in the meantime look ruefully at a tin-box full of unsaleable title deeds.
But there is no need to go abroad to see big fluctuations in real property values. Some of us can remember the time when ground near Hindhead fetched less than £10 an acre as heathy and indifferent grazing. Since Hindhead became a health resort and an opulent suburb the price per acre ranges up to £2,000. Contrariwise, streets of what were formerly fashionable mansions in certain parts of London are now dwelt in by a precarious population of weekly lodgers and are little better than slums.
Such are fluctuations which the investor in mortgages has to face. But if the fluctuation be upward he is paid off and has to find another investment. If it be downward, he loses his money or some of it, after a host of worries and legal technicalities and expenses. For you and me, it is a case of "no bid." As [[Author:Dante|Dante]] says, "let us not speak of them, but look and pass."<ref>''[[Inferno (Dante)|Inferno]],'' Canto III, "Non ragionar di lor, ma guarda, e passa."</ref>
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{{ph|class=chapter num|Chapter VIII}}
{{ph|class=chapter title|A Company Balance-sheet|level=2}}
{{sc|When}} the investor turns from public debts to enterprise, he walks out of a mist into twilight. We have seen how much guesswork and obscurity surrounds the question of the solvency of a Government or a public body, and how much faith and sentiment is needed by those who put money into the debts of the best of them, in the hope that it will be safe for twenty years or so. When we come to examine the question of the earning power of a company, we are faced by the baffling cryptogram of the balance-sheet, more interesting as a puzzle than informing as a statement of fact, and the apparently more illuminating record of the profit and loss account, which, however, merely tells us what the directors, usually in the best of good faith, think that the company has earned. But profit, as Mr. Wells says, "is the economic riddle that still puzzles us to-day."<ref>''[[Outline of History]],'' Chapter XXXVII, § 11, p. 608.</ref>
Concerning the efficiency of balance-sheets
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in misleading—"lying in every line" as he puts it—language much stronger than I should care to use has been employed by Sir [[Author:Josiah Stamp|Josiah Stamp]]; as a leading official of the Inland Revenue office and the director and secretary of a great industrial company with interests in many others, he has had unique opportunities for judging figures as exponents of facts. Usually a restrained writer, fond of the apt and judicious rather than the emphatic phrase, he holds the loud pedal down hard when he deals with the balance-sheet. As witness:—
"Our modern fetish of a 'safe' or 'sound' balance-sheet . . . lies in almost every line and yet is approved professionally because it overstates no assets and understates no liabilities, while it has valuable premises written down to negligible figures and reserves hidden in innumerable places, or profits 'held up' and 'tucked away.' 'The truth, the whole truth and nothing but the truth' cannot be derived from the modern balance-sheet so vaunted for its prudence; but prudence is just as possible without departing from what a balance-sheet ought to be—a faithful record of the employment of the total capital invested in the business, whether as an original outlay or retained profits, from which the ''true'' rate of profit on invested capital can be determined.
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Has the shareholder, who wishes to sell his holding, no rights as to some real knowledge of the value of what he is selling? . . . If it is said that all we are concerned with in the balance-sheet is that it is a final clear up of the accounts, I have nothing more to say. If you say two balance-sheets of the same concern can be quite different and yet both be equally accurate and true and desirable, I have nothing to say. When I was a surveyor of taxes, I often had people coming to me with sheets of paper and saying, 'Well, I do not keep much of accounts, but I have made up that for the bank manager, and it puts the best face on things.' One day I was talking to a bank manager friend, and he said that people often came to him with accounts and said, 'Here is a thing I had to prepare for the tax people, and so I am at least as right as that.' To one it was to be a maximum, to the other a minimum. Ought the balance-sheet to be a thing you can pull this way and that? If that is our idea, it may well be that it is destined to be radically changed in the next generation. Now, why the financial community should acquiesce in a condition of things in which a balance-sheet can be almost anything I cannot imagine. Auditors' certificates refer not merely to it being corect accord-
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ing to the books, but truly and faithfully representing the condition of the business."<ref>''[[Current Problems in Finance and Government]],'' by Sir Josiah Stamp, G.B.E., D.Sc., p. 14.</ref>
This exposure of the value of a balance-sheet as a guide to investors and shareholders is all the more significant and suggestive, in that it was uttered in the course of an address delivered at an annual conference of the Society of Incorporated Accountants and Auditors.
Nevertheless, it is the only guide, with or without a profit and loss account which is based on it, that is vouchsafed to the public by a large number of very important companies and it cannot be left out altogether, much as Sir Josiah's words would tempt one to save time, space and patience by leaving the balance-sheet buried under the heap of contumelious epithets that he has piled upon it.
When one picks up a balance-sheet one sees two lists of things with figures against them on one side and the other of a sheet of paper, usually with a dividing line down the middle. The left side, in English practice, is headed Liabilities, or Dr. (signifying debtor) and the right side Assets, or Cr. = Creditor. It thus shows on one side what the Company owes, on the other what it is owed or has got. The difference between the value put on the assets
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and that of the liabilities is the balance, which is profit, and is available for distribution as dividend or allocation to reserve, or to be carried forward to next year. It is added to the figures of the liabilities to make the two sides agree. If the company has made a loss, the assets are less than the liabilities in value, and the balance appears on the assets side.
It is sometimes disconcerting to the uninitiated to find the company's capital and reserves among its liabilities, because they think that these are items which it must have got and must possess and that therefore they ought to be among the assets. But a moment's thought makes it clear that the capital is the money subscribed by the original shareholders and is consequently owed, and has to be accounted for by the company to them, which it does by showing assets on the other side, in which the money has been sunk; and likewise the reserve fund has been built up out of sums reserved out of profits, or received by the issue of shares at a premium, and similarly is owed to the shareholders.
The sum put down under capital sometimes includes shares that have been issued, not against money subscribed, but in part payment for the business acquired, if the company bought an existing business, or for services
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rendered in starting the enterprise; but this is a complication that need not detain us. The stock or shares have been issued against "value received "or thought to have been received, and so their owners are part proprietors of the company to whom it has to account for the sums credited to them.
After this preliminary survey let us look at the details of a comparatively simple balance-sheet and see how much it tells us that would be a trustworthy guide to a shareholder or to anybody who was considering a purchase of part of its debt or share capital. Here is the slightly simplified balance-sheet, as on June 30, 1925, of Messrs. Bass Ratcliff and Gretton, famed as brewers wherever the English language is spoken, and in a few other places besides:—
{| style="text-align: left; font-size: 92%; margin: auto; padding: 2em;"
|+
|-
! colspan="2" style="text-align: center; | {{sc|Liabilities}}
! colspan="2" style="text-align: center;" | {{sc|Assets}}
|-
| Creditors || £1,923,348
| Cash || £585,350
|-
| 4½% Deb. Stock || 1,360,000
| Investments || 1,823,926
|-
| 3½% Deb. Stock || 560,000
| Bills receivable || 5,674
|-
| 5% Pref. Stock || 1,360,000
| Debtors on Trade Account || 1,308,064
|-
| Ord. Shares || 2,040,000
| Stocks of Hops, Ale, etc., and movable plant || 1,406,198
|-
| Reserve Fund || 950,000
| Freehold breweries, etc., and fixed plant || 1,160,514
|-
| Profit and Loss || 420,097
| Licensed properties and trade loans || 1,523,719
|-
| colspan="2" style="text-align: right;" | '''£8,613,445'''
| Goodwill || 800,000
|-
| colspan="4" style="text-align: right;" | '''£8,613,445'''
|}
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It is a nice strong, mellow balance-sheet, worthy of the generous beverage that has built it up. Looking at the liabilities first, let us note the most important feature on the debit side of this and every other balance-sheet. It has been said that the capital and reserves of a company are owed by it to its shareholders. Such a debt is evidently on a different plane from debts owed to outsiders, and the first thing to be noted is the proportion of outside debt to shareholders' claims.
The outside claimants (debenture holders and creditors) against Messrs. Bass are owed £3,843,000 out of a total of over £8,613,000 millions; so that if the company went into liquidation and the assets realized the values placed on them, there would be £4,770,000 to be divided among the shareholders. The preferred shareholders having been paid off at par, there would be £3,410,000 for shareholders, the face value of whose claim is only £2,040,000, giving them an apparent bonus of £1,370,000 among them. This increment, however, is by no means "unearned," being exactly accounted for by the Reserve Fund, accumulated out of past profits, and the Profit and Loss balance of £420,000 which belongs to the shareholders on the assumption that there were, at the date of the balance-sheet,
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no arrears of interest or dividend due to debenture holders or preference shareholders.
From the point of view of the creditors the position is different, but quite comfortable. They rank first, but, naturally, only to the extent of their claim. All that concerns them taken as a whole is to be sure that out of assets valued at over 8½ millions, their aggregate debt of £3,843,000 will be met in full, and the margin is surely large enough to satisfy the most exacting, especially when they notice that debtors, investments, cash and bills receivable come to £3,723,014, almost enough to satisfy them, without disposing of any of the freehold brewery site and buildings, or the tied houses, or the stock of materials and beer made and in the making, to say nothing of that elusive and incalculable item, the goodwill.
Creditors, as need hardly be said, are not an aggregate all on the same basis, and anyone contemplating a purchase of Bass Debenture stocks would have to be careful to see in what order they rank in priority of claims and how much power the directors have to put claims ahead of them in borrowing money for the purposes of the business. But when all this has been investigated it will appear that the position is as sound as a straightforward
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balance-sheet can make it, with an article of world-wide consumption and fame behind it.
But now let us see what a sour, jaundiced, liverish critic—and it is in this spirit that the prudent investor will scan every financial statement put before him—can say against the attractions of the Bass balance-sheet.
He will begin by pointing out, with perfect truth, a defect that is common to nearly all balance-sheets—all, it may be said, except those in which the assets consist of nothing but cash in hand or at a first-class bank, and securities quoted, and actively dealt in, on the Stock Exchange. This defect is that whereas the liabilities give you figures which are certain facts, the assets are expressed in figures which are, with the exception of the cash and investments mentioned above, to a certain extent a matter of guesswork. The figures may be too high or too low (our liverish friend, of course, will assume that they are too high), but it would be a miracle if any of them proved to be exactly correct if the assets were sold.
Cash is a definite and known amount; securities quoted on the Stock Exchange may reasonably be expected to be sold at or near the prices at which they have lately changed hands. But when we come to half-brewed beer in vats, and still more when we come to
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bricks and mortar in the form of breweries and public houses, the difference between what they may be expected to be worth and what they may actually fetch may be very considerable.
To point his moral and adorn his tale, he might cite the recent reconstruction of Vickers, Ltd., in the course of which it was found necessary to write more than ten millions off assets standing at 22¼ millions, and further to provide 2¼ millions to meet "contingent and other liabilities expected to accrue." (''Economist,'' December 12, 1925.)
After this general denunciation of all balance-sheets, the critic would proceed to dilate in detail on the one before us. First of all, he would say that even assuming the figures of the assets to be correct, the position only represents the present situation of a business which is a highly prosperous member of a trace which many people believe to be doomed, because the consumption of alcoholic liquor is alleged to be diminishing; nearly the whole of the North American Continent is already (or is supposed to be) dry; and some prophets tell us that in a decade or two the social and economic results of the American experiment will be so overwhelming that the rest of the world will be driven perforce on to the water
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wagon. In that day Messrs. Bass, if still existing, will be brewing ginger beer.
In the meantime there would be a bad time of dwindling demand to go through, and on the assumption of this bad time the critic will proceed. Cash, he will say, looks very nice at half a million and more, but if bad times came and it were necessary for the brewers to fight for the diminishing thirst of the public there would not be nearly so much of that cash before the fight had gone far. The same thing can be said of investments. It is an imposing total, but even supposing that they can be sold to realize the price—and we all remember days in 1914 when very few securities could be sold at all—would the total still be as imposing after a few years of depression in the drink trade?
And these are the plums in the assets pudding, because their value does not depend on that of beer; the jaundiced critic would only begin to enjoy himself when he proceeded to deal with the others. Debtors and bills receivable, he would say, are, or may be, very good assets as long as brewing and selling beer is a prosperous business, but if it were afflicted by misfortunes that affected Messrs. Bass, their debtors—the trade connections who have been supplied on credit—would almost certainly be affected even more severely, and who knows
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how much they could pay? And stocks, brewery premises and tied houses are inevitably all in the same beer-logged boat. The sort of critic we are imagining might even be guilty of making a bad pun about assets being sometimes too liquid, when liquor is out of fashion.
But when he comes to goodwill, he will really open his shoulders and slog. For he will tell us, which is true, that goodwill is an item never seen in the sort of balance-sheet that is produced by the elect of the financial world, the banks and insurance companies, and will go on to say, what is much more doubtful, that it has no right to be in any balance-sheet at all, but ought to have been written off years ago out of profits; and that this is a case in point because the value of the Bass goodwill depends entirely on the fame of their beer, and if the public gives up drinking beer, this value becomes a vanishing quantity.
Finally such a critic might add that any balance-sheet is worse than useless as a guide to the position of a company, because the people who draw them up, and the authorities whose business it is to examine them, have not yet made up their minds on the very important question as to what a balance ought to show, whether it should set out to display the way in which the company's money has been spent, or
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should try to indicate the sum that the assets might, if sold, be expected to fetch.
This criticism is unfortunately true. If you look back a few pages at Sir Josiah Stamp's observations with which this chapter began, you will see that even this very clear-sighted examiner of balance-sheets expresses himself with a certain inconsistency. He tells us very clearly what a balance-sheet ought in his opinion to be—namely a "faithful record of the employment of the total capital invested in the business, whether as an original outlay or retained profits." This surely can only mean that what should be shown is all the money that has been spent in purchasing the assets and in making provision against the inevitable decline, owing to depreciation by wear and tear and "obsolescence," in their value. In other words the full amount charged against depreciation of wasting assets: (such as machinery, plant, etc.) and against provision for doubtful debts, declining value of investments and other such precautionary expenditure, should be clearly shown either by being put down as written off certain assets or included in a depreciation fund among the liabilities, the assets being left at the sums that they cost.
This system would certainly give us a
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balance-sheet which would clearly represent some quite important facts. It would be contrary to the general practice, by which directors do not state the full amount that is taken from revenue for this purpose, with the result that there are, as Sir Josiah says, "reserves hidden in innumerable places," and in the case of ill-financed companies, there are undisclosed losses in equally numerous spots.
But then, if this be what a balance-sheet ought to be, it will break down under the next demand that Sir Josiah makes upon it. "Has the shareholder," he proceeds to ask, "who wishes to sell his holding no rights as to some real knowledge of the value of what he is selling?" And this surely must mean that the balance-sheet ought to show not what has been spent upon the assets, but what they ought to be expected to fetch, if sold; or to cost, if they had to be replaced. If this be the true basis of a balance-sheet, a company would not only be entitled, but obliged, in times of rapidly rising prices, to write up the value of those assets which had risen in price.
Equally confusing to the layman, who endeavours to cull wisdom from the sayings of these learned authorities, are the observations of Mr. Pixley in his ''[[Duties of Auditors]]'' that has
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gone through so many editions. In his chapter on the Credit side of Balance-sheets, he begins by insisting that there are strong reasons for not calling it the Assets side, and says the "professional accountants, who themselves used the term for many years, have lately been impressed at the meaning endeavoured to be put upon it, it never having previously occurred to them that anyone could truthfully assert that they believed that the amounts opposite the items on the credit side of a balance-sheet were their realizable actual value."<ref>Pixley's ''Duties of Auditors,'' p. 468.</ref>
But this actual realizable value seems to be just what Sir Josiah Stamp thinks that a shareholder ought to be able to see. Moreover, Mr. Pixley himself, on the very next page, says that "at the same time it must not be understood that an auditor has simply to ascertain that the amounts taken credit for in the balance-sheet in respect of property or assets are merely their book values. Prior to the auditor commencing his duties, the figures to be inserted in respect of these items have, of course, to be settled by the directors, and the groundwork upon which they have to arrive at the figure to be taken credit for in respect of each item is, of course, the balances of the Ledger Accounts. This is also the basis from
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which the auditor starts in his endeavour to satisfy himself that the amount finally decided upon by the directors is, or is not, correct." He starts from the book values, but the use of this word evidently implies that he does not stop there. Where does he go next, and where does he arrive finally, and by what test does he satisfy himself that the figure finally decided upon by the directors is, or is not, "correct"?
If the realizable value of the assets is what ought to be shown, it is evidently a matter of guesswork because the realizable value of anything, except a very few securities and commodities in which there is a quoted price and a really free market, can only be known by taking it into the market and selling it. Moreover there will be a very great difference in the guesses that we shall make at it, according as we decide whether realizable value is to be old iron, scrap-heap value, or value as a going concern. If, by a great effort of the imagination, one could conceive the Bass brewery as a derelict failure, the value of its site, buildings, machinery, plant, book debts would be ''x;'' the value of these items as parts of a great concern that is earning a profit of nearly half a million pounds a year, is, or may fairly be argued to be, ''x'' multiplied by something considerable. But
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as to what this "something considerable" should be, is a matter in which opinions will differ enormously. And the question is all the more complicated because it will clearly depend on the rate of profit being earned, and the rate of profit depends on the view that is taken concerning the value to be placed on the assets.
For if the figures of the assets, or the items on the creditor side, need to be reduced or raised in order to be a "correct statement," the difference between the assets and the liabilities will be altered, and this difference is what makes profit.
Let us see by means of a very much simplified example, how the process works of arriving at profit. Let us suppose a little company starting with a balance-sheet like this:
{| style="text-align: left; font-size: 100%; margin: auto; padding: 2em;"
|+
|-
! colspan="2" style="text-align: center; | {{sc|Liabilities}}
! colspan="2" style="text-align: center;" | {{sc|Assets}}
|-
| Capital || £200,000
| Cash || £5,000
|-
|||
| Materials || 50,000
|-
|||
| Buildings and Plant || 145,000
|}
At the end of its first year it has worked up its stock and sold it for £100,000, paid £20,000 in wages, taxes and all other expenses and replaced its material at a cost of £50,000. It has (in order to simplify) worked entirely on a cash basis and so has received £100,000
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and paid out £70,000 and its position will be stated thus when the directors come to draw up the balance-sheet for public issue.
{| style="text-align: left; font-size: 100%; margin: auto; padding: 2em;"
|+
|-
| Capital || £200,000
| Cash || £5,000
|-
| Balance || 30,000
| Materials || 50,000
|-
|||
| Buildings and Plant || 145,000
|-
| || £230,000
| || £230,000
|}
The amount of net profit finally shown will depend entirely on the view that the directors take about the figures to be put into the final balance-sheet against the items on the credit side apart from cash, which is a known quantity. Material may have fallen in value since they bought it and there may be much discussion as to whether it ought to be written down by io per cent., by 20 per cent. or by nothing at all. The machinery and plant, being brand new, some will argue that there is no need to write them down at all, while the more prudent will urge that their ultimate destiny is the scrap-heap, that the mere fact that they have done a year's work takes about 50 per cent. off their value for selling purposes and that a start ought to be made at once with the writing down process.
If compromise is finally reached on the basis of a 5 per cent. all round reduction in
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the doubtful assets, the balance-sheet will be drawn up thus:
{| style="text-align: left; font-size: 92%; margin: auto; padding: 2em;"
|+
|-
| Capital || £200,000
| Cash || £35,000
|-
| Profit || 20,250
| Stock || 47,500
|-
|||
| Buildings and Plant || 137,750
|-
| || £220,250
| || £220,250
|}
If no writing down is decided on, the profit will remain at the original £30,000; if 10 per cent. is taken off the doubtful items, it will come down to £10,500.
This simplified example shows us that the profits shown as earned by all profit-earning concerns, depend ultimately on what the directors think about the figure to be set upon those assets in the balance-sheet, the value of which cannot from their nature be definitely ascertained, without the expensive and tedious process of expert valuation which also is liable to error. The opinion of the directors is subject to comment by the auditors and criticisms by the shareholders, but, as a general rule, their decision is final. As has been shown, the problem that they have to consider lends itself to argument, and is open to wide differences of opinion on the part of people who are honestly trying to do the right thing; and the conclusion of these honest, but fallible, gentlemen decides the profit that is earned.
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It may be said that their decision can only modify the amount of profit shown, and could not make a loss into a profit. Ultimately and in the long run, this is certainly true, for bad finance brings its day of reckoning; but the day is often delayed, and in the meantime book-keeping agility can perform wonderful feats.
Moreover it must be noted that a particularly clear and simple balance-sheet was chosen as the specimen for examination. In those of the great industrial combines, whose assets consist largely of securities of other companies, all the doubts and difficulties that have faced us are many times multiplied.
What is the practical conclusion to be drawn by the investor? It seems to me to be this, that since the value placed on most of the assets of a balance-sheet is, to a great extent, a matter that can only be guessed at, and is actually arrived at by the opinion of the Board of Directors, the most important asset that a company can possess, after, and perhaps even before, the technical efficiency in production that its business requires, is an honest and prudent Board. Fortunately this asset is possessed by the great majority of companies, because without it they would very soon perish. But there are degrees, and the personality of
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the Board and the traditions under which they conduct what may be called the balance-sheet side of the business is not only of the highest importance, but is also a matter on which the ordinary investor is likely to have even less information than upon the conditions and prospects of any enterprise in which he is interested.
Having thus bewildered and puzzled ourselves by trying to discover what a balance-sheet is meant to convey and finding that on its credit it consists chiefly of figures that may be too low or may be too high, but are almost certain to be an inadequate guide to the value of the business, let us go back to the Bass balance-sheet and see what sort of reply the Board would make to the observations of the ultra-critical critic which were set forth above.
They would probably admit
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(1) That the figures set against most of the assets can only be arrived at by taking their cost price and writing off from it whatever sums the Board thinks right to deduct for depreciation and that consequently these figures are a matter of the Board's opinion. Nevertheless they would say
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(2) That a good and honest Board, such as most companies possess, assisted by the highly trained skill of the auditors, does its best to make full and sufficient provision for depreciation and is in fact likely to err on the side of providing too much rather than too little, with the result that they are flayed by Sir Josiah Stamp for having "hidden reserves" and "profits tucked away";
(3) That since there can be no certitude, it is surely better to understate rather than overstate the value of doubtful assets; and that a good balance-sheet should try to state them at, or below, their realizable value.
(4) That all the dismal vaticinations of the imaginary and imaginative critic about the day when England will be dry and Bass will be brewing ginger beer, and all the present breweries, tied houses, plant, stock, goodwill and book debts will be of problematical value, is beside the mark; because a balance-sheet is not meant to be a prophecy showing what the business is going to be doing in twenty years' time, but a picture of its condition to-day and that all that a
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Board can do is to draw that picture as accurately as it can.
(5) That as to goodwill, the balance-sheet might easily have been made prettier in the eyes of many critics, if instead of amassing a Reserve of £950,000 the Board had written off, as they could evidently have easily done, the whole of the £800,000 at which goodwill is valued. But that nevertheless under modern conditions of industry selling power is almost, if not quite, as important as power to make a good article, that a Bass label on a bottle has a quite miraculous power as a seller, and in short that if there be any enterprise in the world that has a right to set out its goodwill as a valuable asset, that enterprise is Bass's brewery.
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After which the chastened investor, having discovered that the soundness of a balance-sheet depends chiefly on that of the Board, as to which he is largely in the dark, and that he cannot expect it to tell him the future, which is what he really wants to know, may well ask whether nothing can be done to make balance-sheets more informing, and, if not, what other
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test he can take if he tries to judge for himself concerning the prospects of a company. Before we try to answer these questions let us see what light is thrown on the question by the Profit and Loss Account.
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{{ph|class=chapter num|Chapter IX}}
{{ph|class=chapter title|The Profit and Loss Account|level=2}}
{{sc|For}} the year ending June 30, 1925, Messrs. Bass, whose balance-sheet has already been the subject of our study, published the profit and loss account on [[Hints About Investments/Chapter 9#131|page 131]], which was attached to the balance-sheet and the directors' report.
On one side we see the receipts of all kinds, less certain expenses, plus the balance brought forward from the previous year; on the other, the payments that have been made, including interim dividend on ordinary shares, and the provisions made for depreciation, etc.; and the two sides tally by the addition to the payments and provisions of the sum that is left over to be carried to the balance-sheet.
A profit and loss account thus shows us the process by which the figures of the balance-sheet are produced, by giving us, among other things, the sums deducted from the book values of property, investments and debts due;
<!-- page break after this page -->
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{| style="text-align: left; font-size: 92%; margin: auto; padding: 2em;"
|+ Balance Sheet as at June 30, 1924
|-
! colspan="2" style="text-align: left; font-variant: small-caps;" | Dr.
! colspan="2" style="text-align: right; font-variant: small-caps;" | Cr.
|-
| To rents, rates, taxes, insurance and compensation fund || £197,387
| By sales of ale, stout, and sundry products, less manufacturing and cooperage expenses, excise duty, brewing licences, and carriage || £1,267,630
|-
| To repairs and renewals of premises and plant || 98,388
| By sundry rents, interest and dividends || 259,298
|-
| To depreciation of freehold and leasehold premises, licensed property and plant || 62,591
| By transfer fees || 168
|-
| To salaries, travelling and agencies expenses, advertising, show cards, labels, stationery, law charges, retiring allowances, subscriptions, gifts, directors’ and auditors’ remuneration and sundries || 543,343
| By balance brought forward, June 30, 1924 || 93,429
|-
| To interest || 7,058
|-
| To bad debts, reserve for doubtful debts, and depreciation of investments || 81,661
|-
| To interest on mortgage debenture stocks || 80,800
|-
| To dividends on preference stock || 68,000
|-
| To interim dividend of 3 per cent. on ordinary shares || 61,200
|-
| To balance carried to balance-sheet || 420,097
|-
| colspan="2" style="text-align: right;" | '''£1,620,525'''
| colspan="2" style="text-align: right;" | '''£1,620,525'''
|}
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those sums are deducted out of the revenue of the company, in order to provide for depreciation of property through wear and tear and obsolescence, for decline in the prices of investments, and for default, whole or partial, on the part of debtors. The result of the process is that the figures at which the assets affected stand in the balance-sheet are reduced and so the margin between liabilities and assets, which constitutes the balance available for distribution, is reduced likewise.
This one shows the imposing total of over a million and a quarter of gross profit, from sales of the company's product, less the cost of producing and conveying it and the charges made by the Inland Revenue for excise duty and brewing licences. A curious inquirer would have liked to see a little more—to have been told what was the sum of the gross sales and how much was taken off under each of the headings into which the expenses were divided. The answer of the Directors would no doubt be that they cannot be expected to give away information which might be valuable to their rivals. This answer must be accepted under present conditions. Perhaps the day will come when the growing curiosity of Labour concerning the nature and extent of profit, and the emphasis now laid on profit sharing
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schemes as a solution for industrial unrest, will oblige all employers to publish really full and informing accounts, observing definite and accepted rules for the treatment of depreciation. But that is another story.
Rents, interest and dividends (presumably from the licensed premises and investments owned by the company) bring in £259,000 odd and with the trifle received on transfer fees (charged by the company for registering transfers of its stocks and shares from one owner to another in its books) and the carry forward from the previous year, £93,429, the total receipts to be accounted for come to £1,620,525.
Looking at the other side of the account we find that what may be called inevitable charges under the headings
(1) rents, rates, taxes, insurance and compensation fund,
(2) salaries and all the other items bunched up with them (though subscriptions and gifts may perhaps be called optional),
(3) interest (presumably to creditors) and interest on debenture stocks,
absorb in all £828,588.
What may be called optional items—those about which the opinion of the directors as to
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how much should be spent or allowed is the deciding factor—are
(1) repairs and renewals of premises and plant,
(2) depreciation of freehold and leasehold premises, licensed property and plant, and
(3) bad debts, doubtful debts and depreciation of investments.
These come to a total of £242,640.
It is in exercising their judgment on the reservation and allocation of this sum, which is enough in this case to pay nearly 12 per cent. on the company's ordinary capital, that the directors have to perform what is perhaps their most responsible duty. In their decision about it, and in parallel decisions which have to be made by all Boards of companies engaged in production, transport and commerce and in nearly all forms of finance, prudent Boards set aside sums that err on the side of over provision for depreciation of property and investments and for doubtful debts, and on the side of excessive lavishness in repairs and renewals so that the property may be always rather more than up to date.
Thereby they act in the best interests of the
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property, the business, the shareholders and themselves; but their excess of virtue lays them open to the charge of putting away hidden reserves, tucking away profits and so forth. Of shareholders, who feel aggrieved on this score, one can only say, as the unwillingly sober sinner said of his completely incapacitated comrade, "I wish I 'ad 'alf 'is complaint."
Imprudent Boards hope for a more favourable opportunity for making fuller provision; fraudulent Boards, which are happily rare, deliberately make provision that they know to be insufficient; and so the amount of the profit that is carried to the balance-sheet is increased at the expense of the efficiency of the business and of the profits of future years, and to the ultimate undoing of the shareholders, and of the directors themselves if they were merely imprudent and in the end we may hope, though it is not safe to bet on it, even if they are fraudulent.
But surely there must be a middle course—a policy that will not write off too much or too little, but will give us the truth, the whole truth, and nothing but the truth?
{{" '}}What is Truth?' quoth jesting Pilate, and paused not for an answer." Who can say what is the strictly correct amount to spend
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on repairs and renewals or to provide for depreciation of investments that have no quotation, or for the doubtfulness of doubtful debtors? If you are going to answer that companies ought not to invest in securities that have no quotation, or lend money to debtors, who are doubtful, then you are putting a drag upon enterprise, which would make business on its present scale impossible. "Wise Venturing," wrote the great Lord Halifax, "is the most commendable Part of human Prudence. It is the upper Story of Prudence, whereas perpetual caution is a kind of underground Wisdom that doth not care to see the Light."
The book values of what may be called the arguable assets are originally the sums paid for land, buildings, machinery, plant and investments and the price of goods sold to buyers who were not in a position to make immediate payment for them. A sum paid for a piece of property is something definite to put down in an account, though within five minutes after it has been paid, and before the ink on the cheque is dry, the buyer may know in his heart that he has paid too much and that he has no right to credit himself with his asset at this figure if he is really making an estimate of what he is worth. It has probably
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happened to most of us to fall in love with a house or a picture or a something and to have paid hastily the sum asked for it lest someone else should snap it up, while one is quite conscious that it would be very difficult to sell it again at anything like the same figure, unless one were fortunate enough to find an equally eager buyer.
In business such individual whims do not often exert much influence, but trade competition sometimes produces startling results, as for example when some years ago the breweries were bidding against one another for the possession of licensed premises which they wanted to acquire and confine to the sale of their own products by making them "tied houses."
If, then, original cost even in the year when the sum is paid for property is not always a figure that can be set against in a balance-sheet that aims at truth—if truth means realizable value—who shall say at what pace it ought to be written down in the years that follow or what is the figure to which it should finally be brought by the process of annual reduction? Evidently there is a great difference in this respect between one item and another. Of land, Mr. Leake says definitely that "for accounting purposes" it "should be
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stated at cost, because the capital outlay thereon does not expire as it does in the case of wasting assets";<ref>''[[Commercial Goodwill]].'' By [[Author:P. D. Leake|P. D. Leake]], pp. 61 and 105.</ref> and again on a later page "Freehold land is not a wasting asset." Here at last we have a bedrock fact on high authority; and yet a heretic might suggest that freehold land is an asset which though it may not waste, very often changes in value. To say nothing of the land owned by a mining company, which exhausts it before it has done with it, because this is evidently an exceptional case, even a factory site may have its value seriously affected by the development of improved transport facilities elsewhere, or by a dozen other influences.
Leasehold land is an item which can be definitely calculated because it is known that so much has been paid for the use of it during so many years, at the end of which it will revert to the owner. Here then the directors and auditors have a question of simple arithmetic to work on, and all that they have to do, or to see done, is the setting aside of an annual sum which will wipe out the book value of leasehold land by the date of the expiry of the lease. But even here there is nearly always a necessity for provision, to an extent which is a matter of opinion rather
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than of certainty, for possible liabilities and expenses at the termination of the lease.
Buildings are a difficult problem. At first sight it would seem that as long as they are well maintained in good working order and all necessary repairs are carried out, they are as good as new, and rather better, for the purposes of the business, because they and the business have grown used to one another and "found" themselves like the ship ''Dimbula'' in [[The Ship that Found Herself|Mr. Kipling's story]]. But a business is not put away to mature like wine in a bottle—and even wine needs re-bottling at intervals. A business has to grow and its buildings seem to shrink like a schoolboy's clothes. At the present moment the Bank of England is rebuilding itself, and its determination, for artistic reasons, to preserve its old outside walls is probably adding considerably to the cost of the process.
As to rapidly wasting assets, such as machinery and plant, there is no doubt that they have to be written down fast because in a less or greater number of years they will be worn out; in some cases it is even possible to calculate the life of a machine with some approach to accuracy. But even then the question of obsolescence has to be considered. In some up-to-date works it is boasted that
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no machine has ever been known to wear out because it has always been superseded by a better one, and sent to the scrap-heap long before it had ceased to work efficiently.
As to unquoted investments a rough value can be arrived at from the income received from them, though there may always be room for much argument as to the basis on which this income should be capitalized; and it may often happen that a holding of shares on which no dividend at all is received may bring indirect business advantages which should rightly figure in a balance-sheet which aims at truth. But the sum at which they ought to figure is a matter which may cause very wide differences of opinion.
And when we come to doubtful debtors, hope pulls one way and fear pulls the other, and who is to decide between them? Trade possibilities and the psychology of the debtor reacting on and confusing one another make them in some ways the most difficult problem of all. Yet Mr. Leake<ref>''Op. cit.,'' p. 25.</ref> says that "it is comparatively easy to estimate the value of book debts, or of stock-in-trade, because such assets are likely to be turned into money within a short period of time." But the mere fact that provision has to be made not only for
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doubtful debts but for definitely stated bad debts, seems to indicate that Mr. Leake's likelihood is not always a certainty.
Stock-in-trade should be capable of fairly close calculation if it be estimated on the basis of cost of materials plus cost of work put into it; but there is probably a considerable difference in the practice of one management and another in the care and caution with which these estimates are made.
Mr. Pixley, indeed, says that "The amount to be taken credit for in respect of stock is of supreme importance in many companies, as it is no exaggeration to state that it is frequently possible to double or treble the apparent profit, where the directors and manager together, or even the latter alone without the knowledge of the former, succeed in deceiving the auditor, and consequently the shareholders. The auditor cannot, of course, be held responsible for the value assigned to this stock, as it is manifestly impossible that he should, even if he were qualified, be able to take or to check the actual measurement or counting of stocks, whether of raw materials or manufactured articles, either by number, weight, or otherwise, but he must use reasonable discretion, when the valuation of the stock is handed to him in satisfying
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himself that it has been arrived at in a systematic manner. . . . In some cases it is desirable to ascertain whether much of the stock has been on hand for a long period; as it may lead the auditor to form the opinion that the price taken credit for should be reduced, either owing to depreciation in the goods themselves, or to the inability of the manufacturer to sell at former prices."<ref>''Duties of Auditors,'' p. 444.</ref>
Incidentally it may be observed that all these endeavours recommended by Mr. Pixley to the auditor seem to be designed to secure that this asset shall be stated at the "realizable" value, which, as we saw above,<ref>[[Hints About Investments/Chapter 8|Chapter VIII]], [[Hints About Investments/Chapter 8#120|p. 120]].</ref> was maintained by him as not being the true meaning of the figures set against the items on the credit side of a balance-sheet.
Everyone, however, will agree that the auditors cannot possibly be expected to value the whole property of the company every year before they certify the balance-sheet. We can expect them to verify the cash and check the prices of the quoted securities. Beyond that, although their skill and discretion and experience may be of immense service to shareholders, we cannot expect more from them than what they claim to have done in the usual
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form of certificate; that is, to have examined the balance-sheet and obtained all the information and explanations that they required, and decided that the balance-sheet is "properly drawn up so as to exhibit a true and correct view of the state of the company's affairs according to the best of our information and the explanations given to us, and as shown by the books of the company."
As to goodwill, opinion concerning the value of this item in a balance-sheet varies from the austere severity which argues that it ought to be written off altogether because there is nothing tangible behind it, to the more lenient judgment which considers that, however intangible, goodwill, which represents the reputation and popularity of a business and its products, is in some ways the most valuable possession that an enterprise can build up or acquire. Volumes might be written on the subject. Here it is enough to remind those who lay stress on the value of goodwill that this value, great as it undoubtedly is as long as the business is successful and the product is popular, dwindles very fast if the wind of popular favour shifts.
Enough has been said to show the investor that if he hopes by the scrutiny of balance-sheet and profit and loss account to arrive at
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conclusions concerning the position of an industrial company, he is only examining a set of figures, many of the most important of which merely express the opinion of the Board and management, subject to examination necessarily limited in scope by the auditors.
It may be possible to check the value of the Board's opinion by looking up its members in the Directory of Directors, seeing what are the other companies that they help to rule and investigating their prosperity. Investors are often advised to cultivate this system and it certainly has its value. But it does not take us very far because the best directors are often those who confine their attention to one or two companies, the affairs of which they understand thoroughly, and consequently have no extended record to show whether they are consistent winners. If, nevertheless, the investor determines to use the balance-sheet as a guide he should be careful to study it in comparison with its predecessors; and to facilitate this comparative study balance-sheets might all be drawn up, as some are now, to show the figures of yesteryear, side by side with those of to-day.
It is true that by this method the student may be multiplying the possibility of error, because the policy of the company in the treatment of its arguable assets may have
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varied—perhaps quite unconsciously—from one year to another. But at least he will be able to make intelligent guesses as to growth or decline, he can mark the amount (or the book value, which is not the same thing) of stock-intrade and draw doubtful inferences concerning the speed or sluggishness of sales of the company's products, and he may try to trace the financial strength of the company's position by noting the extent to which it is pledging its credit as compared with the amount that it is owed by other parties. Even here, however, it is dangerous to be too dogmatic. Critics of balance-sheets often pat companies on the back because the creditor item among the liabilities is less than the sundry debtors among the assets; and there is certainly a satisfaction in seeing that a company in which one is interested owes less than it is owed; but a big overdraft at a bank is the best guarantee of solvency that a company can have, and a large sum due from debtors may be only an indication that business is being pushed not by selling a good article cheap but by giving credit to purchasers, too many of whom will some day have to be provided for as bad and doubtful debtors.
Having wallowed so long among the quicksands which surround any attempt to test from a company's accounts the real extent of its
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profits, let us see if we cannot arrive at a small patch of solid ground. Let us take the profit for granted on our confidence—usually well based—in the integrity and prudence of the Board, and test our opinion of the company's soundness by the use that they make of it. As a rough generalization it may be said that this soundness will be in an inverse ratio to the proportion which the profit distributed as dividend bears to the amount of the profit declared. If only half the profit is distributed to shareholders all is very well (always barring the industrial risk that may overwhelm the best financed industrial concern); if nine-tenths of the profit goes in dividend things do not look nearly so well; if all the profit is distributed and still more if the dividend is only paid by drafts on reserves or on the amount carried forward, we are justified in shaking our heads, unless this action is accounted for by special conditions which are not likely to recur. But this subject deserves a chapter to itself.
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{{ph|class=chapter num|Chapter X}}
{{ph|class=chapter title|The Allocation of Profit|level=2}}
{{sc|Let}} us return to the report and balance-sheet of Messrs. Bass, Ratcliff & Gretton and see what the directors of this company do with the profit at which they arrive after making the provisions recorded in the last chapter.
According to their statement in the report the profit amounts to £537,000 before charging interest on Debenture Stock, but since interest on Debenture Stock is a charge that has to be met, unless a company is prepared to compound with its creditors or commit an act of bankruptcy, it seems to be sounder and more logical to take off this interest, which comes to £81,000 for the year, before we arrive at the profit which the Board may or may not distribute to shareholders. On this basis Messrs. Bass's profit for the year to June 30, 1925, was £456,000.
Of this sum £68,000 goes in dividend on the preference stock, and £265,000 in
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dividends and bonus on the ordinary shares, making a total of £333,000 distributed.
Reserve Funds receive £150,000 in all, but, as the amount carried forward is reduced by £27,000, the net amount actually put away is £123,000.
Thus, out of a total profit of £456,000 the directors distribute £333,000 (or roughly 73 per cent.) and hold back £123,000, or roughly 27 per cent.
The calculation can be made still more favourable if we deduct from the Profit the sum due to the Preference shareholders, whose rights and position will be discussed in a later chapter. Preference dividends can be "passed" (that is to say, left unpaid), without involving a company in bankruptcy, since they are a payment due to proprietors or partners in the business and not to creditors; but as in this case they are cumulative, which means to say that until they are paid the ordinary shareholders can receive no dividend, and as any prosperous company pays its preference dividends as a matter of course, and as punctually as the interest on its debts, it cannot be contended that they are an optional payment in the same sense as dividends paid on ordinary capital.
On this system we arrive at £388,000 as
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the really divisible profit, after providing for debenture interest and preference dividend. Out of this £388,000 the directors pay £265,000, or 68 per cent., in dividend and hold back £123,000, or 32 per cent.—not far off a third.
It has also to be noted that the allocation of £50,000 to Reserve Fund raises it to a million, or nearly half the amount of the ordinary capital, which stands at £2,040,000, so that shareholders who are hungry for large dividends (as all human shareholders naturally are in view of the risks that they take) may feel that the directors have done quite enough in the matter of piling up reserves out of money which might have increased the current income of shareholders. And we find in the Report a sentence which indicates that the Board feels that it has to explain its action in pursuing still further the policy of building up reserves. For they observe, after stating that the total distribution to ordinary shareholders recommended is 11 per cent. and a bonus of 2 per cent., "it is also proposed to place £50,000 to Reserve Fund (which will then amount to £1,000,000) and, in addition to the regular yearly amounts written off the Property Account, it is considered prudent to provide a further £100,000 for depreciation," etc. More
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over they also add, what appears to be a sentence that is inserted regularly in all their reports—"the directors consider that they have made sufficient provision for contingencies which may be reasonably foreseen."
So having built up an ordinary Reserve Fund of a million pounds, they have now started a new fund called Reserve for Property Depreciation, with £100,000, of which £27,000 comes out of the amount carried forward out of past profits and £73,000 out of the profits of the year under review.
It is this policy of building up reserves which has to be explained and almost apologized for to shareholders, which gives the ordinary shareholder in a prosperous company the great advantage that the value of his property is continually increased for him by an act of periodical saving and reinvestment, which is carried out on his behalf by the Board, and brings compound interest in to work for him with its rapidly accumulative effect.
In this case it has made him not only a shareholder in what is perhaps the best-known brewery in the world, but also a part proprietor in an investment company which holds investments standing in the balance-sheet at £1,824,000 and so not far from
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covering the whole of the ordinary capital of £2,040,000. These investments are described as in "British Funds, Colonial and Foreign stocks and bonds; railway preference stock and sundry debentures and shares," and as standing "at or below current quotations or valuations." The curious, of course, would like to know something as to the proportions which these very various classes of securities bear to the total invested, and a full list of the investments held would evidently make this item in the balance-sheet much more interesting. We shall find, however, that many of even the purely investment companies think it advisable not to let the public know in what securities the funds entrusted to them by their shareholders and creditors are placed; and there may be good reasons for this reticence, that are not evident to the layman.
By the reserve fund policy the shareholder is given an increasing value in his property through the retention by the Board of money that has been earned for him and its reinvestment either in extension of the enterprise or in holdings of the shares of companies in which the enterprise is interested or in outside securities.
This policy has one drawback—it misleads
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critics, especially those who fancy that there is something wicked about earning profits, by exaggerating the apparent return on the company's capital. For instance if a company with a capital of £1,000,000 has accumulated reserves of £500,000 and earns a profit of £150,000, it seems to be earning 15 per cent. on its capital of a million, but what it is really doing is to earn 10 per cent. on a total capital of a million and a half, because the half-million of reserves is in fact fresh capital that has been added out of profits. It is thus liable to be called a {{hinc|blood-sucking}} exploiter earning 15 per cent. out of the patient public, whereas it is only earning 10 per cent. for its patient shareholders who have seen part of their profits held back year by year and put into the expansion of the business.
To correct this misapprehension and secure the acquiescence of the shareholders in the continuance of the reserve fund policy, it is now a common practice for Boards of Directors to capitalize reserve funds or part of them by an issue of bonus shares, that is by an issue of shares to shareholders without payment on their part, by the conversion of reserves into shares.
If we return to the example just imagined, of a company with a capital of £1,000,000
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(and suppose that it is in £1 shares) and reserves of £500,000, the reserve would be capitalized by the issue to the shareholders of one new share for every brace of shares held. The result would be that on the liabilities side of the balance-sheet instead of seeing
{| style="text-align: left; font-size: 92%; margin: auto; padding: 2em;"
|Capital
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|£500,000
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the legend would run:
{| style="text-align: left; font-size: 92%; margin: auto; padding: 2em;"
|Capital
|£1,500,000
|}
and the Reserve Fund would be wiped out, leaving a clean space for the Board to begin building it up again.
This operation of capitalizing reserves is usually hailed as a "bull point" by shareholders and speculators, and is presumed to confer some juicy benefit on the former. In fact it merely gives them in the form of shares what was already theirs in the form of reserves. It has no effect whatever on the assets or earning power of the company, and unless the profits increase the shareholders will in future receive no more in dividend from their larger holding than they would have had if no such change had been made.
The real advantage of it is that it shows more clearly the true facts of the case and the true rate that the company is earning on the
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capital that its shareholders have actually put into the business or have had put in for them by the Board. It also pleases and cheers the shareholders and makes some of them think that they are better off, and reconciles them to seeing the Board building up the reserves in later years, and so continuing the process by which their property and earning power are expanded.
Some companies can achieve the same result—an increase of capital through the channel of reserve funds—by issuing shares, to their own shareholders or to the public, at a premium. It goes without saying that in order to do so their shares must stand high in the market.
We thus find that though the profits shown as earned by a company are, as a test of its position, full of misleading uncertainties, the use that the Board makes of the profit declared has some significance. We are in touch with definite fact when we ask how much of the profit remaining after meeting all charges, including preference dividend, is paid away in dividend and how much is put to reserve or added to the amount carried forward.
In its quarterly examination of the profits of industrial companies the ''Economist'' works out the proportion of profit put to reserve.
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The average shown by the 1,443 company reports examined during the four quarters ending June 30, 1925, came to 22.3 per cent. But the ''Economist'' arrives at its proportion by including preference dividends as part of the sum distributed out of net profit. It seems to me that one gets a fairer result by deducting preference dividend—as practically a fixed charge—from net profit in order to get the divisible balance. There is then the true balance left, which may be distributed in ordinary dividend or carried to reserve or added to the amount carried forward, and it is the division of this balance which is of some use as a test. On this basis the average performance of the 1,443 companies whose reports were investigated by the ''Economist'' works out at 72.2 per cent. to ordinary dividend and 27.8 per cent. to reserve or kept in hand.
As need hardly be said, the test is far from precise, for variations in the form of the companies' capitals and debts make the comparison, to some extent, misleading. But as a rough guide in a country where pitfalls are plentiful and signposts are mostly incorrect, it may be better than none. It leads us to the conclusion that the investor may be well advised to insist that any company in which
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he invests is at least up to average in this respect.
It is interesting to note that in America industrial companies as a whole appear to distribute only half their earnings as dividends. So, at least, it is stated on page 142 of Messrs. Foster & Catching's lately published book on ''Profits.'' Possibly the high proportion of water in the capital, that is usual at the outset in American industrials and is squeezed out gradually by allocations from profits, accounts for this apparently austere ideal on the other side of the Atlantic.
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{{ph|class=chapter num|Chapter XI}}
{{ph|class=chapter title|The Forms of Company Securities|level=2}}
{{sc|Public}} Debts, the first form of Stock Exchange investment that we considered, were to this extent simple, that they all implied a contract by which the investor became a creditor entitled to a fixed rate of interest and usually a capital sum to be some day repaid by the debtor.
Company securities, as a preliminary to the consideration of which we have been looking for a meaning in company accounts, are complicated in that they give the investor the choice of creditorship or ownership.
For those who like to be creditors, companies provide debts, in the form of bonds, debentures and debenture stocks, similar to the bonds and stocks issued by Governments and public bodies and, occasionally, interest bearing notes, usually with an early date of maturity, similar to the Treasury bills and Exchequer bonds with which Governments cater for the appetite that likes to see its money back soon.
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For those who like ownership with the greater risk and more luxurious prizes that are its lot, companies provide ordinary, or common, shares and stocks.
For those who love compromise and a ''via media''—less risk than is run by the ordinary shareholder and a higher yield than is given to the debtholder—companies provide preference or preferred shares and stocks.
These are the three main divisions, and, though there are many intermediate varieties with fancy names, they nearly all fall in fact into one of these classes. The debtholder takes the first bite out of the revenue of the company (after wages, salaries, taxes and other expenses have been met): the preference holder comes next and the ordinary shareholder takes such share of the balance as is not kept in hand by the directors or placed to reserve fund.
The position of the company debtholder is, usually, much the same as that of the holder of public debts—he is entitled to a fixed rate of interest, either for all time or up to the date at which his bond or stock is due for repayment. This date is either definitely fixed, or may be determined by the hazard of a draw, when the securities are numbered and part of them is drawn yearly or half-yearly for repayment. Payment is usually at par or the face value of
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the bond, but sometimes a small bonus is thrown in on redemption, and £105 or so is paid for the £100 stock or bond. This is usually confined to cases in which the debtor has a right of redeeming at an early date, as when a company issues bonds redeemable, at its option, at £105 in ten years or at £100 in thirty years. In the case of Bass & Co. the 4½ and 3½ per cent. Debentures are redeemable at the option of the company at 117 and 110 respectively.
In addition to these rights and frillings, holders of company debts, such as are described as mortgage bonds or mortgage debentures, have the right of foreclosure over part or all of the company's property in the event of its defaulting in the interest payments or redemption service. The value of this right evidently depends on the price at which the property pledged could, in case of foreclosure, be sold for the benefit of the creditors. And so here we find ourselves back in the region of guesswork. And very often we do not even know the book values of the assets that we are trying to guess about. Prospectuses frequently offer notes or debentures, with the label "first mortgage" attached, and say, for example, that they are specifically charged on the freehold and leasehold property, and then give a
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statement of assets in which the said freeholds and leaseholds are jumbled up with the machinery and plant under one heading, so that it is not possible to tell even what is the balance-sheet value of the property specifically charged. And even if we knew that, the price that would be secured by a sale, at a time when the company was in difficulties, is still a matter of surmise. As to the "first floating charge" on all the assets, with a pledge that the Board will not put any charge ahead of it, except if necessary for "advances in the ordinary course of business"—and some such phrase is often found when debentures are issued—this protection is not a very sure shield for holders, since advances in the ordinary course of business would be more than likely, if the enterprise were straitened for funds, to be on a considerable scale.
An additional protection is secured for industrial debenture holders by the appointment of trustees to watch over their interest. The efficiency of their vigilance, however, is likely to be impaired if, as often happens, one or more of the trustees is also a member of the Board. If all goes well there is no objection, because the trustees only become important when all is not well; then, the interests of the creditors and those of the shareholders are likely
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to clash, and it is not right for one man to represent them both.
In the case of railways, mortgage rights are often of great value, especially when the property pledged to the bond or debenture issue is in a position that is of importance to the working of the whole property. In England, railway debenture stocks do not carry mortgage rights. But the first mortgages granted by the American railroads have been, in the past, a source of great strength to the holders of bonds issued under them, whose rights have been respected at times of most ruthless reconstruction. At the same time, it must not be supposed that because a bond has a first mortgage it is therefore a sound security. Mr. [[Author:John Moody|John Moody]], that eminent authority on American and other investments, says that: "Another false notion regarding the genuineness of a given railroad bond is the theory that a bond secured by a mortgage is always better than one which is not so secured. Of course in the majority of cases this is true, but there are numerous instances where a debenture bond, which is a mere promissory note, is a far better security than one which is protected by a direct mortgage lien. For a case in point, one might mention the New York Central Railroad Debenture Sixes. These bonds were not secured by
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any mortgage whatever on the property, and they were subject to a great mass of other obligations of prior security. And yet they were a far higher grade investment . . . than hundreds of first mortgage bonds of various other railroads throughout the country."<ref>''[[Profitable Investing]],'' by John Moody, B. C. Forbes Publishing Company, New York, p. 36.</ref>
Then there are the income bonds or income debentures, a form of security that is rare and generally unsatisfactory because it is usually nothing but a preference share trying to look impressive by calling itself a bond. On them interest is paid if it be earned during the year or period for which it is due. On bonds and debentures it is nearly always the rule that interest, whether earned or not, has to be paid somehow sometime; it cannot be "passed" and forgotten.
But one of the most important things that an investor has to learn and to keep remembering always is not to take the names attached to securities at their face value; not to think, for instance, that because a stock is called a first mortgage bond or debenture it therefore necessarily is a first charge on the property that has issued it. If he jumps to this conclusion and acts on it he may find when it is too late that the stock once carried
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a first charge but that in the course of a period of misfortune the Board found it necessary to raise funds by an issue ranking ahead of the first charge and probably described as a "prior lien."
Of course the consent of the first mortgage holders was required before this could be done, and no doubt they only granted it because after many meetings of protest and much correspondence in the press, they were convinced that if they did not do so any attempt to enforce their rights would lead to results disastrous to themselves. Every security has to be tested not by the names attached to it but by its actual position with regard to a share in the revenue of the concern which has issued it, and in its assets in the event of liquidation.
Preference shares are a compromise, dear to minds that love this refuge, despised by the hearty whole-hogger who says: "Give me one thing or the other." The objection to them is that if fortune frowns on the enterprise the rights of the preference holders are apt to be set aside. As we have seen this sometimes happens even to first mortgage debenture holders, in spite of the weight of their legal rights and the special protection that is given them by the existence of trustees specially
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appointed to watch over their interests; much more is it likely when it is a matter of preference holders who are not creditors at all but only what may be called limited partners in the ownership of the concern.
A preference holder who has not a right to a "cumulative" dividend—which has to be paid, if not this year next year or some other year before the ordinary holders get anything—has, indeed, very little right that is worth assailing. He takes his fixed dividend if earned and goes without it if it is not. It is the cumulative right that makes the preference worth having, and it is the one that the holder is likely to be asked to forego if a series of bad years has piled up arrears of dividend due to him that put the resumption of dividends on the ordinary shares into the dim future. In such a case a threat of immediate liquidation held at the heads of the preference holders and an intimation that liquidation will mean that little or nothing will be saved for them from the wreck, leaves them little choice about accepting any scheme of reconstruction involving the sacrifice of all or part of their arrears of dividend, a lower rate in future and possibly the surrender for the future of their cumulative "privilege." The directors represent the ordinary shareholders and the
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preference holders have only themselves to take care of them.
Such things happen when things go wrong. But then, when things go wrong, all the investors in all the securities of the company concerned are bound to be affected. They are like a row of ninepins—if the first one hit by misfortune, the ordinary shareholder, is hit hard enough to fall over he will hit the preference holder; and if he does so hard enough to knock him over, the debenture holder will not escape without a blow; if he still gets his interest he will not be feeling nearly so comfortable about his investment, and if he happens to want to sell, the fact the preference and ordinary are paying nothing will make a serious difference to the price that he will get in the market.
Nevertheless the right to take interest or dividend ahead of somebody else is always a comfort to those who like the safe side and are ready to pay for it by taking a lower rate of interest. When things go wrong the other fellow is hit first, and if they go only a little wrong the preference holder is not hit at all. Many investors look with satisfaction on a nice collection of well-chosen preference shares; they are confined to their fixed rate—or usually so—and may sometimes look with envy at the
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swelling dividends of the ordinary holders who come after them. But the fact of increased dividends for ordinary shareholders makes the preference holders' dividend more certain, gives them sounder sleep on their security and enables them to sell it better if they want to turn it into cash. Preference shares in a good and successful industrial concern are, as long as it is successful, as comfortable an investment as anyone can desire, especially when there is no debenture debt ahead of them.
Moreover financial ingenuity has devised a kind of preference share which combines all the advantages of a fixed preferential and sometimes cumulative rate with a share in profits after a certain rate has been paid on the ordinary. This is the "participating" preference share. Its holder gets all the security that his position can provide and at the same time has some share in prosperity if prosperity is abundant enough to give the ordinary shareholder an adequate return for his greater risk, and leave a divisible balance over. There is a good deal of equity in this principle, and it frees the preference holder's position from the objection that is often raised against it, namely that when things go wrong his rights are invaded and
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that when they go right he gets his fixed rate and no more.
Hitherto the participating preference share has been issued almost solely by companies which, from the nature of the enterprise conducted, are more liable to fluctuations of fortune than those which are engaged in transport or industry in the narrower sense of the word. It is a pity that this is so, because a participating preference has thus acquired a slightly speculative association, which is an obstacle in the way of its wider adoption.
Some preference shares and stocks are called "guaranteed," and get from this high-sounding name more consideration than they deserve from investors. This was shown when the real nature of the guarantee of the Grand Trunk Railway of Canada's guaranteed stock was revealed in the strong light of disaster. All that it meant was that the company guaranteed to pay the interest if it could, just as it promised to pay, if it could, the dividends on the various preference issues. Investors are apt to assume that a guaranteed stock is necessarily guaranteed by some outside authority which is not affected by the fortunes of the company, and sometimes this is so, but by no means always. The guaranteed stocks of the British railway companies rank before the preferences
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and the dividend on them is cumulative, but the guarantee is merely that of the companies. "Guaranteed" is thus a label that needs careful scrutiny when attached to a security.
Such are the securities—giving the rights and limitations of creditorship and limited ownership—which rank ahead of the real out-and-out owner, the ordinary shareholder, who takes what is left when these limited claims have been met. He takes it either in the form of dividend paid into his pocket, or in the form of reserve funds built up by the directors to increase his property and his future dividends; or he takes it with the best grace that he can muster if it be a minus quantity or a profit too small to make a dividend. He is the "functionless" person who takes the first risk and the last profit, but the last profit, how great so ever it be, is his.
Simple as his position is, as compared with the precedences and differences by which the prior charges are distinguished, it is sometimes subject to complications. One we have seen in examining the participating preference. Where it exists the ordinary divides with it—in proportions that vary according to the terms on which the participating preference is issued—any surplus left after a fixed rate has been paid to itself.
{{nop}}
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Then there is the deferred or management or founders' share, usually of quite nominal face value, which also takes a share of the profits after a certain rate has been paid on the ordinary. It used to be fashionable to denounce these shares as necessarily a wicked feature of company finance, but they are not necessarily so. When issued to those who have been, or are, helpful in organizing or carrying on the company, they may be a quite legitimate form of payment for highly important services.
And occasionally—such is the incorrigible habit of using words in different senses in which finance insists on indulging—shares are called ordinary which are really preferences, entitled to a fixed rate of dividend and no more, with a deferred share behind them enjoying the real rights and risks of ownership. But this arrangement is rare. As a rule the ordinary or common shareholder is the real owner to whom the property belongs, subject to the limited claims of the creditors and preferred partners.
As has been already indicated, old-fashioned investment doctrine looked on the ordinary share as so risky that anyone who held it became a speculator; those who upheld it confined the attention of seekers after a safe income to bonds, debentures and preferences, regarding
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preferences as a doubtful concession. Sound as this doctrine undoubtedly is, since the first and second charges on income are evidently safer than the third and last, it is possible to doubt whether comparative safety with fixed rate is necessarily and always preferable to comparative risk with possibility of expansion of income. If we could know that a company is going to be highly successful, we should certainly take its ordinary shares rather than the prior charge securities. If we have good reason to expect, from its past performances, that it is likely to be so, the question arises whether the chance of expanding success cannot fairly be weighed against the limitation imposed on the income of the debenture and preference holder.
For safety, such as is given by the best industrial debenture, is only relative. If misfortune does happen, debenture holders will be affected, directly by loss of interest and capital, or remotely by anxiety and a lower price for the security if it has to be sold. This relative safety is accompanied by an absolute limit on the income. The owner or ordinary shareholder, on the other hand, is relatively less certain to get any income, but no limit is imposed, by the terms of his holding, on the possibility of its expansion, and this possibility,
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as we have seen, is favoured by the reserve fund policy, which continually expands the earning power of any business to which it is consistently and successfully applied.
There is thus a good deal to be said for the view that, if one goes into industrial investments at all, the greater risk plus possible expansion carried by the ordinary share is a sounder business proposition, if adequate skill and knowledge can be applied to selection, than the smaller risk plus limit on income carried by the debenture and preference.
This view has been supported by the striking results of investigations lately carried out in America and referred to on [[Hints About Investments/Chapter 1#14|page 14]] of [[Hints About Investments/Chapter 1|Chapter I]]. It is time to examine them more closely.
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{{ph|class=chapter num|Chapter XII}}
{{ph|class=chapter title|The Strength of the Ordinary Share|level=2}}
{{sc|As}} was shown in our chapter on Trade Cycles and Price Fluctuations, when commodity prices fall there is a tendency for fixed rate investments to rise, because money becomes plentiful and cheap and pushes them up, but for the profits and consequently the prices of ordinary shares to be diminished, because the lower prices make the finished article fetch less than would otherwise have been the case by the time it has gone through the process of manufacture, while food and materials are losing value all the time that they are moving through the hands of merchants and middlemen. If these tendencies act with sufficient strength and are not balanced by counteracting influences, one would therefore expect, in periods of falling commodity prices, fixed interest securities to rise and ordinary shares to fall and to disappoint their holders in the matter of income.
{{nop}}
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Mr. Edgar Lawrence Smith, author of ''[[Common Stocks as Long Term Investments]],''<ref>Macmillan, New York.</ref> relates in his Introduction that his book is the record of a failure—the failure of facts to support a theory. The theory was the one just referred to, that at a time when the buying power of money is rising, that is, when the prices of goods and services are falling, bonds are a better investment than common shares, as they were, in the belief of the theorist, from the close of the American Civil War in 1866 up to 1896, a time when the buying power of the dollar rose steadily.
Mr. Smith subjected this theory to the test of historical investigation, covering the period from 1866 to the end of the century, and found that high grade bonds failed to demonstrate themselves as having been the better investment. So he went on with his tests because he felt that "the facts assembled seemed worthy of further investigation. If they would not prove what we had hoped to have them prove, it seemed desirable to turn them loose and to follow them to whatever end they might lead." So he made a series of tests to see "how it would work out, if our fathers had invested solely in common stocks, not with the thought of immediate speculative gain, a thought
/foot//
{{smallrefs}}
//foot/
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that is unfortunately most difficult to eliminate from the choice of common stocks, but with the sober-minded purpose of providing (1) constancy of income, and (2) safety of principal."
In making these tests he had to be careful to avoid what the Stock Exchange calls "jobbing backwards"—that is applying what we know to-day to problems of yesterday or yesteryear. If he had attempted to let his imaginary investor in the past choose stocks that seemed to be the best to buy, he would almost certainly have been influenced by what is known now about their subsequent history. So the only principle of sound investment that he could apply to the choice of stocks was that of diversification. Each test assumed the investment of approximately $10,000 (£2,000) in ten different common stocks of large companies and of an equal amount in "high grade bonds." The stocks chosen were selected by some quite mechanical method—those in which there had been the largest number of transactions during the week in which the investment was supposed to have been made, or those which showed the highest yield on the basis of the previous year's dividend, with the most consistent dividend record.
It was also thought necessary to assume that the supposed investor had no further funds
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beyond his $10,000 for subscribing to additional stock if offered by his companies, and therefore had to sell his "rights" on these occasions at the average price that they would have fetched during the first thirty days in which they were quoted; and for the same reason he was forced to sell any fractional shares that might come to him by way of stock dividend; the proceeds of these sales were added to current income. Whole shares received by way of stock dividend were retained and increased the value of his capital holding and the amount of his income in after years. As he has no funds out of which to meet "assessments," the American term for further capital demanded from stockholders, in the event of reconstructions, he has to sell out whenever these unfortunate experiences occur, and he naturally does so at considerable losses. Otherwise he makes no change in his holding of common stocks during the periods which range from seventeen to twenty-two years; when his bonds are paid off he has to reinvest, but he leaves his shares alone and they are only changed by consolidations and amalgamations.
The remarkable result of these tests is that in every case out of the twelve tests given the investor would have had a higher income from common shares than from bonds; in every case except one the advantage is on the side of the
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common shares when income and increase in capital value are added together. In one case only is the advantage on the side of the bonds, and that is because the rise in capital value of the bonds was great enough to offset the larger income from the shares.
The first test is made by the investment of $10,000 in the first full week of January, rgor, on the top of a quick rise in security prices during the last months of 1900. The investor is supposed to have put as nearly as he could $1,000 each into the ten industrial stocks in which there had been most transactions. These were American Sugar, American Tobacco, Continental Tobacco, People's Gas, Tennessee Coal and Iron, Western Union Telegraph, Federal Steel, Amalgamated Copper, American Smelting and American Tin Plate.
At that time fifteen high grade railroad bonds were selling at prices yielding 3.95 per cent. But in order to give the bond every chance, the investor was supposed to have made his bond investment so as to earn 4 per cent. and to have chosen his bonds so well that during the period from January, 1901, to December 31, 1922, none of them lost any value owing to poor credit or high interest rates.
The result of this test is that the holding of common stocks, which were bought for $10,002
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in January, 1901, had a market value on December 31, 1922, of $15,422—an increase of over 50 percent. The total income received from them was $19,781, averaging a shade less than 9 per cent., as compared with 4 per cent. on the bonds, and the total advantage on the side of the shares, capital increase and extra income together, was $16,401. And this is on the assumption, probably highly flattering to them, that there had been no decline in the prices of the bonds in a period during which the biggest war that ever happened had raised the rate of interest on gilt-edged securities.
It was to be expected that in this period, 1901-22, ordinary shares would be a more profitable investment than bonds, because it was a time of rising commodity prices and interest rates and of feverish industrial activity. Mr. Smith, while freely admitting this, maintains that "regularity of income in this first test was maintained through two severe industrial depressions and the greatest war in history." In claiming regularity of income, however, he seems rather to strain the meaning of the word, as is shown by his own very clear statement year by year of the cash income received from the shares. For the first year it was just over 8.2 per cent., and it went on as follows year by year: 5.9, 5.6, 5.1, 7, 10, 8.8,
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8.6, 9.1, 10.7, 8.7, 10.4, 10.5, 8.8, 7.4, 10.5, 14.1, 14.1, 9.3, 9.6, 7.8 and 7.4. The "peak years," when 14 per cent. was earned, were 1917 and 1918, when American industry was making abnormal war profits, and an income which starts at 8 per cent. and leaves off at 7½ per cent., having touched 14 and 5 per cent. in the meantime, can hardly be called regular. The really striking point, however, is that the share income at its nadir in 1904 was still above 5 per cent., and so better than the 4 per cent. which was credited to the bond investment.
The more interesting tests, however, are those which are taken for periods in which commodity prices were falling, so that industrial profits might be expected to have been on a much lower scale. And so we find them, though not low enough to bring the income from them below that which would have been earned by bonds. In Test No. 4, from 1880 to 1899, the total income from shares in twenty years comes out at $14,528, an average of $726.4 on an investment of $10,163, or roughly 7¼ per cent. as compared with 9 per cent. in the first test. Fluctuations are also much less lively, the highest point being $923 in 1882, and the lowest $622 in 1886. But it should be noted that in this test railroad shares were
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included owing to the scarcity of industrial companies in those remote days. At the time of this test, bonds could be bought to yield 505 per cent., and are estimated to have shown no change in market value during the period. Thus the yield from the shares was substantially higher on the average and materially higher in their least profitable year, while their original purchase price of $10,163 in 1880 compares with a market value of $13,616 at the end of 1896, and $18,817 at the end of 1899.
Mr. Smith considers that the results of Test No. 5, covering the period from 1866 to 1885, are by far the most significant, since this was a period which witnessed a recovery in the buying power of the dollar, which "had had no counterpart since the Napoleonic Wars and has as yet had no other. . . . Based upon the change in the purchasing power of the dollar, there has never been a period which so favoured the purchase of long term bonds as against the purchase of common stocks as the period from 1866 to 1885."
Nevertheless, even in this test, common stocks more than held their own, their advantage in aggregate income offsetting the greater capital appreciation in the case of the bonds. They even succeeded in showing a small capital increase, a fact which seems to have surprised
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the investigator considerably, for he says: "We find, after the greatest increase in the purchasing power of the dollar that this country has ever experienced or is ever likely to experience, that his [the imaginary investor's] holdings in 1885 have a market value of $10,936, an actual increase, where, if no other factor than the appreciating dollar were in force, a drastic decrease was to have been expected." Whether a drastic decrease in prices of industrial shares was to be expected would depend, however, rather on the view that one takes of the probability that the fall in the rate of interest which almost always accompanies a fall in commodity prices would tend to maintain the prices of shares by making money plentiful and cheap. It or some other influence certainly did so in this case, in spite of a considerable decline in the earning power of the ten selected investments. Just as in England in the spell of low prices and cheap money which culminated in 1896-97, when 23 per cent. Consols rose to 114, those which were thought to be the soundest Home Railway ordinary stocks rose to a level at which they only returned about 3 per cent. to the buyer.
With regard to the income received under this test, Mr. Smith seems to depart for a moment from the serene impartiality with which
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he reviews the results of his investigation. For he says on page 46: "We have seen how steady an income return was paid during the period on the diversified list of stocks, selected for Test No. 5." But in fact the annual return was, from his figures, as follows:
{| style="text-align: left; font-size: 92%; margin: auto; padding: 2em;"
|-
| 1866 || $1,093.00
|-
| 1867 || 1,106.00
|-
| 1868 || 976.80
|-
| 1869 || 1,018.30
|-
| 1870 || 925.00
|-
| 1871 || 970.00
|-
| 1872 || 1,085.00
|-
| 1873 || 966.00
|-
| 1874 || 891.50
|-
| 1875 || 761.25
|-
| 1876 || $687.00
|-
| 1877 || 752.00
|-
| 1878 || 674.50
|-
| 1879 || 729.00
|-
| 1880 || 812.00
|-
| 1881 || 800.00
|-
| 1882 || 663.00
|-
| 1883 || 569.50
|-
| 1884 || 519.00
|-
| 1885 || 565.00
|}
If this be a "steady" income it is one which may well have made its owner feel uncomfortable. For if we add the receipts of the last two years of the period together we find that they are $1,084, just nine dollars less than the income received in the first single year of the period and twenty-two dollars less than in the second. In other words the income at the end of the period was half what it had been at the beginning. On the other hand the fall in income would have been balanced by the fall in prices. But the bond-holder, whose money income would have been constant at 607.7, would have had a much fuller benefit from this increase in its buying power.
Mr. Smith's tests, however, should be
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examined in detail by those who wish to study this interesting problem of the relative advantages of industrial ordinary shares and prior charges and the question whether the, only comparatively, greater risk carried by the former is or is not outweighed by the possibility of indefinite expansion in income and value attached to them, if they imply ownership in a well-conducted and well-financed business.
We have seen the broad result reached by his investigations, that out of twelve tests only one ended in favour of the bond, and that was only so because their greater capital appreciation had more than offset a larger income received from the shares.
The conclusion at which he arrives is that these tests are not in themselves conclusive, but "cumulatively they tend to show that well-diversified lists of common stocks selected on simple and broad principles of diversification respond to some underlying factor which gives them a margin of advantage over high grade bonds for long term investment."
This underlying factor he finds in the reserve fund policy—in the fact that the "directors of conservatively managed corporations over a period of years will never aim to declare all the company's net earnings in dividends.
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They will turn back a part of such earnings to surplus account, and invest this increasing surplus in productive operation. Such a policy successfully carried out is in fact a practical demonstration of the principle of compound interest" (p. 77).
Nevertheless, before we accept Mr. Smith's conclusion that there is a margin of advantage in favour of common stocks and shares, certain features about his tests have to be noted.
First, that they all refer to the United States, a country which has, ever since the end of its Civil War in 1865, enjoyed amazing growth and prosperity, tempered by short-lived panics and setbacks. This prosperity was due to the activity of a highly intelligent and enterprising people in opening up, with the assistance of a great stream of immigrants and of capital from the Old World, a country of enormous potential resources which at the beginning of the period had hardly begun to be tapped.
Second, that the industries whose securities have been used as tests have thus been especially favoured by the circumstances under which the population for which they catered has grown in numbers and in wealth with the assistance of foreign credit and capital, and
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have also in some cases been granted artificial advantages, at the expense of the consuming public, by the high tariff policy of the United States.
Third—and perhaps most important—eight out of the twelve test periods chosen ended in 1922, and so covered a time in which American industry was making extra-special and abnormal profits out of the European belligerents during the war and then during the after-war boom. It was not only the directly war industries—the growers of food and materials and the makers of munitions—that reaped these profits, but all the industries of the country benefited by the stream of wealth which the war poured into America, converting her from a debtor country into one which holds all the world in fee.
For these reasons I venture to think that we should add a few words to the conclusion quoted on p. 182 and say that diversified lists of common shares in the industries of a country that is enjoying exceptional growth and prosperity give them a margin of advantage over high grade bonds.
With this modification the conclusion represents much more exactly what Mr. Smith has really proved. How far does it help us in trying to secure the ideal which we have
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sketched for the investor of securing from his investments an increasing income and growing capital value?
Shall we be justified by it in selling all the gilt-edged securities that we hold, putting the proceeds into ordinary stocks and shares representing ownership in industry, commerce, transport and agriculture, and expecting the Board of our companies to do the trick for us by steady additions to reserves which will put compound interest on our side?
It should be noted that Mr. Smith suggests (p. 104) that the annual excess income from stocks should be treated "as a genuine reserve against the supposed risk of holding common stocks." He proposes to grant the investor only the right to spend the amount that he would have received from an investment in bonds, and to make him reinvest the annual surplus income from stocks each year as he receives it. But how many ordinary investors—could be trusted to carry out this policy, or even, if the necessary self-control were present, to make all the calculations and adjustments that would be required?
But apart from this after-thought, we have to remember that the industrial risk which is inseparable from an investment in any particular industry cannot be eliminated by the
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process of diversification. It is lessened by diversification, but in these times there is nearly always a good deal of sympathy between one industry and another.
Moreover, excellent as the effects of the reserve fund policy are when successfully carried out, its success, and the power of the directors to carry it out at all, depend on the efficiency with which the industry is conducted on its technical side. If profits are not earned there is nothing to put to reserve; and if the sums put to reserve are invested in expansions of the business that do not pay, they bring no advantage to shareholders, whose dividends have been diminished to provide them. Ordinary shares in a company that is profitably conducted and continually puts part of its profit into expansion are as good an investment as can be found, but profitable operation in any particular industry is evidently a factor that can be relied on with much less confidence when we try to peer into the future than, for example, the total taxable capacity of a great and wealthy people.
With these reservations it seemed to be desirable to make a test of our own, applying the reserve fund policy as a practical guide in the selection of industrial ordinary securities.
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So I asked my friend and former colleague, [[Author:Gilbert Layton|Gilbert Layton]] of the ''Economist,'' who spends much of his time on company accounts, to see what would have happened to an investor who had, in 1910, invested in six industrial ordinary shares or stocks, with this principle to guide him.
The imaginary investor took the six companies which had put to reserve the largest proportion of their available balance, after payment of preference dividend, during the years 1905 to 1909. The accounts tested were those of concerns with a paid-up capital of £1 million and upwards, and companies paying an ordinary dividend of less than 5 per cent. were excluded. Some such limit is evidently essential; since otherwise a company which had fared so ill that it paid nothing, and carried forward all its small earnings, would be hailed as a model of good finance. The companies are shown in the order of the proportions reserved, the Eastern Telegraph having reserved the largest and Pease & Partners the smallest percentage of the six companies.
The price of purchase is assumed to be the middle price of December, 1910, thus giving the supposed investor time to make his investigation into the accounts of the companies for the
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preceding five years. Here is the result of the test:—
{| class="wikitable" style="font-size: 92%; margin: auto;"
|+
! Company
! Bought in Dec. 1910 at
! Value June 30, 1925.
! Increase or Decrease in Value.
! Average Income per cent. 14 years.
|-
| Eastern Telegraph (£100)
| 135
| 175½
| +30%
| 6.349 (tax free from 1919)
|-
| Howard & Bullough (£1)
| 2⅛
| 1¾<ref>Share bonus of 33⅓ per cent. (1918).</ref>
| +9.8%
| 8.091
|-
| Babcock & Wilcox (£1)
| 5
| 2½<ref>Two share bonuses of 100 per cent. (1912 and 1922).</ref>
| +108%
| 6.786 (all tax free)
|-
| Bradford Dyers
| 1
| 2
| +100%
| 15.821
|-
| Fine Cot'n Spinners (£1)
| 1¾
| 3<ref>Two bonuses of one 5% Preferred Ordinary Share (1913 and 1919) for every 5 ordinary shares.</ref>
| +120.6%
| 7.620
|-
| Pease & Partners
| 12 (£10)
| 11/16 (£1)<ref>Share bonus of 20 per cent. (1919).</ref>
| -31.25%
| 10.340 (tax free from 1919)
|-
! Total
|
|
| +54.86%
| 9.168
|}
The year by year performance of the companies was as follows:—
The Eastern Telegraph Company paid a dividend of 7 per cent. for the first four years, 8 per cent. for the next four, and 10 per cent., free of income tax, for the remaining six years.
Howard & Bullough paid 15 per cent. for the first two years, and with the second dividend distributed a bonus of 33⅓ per cent. In the following year the rate was 15⅚ per cent., but for the next four years it dropped to 10 per
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cent. In 1918 the dividend was 15 per cent., and there was also a capitalized bonus of 33⅓ per cent. Then followed three years of 10 per cent. on the larger capital, the dividend being increased to 17½ per cent. in 1922 and to 20 per cent. in 1923. In 1924 the ordinary capital was increased to £1,250,000 and the dividend fell to 124 per cent.
Our investor was fortunate in his holding of Babcock & Wilcox, for in the first year he received a capitalized bonus of 100 per cent. in addition to a dividend of 28 per cent. on his original purchase. Throughout the fourteen years this company paid its ordinary dividend free of income tax. In the second and third years the rate fell to 16 per cent. on the larger capital, dropped to 14 per cent. for the next year, rose to 15 per cent. for the next five, then to 16 per cent. for two, and then to 20 per cent. for 1922, when once again a capitalized bonus of 100 per cent. was distributed. In the last two years the dividend on the quadrupled capital was at the rate of 12 per cent.
The capital of Bradford Dyers' Association remained unchanged throughout the period, while the dividend increased in several stages from 6 per cent. in 1911 to 22½ per cent. in 1919. It then fell to 20 and 10 per cent. in the two following years, rose to 35 per cent. in
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1922, and dropped to 25 per cent. in the last two years.
The dividend of the Fine Cotton Spinners' & Doublers' Association was at 8 per cent. in 191 and remained at that figure until 1917, when it was raised to 10 per cent. for two years. In 1919 the rate was 12 per cent., followed by 20 per cent. in 1920. Then came a drop to 10 per cent. for 1921 and 8 per cent. for 1922, followed by 12½ and 14 per cent. for the last two years respectively. In 1913 and 1919 the shareholder received bonuses of one 5 per cent. Preferred Ordinary share for every five ordinary shares held.
The Pease & Partners' dividend was 8 per cent. for the first two years, then 12 per cent. for two years, followed by 10 per cent. and 15 per cent. In 1917 and 1918 the rate was 17½ per cent., and in 1919 12½ per cent. free of tax, together with a capitalized bonus of 20 per cent. In 1920 the rate went up to 18 per cent., but fell to 14 and 5 per cent. in the two following years. In 1923 it rose to 6 per cent., and in 1924 to 8 percent. This, as may be seen from the table, is the only case in which our investor's capital has suffered depreciation over the fourteen years; it is accounted for by the fact that in 1925 the dividend fell away to 1½ per cent., owing to the severe depression in the iron and
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steel trades. The aggregate investment in the six companies, however, has appreciated by over 50 per cent. and our investor has received a dividend rising from 5.9 to 11.4 and averaging over 9 per cent.
The investigation is on too small a scale to prove much. But, as far as it goes, it is interesting and encouraging, especially when we consider that the period covers two cataclysms—the beginning of the war and the after-war collapse—and a spell, still continuing at the end of the test in June, 1925, of severe industrial depression.
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{{ph|class=chapter num|Chapter XIII}}
{{ph|class=chapter title|Financial Investments|level=2}}
{{sc|We}} have seen that the margin in favour of ordinary shares and stocks which seems to have been established by Mr. Smith's extremely interesting tests was based on earnings made under conditions so exceptional that it can hardly be taken as proved in the case of the industries of any other country. Even in America one does not feel quite certain that industrial profits are going to be so fat in the future, when once the exceptional circumstances now in favour of the United States have given way to more normal conditions. We have yet to see the effect of the restrictions on immigration by which one of the causes of amazing economic expansion has been seriously weakened.
All that, for the purposes of really fastidious investors, has been proved by these investigations is that ordinary shares have advantages which make it impossible to regard them as necessarily so speculative that we ought to feel rather ashamed of possessing them.
At the same time, the preceding pages have
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been written in vain if they have not shown how difficult it is for the ordinary investor to weigh the real merits of any security from a public debt down to a share in a mine that is some day going to flood the world with platinum. We have seen how many guesses we have to make in considering the taxable capacity of a country and the policy that its rulers are likely to follow in husbanding its resources; and that the earning power of a company is to a great extent dependent on the opinion of the directors concerning the figures at which the assets should be stated in the balance-sheet; and a great accounting authority has been quoted who said that the amount taken credit for in respect of one asset alone—stock-in-trade—may double or treble the apparent profit if it be put too high.<ref>Pixley, p. 444.</ref> With his feet in these quicksands and his head in this fog, through the rifts in which he can only get glimpses of what may be fact and may be mirage, the ordinary investor may well hesitate about any attempt at industrial investment, even when his hand be held by a most cautious and intelligent stockbroker.
To the author of ''Common Stocks as Long Term Investments,'' the dangers surrounding the choice by any individual investor were so evident that he ends his book by advising him
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to put the task of investment management into the hands of bodies specially organized for this purpose.
"It is," he says, "a task that can be properly undertaken only by an organization in which men of varied experience and training in the financial field unite with the single purpose of applying their best combined judgment continuously, with the least managerial complications, to the supervision of a single investment fund in which a large number of individual investors may participate. Thus, alone, may the best results be obtained."
This conclusion points the way for the investor in favour of investment in something like the British Trust Companies, by means of which he acquires ownership in companies which exist for the purpose of taking off his shoulders the burden of choosing investments, and becomes at once associated with a co-operative investment body of the kind indicated by Mr. Smith. By this system he passes over to hands which certainly are more skilful and experienced than his own the task of making a selection among the thousands of investments which will do so well for him if he chooses well and will inflict disappointment upon him if he makes mistakes.
That a holding in a prosperous and well
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established Trust Company should form part of the collection of investors who aim at increase of income and capital will be readily agreed, and the advantages of these companies will be set forth fully later. For the moment, however, it must be observed that a blind purchase of Trust Company ordinary stocks or shares can by no means be relied on as a royal road to investment salvation. The history of the British Trust Companies has been marked by striking successes, but has also been strewn with wreckage and disaster. In fact the difficulties that face the ordinary investor are never more clearly shown than when we contemplate the mistakes that have been made in the past by the skilful and well-informed managers of investment companies.
What we are looking for at present is some kind of investment by which it may be possible to secure the compound interest advantage that is achieved by the reserve fund policy for ordinary shareholders, while eliminating as far as possible the industrial risk which we saw to be inseparable from the privilege of ownership in any industrial enterprise.
Such investments are to be found in the shares of banks and discount companies and of insurance companies. Their service to industry is obvious, since industry as at present
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organized could not continue for a day without them; and at the same time this service is so widely spread over industry as a whole that the principle of diversification is introduced by the holding, for example, of shares in a single great bank to a much greater extent than any ordinary investor could hope to secure by subdivision of his investments into different industries.
This very wide spread of the net with which banking, bill-discounting and insurance sweep the waters of industry and commerce does not by any means eliminate risk. Those who know most about the conduct of these enterprises will acknowledge most readily that it is very easy to make mistakes in carrying them on; but if investment is confined to the shares of the large and well-established companies, then the vast resources handled, the great body of tradition and experience at the disposal of those who manage them, and the inevitable demand for their services by trade as a whole, whatever may be the fluctuations in the fortunes of its various branches, give a solidity and stability to their earning power such as no form of purely industrial investment can rival.
Competition among them is keen, but the position of the leading companies is so firmly established that there seems to be little likeli-
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hood that it can be dangerously assailed by the emergence of new stars in this firmament. In the great increase in production and exchange that seems now to be possible, if mankind will give more attention to production and less to quarrels about the division of the product, these great financial institutions should play an enormously important and reasonably profitable part. And out of the profits that they make we may be as sure as we can be of anything about the financial future that they will continue, in the interest of the invincible strength that is necessary to their existence, the policy of building up reserves which is conducive to the expansion of the shareholders' income.
One serious drawback most of their shares carry, from the point of view of the investor who likes to feel that, within the limits of investment conditions, he has not left a single chink in his armour through which he can be smitten. They nearly all carry a liability which in some cases is considerable in amount. It may be true—probably is true—that this liability is purely nominal—that in view of the terrific shocks which have been successfully met in the last dozen years by the financial machine without any question even remotely arising of a demand on the shareholders of the banks and discount companies and insurance societies that they
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should meet the liability on their shares, it is not possible to think of any cataclysm which would put any one of them into liquidation. But there the liability is, and it cannot be forgotten altogether.
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{{ph|class=chapter num|Chapter XIV}}
{{ph|class=chapter title|Investments in Banks and Discount Companies|level=2}}
{{sc|A glance}} at a bank balance-sheet shows at once one of the great advantages that shareholders in these institutions enjoy, namely, the enormous sums handled in relation to the amount of the shareholders' capital employed. The consequent diversification of risk is evident. Here are the figures on December 31, 1924, of the Westminster Bank, which we will take as the oldest of the London Joint Stock Banks, apart from the Bank of England, which stands by itself.
{| style="max-width: 40em; font-size: 92%; margin: auto;"
|-
! colspan="2" |
|-
| Capital paid up || £9,051,718
| Coin, notes and balances with Bank of England || £34,185,041
|-
| Reserve || 9,051,718
| Balances with and cheques in course of collection on other banks || 10,309,104
|-
| Current, deposit and other accounts || 272,832,400
| Money at call and short notice || 23,399,849
|-
| Notes in circulation || 14,616
| Bills discounted || 41,970,486
|-
| Acceptances, endorsements, etc. || 16,430,325
| Investments || 53,307,672
|-
| Profit and Loss || 1,238,038
| Shares in other banks || 2,991,706
|-
| ||
| Advances to customers || 121,946,012
|-
| ||
| Liability of customers for acceptances, etc. || 16,430,325
|-
| ||
| Banks and other premises || 4,078,620
|-
| || '''£308,618,815'''
| || '''£308,618,815'''
|}
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It will be seen that the total of the balance-sheet is more than thirty times the size of the paid-up capital, so that every £1 share in the bank gives its holder what may be called a remote reversionary interest in more than £30 worth of assets. He has, of course, no claim on a pennyworth until the holders of current and deposit accounts have been paid the whole of their £273 millions and all other liabilities have been met, so that if the assets were sold at the prices set against them his share would not amount to much more than £2; in fact, as we shall see later, the assets would probably fetch more, and it may be noted that besides the paid-up capital contributed by shareholders they have added just as much again out of profits held back and put into reserve fund. But the fact that for every pound that the shareholders have so invested in capital and reserve the public has put more than fifteen pounds into the hands of the bank for temporary employment enables the bank to spread the shareholders' risk by pouring out its funds over an enormous body of first-class securities and well-selected borrowers, and at the same time to earn a satisfactory profit by means of a narrow margin between the earnings on the assets and the payments due to depositors.
Looking more closely at the assets we see that
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in the full balance-sheet as set out by the bank, the investments were subdivided into War Loans and other securities of or guaranteed by the British Government, which account for 51¾ millions of the total, the balance of a million and a half being composed of "Colonial Government securities, British Corporation stocks and other investments." As a matter of interest and guidance for the public it would be kind of the banks to tell us exactly what investments they hold, instead of leaving us wondering what those "other investments" mean.
The items which I summarized as "shares in other banks," amounting to nearly three millions, consist in fact of shares in the Westminster Foreign Bank (£1,080,000), an institution founded to carry the Westminster's prestige and services abroad, and in the Ulster Bank £1,911,706.
It will be noted that by far the largest item £122 millions out of a total of £308½ millions—is made up of Advances to Customers. Those hundred and twenty-two millions are the means by which the bank gives the most direct assistance to the country's industry, and the large total shows how a shareholder in one bank is able to feel that he owns part of a machine which distributes credit to thousands of borrowers in different parts of
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England for the financing of various kinds of industry.
Bills discounted perform the same function to some extent; but in the first place they probably contain a large proportion of Treasury bills and thereby finance the Government rather than industry; and in the second, it is likely that a large part of the commercial bills held are drawn to finance foreign trade, and so, though of enormous importance to a country which could not live without foreign trade, are less directly a home product, though at the same time widening still further the diversification of risks which is provided by investment in bank shares.
Money at call and short notice means loans to discount houses, bill-brokers and—stockbrokers engaged in financing the floating mass of bills of exchange and securities which form the stock-in-trade of Lombard Street and Capel Court.
It is interesting to look back at our investigation of an industrial balance-sheet, and to compare the assets shown by a bank in the light of the difficulty that we found in the case of a well-known brewery of being certain as to the likelihood that the assets if realized would fetch the sums set against them.
The assets of Messrs. Bass came to a total
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of over 84 millions, of which rather more than £585,350 was in cash, and £1,823,926 was in investments in British Funds, Colonial and Foreign stocks and bonds, railway preference stocks and sundry debentures and shares "at or below current quotations or valuations." The other six millions were made up of bills receivable, debtors on trade account, stocks of material, stores and movable plant, freehold and leasehold premises and fixed plant, licensed properties, trade loans, goodwill and trade marks.
We found that the figures set against all these items depend to a great extent on the opinion held by the Board and the managers concerning the value that should be set upon them for balance-sheet purposes, and that this was an inevitable feature in the great majority of industrial balance-sheets. We also saw reason to believe that most Boards and managers would err on the side of undervaluing rather than overstating these necessarily doubtful assets.
In the case of the banks, the proportion of doubtful assets is much smaller. There is no doubt about the cash and practically none about the loans at call and short notice, which are lent to first-class firms on first-class security. The bills of exchange are also for
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definite sums due, from the British Government or from accepting houses, usually of the highest credit. The investments are nearly all obligations of the British Government and the small outside minority are pretty certain to be publicly quoted and easy to deal in at the quoted price. The Advances to customers are also loans for definite amounts made to customers, concerning whose standing and solvency the banks have exceptionally good opportunities of satisfying themselves; and the liability of customers against acceptances is in the same category, though, in this case, the bank has not lent its money, but only its name, thereby incurring a liability to pay a sum if the customer fails to do so, and this liability appears on the debit side of the balance-sheet.
All these items, representing more than 300 millions out of the 3084 millions which is the sum total of the assets, are a matter of a definite sum owned by or owed to the bank, or represented by securities saleable at or above the figure set against them. In the case of the advances to customers and the customers' liability on acceptance there must be, and in those of the short loans and discounts there may be, some question whether all the multifarious borrowers who have had
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credit supplied by the bank will be able to meet their obligations in full, in view of all the widespread industrial and commercial risks that they are facing.
But there are two important differences between the doubtful assets of a bank and those of an ordinary industrial company. The directors and managers of a bank have a better chance of being able to judge of their value; they are experts in credit, that is, in the solvency of the people to whom they lend, or for whom they accept bills, or whose bills they discount. They are thus only doing what is their own regular job when they make estimates of the value of their promises to pay; whereas an industrial director, in putting a figure against land and buildings, plant and machinery and trade debtors, must often be called on to decide the values of articles on which his opinion, as valuer, is not quite that of an expert.
And the second difference is, that whereas we have reason to hope that the Boards of most industrial companies—at least those which have stood the test of time through a reasonably long life—err on the side of prudence and caution in valuing their assets for balance-sheet purposes, with the banks it is a matter of common knowledge; doubtful
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assets are written down ruthlessly, and they hold, in fact, large hidden reserves owing to the lowness of the figure set against their Advances to Customers, their premises and every other item which gives them an opportunity of exercising a damnatory imagination. They have also a habit of putting away profits earned on sales of investments. The ''[[Economist Banking Supplement]]'' of May 9, 1925, quoted Mr. Beaumont Pease, of Lloyds Bank, as having told his shareholders that such sales had "yielded substantial profits; but these," he added, "we have not brought into our profit and loss figures, preferring the more conservative method of keeping them in our internal reserves. . . . They are safely there, however, employed in the business, ready for any emergency, earning you extra profits."
The liabilities' side has already been explained, sufficiently for our present purpose, in commenting on the assets. Perhaps it is worth while to add that the tiny item of notes in circulation is a ''rara avis'' in the balance-sheet of a leading English bank, since those with London offices are not allowed to issue notes in England, this privilege being reserved to the Bank of England. The notes outstanding in this case represent the circulation of an
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Isle of Man bank, which has been absorbed by the Westminster.
The outstanding feature on the debtor side is the huge total of the deposit and current accounts, money placed with the bank by the public, which has the right to demand its repayment at once in the case of current accounts and practically at once in that of deposit accounts, since no bank could refuse a depositor who was in a hurry the power to waive the necessary notice in return for some sacrifice of interest. It is the ever-present possibility of a demand for cash by holders of current and deposit accounts that compels the banks to keep their assets so liquid and so well written down, that their shareholders can read the figures set against them with a different feeling from that with which they regard the values on the right side of the ordinary commercial balance-sheet.
Another item that is what advertisers call a "talking point" is the reserve fund standing at the same figure as the paid-up capital. Some banks have reserve funds which exceed this cent per cent. of capital—the Ulster Bank in which the Westminster holds a considerable share showed in its balance-sheet, dated November 29, 1924, capital paid up £500,000 and reserve fund £900,000. The latter has
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since been increased by £100,000, and now stands at 200 per cent. of capital paid up. The Westminster, as we shall see when we look at the Profit and Loss Account, left the Reserve Fund at the figure shown in the balance-sheet, but put away £625,000, out of a net profit of £2,013,5O2, in allocations to Bank Premises Account, Rebuilding Account, Contingent Fund, and addition to carry forward, besides £100,000 placed to Provident Fund, presumably for the benefit of the employees.
This policy of building up big reserves, the benefits of which to the shareholder have already been dilated on with "damnable iteration," has a disadvantage, also already noted, of giving an appearance of a much higher rate of profit earned than is derived from the capital actually invested. The banks declare dividends on their paid-up capital, but they earn them on capital plus reserve fund plus hidden reserves, all of which have been put in directly or indirectly by the shareholders.
For example, in the report now before us the Westminster directors propose to pay a dividend which will make, with the interim distribution already paid, 20 per cent. for the year on the £20 shares £5 paid, and 12½ per
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cent for the year on the £1 shares. This looks like a very handsome rate and gives a misleading view of the profit to be earned by banks because, as we have seen, the reserve fund is as big as the paid-up capital and there are hidden reserves besides, so that the real rate of dividend has to be found by dividing the apparent rate by something over 2.
The Profit and Loss Account may be summarized thus:—
{| style="max-width: 40em; font-size: 92%; margin: auto;"
|-
! colspan="2" |
|-
| Dividends || £1,287,887
| Balance brought forward || £568,480
|-
| Premises Account || 100,000
| Net profit after making provision for bad and doubtful debts || 2,013,502
|-
| Rebuilding Account || 300,000
| ||
|-
| Contingent Fund || 200,000
| ||
|-
| Provident Fund || 100,000
| ||
|-
| Carried forward || 594,095
| ||
|-
| || '''£2,581,982'''
| || '''£2,581,982'''
|}
It will be noted that the banks are far from lavish in the information that they supply in their profit and loss accounts. They tell their shareholders the amount of the net profit and what has been done with it and "the rest is silence." As to the amount of the gross profit and of the expenses—how much went in taxes, directors' fees, salaries, etc., and how much was appropriated to provision for bad and doubtful debts—on all these matters the Profit and Loss Account that is now before us
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lies low and says nothing, following the prevalent practice of its peers. "Very few of the British banks," says the ''Economist Banking Supplement'' of May 9, 1925, "published the figures of their gross profits. Barclays still sets a good example in this respect."
Perhaps this dignified reticence on the part of the banks is necessitated by their peculiar position; living and trading, as they must, on a reputation which is beyond a breath or whisper of suspicion, they have to be not only above reproach but above the possibility of misunderstanding by some irresponsible person with a pen in his hand who might make misleading and damaging comments if he saw that a bank, or several banks, had been obliged, for example, to make a considerable amount of provision for bad debts. And in pursuing a policy of reticence the banks can plead the example of the Bank of England, which never publishes a Profit and Loss Account at all, or anything else besides a weekly account which is largely incomprehensible. An official of the Bank, who had a keen eye for the absurdities of life, once told me that he had two weekly treats, one on Wednesday when he enjoyed his ''Punch,'' the other on Friday when he read the attempts of
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an intelligent Press to expound to its readers the meaning of the Bank return.
Whether justified or no, this reticence of the banks concerning the details of their business is not helpful to those who are considering investment in their shares. Combined with the mystery which the possession of large hidden reserves enables them to throw over the process of meeting losses, it gives the whole business an appearance of easily earned and regularly accruing profits and so whets the appetite of those reformers who want to nationalize the banks, and think that their job is so simple that even a Government office could do it. It is true that Mr. Sidney Webb, when he put forward a scheme for their nationalization in the ''Contemporary Review'' of July, 1918, proposed that the most difficult part of banking, the lending of money to industry, should be left to "a series of financial concerns, whose business it should be to discount the bills and satisfy the requests for loans of those profit-makers who now appeal to the bankers."<ref>The evident objections to this scheme were discussed in ''[[War Time Financial Problems]],'' by H. Withers.</ref> But younger enthusiasts have been more daring.
The possibility of nationalization is thus one which a doubting purchaser of bank shares
/foot//
{{smallrefs}}
//foot/
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has to consider. It is, I believe, a plank in the programme of the Labour Party, but recent experience has shown that Socialist Governments that have taken office on the Continent have been not at all in a hurry to nationalize anything, and the separation of central banks—and still more of the outer banking machinery—from political influence is now recognized as essential, if the monetary world is to be saved from the wild-cat achievements of Governments in currency debasement, that marked the war and after-war period. I think it would be pretty safe to bet against the {{SIC|nationalizaion|nationalization}} of our banks during the next twenty years, but one cannot be certain about the jump of the political cat.
A more immediately practical fact, for the possible investor, is the notion that one finds current among bankers, arising partly out of the talk about nationalization, that it is a questionable policy for them to increase their dividends and that they should rather regard their business as an enterprise to be carried on purely in the public interest.
Over a long period of years increases in dividends by the English bank have been scarce; for some time before the war the banks were writing down their investments, having made the mistake (as we all see now) of
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thinking that Consols and other undated or long-dated securities were nice securities for them to hold; and during and since the war—a period which covered the commercial cataclysm of 1920 and 1921, when the prices of commodities were halved—they must have had a good deal of provision to make for the consequences of mishaps to their customers in and after that appalling time.
Now, their position must be greatly strengthened by the writing down of the last twenty years, but if they propose to adopt a self-denying ordinance in the matter of future increases of dividends, shareholders who are buying fully paid shares in English banks which pay them less than 5 per cent. will perhaps feel aggrieved. They will certainly have a strong ground for arguing that part of any increased profit that may be earned during less trying times ahead should fall into the pockets of shareholders.
This view about dividends, however, does not yet seem to have crossed the border, for the Royal Bank of Scotland makes the timely announcement, as I end this chapter, of an increased dividend, following four successive increases.
Moreover, since the above was written the Westminster has announced, with its report for
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1925, a bonus to shareholders in the form of new shares.
On a smaller scale the discount companies enjoy the same advantages as the banks, of handling a mass of money many times the size of their capital We saw that the Westminster Bank, with a paid-up capital of nine millions, held nearly 273 millions deposited with it by the public. When we look at the balance-sheet of the Union Discount Company, the largest of the joint stock companies that engage in this kind of business, we find that, with a paid-up capital of £1,125,000, it held forty millions "in loans and deposits, including provision for contingencies." Let us summarize its balance sheet of December 31, 1924:—
{| style="max-width: 40em; font-size: 92%; margin: auto;"
|-
! colspan="2" |
|-
| Capital paid up || £1,125,000
| Cash at bankers || £1,320,683
|-
| Reserve Fund || 1,475,000
| British Govt. and other securities || 5,724,642
|-
| Provident Fund || 198,732
| Loans at call and short dates || 474,524
|-
| Loans and deposits, etc. || 40,100,868
| Bills discounted || 47,023,680
|-
| Bills {{hinc|re-discounted}} || 11,053,918
| Debtors || 9,322
|-
| Rebate on bills discounted || 423,485
| Premises || 140,000
|-
| Profit and loss (less appropriations) || 315,848
|-
| || '''£54,692,851'''
| || '''£54,692,851'''
|}
The position of the company is clear and pleasant; it has borrowed forty millions, put a net sum of thirty-six millions into bills
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of exchange (this being the total of bills discounted less bills {{hinc|rediscounted}}) and six millions into investments and loans, and it holds more than its paid-up capital in cash at bankers.
We thus see at a glance the function that is performed by these companies and the private firms which engage in the same business. They act as merchants in the market for bills of exchange, which are the currency of international trade, keeping a large stock of them in hand so that they may be able to provide, for the banks and other purchasers, bills of the date and class that are required by the buyer.
In order to finance this mass of credit-merchandize, they borrow from the banks and finance houses and from the India Council and anyone else who wants to place funds for a time. Their utility is obvious—they provide a reservoir into which the floating cash of Lombard Street may be poured to earn the current rate of interest for short loans, and another reservoir which holds the floating supply of bills of exchange which finance the home and foreign trade of Great Britain, and of many other countries, and (at present in the form of Treasury bills) form the greater part of this country's floating debt.
{{nop}}
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They thus have two considerable advantages over their big brothers, the banks, whom they serve both as borrowers of surplus cash and providers of bills of exchange.
In the first place they have nothing to do with the queer old public and have not always to provide against its whims about the custody of its money. Their liability is not to thousands of depositors all over the country, but to a few banks and first-rate firms in the city or in the world of finance, from whom they borrow and from whom they can, more or less, rely on reasonable treatment in times of difficulty. Their chief asset is not, like that of the banks, a mass of advances to industrial, commercial and other customers, with exacting ideas about the extent and price of the credit that they ought to be granted, but a portfolio of bills of exchange, most of them accepted or endorsed by the British Government or by banks and accepting houses so eminent and respected that the "bank bills" which they create, for financing the trade of the world, are often quoted at a higher price than British Treasury bills, now that the latter are so enormously plentiful. Moreover, their assets, in bills and securities, being constantly used as pledges for advances, are subjected to continued scrutiny by lenders.
{{nop}}
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Their second advantage is that most of their business is done within a square mile of their offices, and that they have none of the difficulty involved by scores of branches but are in close and constant personal touch with their most important connections.
Although it would be interesting to know how much of the Union Discount's investments consists of British Government and how much of other securities and of what kind these latter may be, it will be noted that owing to the high standing of those responsible for meeting the bills which make up the greater part of the company's assets, the question of doubtful assets hardly arises in the balance-sheet of a discount house. Acting as they do as intermediaries for the banks, it is an essential of their business to be above reproach in its conduct, and to add continually to the strength of their position by an active reserve fund policy and by caution in the question of rebating—that is estimating the present value of—their bills of exchange.
From the Profit and Loss Account of the Union Discount it appears that it made a gross profit for the year 1924, after making provision for contingencies, of £753,000. Deducting expenses, £76,000, and rebate £423,000, we find a net profit of £254,000. The company
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pays £172,000 in dividend and bonus, puts £60,000 to reserve and premises and £10,000 to provident fund, and adds £11,000 to carry forward.
The disadvantages of these companies from the investor's point of view are:—
(1) There is a liability on the shares, most unlikely to be enforced, but still there.
(2) There are only three of them to be invested in, and
(3) The market in the shares is far from free.
But in the matter of stability of the business their advantage over any ordinary industrial investment is evident since, whatever may happen to this trade or that, there is always a mass of trade to be financed. The distribution of risk is world-wide in extent, and the elimination of risk is the constant aim of the experts, trained to tell a good bill almost by the feel of it, who manage these companies.
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{{ph|class=chapter num|Chapter XV}}
{{ph|class=chapter title|Investments in Insurance Shares|level=2}}
{{sc|As}} we saw in [[Hints About Investments/Chapter 2|Chapter II]], life insurance is a form of investment that should come first on the list of those undertaken by anyone who has dependents to provide for in the event of his demise; and the shares of the companies which provide life and other kinds of insurance will also be found to be highly attractive to anyone who wants the advantage carried by ordinary shares but seeks to reduce the risk that necessarily goes with them.
This attraction consists, as in the example of banks and discount companies, in the fact that enormous funds are handled in proportion to the capital invested, and that insurance is a great huge world-embracing business and is always going on, with a certain ebb and flow of activity and profit, but free from the wide fluctuations that may affect a particular industry. Whether trade is good or bad, those who carry it on have to insure against fire and shipwreck
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and other trade risks; though if trade is bad there are fewer ships sailing and fewer goods in transit, though there may be more in the warehouses.
Insurance is a very complicated and difficult business, and the complications and difficulties reflect themselves in the accounts and balance-sheets published by the companies, especially those of the kind usually described as composite, because they usually carry on several different kinds of insurance business, the main divisions being life, fire, marine, employers' liability and sickness and accident.
All these different divisions require highly specialized skill, though the life department is now comparatively simple owing to the mass of knowledge that has been acquired, through more than a century of investigation and record, concerning the probabilities of the length of human life. Given the requisite medical skill to judge whether an applicant for insurance is sound in wind and limb—and a few other particulars—or how much allowance should be made for any weakness that may be detected, a skilled actuary can easily work out his expectation of life—barring accidents. Moreover, as the mortality tables on which the companies work are necessarily the result of past experience, and as improved sanitation, medical
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knowledge and surgery are continually adding to the span of human life, those who sell life insurance have long been selling an article which was really rather less valuable than they believed it to be; and so we constantly find the companies reporting that their mortality experience has been considerably below expectation. Which means to say that the bargain made with the assured has been in favour of the companies, though the assured have been able to share in this advantage by means of "with-profit" policies.<ref>See [[Hints About Investments/Chapter 2|Chapter II]], [[Hints About Investments/Chapter 2#28|28]].</ref>
Another factor in their favour is that those who insure their lives are likely from this very fact to be good lives, because they are likely to apply to living the same prudence and forethought and intelligence concerning responsibilities that led them to the act of insuring. So that the life risk is "selected." On the other hand, though the Black Death no longer ravages Europe, influenza sometimes has an appreciable effect on the death-rate.
In other forms of insurance, this favourable selection does not help those who provide them. All ships of any value that sail are insured with their cargoes and in some cases the selection is the other way. At least I have heard it suggested that an owner driver who has insured
/foot//
{{smallrefs}}
//foot/
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his car becomes immediately much less careful in driving; and the exponents of auto-suggestion would probably tell us that anyone who insures against sickness is likely to be ill, from the mere fact that he thinks about it.
Competition in insurance is keen, especially in foreign countries, and most of our great composite companies do a large business abroad; and its management needs the highest skill and vigilance to keep an even balance between the necessity of working at rates which shall meet competition and attract custom, and that of making full provision against the risks involved. At the same time insurance business is one in which established reputation and prestige are of enormous value—if you buy a knife or a pair of boots you have got your article and there's an end on't, and you are not concerned further with the seller. If you buy insurance of your warehouse against fire or of your ship against marine risks, you are very greatly concerned to be certain that the seller will, if you have to make a claim at some future date, be not only solvent but prompt and fair in meeting it. It need not be said that in these respects the British offices have an unrivalled reputation the world over, so that as long as they are given a fair chance by local legislators, they are well equipped to keep their flag flying.
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But it was remarked by the ''Economist'' in its issue of May 30, 1925, that "an element of nationalism has to be reckoned with, the tendency in many countries nowadays being to regard insurance as a local preserve for national companies."
The accounts of the composite companies are so voluminous and complicated that any detailed examination of them would only confuse the ordinary investor, for whom this work is devised, and overload this chapter to a weight and size out of all proportion to the scale of our building. As to the balance-sheet, it is enough to say that the "doubtful assets" almost non-existent, if we assume, as we may, that the mortgages are well secured and that the investments are quoted and marketable. In one that is before me the assets are composed as follows:—
{| style="max-width: 40em; font-size: 92%; margin: auto;"
|-
| Mortgages and loans
| £517,181
|-
| Investments
| 16,872,725
|-
| Freehold and leasehold premises, ground rents, etc.
| 1,982,290
|-
| Branch Agency and other balances
| 3,292,361
|-
| Due from other companies, or departments of the company
| 910,518
|-
| Outstanding premiums and interest
| 200,700
|-
| Bills receivable
| 50,591
|-
| Cash and stamps
| 2,641,164
|-
|
| '''£26,467,530'''
|}
It looks like a nice collection, though we are
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largely left to guess about its contents. Mortgages which we found in [[Hints About Investments/Chapter 7|Chapter VII]] to be unsuitable for the private investor we saw at the same time to be excellent for institutions like insurance companies, which can command the skill and attention necessary for their vigilant and constant scrutiny; and their amount in this case is less than half a million out of a total of 26½ millions.
Of the investments, four millions odd are British Government securities, £953,000 are Indian and Colonial Government, £2,886,000 Foreign Government, and £6,784,000 are Railway and other debentures and debenture stocks, home and foreign, these items making up nearly £14¾ millions out of the total of 16¾. British municipal and county securities only amount to £128,000, and there are £290,000 of "Railway and other" ordinary stocks and shares.
It was noted above that the list of investments is almost entirely uninforming. The insurance companies are bound by the [[Assurance Companies Act of 1909]] to draw up a balance-sheet according to the Third Schedule of the Act. The headings shown are those provided by the Schedule. As usually happens with these well-meant official regulations, those bound by them naturally think that, having duly followed them,
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they have done all that is required, and as we see, the Schedule drawn up by the wisdom of Parliament seems to be designed to tell us almost nothing about the investments of insurance companies.
It makes the companies show (which is something) how much is in British Government securities, but such headings as Railway and other debentures or ordinary stocks, and Foreign Government securities are quite worthless to anyone who wants to know what securities the companies hold. Foreign Government securities range from the obligations of the United States to those of Honduras; and "Railway and other ordinary" might include wild cat mining or oil shares. It would be an education for most of us to be able to see what are the investments of the great insurance companies; as it is, we can only see that they are divided into certain headings, and once more call upon that confidence in the directors and managers, which has so often to act as a crutch for the groping investor, to guide us to the belief that all these are sound and suitable. Fortunately the crutch generally does its work; but if all the great insurance companies would publish with their balance's heets a full list of their investments, they would provide a most useful guide to those
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who are less well equipped for selecting securities.
That there is no objection to their doing so is shown by the fact that some of them do it. The balance-sheet of the Clerical, Medical and General Life Assurance Society, for example, gives every investment in detail, and a very interesting study they make, and will repay careful examination by investors who want to see how this successful company succeeds in earning a net yield of £4 15s. 4d. per cent., after deduction of income tax, on its invested funds. Points that strike one are the small amounts held in Home Railway prior charge stocks (£19,000) and home municipal securities (£10,000), though the loans on parochial and other rates come to a handsome sum (£298,000). The outstanding features, however, are the imposing figures of the mortgages (£2,013,000) and the British Government securities and guarantees (£2,180,000), which with the various loans (£1,106,000) make up well over five millions out of a total of £8,881,000 of assets.
As to the complications of insurance accounts and the high proportion of net revenue that the companies put to reserve, both will best be exemplified by the following extracts from the first article in the ''Economist's Insurance''
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''Supplement'' of July 12, 1925, giving the generals results for the year 1924:—
"In this brief preliminary survey we are concerned with the broad effects of the year and its contribution to the resources of British insurance. It is rather misleading to talk or write of 'profits' when we are considering the underwriting surpluses of insurance companies, those balances of the annual premiums which remain over after claims, expenses, and unexpired liabilities have been met. In the technical and legal sense they are, of course, profits belonging to the shareholders. But, unlike the profits of an ordinary trading company, they are not, except to a very small extent, available for distribution. These annual profits of insurance—or, as we prefer to call them, these annual surpluses—are the materials, and the sole materials, out of which the powerful structure of insurance is built up. They provide the slowly accumulating reserves for contingencies upon which security rests, and without which insurance, from the public point of view, would be little better than a gamble. In order to achieve security of the highest class, these annual surpluses, when they are earned, are always treated as funds held in trust for the public rather than as cake to be cut up and divided among shareholders. Out of
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them British taxes are paid, and almost the whole balance, sometimes even more than the balance, is put away to permanent reserve. Dividends are based, not on these surpluses, but upon the interest earned by the reserves. This sound system of insurance finance has been taught to the world by the British companies, and no other system will give that endurance and impeccable security which is of the essence of insurance, and without which insurance is a mockery.
"Last year the fire insurance offices did fairly well, in spite of rather unfavourable results in the United States. The accident and miscellaneous departments, though not productive of large surpluses, did better than in 1923. Marine insurance remained in the trough of the wave, and showed few, if any, signs of becoming seaworthy. Life assurance was prosperous, but as the bulk of the surpluses in this class of insurance, even in proprietary companies, goes in bonuses to policy-holders, it is not a large contributor to profit and loss accounts.
"While making up the figures for the table of general results on the opposite page, we have observed certain recognized principles. The underwriting surpluses in the fire, accident and miscellaneous accounts were arrived at after charging against premiums all the claims paid
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and outstanding, all expenses and commissions, including those carried to profit and loss accounts, and including colonial and foreign
{{c|{{uc|Underwriting Results, Interest, Taxes and Dividends}}}}
{| class="wikitable"
|-
! Company.
! Net Underwriting Surplus.
! Interest Net, less Debenture Interest.
! Taxes.
! Dividends for 1924.
|-
|
|£
|£
|£
|£
|-
| Alliance
| 449,805
| 303,733
| 17,125
| 434,000
|-
| Atlas
| 174,603
| 122,127
| 46,762
| 143,000
|-
| British Dominions
| 43,964
| 117,335
| 25,000
| 143,152
|-
| British General
| 86,933
| 50,100
| —
| 40,687
|-
| Caledonian
| 74,328
| 74,052
| 30,925
| 74,981
|-
| Commercial Union
| 1,018,201
| 728,163
| 271,433
| 826,000
|-
| Employers' Liability
| 121,603
| 268,537
| 116,079
| 287,818
|-
| General Accident
| 175,428
| 179,221
| 143,821
| 89,358
|-
| Guardian
| 248,577
| 142,283
| 48,776
| 163,069
|-
| London Assurance
| 115,729
| 237,429
| 50,000
| 212,865
|-
| London and Lancashire
| 754,158
| 387,001
| 184,741
| 407,603
|-
| Motor Union
| 62,126
| 69,225
| —
| 84,940
|-
| North British
| 575,058
| 398,596
| 101,711
| 375,554
|-
| Northern
| 222,999
| 246,682
| 56,037
| 297,254
|-
| Phoenix
| 383,742
| 421,772
| 55,621<ref>Refund</ref>
| 463,556
|-
| Royal
| 781,937
| 1,034,245
| 130,000
| 1,134,351
|-
| Liverpool and London and Globe
| 511,260
| 382,222
| 50,000
| 413,777
|-
| Royal Exchange
| 90,909
| 170,688
| 48,254
| 152,898
|-
| Scottish Union
| 201,095
| 124,669
| 62,938
| 116,250
|-
| Sun
| 220,388
| 181,220
| 48,579
| 186,000
|-
| Yorkshire
| 156,895
| 98,966
| 58,844
| 112,548
|}
taxes when specified in the companies' accounts, and the amounts required to maintain the reserves for unexpired risks at 40 per cent. of the premium incomes. When the premium income
/foot//
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falls the yearly contribution to current reserve is negative, and becomes an addition to the surplus; but when the premium income increases it is positive, and a reduction of the apparent surplus. With marine insurance we have been obliged to adopt a different system. No one knows how a marine account works out except the officials of the individual companies, and they only after an account has been finally closed. For marine surpluses we have taken the amounts transferred to profit and loss by the companies in respect of the latest closed year. For the contribution of life assurance we have taken those amounts which have been disclosed by valuations as belonging to shareholders, and accordingly carried to profit and loss.
"So much for surpluses. The interest receipts are those yielded by the available funds, other than life and capital redemption, less income tax and less debenture interest payable by the companies. The taxes, which are chargeable against surpluses, are in most cases British taxes only. But where a few companies have lumped all their taxes together and put them into profit and loss account, we have been obliged to follow them. Dividends are those provided in respect of 1924; many of them have been increased as compared with 1923. In-
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creases in dividend are permissible, as and when the interest yielded by the funds increases.
"After applying the above principles we find that the total surpluses of the twenty-one companies in our table amounted to £6,469,747 before charging taxes. Taxes, net, required in the aggregate £1,535,404, so that there remained £4,934,343 as the final surplus from all sources on about £100 millions of premium income (excluding life premiums). The dividends provided for 1924 cost £6,159,661, towards the payment of which the interest receipts on the funds yielded £5,638,288, leaving only £521,373 to be drawn from the surplus. We see, therefore, that the aggregate surplus of £4,943,343 was disposed of as follows: £4,{{SIC|412, 970|412,970}} undivided and set aside to strengthen reserves, and £521,373 expended in the payment of dividends."
It is an amazing exhibition of successful business and financial strength, and those who acquire proprietorship in it by a purchase of insurance shares do so usually at prices which make them pay high for a partnership in these assets and this wonderful organization. Many insurance shares stand at prices which yield to the buyer a rate of dividend which is considerably below the yield from Government securities—some of them less than 3 per cent.—and so
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discount a good deal of future increase. The few debenture stocks that these companies have outstanding are as fine a security as anyone could want, but they are scarce and high priced and difficult to buy.
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{{ph|class=chapter num|Chapter XVI}}
{{ph|class=chapter title|Trust Companies' Securities|level=2}}
{{sc|In}} the early days of the Trust companies, when their history was chequered by the ailments of infancy, they were described by a city wit as institutions formed to hold collectively securities which no individual would look at. It was a pleasant gibe with just a spark of truth in it, because it is in fact quite possible for companies handling large funds, and consequently able to diversify risk on a large scale, to take investment risks which the prudent private investor should avoid. But it was said very many years ago, and the securities of the well conducted Trust companies have now established themselves as in many ways the finest form of investment that one can want.
And so they ought to be. As we have seen, the investor is born to risk and uncertainty as the sparks fly upward, and his chief refuge from these dangers is diversification. The Trust
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companies can diversify diversification. Shares in big industrial combines give diversification, and so still more widely, as has been shown, do shares in banks and discount companies and insurance companies, and a Trust company can hold all these things and many others, so that their shareholders acquire partnership in diversification carried to the highest possible point.
In security of income, derived from a well-chosen collection of investments in all parts of the world, and yielding a revenue many times as large as the interest on the debenture stocks, the debentures of the best Trust companies are hard to beat. Their preference or preferred stocks come not far behind; and the ordinary or deferred stocks and shares, when one can get them, give one a share in revenue earned by highly trained skill and experience in investing, and a share in capital value which grows by constant allocations to reserves.
Moreover, Trust companies have two great advantages over the ordinary investor; they do a considerable business in underwriting new issues, and thereby either increase their revenue or get, at the underwriting price, securities that they wish to hold; and also, as a Trust company chairman lately expressed it, "many of the best things are offered privately to the invest-
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ment Trusts before they are put upon the market."
The business of managing a Trust looks easy to an outsider who has never tried it. If one were to start to-day, with the right people behind it, it ought to be able to raise a million capital and split it into £600,000 5 per cent. preference and £400,000 ordinary; whatever it could earn above 5 per cent. on its investments would thus be available after paying that rate to its ordinary shareholders, for dealing with preliminary expenses and starting a reserve fund, the return from which as invested would increase the income of the ordinary shareholder. And profits, if any, from underwriting new issues and from realizations of securities, would be available for the same purposes. If the first few difficult years are passed, the rest of the life of the concern should be one of increasing income, as long as it steadily adheres to the principle of always dividing less than it earns and putting the balance into well-selected securities.
It looks easy, but the career of Trust companies has been by no means uniformly successful. An interesting pamphlet<ref>Published by the Bureau of Foreign and Domestic Commerce, U.S. Dept. of Commerce, Trade Information Bulletin, No. 88, April, 1923.</ref> on
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British Investment Trusts, by Mr. Leland L. Robinson, American Trade Commissioner in London, says that "fully one-quarter of the investment trusts have been remarkably successful," which shows very clearly that the purchase of their securities is not a thing to be done with one's eyes shut, and makes one wonder why the proportion of professional success, on an apparently not too difficult job, should have been so low. Perhaps there is a temptation to think that diversification is all that matters, whereas without skill and care it is useless. With skill and care it works wonders. Mr. Robinson gives a most interesting analysis of the highly successful career of the Edinburgh Investment Trust, which began with a dividend of 8 per cent. on its deferred stock for 1890, came down gradually to 2 per cent. for 1895 and 1896, and since then has gone ahead steadily to 20 per cent. in 1916, and now pays a dividend of 12 per cent. on a deferred capital more than doubled by the capitalization of reserves. It has in all distributed to its deferred shareholders £278,000 of deferred stock, £64,000 in debentures and £58,000 in preferred stock.
It is a wonderful record of success, and this is not the most successful of the Scottish Trusts in the matter of past record, its career having
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begun, like that of many of the English Trusts, at a bad moment, just before the 1890 crisis, which led to an American panic of 1893, complicated by difficulties in Australasia. Scotsmen maintain, and with good reason, that they know better than anyone how to manage investment Trusts, and that the remoteness of Edinburgh from London is by no means a disadvantage.
The Edinburgh Investment Trust does not publish a list of its investments, but Mr. Robinson was able to tell us that its policy "has been to invest considerable funds in common shares." Its chairman told him that the secret of investment Trust management is to "avoid losses on holdings and allow a portion of net revenue to accumulate at compound interest." This, of course, is the "reserve fund policy," the benefits of which have been so often shown in previous pages. In its report dated March 28, 1925, it stated that its investment funds are distributed over 397 investments, an average of £3,620 in each. According to the usual valuation the investments at the close of the company's year (March 15) were worth over £340,000 more than the amount at which they appear in the balance-sheet, which amount was £1,438,226 6s. 1d.
From the point of view of the curious inquirer,
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it is much to be regretted that so few Trust companies publish a list of their investments. It has been stated that only about a quarter of those quoted in London Stock Exchange official lists give this information. Mr. Robinson, in his bulletin quoted from above, says that it is felt that the companies "would be handicapped in realizing on their holdings if knowledge of the extent of these holdings were public property." And practical Trust company men do not see why they should give away the secrets of their business.
These reasons may be sound, but reticence on the point is the more unfortunate because an attack on the investment policy of the Trust companies, in one important particular, was made by Mr. Harman of the Rock Investment Company in a speech reported in ''The Times'' of September 3, 1925; since it is always useful to investors to hear criticisms, let me give Mr. Harman's words:—
"We feel," he said, "that there is something fundamentally wrong in one investment company—except in quite exceptional circumstances—making permanent investments in the junior stocks of other investment companies. I know that the practice is a common one, but I am sure it is a very bad one. . . . My real objection is that it tends eventually to lead to
-239
a fool's paradise. I am sure very few of you realize to what a large extent certain investment trust companies purchase one another's stocks. The purchases are usually made because of knowledge that the 'break-up' value is such-and-such a figure, whereas the market price is only such-and-such. However, if all the investment companies will continue to buy one another's junior stocks, naturally the break-up values of all will go up and up, until one fine day, when the buying movement is replaced by a selling movement, they will go down and down. . . .
"This financially incestuous buying of one another's junior stocks has in my opinion arrived at such a point that careful investors ought now to discriminate between stocks of those companies which make a practice of it and those which do not. . . .
"I think many will agree with me that in view of the large amount of capital invested in investment trust company stocks the market in them is extraordinarily restricted, which is a great pity from many points of view. The prevailing tendency to which I have referred intensifies the narrowness of the market. . . .
"As we all know, investment trust companies—have for some time past been having a very good time. However, most of the older
-240
of the companies have at some stage or other in their history had to go through periods of difficulty, and it would be foolish to think that such difficult periods cannot recur. Accordingly, in my view, companies should be extra careful at this moment of their prosperity to correct, while they are able to do so, any basic errors in their policy, such as the one to which I have drawn attention, thereby putting themselves in a better position to meet the period of depression which, as experience teaches us, usually succeeds a period of elation."
It follows from the nature of the work done by these companies that their expenses are extremely minute. Our friend, the Edinburgh Investment Trust, shows, in its revenue account, interest and dividends received, less income tax £86,950, and management expenses £4,600; this leaves £82,350 as total net revenue before paying debenture interest. As debenture interest, less tax, requires £12,400, it is more than six and a half times covered. As far as capital security goes, the investments, as we have seen, stand at £1,438,000, and are valued at £1,778,000, so that at the date of the balance-sheet the £400,000 of debentures was secured on assets worth more than four times as much. Even the preference stock's dividend is covered more than five and a half
-241
times, its capital more than 3.8 times. The ordinary shareholders get 12 per cent. on a capital that has been more than doubled by bonus share distributions, to say nothing of the income that they get from bonus distributions of debenture and preference stocks. With these results and with the great diversification of risk secured, and the reserve fund policy that is the corner-stone of sound Trust company finance, it is clear that those who invest in Trust companies have done extremely well, as long as they have invested in the right ones. But then, as has been shown, the stock of the good ones very seldom comes to market, and there are plenty of companies which have been unfortunate.
In London, as might be expected, the expenses are at a higher ratio to income. The Industrial and General Trust, in its report to March 31, 1925, showed total income £362,706, and its expenses included rent, salaries, office and general expenses £17,448, directors' fees £12,500, legal expenses £299, auditors' fees £525, special disbursements £567, trustees for debenture holders £350—a total of £31,689; and there was also £766 for staff pension fund. This company paid 14 per cent. on its ordinary stock for the year, absorbing £135,625 out of a divisible balance (after
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paying the preference dividend) of £212,566, leaving about £77,000 to be added to reserve or used for extinction of debenture stock, rebate and expenses. It not only gives a detailed list of investments, but the following very interesting classification, showing among other things that it has, like the Edinburgh Investment Trust, been a practical believer in the benefit of a diversified holding of ordinary and deferred stocks and shares:—
{{c|{{uc|Summary of Investments of the Industrial and General Trust}}}}
{{c|{{fine|{{sc|I.—Showing Manner of Distribution Amongst Different Classes of Undertakings}}}}}}
{| style="max-width: 40em; font-size: 92%; margin: auto;"
|-
| Industrial
| 47.67 per cent.
|-
| American and Foreign Railways
| 19.01 {{ditto|per cent.}}
|-
| Banks and Financial
| 11.74 {{ditto|per cent.}}
|-
| Government Securities and Municipal Loans
| 10.15 {{ditto|per cent.}}
|-
| Home and Colonial Railways
| 5.67 {{ditto|per cent.}}
|-
| Tramways and Omnibus
| 3.46 {{ditto|per cent.}}
|-
| Land and Property
| 1.42 {{ditto|per cent.}}
|-
| Shipping
| .88 {{ditto|per cent.}}
|-
|
| 100.00
|}
{{c|{{fine|{{sc|II.—Showing Classification According to Localities}}}}}}
{| style="max-width: 40em; font-size: 92%; margin: auto;"
|-
| Great Britain
| 38.13 per cent.
|-
| South America, excluding the Argentine Republic
| 14.35 {{ditto|per cent.}}
|-
| Argentine Republic
| 13.07 {{ditto|per cent.}}
|-
| British Dominions and Dependencies
| 12.73 {{ditto|per cent.}}
|-
| United States of America
| 9.05 {{ditto|per cent.}}
|-
| Europe, excluding Great Britain
| 4.87 {{ditto|per cent.}}
|-
| Asia and Africa, excluding British Dominions and Dependencies
| 4.36 {{ditto|per cent.}}
|-
| Mexico and Central America
| 3.44 {{ditto|per cent.}}
|-
|
| 100.00
|}
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{{c|{{fine|{{sc|III.—Classification According to the Denomination of the Securities}}}}}}
{| style="max-width: 40em; font-size: 92%; margin: auto;"
|-
| Bonds, and Debenture and Guaranteed Stocks
| 40.29 per cent.
|-
| Preference Shares and Stocks
| 17.42 {{ditto|per cent.}}
|-
| Ordinary and Deferred Shares and Stocks
| 42.29 {{ditto|per cent.}}
|-
|
| 100.00
|}
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{{ph|class=chapter num|Chapter XVII}}
{{ph|class=chapter title|Some Conclusions|level=2}}
{{sc|"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
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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. [[Author:H. G. Wells|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."<ref>In an article in the ''[[American Magazine]],'' February, 1924.</ref>
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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
-247
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
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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
-249
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 share-
-250
holders 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
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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.<ref>These figures are taken from the ''Economist'' banking numbers.</ref> 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.
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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.
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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.
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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
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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.
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{{ph|class=chapter num|Chapter XVIII}}
{{ph|class=chapter title|The Ignorant Investor|level=2}}
{{sc|We}} are all, who are outside the circle of professional experts, ignorant about investments, and so also are some who are inside it; but there are degrees. The ignorant investor with whose plight I am now concerned is the really blatantly ignorant one, who constantly falls a victim to knavery not because of his or her greed or stupidity, but because of sheer ignorance of the whole business and lack of a sound and disinterested adviser.
It is easy to tell people, as I have in the foregoing pages, that investment is a very difficult matter and that the best way of dealing with it is to find a good stockbroker and follow his advice. But what if they do not know a stockbroker, and what if they happen to fall into the hands of a bad one?
It is easy also to tell people to consult their bank manager. But many people have not a banking account, and sometimes the advice given by bank managers is unfortunate.
{{nop}}
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It is really a serious problem, because the losses incurred year in year out by these unfortunates must run into big figures, and, apart from the individual hardship involved, we cannot afford to lose capital in this way. Moreover, the existence of this evil produces a swarm of human vermin who live on it, and it is an ugly blot on our financial system which invites and receives acrid but justified comment from its critics.
Some radical improvement in our investment machinery seems to be needed, and all the more because of the great increase in the investment habit, among classes in which it was formerly uncommon, during and since the war. The social importance of this growing democratization of capitalism is difficult to exaggerate, and it will mean disaster if the stimulus is checked by losses due to bad investment. Another cause which makes this problem urgent is the prominence lately given to profit-sharing as conducive to industrial co-operation. Most profit-sharing schemes invite, or even oblige, the wage earner to invest his share of profit in the company that employs him. Thereby he puts too many eggs into one basket and risks capital loss, as well as loss of his job, if the company falls on evil days. It is surely much more desirable that he should
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invest outside, through some sound and trustworthy channel.
When one airs these views in the company of business men they are apt to agree and then to observe that there would not be much, if any, profit attached to solving the problem because it would mean expensive propaganda and, at best, a great deal of business in piffling amounts; moreover, that it does not seem to be anybody in particular's job.
What I should like to see would be a trust company with an absolutely undoubted Board—either formed ''ad hoc,'' or one of those already in existence—which would, along with its ordinary business, make a speciality of catering for the ignorant investor by taking his money and issuing shares (perhaps participating preference) to him.
Or one or some of the great insurance companies might take the matter up as a special line, forming a separate company or branch for this purpose. They all have a body of experts on investing, but of course they have already so much to invest that they hardly know where to put it. But this special line might be helpful to them in their insurance business.
Whatever company or institution took the business up would be obliged, if it meant to deal thoroughly with the problem of the
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ignorant investor, to spend a good deal on publicity, so that everyone who has money to invest might know that some trustworthy concern was prepared to take charge of its investment. It does not look like a highly profitable enterprise, but the huge profits that have been made by providing insurance and tobacco to millions of the impecunious seem to indicate that sound investment might be popularized to the benefit of the pioneers. And the benefit to the public would be enormous./last/
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