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articipating Debentures, due in 2930, are callable after April 1, 1942, at the average market price for the issue during the six months preceding notice of redemption but at not less than the original issue price (which was over 230% of the par value). The Kreuger and Toll 5% Participating Debentures had similar provisions.
Even in the case of a convertible issue a callable feature is technically a serious drawback because it may operate to reduce the duration of the privilege. Conceivably a convertible bond may be called just when the privilege is about to acquire real value.8
But in the case of issues with stock-purchase warrants, the subscrip- tion privilege almost invariably runs its full time even though the senior issue itself may be called prior to maturity. If the warrant is detachable, it simply continues its separate existence until its own expiration date. Fre- quently, the subscription privilege is made “nondetachable”; i.e., it can be exercised only by presentation of the senior security. But even in these
8 This danger was avoided in the case of Atchison, Topeka and Santa Fe Railway Convertible 41/2s, due 1948, by permitting the issue to be called only after the conversion privilege expired in 1938. (On the other hand, Affiliated Fund Secured Convertible Debentures are callable at par at any time on 30 days’ notice, in effect allowing the company to destroy any chance of profiting from the conversion privilege.)
Another protective device recently employed is to give the holder of a convertible issue a stock-purchase warrant, at the time the issue is redeemed, entitling the holder to buy the number of shares of common stock that would have been received upon conversion if the sen- ior issue had not been redeemed. See Freeport Texas Company 6% Cumulative Convertible Preferred, issued in January 1933. United Biscuit 7% Preferred, convertible into 21/2 shares of common, is callable at 110; but if called before Dec. 31, 1935, the holder had the option to t |
give the holder of a convertible issue a stock-purchase warrant, at the time the issue is redeemed, entitling the holder to buy the number of shares of common stock that would have been received upon conversion if the sen- ior issue had not been redeemed. See Freeport Texas Company 6% Cumulative Convertible Preferred, issued in January 1933. United Biscuit 7% Preferred, convertible into 21/2 shares of common, is callable at 110; but if called before Dec. 31, 1935, the holder had the option to take $100 in cash, plus a warrant to buy 21/2 shares of common at 40 until Jan. 1, 1936.
instances, if the issue should be redeemed prior to the expiration of the purchase-option period, it is customary to give the holder a separate war- rant running for the balance of the time originally provided.
Example: Prior to January 1, 1934, United Aircraft and Transport Corporation had outstanding 150,000 shares of 6% Cumulative Preferred stock. These shares carried nondetachable warrants for one share of com- mon stock at $30 a share for each two shares of preferred stock held. The subscription privilege was to run to November 1, 1938, and was protected by a provision for the issuance of a detached warrant evidencing the same privilege per share in case the preferred stock was redeemed prior to November 1, 1938. Some of the preferred stock was called for redemption on January 1, 1933, and detached warrants were accordingly issued to the holders thereof. (A year later the remainder of the issue was called and additional warrants issued.)
Third Advantage of Warrant-bearing Issues. Subscription-war- rant issues have still a third advantage over other privileged securities, and this is in a practical sense probably the most important of all. Let us consider what courses of conduct are open to holders of each type in the favorable event that the company prospers, that a high dividend is paid on the common, and that the common sells at a high price.
1. Holder of a participating issue:
a. |
ue was called and additional warrants issued.)
Third Advantage of Warrant-bearing Issues. Subscription-war- rant issues have still a third advantage over other privileged securities, and this is in a practical sense probably the most important of all. Let us consider what courses of conduct are open to holders of each type in the favorable event that the company prospers, that a high dividend is paid on the common, and that the common sells at a high price.
1. Holder of a participating issue:
a. May sell at a profit.
b. May hold and receive participating income.
2. Holder of a convertible issue:
a. May sell at a profit.
b. May hold but will receive no benefit from high common dividend.
c. May convert to secure larger income but sacrifices his senior position.
3. Holder of an issue with stock-purchase warrants:
a. May sell at a profit.
b. May hold but will receive no benefit from high common dividend.
c. May subscribe to common to receive high dividend. He may invest new capital, or he may sell or apply his security ex-warrants to provide funds to pay for the common. In either case he undertakes the risks of a common stockholder in order to receive the high dividend income.
d. May dispose of his warrants at a cash profit and retain his original security, ex-warrants. (The warrant may be sold directly, or he may subscribe to the stock and immediately sell it at the current indicated profit.)
The fourth option listed above is peculiar to a subscription-warrant issue and has no counterpart in convertible or participating securities. It permits the holder to cash his profit from the speculative component of the issue and still maintain his original investment position. Since the typ- ical buyer of a privileged senior issue should be interested primarily in making a sound investment—with a secondary opportunity to profit from the privilege—this fourth optional course of conduct may prove a great convenience. He is not under the necessity of selling the entire commitment |
counterpart in convertible or participating securities. It permits the holder to cash his profit from the speculative component of the issue and still maintain his original investment position. Since the typ- ical buyer of a privileged senior issue should be interested primarily in making a sound investment—with a secondary opportunity to profit from the privilege—this fourth optional course of conduct may prove a great convenience. He is not under the necessity of selling the entire commitment, as he would be if he owned a convertible, which would then require him to find some new medium for the funds involved. The reluc- tance to sell one good thing and buy another, which characterizes the typical investor, is one of the reasons that holders of high-priced convert- ibles are prone to convert them rather than to dispose of them. In the case of participating issues also, the owner can protect his principal profit only by selling out and thus creating a reinvestment problem.
Example: The theoretical and practical advantage of subscription-war- rant issues in this respect may be illustrated in the case of Commercial Investment Trust Corporation 61/2 % Preferred. This was issued in 1925 and carried warrants to buy common stock at an initial price of $80 per share. In 1929 the warrants sold as high as $69.50 per share of preferred. The holder of this issue was therefore enabled to sell out its speculative component at a high price and to retain his original preferred-stock com- mitment, which maintained an investment status throughout the depres- sion until it was finally called for redemption at 110 on April 1, 1933. At the time of the redemption call the common stock was selling at the equivalent of about $50 per old share. If the preferred stock had been con- vertible, instead of carrying warrants, many of the holders would undoubtedly have been led to convert and to retain the common shares. Instead of netting a large profit they would have been faced with a substa |
mitment, which maintained an investment status throughout the depres- sion until it was finally called for redemption at 110 on April 1, 1933. At the time of the redemption call the common stock was selling at the equivalent of about $50 per old share. If the preferred stock had been con- vertible, instead of carrying warrants, many of the holders would undoubtedly have been led to convert and to retain the common shares. Instead of netting a large profit they would have been faced with a substantial loss.
Summary. To summarize this section, it may be said that, for long-pull holding, a sound participating issue represents the best form of profit-
sharing privilege. From the standpoint of maximum price advance under favorable market conditions, a senior issue with detachable stock- purchase warrants is likely to show the best results. Furthermore, subscription-warrant issues as a class have definite advantages in that the privilege is ordinarily not subject to curtailment through early redemp- tion of the security, and they permit the realization of a speculative profit while retaining the original investment position.
Chapter 24
TECHNICAL ASPECTS OF
CONVERTIBLE ISSUES
THE THIRD DIVISION of the subject of privileged issues relates to technical aspects of each type, separately considered. We shall first discuss convert- ible issues.
The effective terms of a conversion privilege are frequently subject to change during the life of the issue. These changes are of two kinds: (1) a decrease in the conversion price, to protect the holder against “dilution”; and (2) an increase in the conversion price (in accordance usually with a “sliding-scale” arrangement) for the benefit of the company.
Dilution, and Antidilution Clauses. The value of a common stock is said to be diluted if there is an increase in the number of shares with- out a corresponding increase in assets and earning power. Dilution may arise through split-ups, stock dividends, offers of subscription righ |
s: (1) a decrease in the conversion price, to protect the holder against “dilution”; and (2) an increase in the conversion price (in accordance usually with a “sliding-scale” arrangement) for the benefit of the company.
Dilution, and Antidilution Clauses. The value of a common stock is said to be diluted if there is an increase in the number of shares with- out a corresponding increase in assets and earning power. Dilution may arise through split-ups, stock dividends, offers of subscription rights at a low price, and issuance of stock for property or services at a low valua- tion per share. The standard “antidilution” provisions of a convertible issue endeavor to reduce the conversion price proportionately to any decrease in the per-share value arising through any act of dilution.
The method may be expressed in a formula, as follows: Let C be the conversion price, O be the number of shares now outstanding, N be the number of new shares to be issued, and P be the price at which they are to be issued.
Then
C (the new conversion price) = CO + NP
O + N
The application of this formula to Chesapeake Corporation Convertible Collateral 5s, due 1947, is given in Appendix Note 36, page 770 on accom- panying CD. A simpler example of an antidilution adjustment is afforded by
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the Central States Electric Corporation 6% Convertible Preferred previously referred to (page 306). After its issuance in 1928, the common stock received successive stock dividends of 100 and 200%. The conversion price was accordingly first cut in half (from $118 to $59 per share) and then again reduced by two-thirds (to $19.66 per share).
A much less frequent provision merely reduces the conversion price to any lower figure at which new shares may be issued. This is, of course, more favorable to the holder of the convertible issue.1
Protection against Dilution Not Complete. Although prac |
06). After its issuance in 1928, the common stock received successive stock dividends of 100 and 200%. The conversion price was accordingly first cut in half (from $118 to $59 per share) and then again reduced by two-thirds (to $19.66 per share).
A much less frequent provision merely reduces the conversion price to any lower figure at which new shares may be issued. This is, of course, more favorable to the holder of the convertible issue.1
Protection against Dilution Not Complete. Although practically all convertibles now have antidilution provisions, there have been excep- tions.2 As a matter of course, a prospective buyer should make certain that such protection exists for the issue he is considering.
It should be borne in mind that the effect of these provisions is to preserve only the principal or par value of the privileged issue against dilution. If a convertible is selling considerably above par, the premium will still be subject to impairment through additional stock issues or a special dividend. A simple illustration will make this clear.
A bond is convertible into stock, par for par. The usual antidilution clauses are present. Both bond and stock are selling at 200.
Stockholders are given the right to buy new stock, share for share, at par ($100). These rights will be worth $50 per share, and the new stock (or the old stock “ex-rights”) will be worth 150. No change will be made in the conversion basis, because the new stock is not issued below the old conversion price. However, the effect of offering these rights must be to compel immediate conversion of the bonds, since otherwise they would lose 25% of their value. As the stock will be worth only 150 “ex-rights,” instead of 200, the value of the unconverted bonds would drop proportionately.
The foregoing discussion indicates that, when a large premium or mar- ket profit is created for a privileged issue, the situation is vulnerable to sudden change. Although prompt action will always prevent loss through |
ice. However, the effect of offering these rights must be to compel immediate conversion of the bonds, since otherwise they would lose 25% of their value. As the stock will be worth only 150 “ex-rights,” instead of 200, the value of the unconverted bonds would drop proportionately.
The foregoing discussion indicates that, when a large premium or mar- ket profit is created for a privileged issue, the situation is vulnerable to sudden change. Although prompt action will always prevent loss through such changes, their effect is always to terminate the effective life of the
1 See Appendix Note 37, p. 772 on accompanying CD, for example (Consolidated Textile Corporation 7s, due 1923).
2 See Appendix Note 38, p. 772 on accompanying CD, for example (American Telephone and Telegraph Company Convertible 41/2s, due 1933).
privilege.3 The same result will follow, of course, from the calling of a priv- ileged issue for redemption at a price below its then conversion value.
Where the number of shares is reduced through recapitalization, it is customary to increase the conversion price proportionately. Such recap- italization measures include increases in par value, “reverse split-ups” (e.g., issuance of 1 no-par share in place of, say, 5 old shares), and exchanges of the old stock for fewer new shares through consolidation with another company.4
Sliding Scales Designed to Accelerate Conversion. The provi- sions just discussed are intended to maintain equitably the original basis of conversion in the event of subsequent capitalization changes. On the other hand, a “sliding-scale” arrangement is intended definitely to reduce the value of the privilege as time goes on. The underlying pur- pose is to accelerate conversion, in other words, to curtail the effective duration and hence the real value of the option. Obviously, any diminu- tion of the worth of the privilege to its recipients must correspondingly benefit the donors of the privilege, who are the company’s common sharehol |
version in the event of subsequent capitalization changes. On the other hand, a “sliding-scale” arrangement is intended definitely to reduce the value of the privilege as time goes on. The underlying pur- pose is to accelerate conversion, in other words, to curtail the effective duration and hence the real value of the option. Obviously, any diminu- tion of the worth of the privilege to its recipients must correspondingly benefit the donors of the privilege, who are the company’s common shareholders.
The more usual terms of a sliding scale prescribe a series of increases in the conversion price in successive periods of time. A more recent vari- ation makes the conversion price increase as soon as a certain portion of the issue has been exchanged.
Examples: American Telephone and Telegraph Company Ten-year Debenture 41/2s, due 1939, issued in 1929, were made convertible into common at $180 per share during 1930, at $190 per share during 1931 and 1932, and at $200 per share during 1933 to 1937, inclusive. These prices were later reduced through the issuance of additional stock at $100, in accordance with the standard antidilution provision.
3 To guard against this form of dilution, holders of convertible issues are sometimes given the right to subscribe to any new offerings of common stock on the same basis as if they owned the amount of common shares into which their holdings are convertible. See the indentures securing New York, New Haven and Hartford Railroad Company, Convertible Debenture 6s, due 1948, and Commercial Investment Trust Corporation Convertible Debenture 51/2 s, due 1949.
4 See Appendix Note 39, p. 773 on accompanying CD, for example of Dodge Brothers, Inc., Convertible Debenture 6s, due 1940.
Anaconda Copper Mining Company Debenture 7s, due 1938, were issued in the amount of $50,000,000. The first $10,000,000 presented were convertible into common stock at $53 per share; the second $10,000,000 were convertible at $56; the third at $59; the fourth |
rtible Debenture 6s, due 1948, and Commercial Investment Trust Corporation Convertible Debenture 51/2 s, due 1949.
4 See Appendix Note 39, p. 773 on accompanying CD, for example of Dodge Brothers, Inc., Convertible Debenture 6s, due 1940.
Anaconda Copper Mining Company Debenture 7s, due 1938, were issued in the amount of $50,000,000. The first $10,000,000 presented were convertible into common stock at $53 per share; the second $10,000,000 were convertible at $56; the third at $59; the fourth at $62, and the final lot at $65. An $8,000,000 issue of Hiram Walker-Goderham and Worts 41/4s, due 1945, was convertible as follows: at $40 per share for the first
$2,000,000 block of bonds; at $45 per share for the next block of
$2,000,000; the third block at $55; and the final block at $60 per share.
Sliding Scale Based on Time Intervals. The former type of sliding scale, based on time intervals, is a readily understandable method of reducing the liberality of a conversion privilege. Its effect can be shown in the case of Porto Rican-American Tobacco Company 6s, due 1942. These were convertible into pledged Congress Cigar Company, Inc., stock at $80 per share prior to January 2, 1929, at $85 during the next three years and at
$90 thereafter. During 1928 the highest price reached by Congress Cigar was 871/4, which was only a moderate premium above the conversion price. Nevertheless a number of holders were induced to convert before the year-end, because of the impending rise in the conversion basis. These conversions proved very ill-advised, since the price of the common fell to 43 in 1929, against a low of 89 for the bonds. In this instance, the adverse change in the conversion basis not only meant a smaller potential profit for those who delayed conversion until after 1928 but also involved a risk of serious loss through inducing conversion at the wrong time.
Sliding Scale Based on Extent Privilege Is Exercised. The second method, however, based on the quantities converte |
onversion basis. These conversions proved very ill-advised, since the price of the common fell to 43 in 1929, against a low of 89 for the bonds. In this instance, the adverse change in the conversion basis not only meant a smaller potential profit for those who delayed conversion until after 1928 but also involved a risk of serious loss through inducing conversion at the wrong time.
Sliding Scale Based on Extent Privilege Is Exercised. The second method, however, based on the quantities converted, is not so simple in its implications. Since it gives the first lot of bonds converted an advan- tage over the next, it evidently provides a competitive stimulus to early conversion. By so doing it creates a conflict in the minds of the holder between the desire to retain his senior position and the fear of losing the more favorable basis of conversion through prior action by other bond- holders. This fear of being forestalled will ordinarily result in large-scale conversions as soon as the stock advances moderately above the initial conversion price, i.e., as soon as the bond is worth slightly more than the original cost. Accordingly, the price of the senior issue should oscillate over a relatively narrow range while the common stock is advancing and while successive blocks of bonds are being converted.
Example: The sequence of events normally to be expected is shown fairly well by the market action of Hiram Walker-Goderham and Worts Convertible 41/4s described on page 312. The bonds, issued in 1936 at par, ranged in price between 100 and 1111/4 during 1936–1939. In the same period the stock ranged between 261/8 and 54. If the initial conversion price of 40 for the stock had prevailed throughout the period, the bonds should have sold for at least 135 when the stock sold at 54. But meanwhile, as the price of the stock rose, successive blocks of the bonds were con- verted (partly under the impetus supplied by successive calls for redemp- tion of parts of the issue), thus t |
nds, issued in 1936 at par, ranged in price between 100 and 1111/4 during 1936–1939. In the same period the stock ranged between 261/8 and 54. If the initial conversion price of 40 for the stock had prevailed throughout the period, the bonds should have sold for at least 135 when the stock sold at 54. But meanwhile, as the price of the stock rose, successive blocks of the bonds were con- verted (partly under the impetus supplied by successive calls for redemp- tion of parts of the issue), thus tipping off higher conversion prices until the $55 bracket was reached in 1937. In consequence the bonds did not appreciate commensurately with the rise in the price of the stock.5
When the last block under such a sliding scale is reached, the compet- itive element disappears, and the bond or preferred stock is then in the position of an ordinary convertible, free to advance indefinitely with the stock.
It should be pointed out that issues with such a sliding-scale provi- sion do not always follow this theoretical behavior pattern. The Anaconda Copper Company Convertible 7s, for example, actually sold at a high pre- mium (30%) in 1928, before the first block was exhausted. This seems to have been one of the anomalous incidents of the highly speculative atmosphere at the time.6 From the standpoint of critical analysis, a con- vertible of this type must be considered as having very limited possibili- ties of enhancement until the common stock approaches the last and highest conversion price.7
The sliding-scale privilege on a “block” basis belongs to the objection- able category of devices that tend to mislead the holder of securities as
5 See pp. 266–267 of the 1934 edition of this work for a more detailed exhibit of a similar record in Engineers Public Service Company $5 Convertible Preferred in 1928–1929.
6 The size of the premium was due in part to the high coupon rate. The bonds were, how- ever, callable at 110, a point that the market ignored.
7 In some cases (e.g., Porto |
ce.7
The sliding-scale privilege on a “block” basis belongs to the objection- able category of devices that tend to mislead the holder of securities as
5 See pp. 266–267 of the 1934 edition of this work for a more detailed exhibit of a similar record in Engineers Public Service Company $5 Convertible Preferred in 1928–1929.
6 The size of the premium was due in part to the high coupon rate. The bonds were, how- ever, callable at 110, a point that the market ignored.
7 In some cases (e.g., Porto Rican-American 6s, already mentioned, and International Paper and Power Company First Preferred) the conversion privilege ceases entirely after a certain fraction of the issue has been converted. This maintains the competitive factor throughout the life of the privilege and in theory should prevent it from ever having any substantial value.
to the real nature and value of what he owns. The competitive pres- sure to take advantage of a limited opportunity introduces an ele- ment of compulsion into the exercise of the conversion right which is directly opposed to that freedom of choice for a reasonable time which is the essential merit of such a privilege. There seems no reason why investment bankers should inject so confusing and contradictory a fea- ture into a security issue. Sound practice would dictate its complete aban- donment or in any event the avoidance of such issues by intelligent investors.
Issues Convertible into Preferred Stock. Many bond issues were formerly made convertible into preferred stock. Ordinarily some increase in income was offered to make the provision appear attrac- tive. (For examples, see Missouri-Kansas-Texas Railroad Company Adjustment 5s, due 1967, convertible prior to January 1, 1932 into
$7 preferred stock; Central States Electric Corporation Debenture 5s, due 1948, convertible into $6 preferred stock; G. R. Kinney Company Secured 71/2 s, due 1936, convertible into $8 preferred stock; American Electric Power Corporation 6s, due 1957, conver |
tible into preferred stock. Ordinarily some increase in income was offered to make the provision appear attrac- tive. (For examples, see Missouri-Kansas-Texas Railroad Company Adjustment 5s, due 1967, convertible prior to January 1, 1932 into
$7 preferred stock; Central States Electric Corporation Debenture 5s, due 1948, convertible into $6 preferred stock; G. R. Kinney Company Secured 71/2 s, due 1936, convertible into $8 preferred stock; American Electric Power Corporation 6s, due 1957, convertible into $7 preferred stock.)
There have been instances in which a fair-sized profit has been real- ized through such a conversion right, but the upper limitation on the market value of the ordinary preferred stock is likely to keep down the maximum benefits from such a privilege to a modest figure. Moreover, since developments in recent years have made preferred stocks in general appear far less desirable than formerly, the right to convert, say, from a 4% bond into a 5% preferred is likely to constitute more of a danger to the unwary than an inducement to the alert investor. If the latter is look- ing for convertibles, he should canvass the market thoroughly and endeavor to find a suitably secured issue convertible into common stock. In a few cases where bonds are convertible into preferred stock, the latter is in turn convertible into common or participates therewith, and this double arrangement may be equivalent to convertibility of the bond into common stock. For example, International Hydro-Electric System 6s, due 1944, are convertible into Class A stock, which is in reality a participating second preferred.
There are also bond issues convertible into either preferred or common or into a combination of certain amounts of each.8 Although any individ- ual issue of this sort may turn out well, in general it may be said that com- plicated provisions of this sort should be avoided (both by issuing companies and by security buyers) because they tend to create confusion.
B |
ational Hydro-Electric System 6s, due 1944, are convertible into Class A stock, which is in reality a participating second preferred.
There are also bond issues convertible into either preferred or common or into a combination of certain amounts of each.8 Although any individ- ual issue of this sort may turn out well, in general it may be said that com- plicated provisions of this sort should be avoided (both by issuing companies and by security buyers) because they tend to create confusion.
Bonds Convertible at the Option of the Company. The unend- ing flood of variations in the terms of conversion and other privileges that developed during the 1920’s made it difficult for the untrained investor to distinguish between the attractive, the merely harmless, and the posi- tively harmful. Hence he proved an easy victim to unsound financing practices which in former times might have stood out as questionable because of their departure from the standard. As an example of this sort we cite the various Associated Gas and Electric Company “Convertible Obligations” which were made convertible by their terms into preferred or Class A stock at the option of the company. Such a contraption was nothing more than a preferred stock masquerading as a bond. If the pur- chasers were entirely aware of this fact and were willing to invest in the preferred stock, they would presumably have no cause to complain. But it goes without saying that an artifice of this kind lends itself far too readily to concealment and possible misrepresentation.9
8 See, for example, the Chicago, Milwaukee, St. Paul and Pacific Railroad Company Convert- ible Adjustment Mortgage 5s, Series A, due Jan. 1, 2000, which are convertible into 5 shares of the preferred and 5 shares of common. For other examples see p. 623 in the Appendix of the 1934 edition of this work.
9 These anomalous securities were variously entitled “investment certificates,” “convertible debenture certificates,” “interest-bearing allotment |
to concealment and possible misrepresentation.9
8 See, for example, the Chicago, Milwaukee, St. Paul and Pacific Railroad Company Convert- ible Adjustment Mortgage 5s, Series A, due Jan. 1, 2000, which are convertible into 5 shares of the preferred and 5 shares of common. For other examples see p. 623 in the Appendix of the 1934 edition of this work.
9 These anomalous securities were variously entitled “investment certificates,” “convertible debenture certificates,” “interest-bearing allotment certificates,” and “convertible obligations.” In 1932 the company compelled the conversion of the large majority of them, but the holder was given an option (in addition to those already granted by the terms of the issues) of con- verting into equally anomalous “Convertible Obligations, Series A and B, due 2022,” which are likewise convertible into stock at the option of the company. The company was deterred from compelling the conversion of some $17,000,000 “51/2% Investment Certificates” after Nov. 15, 1933, by a provision in the indenture for that issue prohibiting the exercise of the company’s option in case dividends on the $5.50 Dividend Series Preferred were in arrears (no dividends having been paid thereon since June 15, 1932).
It is interesting to note that the Pennsylvania Securities Commission prohibited the sale of these “Convertible Obligations” in December 1932 because of their objectionable provi- sions. The company resisted the Commission’s order in the Federal District Court of
Bonds Convertible into Other Bonds. Some bonds are convertible into other bonds. The usual case is that of a short-term issue, the holder of which is given the right to exchange into a long-term bond of the same company. Frequently the long-term bond is deposited as collateral secu- rity for the note. (For example, Interborough Rapid Transit Company 7s, due 1932, were secured by deposit of $1,736 of the same company’s First and Refunding 5s, due 1966, for each $1,000 note, and they |
t Court of
Bonds Convertible into Other Bonds. Some bonds are convertible into other bonds. The usual case is that of a short-term issue, the holder of which is given the right to exchange into a long-term bond of the same company. Frequently the long-term bond is deposited as collateral secu- rity for the note. (For example, Interborough Rapid Transit Company 7s, due 1932, were secured by deposit of $1,736 of the same company’s First and Refunding 5s, due 1966, for each $1,000 note, and they were also convertible into the deposited collateral, the final rate being $1,000 of 5s for $900 of 7% notes.) The holder thus has an option either to demand repayment at an early date or to make a long-term commitment in the enterprise. In practice, this amounts merely to the chance of a moderate profit at or before maturity, in the event that the company prospers, or interest rates fall, or both.
Unlike the case of a bond convertible into a preferred stock, there is usually a reduction in the coupon rate when a short-term note is con- verted into a long-term bond. The reason is that short-term notes are ordinarily issued when interest rates, either in general or for the specific company, are regarded as abnormally high, so that the company is unwill- ing to incur so steep a rate for a long-term bond. It is thus expected that, when normal conditions return, long-term bonds can be floated at a much lower rate; and hence the right to exchange the note for a long-term bond, even on a basis involving some reduction in income, may prove to be valuable.10
Convertible Bonds with an Original Market Value in Excess of Par. One of the extraordinary developments of the 1928–1929 financial
Philadelphia but later dropped its suit (see 135 Chronicle 4383, 4559; 136 Chronicle
326, 1011).
10 See the following issues taken from the 1920–1921 period: Shawinigan Water and Power Company 71/2% Gold Notes, issued in 1920 and due in 1926, convertible into First and Refunding 6s, Series B, due 1950 |
s involving some reduction in income, may prove to be valuable.10
Convertible Bonds with an Original Market Value in Excess of Par. One of the extraordinary developments of the 1928–1929 financial
Philadelphia but later dropped its suit (see 135 Chronicle 4383, 4559; 136 Chronicle
326, 1011).
10 See the following issues taken from the 1920–1921 period: Shawinigan Water and Power Company 71/2% Gold Notes, issued in 1920 and due in 1926, convertible into First and Refunding 6s, Series B, due 1950, which were pledged as security; San Joaquin Light and Power Corporation Convertible Collateral Trust 8s, issued in 1920 and due in 1935, convert- ible into the pledged Series C First and Refunding 6s, due 1950; Great Western Power Company of California Convertible Gold 8s, issued in 1920 and due in 1930, convertible into pledged First and Refunding 7s, Series B, due in 1950.
Another type of bond-for-bond conversion is represented by Dawson Railway and Coal 5s, due 1951, which are convertible into El Paso and Southwestern Railroad Company First 5s, due 1965 (the parent company, which in turn is a subsidiary of the Southern Pacific). Such examples are rare and do not invite generalization.
pyrotechnics was the offering of convertible issues with an original mar- ket value greatly in excess of par. This is illustrated by Atchison, Topeka and Santa Fe Railway Company Convertible 41/2s, due 1948, and by American Telephone and Telegraph Company Convertible 41/2s, due 1939. Initial trading in the former on the New York Curb Market (on a “when issued” basis) in November 1928 was around 125, and initial trad- ing in the latter on the New York Stock Exchange (on a “when issued” basis) on May 1, 1929, was at 142. Obviously investment in the bonds at these levels represented primarily a commitment in the common stock, since they were immediately subject to the danger of a substantial loss of principal value if the stock declined. Furthermore the income return was entirely too low to |
g in the former on the New York Curb Market (on a “when issued” basis) in November 1928 was around 125, and initial trad- ing in the latter on the New York Stock Exchange (on a “when issued” basis) on May 1, 1929, was at 142. Obviously investment in the bonds at these levels represented primarily a commitment in the common stock, since they were immediately subject to the danger of a substantial loss of principal value if the stock declined. Furthermore the income return was entirely too low to come under our definition of investment. Although it may be thought that the stockholders were acquiring a normal invest- ment through the exercise of their subscription right to purchase the issues at par, the essential nature of their commitment was determined by the initial market value of the security to which they were subscrib- ing. For this reason we think such financing should be condemned, because under the guise of an attractive investment it created a basically speculative form of security.
A Technical Feature of Some Convertible Issues. A technical fea- ture of the American Telephone and Telegraph convertible issue deserves mention. The bonds were made convertible at 180, but, instead of present- ing $180 of bonds to obtain a share of stock, the holder might present $100 of bonds and $80 in cash. The effect of such an option is to make the bond more valuable whenever the stock sells above 180 (i.e., whenever the con- version value of the bond exceeds 100). This is illustrated as follows:
If the stock sells at 360, a straight conversion basis of 180 would make the bond worth 200. But by the provision accepting $80 per share in cash, the value of the bond becomes 360 - 80 = 280.
This arrangement may be characterized as a combination of a conver-
sion privilege at 180 with a stock purchase right at 100.
Delayed Conversion Privilege. The privilege of converting is some- times not operative immediately upon issuance of the obligation.
Examples: This was true, for examp |
ed as follows:
If the stock sells at 360, a straight conversion basis of 180 would make the bond worth 200. But by the provision accepting $80 per share in cash, the value of the bond becomes 360 - 80 = 280.
This arrangement may be characterized as a combination of a conver-
sion privilege at 180 with a stock purchase right at 100.
Delayed Conversion Privilege. The privilege of converting is some- times not operative immediately upon issuance of the obligation.
Examples: This was true, for example, of Brooklyn Union Gas Com- pany Convertible 51/2s, discussed in Note 38 of the Appendix on accom- panying CD. Although they were issued in December 1925, the right to
convert did not accrue until January 1, 1929. Similarly, New York, New Haven, and Hartford Railroad Company Convertible Debenture 6s, due in 1948, although issued in 1907, were not convertible until January 15, 1923; Chesapeake Corporation Convertible 5s, due 1947, were issued in 1927 but did not become convertible until May 15, 1932.
More commonly the suspension of the conversion privilege does not last so long as these examples indicate, but in any event this practice intro- duces an additional factor of uncertainty and tends to render the privi- lege less valuable than it would be otherwise. This feature may account in part for the spread, indicated in Note 38, page 772, of the Appendix on accompanying CD, which existed during 1926, 1927, and the early part of 1928 between the Brooklyn Union Gas Company 51/2s and the related common stock.
Chapter 26
SENIOR SECURITIES OF
QUESTIONABLE SAFETY
AT THE LOW point of the 1932 securities market the safety of at least 80% of all corporate bonds and preferred stocks was open to some apprecia- ble degree of doubt.1 Even prior to the 1929 crash the number of specu- lative senior securities was very large, and it must inevitably be still larger for some years to come. The financial world is faced, therefore, with the unpleasant fact that a |
the related common stock.
Chapter 26
SENIOR SECURITIES OF
QUESTIONABLE SAFETY
AT THE LOW point of the 1932 securities market the safety of at least 80% of all corporate bonds and preferred stocks was open to some apprecia- ble degree of doubt.1 Even prior to the 1929 crash the number of specu- lative senior securities was very large, and it must inevitably be still larger for some years to come. The financial world is faced, therefore, with the unpleasant fact that a considerable proportion of American securities belong to what may be called a misfit category. A low-grade bond or pre- ferred stock constitutes a relatively unpopular form of commitment. The investor must not buy them, and the speculator generally prefers to devote his attention to common stocks. There seems to be much logic to the view that if one decides to speculate he should choose a thoroughly specula- tive medium and not subject himself to the upper limitations of market value and income return, or to the possibility of confusion between spec- ulation and investment, which attach to the lower priced bonds and pre- ferred stocks.
Limitation of Profit on Low-priced Bonds Not a Real Draw- back. But however impressive may be the objection to these nondescript securities, the fact remains that they exist in enormous quantities, that they are owned by innumerable security holders, and that hence they must be taken seriously into account in any survey of security analysis. It is rea- sonable to conclude that the large supply of such issues, coupled with the lack of a natural demand for them, will make for a level of prices below their intrinsic value. Even if an inherent unattractiveness in the form of such securities be admitted, this may be more than offset by the attrac- tive price at which they may be purchased. Furthermore, the limitations
1 See Appendix Note 42, p. 776 on accompanying CD, for data on bond prices in 1931–1934 and 1939.
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onable to conclude that the large supply of such issues, coupled with the lack of a natural demand for them, will make for a level of prices below their intrinsic value. Even if an inherent unattractiveness in the form of such securities be admitted, this may be more than offset by the attrac- tive price at which they may be purchased. Furthermore, the limitations
1 See Appendix Note 42, p. 776 on accompanying CD, for data on bond prices in 1931–1934 and 1939.
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of principal profit in the case of a low-priced bond, as compared with a common stock, may be of only minor practical importance, because the profit actually realized by the common-stock buyer is ordinarily no greater than that obtainable from a speculative senior security. If, for example, we are considering a 4% bond selling at 35, its maximum possible price appreciation is about 70 points, or 200%. The average common-stock pur- chase at 35 cannot be held for a greater profit than this without a danger- ous surrender to “bull-market psychology.”
Two Viewpoints with Respect to Speculative Bonds. There are two directly opposite angles from which a speculative bond may be viewed. It may be considered in its relation to investment standards and yields, in which case the leading question is whether or not the low price and higher income return will compensate for the concession made in the safety factor. Or it may be thought of in terms of a common-stock commitment, in which event the contrary question arises; viz., “Does the smaller risk of loss involved in this low-priced bond, as compared with a common stock, compensate for the smaller possibilities of profit?” The nearer a bond comes to meeting investment requirements—and the closer it sells to an investment price—the more likely are those interested to regard it from the investment viewpoint. The opposite approach is evi- dently suggested i |
Or it may be thought of in terms of a common-stock commitment, in which event the contrary question arises; viz., “Does the smaller risk of loss involved in this low-priced bond, as compared with a common stock, compensate for the smaller possibilities of profit?” The nearer a bond comes to meeting investment requirements—and the closer it sells to an investment price—the more likely are those interested to regard it from the investment viewpoint. The opposite approach is evi- dently suggested in the case of a bond in default or selling at an extremely low price. We are faced here with the familiar difficulty of classification arising from the absence of definite lines of demarcation. Some issues can always be found reflecting any conceivable status in the gamut between complete worthlessness and absolute safety.
Common-stock Approach Preferable. We believe, however, that the sounder and more fruitful approach to the field of speculative senior securities lies from the direction of common stocks. This will carry with it a more thorough appreciation of the risk involved and therefore a greater insistence upon either reasonable assurance of safety or especially attractive possibilities of profit or both. It induces also—among intelli- gent security buyers at least—a more intensive examination of the cor- porate picture than would ordinarily be made in viewing a security from the investment angle.
Such an approach would be distinctly unfavorable to the purchase of slightly substandard bonds selling at moderate discounts from par. These, together with high-coupon bonds of second grade, belong in the category
of “business men’s investments” which we considered and decided against in Chap. 7. It may be objected that a general adoption of this attitude would result in wide and sudden fluctuations in the price of many issues. Assuming that a 4% bond deserves to sell at par as long as it meets strict investment standards, then as soon as it falls slightly below these stan- |
andard bonds selling at moderate discounts from par. These, together with high-coupon bonds of second grade, belong in the category
of “business men’s investments” which we considered and decided against in Chap. 7. It may be objected that a general adoption of this attitude would result in wide and sudden fluctuations in the price of many issues. Assuming that a 4% bond deserves to sell at par as long as it meets strict investment standards, then as soon as it falls slightly below these stan- dards its price would suffer a precipitous decline, say, to 70; and, con- versely, a slight improvement in its exhibit would warrant its jumping suddenly back to par. Apparently there would be no justification for inter- mediate quotations between 70 and 100.
The real situation is not so simple as this, however. Differences of opin- ion may properly exist in the minds of investors as to whether or not a given issue is adequately secured, particularly since the standards are qual- itative and personal as well as arithmetical and objective. The range between 70 and 100 may therefore logically reflect a greater or lesser agree- ment concerning the safety of the issue. This would mean that an investor would be justified in buying such a bond, say, at 85, if his own considered judgment regarded it as sound, although he would recognize that there was doubt on this score in the minds of other investors that would account for its appreciable discount from a prime investment price. According to this view, the levels between 70 and 100, approximately, may be designated as the range of “subjective variations” in the status of the issue.
The field of speculative values proper would therefore commence somewhere near the 70 level (for bonds with a coupon rate of 4% or larger) and would offer maximum possibilities of appreciation of at least 50% of the cost. (In the case of other senior issues, 70% of normal value might be taken as the dividing line.) In making such commitments, it is reco |
o this view, the levels between 70 and 100, approximately, may be designated as the range of “subjective variations” in the status of the issue.
The field of speculative values proper would therefore commence somewhere near the 70 level (for bonds with a coupon rate of 4% or larger) and would offer maximum possibilities of appreciation of at least 50% of the cost. (In the case of other senior issues, 70% of normal value might be taken as the dividing line.) In making such commitments, it is recommended that the same general attitude be taken as in the careful purchase of a common stock; in other words, that the income account and the balance sheet be submitted to the same intensive analysis and that the same effort be made to evaluate future possibilities—favorable and unfavorable.
Important Distinctions between Common Stocks and Specu- lative Senior Issues. We shall not seek, therefore, to set up standards of selection for speculative senior issues in any sense corresponding to the quantitative tests applicable to fixed-value securities. On the other hand, although they should preferably be considered in their relationship to the common-stock approach and technique, it is necessary to appreciate
certain rather important points of difference that exist between common stocks as a class and speculative senior issues.
Low-priced Bonds Associated with Corporate Weakness. The limitation on the profit possibilities of senior securities has already been referred to. Its significance varies with the individual case, but in general we do not consider it a controlling disadvantage. A more emphatic objection is made against low-priced bonds and preferred stocks on the ground that they are associated with corporate weakness, retrogression, or depression. Obvi- ously the enterprise behind such a security is not highly successful, and furthermore, it must have been following a downward course, since the issue originally sold at a much higher level. In 1928 and 1929 this consid- |
ce varies with the individual case, but in general we do not consider it a controlling disadvantage. A more emphatic objection is made against low-priced bonds and preferred stocks on the ground that they are associated with corporate weakness, retrogression, or depression. Obvi- ously the enterprise behind such a security is not highly successful, and furthermore, it must have been following a downward course, since the issue originally sold at a much higher level. In 1928 and 1929 this consid- eration was enough to condemn all such issues absolutely in the eyes of the general public. Businesses were divided into two groups: those which were successful and progressing, and those which were on the downgrade or making no headway. The common shares of the first group were desir- able no matter how high the price; but no security belonging to the sec- ond group was attractive, irrespective of how low it sold.
This concept of permanently strong and permanently weak corpora- tions has been pretty well dissipated by the subsequent depression, and we are back to the older realization that time brings unpredictable changes in the fortunes of business undertakings.2 The fact that the low price of a bond or preferred stock results from a decline in earnings need not signify that the company’s outlook is hopeless and that there is noth- ing ahead but still poorer results. Many of the companies that fared very badly in 1931–1933 regained a good part of their former earning power, and their senior securities recovered from exceedingly low prices to investment levels. It turned out, therefore, that there was just as much reason to expect substantial recoveries in the quotations of depressed senior securities as in the price of common stocks generally.
Many Undervalued in Relation to Their Status and Contractual Posi- tion. We have already mentioned that the unpopularity of speculative senior securities tends to make them sell at lower prices than common stocks, in relation to the |
ir senior securities recovered from exceedingly low prices to investment levels. It turned out, therefore, that there was just as much reason to expect substantial recoveries in the quotations of depressed senior securities as in the price of common stocks generally.
Many Undervalued in Relation to Their Status and Contractual Posi- tion. We have already mentioned that the unpopularity of speculative senior securities tends to make them sell at lower prices than common stocks, in relation to their intrinsic value. From the standpoint of the intelligent buyer this must be considered a point in their favor. With
2 But see later references to The Ebb and Flow of Investment Value, by Mead and Grodinski, published in 1939, which strongly espouses the thesis stated in the previous paragraph (infra, p. 371 and Appendix Note 71, p. 845 on accompanying CD).
respect to their intrinsic position, speculative bonds—and, to a lesser degree, preferred stocks—derive important advantages from their con- tractual rights. The fixed obligation to pay bond interest will usually result in the continuation of such payments as long as they are in any way pos- sible. If we assume that a fairly large proportion of a group of carefully selected low-priced bonds will escape default, the income received on the group as a whole over a period of time will undoubtedly far exceed the dividend return on similarly priced common stocks.
Preferred shares occupy an immeasurably weaker position in this regard, but even here the provisions transferring voting control to the sen- ior shares in the event of suspension of dividends will be found in some cases to impel their continuance. Where the cash resources are ample, the desire to maintain an unbroken record and to avoid accumulations will frequently result in paying preferred dividends even though poor earnings have depressed the market price.
Examples: Century Ribbon Mills, Inc., failed to earn its 7% preferred dividend in eight out of the thirteen |
but even here the provisions transferring voting control to the sen- ior shares in the event of suspension of dividends will be found in some cases to impel their continuance. Where the cash resources are ample, the desire to maintain an unbroken record and to avoid accumulations will frequently result in paying preferred dividends even though poor earnings have depressed the market price.
Examples: Century Ribbon Mills, Inc., failed to earn its 7% preferred dividend in eight out of the thirteen years from 1926 to 1938, inclusive, and the price repeatedly declined to about 50. Yet the preferred dividend was continued without interruption during this entire period, while the common received a total of but 50 cents. Similarly, a purchaser of Uni- versal Pictures Company First Preferred at about 30 in 1929 would have received the 8% dividend during three years of depression before the payment was finally suspended.
Contrasting Importance of Contractual Terms in Speculation and Invest- ment. The reader should appreciate the distinction between the investment and the speculative qualities of preferred stocks in this matter of dividend continuance. From the investment standpoint, i.e., the dependability of the dividend, the absence of an enforceable claim is a disadvantage as com- pared with bonds. From the speculative standpoint, i.e., the possibility of dividends’ being continued under unfavorable conditions, preferred stocks have certain semicontractual claims to consideration by the directors that undoubtedly give them an advantage over common stocks.
Bearing of Working-capital and Sinking-fund Factors on Safety of Speculative Senior Issues. A large working capital, which has been characteristic of even nonprosperous industrials for some years past, is much more directly advantageous to the senior securities than to the com- mon stock. Not only does it make possible the continuance of interest or
preferred-dividend payments, but it has an important bearing also on t |
y the directors that undoubtedly give them an advantage over common stocks.
Bearing of Working-capital and Sinking-fund Factors on Safety of Speculative Senior Issues. A large working capital, which has been characteristic of even nonprosperous industrials for some years past, is much more directly advantageous to the senior securities than to the com- mon stock. Not only does it make possible the continuance of interest or
preferred-dividend payments, but it has an important bearing also on the retirement of the principal, either at maturity or by sinking-fund opera- tions or by voluntary repurchase. Sinking-fund provisions, for bonds as well as preferred stocks, contribute to the improvement of both the mar- ket quotation and the intrinsic position of the issue. This advantage is not found in the case of common stocks.
Examples: Francis H. Leggett Company, manufacturers and whole- salers of food products, issued $2,000,000 of 7% preferred stock carrying a sinking-fund provision which retired 3% of the issue annually. By June 30, 1932, the amount outstanding had been reduced to $608,500, and, because of the small balance remaining, the issue was called for redemp- tion at 110, in the depth of the depression. Similarly, Century Ribbon Mills Preferred was reduced from $2,000,000 to $544,000 between 1922 and 1938; and Lawrence Portland Cement Company Debenture 51/2s were reduced from $2,000,000 to $650,000 on December 31, 1938, the balance being called for redemption on April 1, 1939.
Importance of Large Net-current-asset Coverage. Where a low-priced bond is covered several times over by net current assets, it presents a spe- cial type of opportunity, because experience shows that the chances of repayment are good, even though the earnings may be poor or irregular. Examples: Electric Refrigeration Corporation (Kelvinator) 6s, due 1936, sold at 66 in November 1929 when the net current assets of the company according to its latest statement amounted to $6,008,900 for |
1, 1939.
Importance of Large Net-current-asset Coverage. Where a low-priced bond is covered several times over by net current assets, it presents a spe- cial type of opportunity, because experience shows that the chances of repayment are good, even though the earnings may be poor or irregular. Examples: Electric Refrigeration Corporation (Kelvinator) 6s, due 1936, sold at 66 in November 1929 when the net current assets of the company according to its latest statement amounted to $6,008,900 for the
$2,528,500 of bonds outstanding. It is true that the company had oper- ated at a deficit in 1927 and 1928, but fixed charges were earned nearly nine times in the year ended September 30, 1929, and the net current assets were nearly four times the market value of the bond issue. The bonds recovered to a price close to par in 1930 and were redeemed at 105 in 1931. Similarly, Electric Refrigeration Building Corporation First 6s, due 1936, which were in effect guaranteed by Kelvinator Corporation under a lease, sold at 70 in July 1932 when the net current assets of the parent company amounted to about six times the $1,073,000 of bonds outstanding and over eight times the total market value of the issue. The bonds were called at 1011/2 in 1933.
Other examples that may be cited in this connection are Murray Corporation First 61/2s, due 1934, which sold at 68 in 1932 (because of current operating deficits) although the company had net current assets
of over 21/2 times the par value of the issue and nearly four times their market value at that price; Sidney Blumenthal and Company 7% Notes, due 1936, which sold at 70 in 1926 when the company had net current assets of twice the par value of the issue and nearly three times the total market value thereof (they were called at 103 in 1930); Belding, Heminway Com- pany 6s, due 1936, which sold at 67 in 1930 when the company had net cur- rent assets of nearly three times the par value of the issue and over four times its market value. |
he issue and nearly four times their market value at that price; Sidney Blumenthal and Company 7% Notes, due 1936, which sold at 70 in 1926 when the company had net current assets of twice the par value of the issue and nearly three times the total market value thereof (they were called at 103 in 1930); Belding, Heminway Com- pany 6s, due 1936, which sold at 67 in 1930 when the company had net cur- rent assets of nearly three times the par value of the issue and over four times its market value. In the latter case drastic liquidation of inventories occurred in 1930 and 1931, proceeds from which were used to retire about 80% of the bond issue through purchases in the market. The balance of the issue was called for payment at 101 early in 1934.
In the typical case of this kind the chance of profit will exceed the chance of loss, and the probable amount of profit will exceed the proba- ble amount of loss. It may well be that the risk involved in each individ- ual case is still so considerable as to preclude us from applying the term “investment” to such a commitment. Nevertheless, we suggest that if the insurance principle of diversification of risk be followed by making a number of such commitments at the same time, the net result should be sufficiently dependable to warrant our calling the group purchase an investment operation. This was one of the possibilities envisaged in our broadened definition of investment as given in Chap. 4.
Limitations upon Importance of Current-asset Position. It is clear that considerable weight attaches to the working-capital exhibit in selecting speculative bonds. This importance must not be exaggerated, however, to the point of assuming that, whenever a bond is fully covered by net current assets, its safety is thereby assured. The current assets shown in any balance sheet may be greatly reduced by subsequent operating losses; more important still, the stated values frequently prove entirely unde- pendable in the event of insolvency.3 |
t Position. It is clear that considerable weight attaches to the working-capital exhibit in selecting speculative bonds. This importance must not be exaggerated, however, to the point of assuming that, whenever a bond is fully covered by net current assets, its safety is thereby assured. The current assets shown in any balance sheet may be greatly reduced by subsequent operating losses; more important still, the stated values frequently prove entirely unde- pendable in the event of insolvency.3
Of the many examples of this point which can be given, we shall men- tion R. Hoe and Company 7% Notes and Ajax Rubber Company First 8s. Although these obligations were covered by net working capital in 1929, they subsequently sold as low as 2 cents on the dollar. (See also our
3 The comparative reliability of the various components in the current-assets figure (cash assets, receivables, inventories) will receive detailed treatment in a discussion of balance- sheet analysis in Part VI.
discussion of Willys-Overland Company First 61/2 s and Berkey and Gay Furniture Company First 6s in Note 34 of the Appendix on accompany- ing CD.4)
EXAMPLES OF LOW-PRICED INDUSTRIAL BONDS COVERED BY NET CURRENT ASSETS, 1932*
Name of issue
Due
Low price 1932
Date of balance sheet
Net current assets†
Funded debt at part† Normal interest coverage
Period Times earned‡
American Seating 6s 1936 17 Sept. 1932 $ 3,826 $ 3,056 1924–1930 5.2
Crucible Steel 5s 1940 39 June 1932 16,163 13,250 1924–1930 9.4
McKesson & 1950 25 June 1932 42,885 20,848 1925–1930 4.1
Robbins 51/2s
Marion Steam 1947 21 June 1932 4,598 2,417 1922–1930 3.9
Shovel 6s
National Acme 6s 1942 54 Dec. 1931 4,327 1,963 1922–1930 5.5
* See Appendix Note 43, p. 777 on accompanying CD, for a brief discussion of the sequel to these examples first given in the 1934 edition of this work.
† 000 omitted.
‡ Coverage for 1931 charges, adjusted where necessary.
We must distinguish, therefore, between the mere fac |
924–1930 9.4
McKesson & 1950 25 June 1932 42,885 20,848 1925–1930 4.1
Robbins 51/2s
Marion Steam 1947 21 June 1932 4,598 2,417 1922–1930 3.9
Shovel 6s
National Acme 6s 1942 54 Dec. 1931 4,327 1,963 1922–1930 5.5
* See Appendix Note 43, p. 777 on accompanying CD, for a brief discussion of the sequel to these examples first given in the 1934 edition of this work.
† 000 omitted.
‡ Coverage for 1931 charges, adjusted where necessary.
We must distinguish, therefore, between the mere fact that the work- ing capital, as reported, covers the funded debt and the more significant fact that it exceeds the bond issue many times over. The former statement is always interesting, but by no means conclusive. If added to other favor- able factors, such as a good earnings coverage in normal years and a gen- erally satisfactory qualitative showing, it might make the issue quite attractive but preferably as part of a group-purchase in the field.
Speculative Preferred Stocks. Stages in Their Price History. Speculative preferred stocks are more subject than speculative bonds to irrational activ- ity, so that from time to time such preferred shares are overvalued in the market in the same way as common stocks. We thus have three possible stages in the price history of a preferred issue, in each of which the market quotation tends to be out of line with the value:
1. The first stage is that of original issuance, when investors are per- suaded to buy the offering at a full investment price not justified by its intrinsic merit.
4 Perhaps it should be added that three of the four issues mentioned in this paragraph had spectacular recoveries from the low prices of the depression (e.g., the new Hoe 7s, which were exchanged for the old 7s, sold at 100 in 1937).
2. In the second stage the lack of investment merit has become manifest, and the price drops to a speculative level. During this period the decline is likely to be overdone, for reasons previously discussed.
3. A third st |
ice not justified by its intrinsic merit.
4 Perhaps it should be added that three of the four issues mentioned in this paragraph had spectacular recoveries from the low prices of the depression (e.g., the new Hoe 7s, which were exchanged for the old 7s, sold at 100 in 1937).
2. In the second stage the lack of investment merit has become manifest, and the price drops to a speculative level. During this period the decline is likely to be overdone, for reasons previously discussed.
3. A third stage sometimes appears in which the issue advances spec- ulatively in the same fashion as common stocks. On such occasions certain factors of questionable importance—such as the amount of divi- dend accumulations—are overemphasized.
An example of this third or irrational stage will be given a little later. The Rule of “Maximum Valuation for Senior Issues.” Both as a safeguard against being led astray by the propaganda that is character- istic of the third stage and also as a general guide in dealing with spec- ulative senior issues, the following principle of security analysis is presented, which we shall call “the rule of maximum valuation for
senior issues.”
A senior issue cannot be worth, intrinsically, any more than a common stock would be worth if it occupied the position of that senior issue, with no junior securities outstanding.
This statement may be understood more readily by means of an example.
Company X and Company Y have the same value. Company X has 80,000 shares of preferred and 200,000 shares of common. Company Y has only 80,000 shares of common and no preferred. Then our principle states that a share of Company X preferred cannot be worth more than a share of Company Y common. This is true because Company Y common represents the same value that lies behind both the preferred and com- mon of Company X.
Instead of comparing two equivalent companies such as X and Y, we may assume that Company X is recapitalized so that the old common is eliminated and the preferr |
red and 200,000 shares of common. Company Y has only 80,000 shares of common and no preferred. Then our principle states that a share of Company X preferred cannot be worth more than a share of Company Y common. This is true because Company Y common represents the same value that lies behind both the preferred and com- mon of Company X.
Instead of comparing two equivalent companies such as X and Y, we may assume that Company X is recapitalized so that the old common is eliminated and the preferred becomes the sole stock issue, i.e., the new common stock. (To coin a term, we may call such an assumed change the “communizing” of a preferred stock.) Then our principle merely states the obvious fact that the value of such a hypothetical common stock can- not be less than the value of the preferred stock it replaces, because it is equivalent to the preferred plus the old common. The same idea may be applied to a speculative bond, followed either by common stock only or by both preferred and common. If the bond is “commonized,” i.e., if it is assumed to be turned into a common stock, with the old stock issues
eliminated, then the value of the new common stock thus created cannot be less than the present value of the bond.
This relationship must hold true regardless of how high the coupon or dividend rate, the par value or the redemption price of the senior issue may be and, particularly, regardless of what amount of unpaid interest or dividends may have accumulated. For if we had a preferred stock with accumulations of $1,000 per share, the value of the issue could be no greater than if it were a common stock (without dividend accumulations) representing complete ownership of the business. The unpaid dividends cannot create any additional value for the company’s securities in the aggregate; they merely affect the division of the total value between the preferred and the common.
Excessive Emphasis Placed on Amount of Accrued Dividends. Although a very small amount of anal |
a preferred stock with accumulations of $1,000 per share, the value of the issue could be no greater than if it were a common stock (without dividend accumulations) representing complete ownership of the business. The unpaid dividends cannot create any additional value for the company’s securities in the aggregate; they merely affect the division of the total value between the preferred and the common.
Excessive Emphasis Placed on Amount of Accrued Dividends. Although a very small amount of analysis will show the above statements to be almost self-evident truths, the public fails to observe the simplest rules of logic when once it is in a gambling mood. Hence preferred shares with large dividend accruals have lent themselves readily to market manipula- tion in which the accumulations are made the basis for a large advance in the price of both the preferred and common. An excellent example of such a performance was provided by American Zinc, Lead, and Smelting Company shares in 1928.
American Zinc preferred stock was created in 1916 as a stock dividend on the common, the transaction thus amounting to a split-up of old com- mon into preferred and new common. The preferred was given a stated par of $25 but had all the attributes of a $100-par stock ($6 cumulative dividends, redemption and liquidating value of $100). This arrangement was evidently a device to permit carrying the preferred issue in the bal- ance sheet as a much smaller liability than it actually represented. Between 1920 and 1927 the company reported continuous deficits (except for a neg- ligible profit in 1922); preferred dividends were suspended in 1921, and by 1928 about $40 per share had accumulated.
In 1928 the company benefited moderately from the prevailing pros- perity and barely earned $6 per share on the preferred. However, the company’s issues were subjected to manipulation that advanced the price of the preferred from 35 in 1927 to 118 in 1928, while the common rose even more spectacularly fr |
en 1920 and 1927 the company reported continuous deficits (except for a neg- ligible profit in 1922); preferred dividends were suspended in 1921, and by 1928 about $40 per share had accumulated.
In 1928 the company benefited moderately from the prevailing pros- perity and barely earned $6 per share on the preferred. However, the company’s issues were subjected to manipulation that advanced the price of the preferred from 35 in 1927 to 118 in 1928, while the common rose even more spectacularly from 6 to 57. These advances were accompa- nied by rumors of a plan to pay off the accumulated dividends—exactly
how, not being stated. Naturally enough, this development failed to materialize.5
The irrationality of the gambling spirit is well shown here by the absurd acceptance of unpaid preferred dividends as a source of value for both the preferred and the common. The speculative argument in behalf of the common stock ran as follows: “The accumulated preferred divi- dends are going to be paid off. This will be good for the common. There- fore let us buy the common.” According to this topsy-turvy reasoning, if there were no unpaid preferred dividends ahead of the common it would be less attractive (even at the same price), because there would then be in prospect no wonderful plan for clearing up the accumulations.
We may use the American Zinc example to demonstrate the practical application of our “rule of maximum valuation for senior issues.” Was American Zinc Preferred too high at 118 in 1928? Assuming the preferred stockholders owned the company completely, this would then mean a price of 118 for a common stock earning $6 per share in 1928 after eight years of deficits. Even in the hectic days of 1928 speculators would not have been at all attracted to such a common stock at that price, so that the application of our rule should have prevented the purchase of the preferred stock at its inflated value.
The quotation of 57 reached by American Zinc common was evidently the |
118 in 1928? Assuming the preferred stockholders owned the company completely, this would then mean a price of 118 for a common stock earning $6 per share in 1928 after eight years of deficits. Even in the hectic days of 1928 speculators would not have been at all attracted to such a common stock at that price, so that the application of our rule should have prevented the purchase of the preferred stock at its inflated value.
The quotation of 57 reached by American Zinc common was evidently the height of absurdity, since it represented the following valu- ation for the company:
Preferred stock, 80,000 sh. @ 118 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,440,000
Common stock, 200,000 sh. @ 57 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,400,000
Total valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,840,000
Earnings, 1928 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481,000
Average earnings, 1920–1927 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188,000(d)
In order to equal the above valuation for the American Zinc Com- pany the hypothetical common stock (80,000 shares basis) would have had to sell at $260 per share, earning a bare $6 and paying no dividend.
5 But years later, in 1936, accumulated preferred dividends were taken care of by a recapital- ization plan which gave the preferred stockholders the bulk of the enlarged common issue.
This figure indicates the extent to which the heedless public was led astray in this case by the exploitation of unpaid dividends.
American Hide and Leather Company offers another, but less striking, example of this point. In no year between 1922 and 1928, inclusive, did the company earn more than $4.41 on the preferred, and the average prof- its were very small. Yet in each of these seven years, the preferred stock sold as high as 66 or higher. This recurring strengt |
he enlarged common issue.
This figure indicates the extent to which the heedless public was led astray in this case by the exploitation of unpaid dividends.
American Hide and Leather Company offers another, but less striking, example of this point. In no year between 1922 and 1928, inclusive, did the company earn more than $4.41 on the preferred, and the average prof- its were very small. Yet in each of these seven years, the preferred stock sold as high as 66 or higher. This recurring strength was based largely on the speculative appeal of the enormous accumulated preferred dividends which grew from about $120 to $175 per share during this period.
Applying our rule, we may consider American Hide and Leather Pre- ferred as representing complete ownership of the business, which to all intents and purposes it did. We should then have a common stock which had paid no dividends for many years and with average earnings at best (using the 1922–1927 period) of barely $2 per share. Evidently a price of above 65 for such a common stock would be far too high. Consequently this price was excessive for American Hide and Leather Preferred, nor could the existence of accumulated dividends, however large, affect this conclusion in the slightest.
Variation in Capital Structure Affects Total Market Value of Securities. From the foregoing discussion it might be inferred that the value of a single capital-stock issue must always be equivalent to the com- bined values of any preferred and common stock issues into which it might be split. In a theoretical sense this is entirely true, but in practice it may not be true at all, because a division of capitalization into senior securities and common stock may have a real advantage over a single common-stock issue. This subject will receive extended treatment under the heading of “Capitalization Structure” in Chap. 40.
The distinction between the idea just suggested and our “rule of maximum valuation” may be clarified as follows:
1. Assume |
on stock issues into which it might be split. In a theoretical sense this is entirely true, but in practice it may not be true at all, because a division of capitalization into senior securities and common stock may have a real advantage over a single common-stock issue. This subject will receive extended treatment under the heading of “Capitalization Structure” in Chap. 40.
The distinction between the idea just suggested and our “rule of maximum valuation” may be clarified as follows:
1. Assume Company X = Company Y
2. Company X has preferred (P) and common (C); Company Y has common only (C )
3. Then it would appear that
Value of P + value of C = value of C
since each side of the equation represents equal things, namely the total value of each company.
But this apparent relationship may not hold good in practice because the preferred-and-common capitalization method may have real advan- tages over a single common-stock issue.
On the other hand, our “rule of maximum valuation” merely states that the value of P alone cannot exceed value of C . This should hold true in practice as well as in theory, except in so far as manipulative or heed- lessly speculative activity brushes aside all rational considerations.
Our rule is stated in negative form and is therefore essentially negative in its application. It is most useful in detecting instances where preferred stocks or bonds are not worth their market price. To apply it positively it would be necessary, first, to arrive at a value for the preferred on a “com- munized” basis (i.e., representing complete ownership of the business) and then to determine what deduction from this value should be made to reflect the part of the ownership fairly ascribable to the existing common stock. At times this approach will be found useful in establishing the fact that a given senior issue is worth more than its market price. But such a procedure brings us far outside the range of mathematical formulas and into the difficult and i |
a value for the preferred on a “com- munized” basis (i.e., representing complete ownership of the business) and then to determine what deduction from this value should be made to reflect the part of the ownership fairly ascribable to the existing common stock. At times this approach will be found useful in establishing the fact that a given senior issue is worth more than its market price. But such a procedure brings us far outside the range of mathematical formulas and into the difficult and indefinite field of common-stock valuation, with which we have next to deal.
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PART IV
THEORY OF COMMON-STOCK INVESTMENT. THE DIVIDEND FACTOR
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I n tr oduc tion to P ar t IV
GO WITH THE FLO W
BY BRUCE BERKOWITZ
n the urban, melting-pot neighborhood where I grew up, one of the most popular retail establishments was the corner variety store. Area residents frequented the place for small, everyday needs—a newspa-
per or magazine or a quart of milk. We kids showed up constantly with what change we had cajoled from family members or earned by running errands, eager to spend it on candy bars, chewing gum, and soft drinks.
The owner had one cash register, seated on a countertop near the front door. Into it went the cash from customers’ purchases. The propri- etor took out what he needed to stock the shelves, pay the rent, maintain the store, and meet his small payroll. If there was anything left after that, the proprietor had the choice of using the remaining cash to invest in the business’s growth, pay down debts, or meet personal living expenses.
Years later, after I had started working in the investment business, I began reading the annual reports written by Berkshire Hathaway chair- man Warren Buffett, which led me to the works of Benjamin Graham an |
took out what he needed to stock the shelves, pay the rent, maintain the store, and meet his small payroll. If there was anything left after that, the proprietor had the choice of using the remaining cash to invest in the business’s growth, pay down debts, or meet personal living expenses.
Years later, after I had started working in the investment business, I began reading the annual reports written by Berkshire Hathaway chair- man Warren Buffett, which led me to the works of Benjamin Graham and David Dodd. I soon realized that the financial operations of this simple variety store represented a good example of free cash flow. Graham and Dodd referred to that excess cash as “earnings power” or “owner earn- ings.” That’s the amount of cash an owner can pocket after paying all expenses and making whatever investments are necessary to maintain the business. This free cash flow is the well from which all returns are drawn, whether they are dividends, stock buybacks, or investments capa- ble of enhancing future returns.
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Graham and Dodd were among the first to apply careful financial analysis to common stocks. Until then, most serious investment analysis had focused on fixed income securities. Graham and Dodd argued that stocks, like bonds, have a well-defined value based on a stream of future returns. With bonds, the returns consist of specific payments made under contractual commitments. With stocks, the returns consist of dividends that are paid from the earnings of the business, or cash that could have been used to pay dividends that was instead reinvested in the business.
By examining the assets of a business and their earnings (or cash flow) power, Graham and Dodd argued that the value of future returns could be calculated with reasonable accuracy. Once determined, this value helps you decide whether to purchase a particular stock. A calcu- lated va |
contractual commitments. With stocks, the returns consist of dividends that are paid from the earnings of the business, or cash that could have been used to pay dividends that was instead reinvested in the business.
By examining the assets of a business and their earnings (or cash flow) power, Graham and Dodd argued that the value of future returns could be calculated with reasonable accuracy. Once determined, this value helps you decide whether to purchase a particular stock. A calcu- lated value of $20 for a stock trading at $10 per share would allow for a profit even if your estimate was off by a few dollars. But if you estimated a $12 value for a stock trading at $10 per share, it would fail to make the buy list; even though the stock was somewhat undervalued, there would not be a sufficient margin for error.
Sharpen Your Pencil
The fundamental problem of equity investing is how to value a company. In the 1930s, that was done by measuring tangible assets. The reason: much of the stock market’s capitalization in that era was based on raw materials (mainly mining companies), transportation (railroads), utilities, and manu- facturing. All of those industries had significant amounts of plant, equip- ment, and inventory. Today, service firms dominate the economy, and, even in manufacturing, much of a firm’s capital comes from intangibles— software, acquired brands, customers, product portfolios—that do not appear explicitly on the balance sheet. For example, relatively little of the value of software companies like Oracle and Microsoft or a business ser- vices firm like Automated Data Processing is captured by tangible assets.
To value equities, we at Fairholme begin by calculating free cash flow. We start with net income as defined under Generally Accepted Account- ing Principles (GAAP). Then we add back noncash charges such as depre- ciation and amortization, which are formulaic calculations based on historical costs (depreciation for tangible assets, amortizati |
of the value of software companies like Oracle and Microsoft or a business ser- vices firm like Automated Data Processing is captured by tangible assets.
To value equities, we at Fairholme begin by calculating free cash flow. We start with net income as defined under Generally Accepted Account- ing Principles (GAAP). Then we add back noncash charges such as depre- ciation and amortization, which are formulaic calculations based on historical costs (depreciation for tangible assets, amortization for intangi- bles) and may not reflect a reduction in those assets’ true worth.
Even so, most assets deteriorate in value over time, and we have to account for that. So we subtract an estimate of the company’s cost of maintaining tangible assets such as the office, plant, inventory, and equipment; and intangible assets like customer traffic and brand identity. Investment at this level, properly deployed, should keep the profits of the business in a steady state.
That is only the beginning. For instance, companies often misstate the costs of employees’ pension and postretirement medical benefits. They also overestimate their benefit plans’ future investment returns or under- estimate future medical costs, so in a free cash flow analysis, you need to adjust the numbers to reflect those biases.
Companies often lowball what they pay management. For instance, until the last several years, most companies did not count the costs of stock option grants as employee compensation, nor did the costs show up in any other line item. Some went so far as to try to mask this options expense by repurchasing large quantities of shares in the open market to offset the stock options exercised by employees. The problem: compa- nies were often paying much more on the open market than they received from employees exercising options granted years before. This difference was rarely reported as an official cost of doing business.
Another source of accounting-derived profits comes from long-term supp |
costs show up in any other line item. Some went so far as to try to mask this options expense by repurchasing large quantities of shares in the open market to offset the stock options exercised by employees. The problem: compa- nies were often paying much more on the open market than they received from employees exercising options granted years before. This difference was rarely reported as an official cost of doing business.
Another source of accounting-derived profits comes from long-term supply contracts. For instance, when now-defunct Enron entered into a long-term trading or supply arrangement, the company very optimisti- cally estimated the net present value of future profits from the deal and
put that into the current year’s earnings even though no cash was received. Enron is gone, but not the practice. Insurance companies and banks still have considerable leeway in how they estimate the future losses arising from insured events or loan defaults. And for any company, gains and losses on derivative contracts are difficult to nail down with precision since the markets for such instruments are thin.
Some companies understate free cash flow because they expense the cost of what are really investments in their growth. For instance, adding new auto insurance customers may cost as much as 20% to 30% more than the cash received from new policyholders in their first year. Some of this excess cost goes to replace customers who did not renew their poli- cies. But if the number of policyholders is growing, a portion of the expense represents investment in growth. Berkshire Hathaway’s GEICO subsidiary does just this, and as a result, accounting earnings understate free cash flow assuming a steady-state business. When Microsoft sells a Windows program, the company recognizes that future servicing costs are part of that sale. Microsoft accounts for these costs by spreading the revenues and expenses over a number of years. The result is to defer profits to future periods a |
of policyholders is growing, a portion of the expense represents investment in growth. Berkshire Hathaway’s GEICO subsidiary does just this, and as a result, accounting earnings understate free cash flow assuming a steady-state business. When Microsoft sells a Windows program, the company recognizes that future servicing costs are part of that sale. Microsoft accounts for these costs by spreading the revenues and expenses over a number of years. The result is to defer profits to future periods and provide the company with a cushion against future adverse developments.
All of these noncash accounting conventions illustrate the difficulty of identifying a company’s current free cash flow. Still, we are far from done. My associates and I next want to know (a) how representative is current cash flow of average past flow, and (b) is it increasing or decreasing— that is, does the company face headwinds or ride on tailwinds?
Cash Flow Where You Least Expect It
Certainly one company facing stiff headwinds in 2008 was Mohawk Industries, a carpeting and flooring firm we first purchased in 2006 at prices in the low $60s. At the time, the company reported GAAP earnings
of $6.70 per share, but our analysis showed free cash flow of $9 per share. Why was free cash flow so much greater than earnings? First, Mohawk had been growing by acquiring some of the smaller players as part of an industrywide consolidation, so it gained economies of scale that allowed the company to reduce capital spending and lower its working capital needs. Even more important, the use of GAAP required Mohawk to take significant charges against its earnings to amortize the intangible assets it had picked up in its buying spree. (The difference between what a company pays for an acquisition and the acquired company’s book value goes on the balance sheet as an intangible asset called “goodwill.”) These charges reduced net income but did not take any cash out of the busi- ness. All told, we calculated that Mo |
nding and lower its working capital needs. Even more important, the use of GAAP required Mohawk to take significant charges against its earnings to amortize the intangible assets it had picked up in its buying spree. (The difference between what a company pays for an acquisition and the acquired company’s book value goes on the balance sheet as an intangible asset called “goodwill.”) These charges reduced net income but did not take any cash out of the busi- ness. All told, we calculated that Mohawk was selling at less than seven times its free cash flow, an attractive valuation. It was akin to buying a bond yielding 14%, with a decent chance that the coupon payments would rise over time.
In 2008, in the midst of a seriously depressed new housing market (most carpeting and flooring go into new construction), Mohawk Indus- tries was still generating $6 to $7 a share of free cash flow. The stock at
$75 a share was trading at around 11 to 12 times free cash flow, still an attractive multiple for a company in a cyclical downswing. True, revenues were slumping, but industry consolidation had largely eliminated once- rampant price-cutting competition among manufacturers. In fact, manu- facturers were able to pass along increased raw materials costs to customers. That has helped to preserve profit margins and cash flow.
While the carpeting and flooring industry will continue to fluctuate with the economy, Mohawk’s management has been able to keep its free cash flow generation fairly steady.
Not surprisingly, investors who search for companies with good free cash flow often find them in mature industries, such as the flooring busi- ness. Capital required for growth is limited and financing demands are
modest, so free cash is plentiful. That’s not usually the case with high- growth companies, but sometimes meticulous analysis will uncover one, such as EchoStar Corp., parent of the DISH satellite TV business.
That company went public in June 1995, on the premise that there |
steady.
Not surprisingly, investors who search for companies with good free cash flow often find them in mature industries, such as the flooring busi- ness. Capital required for growth is limited and financing demands are
modest, so free cash is plentiful. That’s not usually the case with high- growth companies, but sometimes meticulous analysis will uncover one, such as EchoStar Corp., parent of the DISH satellite TV business.
That company went public in June 1995, on the premise that there was room for another pay-TV provider. By 2000, at the peak of Wall Street’s infatuation with all things tech, EchoStar had 3.4 million sub- scribers, an enterprise value (market value of equity, plus net debt) of approximately $30 billion, and a reported annual loss of nearly $800 mil- lion. Worse yet, the company was consuming cash like crazy as it sought to build its infrastructure and customer base—and that alone would take it off many value investors’ radar.
Fast forward five years, and the subscriber count topped 12 million.
With many of the start-up costs behind it, free cash was flowing and growing—monthly subscriber fees are a pretty reliable income stream. Yet at that time, in 2005, EchoStar’s enterprise value was just $17 billion. Clearly, the market was not giving the company much credit for its cash- generating abilities. That allowed Fairholme to purchase shares in an excellent franchise business with a double-digit free cash flow yield while risk-free investments were paying 5%.
Some companies produce plentiful cash flow, but their corporate structures mask it. That’s the case with Leucadia National, a holding com- pany with an eclectic mix of businesses. Leucadia’s portfolio of busi- nesses resembles that of Buffett’s Berkshire Hathaway. While these companies in aggregate do not necessarily produce steady cash flow for the holding company, at the subsidiary level cash flow can be very good, and ultimately that value will benefit the parent company. Leucadia’s f |
ing 5%.
Some companies produce plentiful cash flow, but their corporate structures mask it. That’s the case with Leucadia National, a holding com- pany with an eclectic mix of businesses. Leucadia’s portfolio of busi- nesses resembles that of Buffett’s Berkshire Hathaway. While these companies in aggregate do not necessarily produce steady cash flow for the holding company, at the subsidiary level cash flow can be very good, and ultimately that value will benefit the parent company. Leucadia’s free cash flow is quite variable and unpredictable, mainly because its man- agers are always buying and selling businesses in its portfolio. But man- agement has proven skillful at deploying the company’s cash. Its net worth has compounded at close to 25% per annum for almost three decades. If you invest in a company such as Leucadia or Berkshire Hath-
away, you are banking on management’s ability to identify investments with high free cash flow.
Leucadia and Berkshire Hathaway point to another important aspect of evaluating free cash flow: how management deploys cash and whether those decisions enhance shareholder value. As mentioned ear- lier, free cash flow can either be returned to shareholders via dividends or share repurchases, or it can be reinvested in the business. Graham and Dodd equated cash returns to shareholders with dividends. The tax advantages of stock buybacks were hardly considered in capital alloca- tion decisions, and in fact, they are of little interest to the institutional investors who dominate today’s markets.
Today, share buybacks at discounted prices are clearly preferable to dividends. The qualifying factor here is the price. If the company buys back undervalued stock, selling shareholders suffer while long-term shareholders benefit. If the company buys its stock at inflated prices, sell- ers benefit and long-term holders lose out. Value investors, having a
long-term orientation, generally look for companies that consistently repurchase their stoc |
stitutional investors who dominate today’s markets.
Today, share buybacks at discounted prices are clearly preferable to dividends. The qualifying factor here is the price. If the company buys back undervalued stock, selling shareholders suffer while long-term shareholders benefit. If the company buys its stock at inflated prices, sell- ers benefit and long-term holders lose out. Value investors, having a
long-term orientation, generally look for companies that consistently repurchase their stocks during periods of undervaluation.
Management must decide when to return cash to shareholders and when to invest it. Earnings intelligently invested will generate higher future levels of free cash flow. On the other hand, poorly invested earn- ings destroy value. Warren Buffett has been an undisputed genius of cap- ital allocation for over 50 years, and no one minds that his Berkshire Hathaway does not pay a dividend. On the other hand, some manage- ments, especially those in struggling industries, would benefit their investors by returning capital to them rather than reinvesting in the busi- ness at low rates of return.
Dividends as Signals
Traditionally, corporate boards have tended to set dividend payouts at levels that are comfortably covered by earnings. That way, a greater share
of earnings is retained in good times. In bad times, dividends are often maintained even if they exceed free cash flow. A board might do that to express its long-term confidence in the business. If earnings are growing, a board will steadily increase the dividends, though usually at a slower pace than earnings.
Now, investors scrutinize companies’ dividend policies as a window into management’s thinking about the durability of the free cash flow. If changes in cash flow were considered temporary, companies presumably would not adjust dividends. If management believed the changes were likely to be permanent, it would adjust dividends accordingly. If manage- ment regarded new investment opport |
rnings are growing, a board will steadily increase the dividends, though usually at a slower pace than earnings.
Now, investors scrutinize companies’ dividend policies as a window into management’s thinking about the durability of the free cash flow. If changes in cash flow were considered temporary, companies presumably would not adjust dividends. If management believed the changes were likely to be permanent, it would adjust dividends accordingly. If manage- ment regarded new investment opportunities as relatively low risk, those opportunities could be financed with debt, allowing dividends to remain untouched. If new opportunities were viewed as relatively risky, they might have to be financed through a reduction in the dividend. If these strategies were honestly executed, they would help investors extrapolate from cur- rent to likely future cash flow and hence, to equity value. In this context, a high dividend level would be a positive factor in equity valuation.
The danger here is that management may be tempted to manipulate the dividend to create an inappropriately favorable picture of future cash flow. Companies under stress, such as General Motors or Citigroup have been, are almost always late to cut their dividends. In such cases investors who buy stocks with unusually rich dividend yields and deterio- rating fundamentals are asking for trouble. These dividends are likely to be sliced. Companies that pay dividends with the proceeds of newly issued equity rather than free cash flow are similarly likely to be manipu- lating investors through false signals. Real estate investment trusts and income trusts, which must pay out virtually all their income to sharehold- ers, are similarly reluctant to reduce their stated distributions.
On the other hand, companies that have free cash to distribute and poor investment prospects should make higher dividend payouts. Also,
companies like Dell Computer and Amazon.com that operate with signifi- cantly negative working c |
free cash flow are similarly likely to be manipu- lating investors through false signals. Real estate investment trusts and income trusts, which must pay out virtually all their income to sharehold- ers, are similarly reluctant to reduce their stated distributions.
On the other hand, companies that have free cash to distribute and poor investment prospects should make higher dividend payouts. Also,
companies like Dell Computer and Amazon.com that operate with signifi- cantly negative working capital—they collect from purchasers before they have to pay suppliers—and little fixed investment have minimal need to reinvest earnings. Yet they stubbornly pay no dividends and accumulate large amounts of cash.
Whose Cash Is It Anyway?
Identifying a company with a big cash stash and the ability to generate more is a great start. But the cash doesn’t do the shareholder any good unless management makes smart investments with it, or returns it to its owners via dividends or share buybacks. Management talent and inten- tions are crucial.
Sometimes there is just too much cash to ignore, even if it is under the control of folks who won’t invest it or distribute it. In those cases activist investors often take large stakes and pressure managers to “unlock the value” in the company; failing that, they try to replace those managers. One way or another, if there’s enough money in the cash regis- ter, somebody will find a way to get it out.
Chapter 27
THE THEORY OF COMMON-
STOCK INVESTMENT
IN OUR INTRODUCTORY discussion we set forth the difficulties inherent in efforts to apply the analytical technique to speculative situations. Since the speculative factors bulk particularly large in common stocks, it follows that analysis of such issues is likely to prove inconclusive and unsatisfactory; and even where it appears to be conclusive, there is danger that it may be misleading. At this point it is necessary to consider the function of com- mon-stock analysis in greater detail. We m |
IN OUR INTRODUCTORY discussion we set forth the difficulties inherent in efforts to apply the analytical technique to speculative situations. Since the speculative factors bulk particularly large in common stocks, it follows that analysis of such issues is likely to prove inconclusive and unsatisfactory; and even where it appears to be conclusive, there is danger that it may be misleading. At this point it is necessary to consider the function of com- mon-stock analysis in greater detail. We must begin with three realistic premises. The first is that common stocks are of basic importance in our financial scheme and of fascinating interest to many people; the second is that owners and buyers of common stocks are generally anxious to arrive at an intelligent idea of their value; the third is that, even when the under- lying motive of purchase is mere speculative greed, human nature desires to conceal this unlovely impulse behind a screen of apparent logic and good sense. To adapt the aphorism of Voltaire, it may be said that if there were no such thing as common-stock analysis, it would be necessary to counterfeit it.
Broad Merits of Common-stock Analysis. We are thus led to the question: “To what extent is common-stock analysis a valid and truly valuable exercise, and to what extent is it an empty but indispensable cer- emony attending the wagering of money on the future of business and of the stock market?” We shall ultimately find the answer to run somewhat as follows: “As far as the typical common stock is concerned—an issue picked at random from the list—an analysis, however elaborate, is unlikely to yield a dependable conclusion as to its attractiveness or its real value. But in individual cases, the exhibit may be such as to permit rea- sonably confident conclusions to be drawn from the processes of analy- sis.” It would follow that analysis is of positive or scientific value only in
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far as the typical common stock is concerned—an issue picked at random from the list—an analysis, however elaborate, is unlikely to yield a dependable conclusion as to its attractiveness or its real value. But in individual cases, the exhibit may be such as to permit rea- sonably confident conclusions to be drawn from the processes of analy- sis.” It would follow that analysis is of positive or scientific value only in
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the case of the exceptional common stock, and that for common stocks in general it must be regarded either as a somewhat questionable aid to speculative judgment or as a highly illusory method of aiming at values that defy calculation and that must somehow be calculated none the less. Perhaps the most effective way of clarifying the subject is through the historical approach. Such a survey will throw light not only upon the changing status of common-stock analysis but also upon a closely related subject of major importance, viz., the theory of common-stock investment. We shall encounter at first a set of old established and seem- ingly logical principles for common-stock investment. Through the advent of new conditions, we shall find the validity of these principles impaired. Their insufficiency will give rise to an entirely different con- cept of common-stock selection, the so-called “new-era theory,” which beneath its superficial plausibility will hold possibilities of untold mis- chief in store. With the prewar theory obsolete and the new-era theory exploded, we must finally make the attempt to establish a new set of logically sound and reasonably dependable principles of common-stock
investment.
History of Common-stock Analysis. Turning first to the history of common-stock analysis, we shall find that two conflicting factors have been at work during the past 30 years. On the one hand there has been an increase in the investment |
ty will hold possibilities of untold mis- chief in store. With the prewar theory obsolete and the new-era theory exploded, we must finally make the attempt to establish a new set of logically sound and reasonably dependable principles of common-stock
investment.
History of Common-stock Analysis. Turning first to the history of common-stock analysis, we shall find that two conflicting factors have been at work during the past 30 years. On the one hand there has been an increase in the investment prestige of common stocks as a class, due chiefly to the enlarged number that have shown substantial earnings, con- tinued dividends, and a strong financial condition. Accompanying this progress was a considerable advance in the frequency and adequacy of corporate statements, thus supplying the public and the securities analyst with a wealth of statistical data. Finally, an impressive theory was con- structed asserting the preeminence of common stocks as long-term investments. But at the time that the interest in common stocks reached its height, in the period between 1927 and 1929, the basis of valuation employed by the stock-buying public departed more and more from the factual approach and technique of security analysis and concerned itself increasingly with the elements of potentiality and prophecy. Moreover, the heightened instability in the affairs of industrial companies and groups of enterprises, which has undermined the investment quality of bonds in general, has of course been still more hostile to the maintenance of true investment quality in common stocks.
Analysis Vitiated by Two Types of Instability. The extent to which common-stock analysis has been vitiated by these two developments, (1) the instability of tangibles and (2) the dominant importance of intangi- bles, may be better realized by a contrast of specific common stocks prior to 1920 and in more recent times. Let us consider four typical examples: Pennsylvania Railroad; Atchison, Topeka, and Santa Fe |
n still more hostile to the maintenance of true investment quality in common stocks.
Analysis Vitiated by Two Types of Instability. The extent to which common-stock analysis has been vitiated by these two developments, (1) the instability of tangibles and (2) the dominant importance of intangi- bles, may be better realized by a contrast of specific common stocks prior to 1920 and in more recent times. Let us consider four typical examples: Pennsylvania Railroad; Atchison, Topeka, and Santa Fe Railway; National Biscuit; and American Can.
PENNSYLVANIA RAILROAD COMPANY
Year Range for stock Earned per share Paid per share
1904 70–56 $4.63 $3.00
1905 74–66 4.98 3.00
1906 74–61 5.83 3.25
1907 71–52 5.32 3.50
1908 68–52 4.46 3.00
1909 76–63 4.37 3.00
1910 69–61 4.60 3.00
1911 65–59 4.14 3.00
1912 63–60 4.64 3.00
1913 62–53 4.20 3.00
1923 48–41 5.16 3.00
1924 50–42 3.82 3.00
1925 55–43 6.23 3.00
1926 57–49 6.77 3.125
1927 68–57 6.83 3.50
1928 77–62 7.34 3.50
1929 110–73 8.82 3.875
1930 87–53 5.28 4.00
1931 64–16 1.48 3.25
1932 23–7 1.03 0.50
1933 42–14 1.46 0.50
1934 38–20 1.43 1.00
1935 33–27 1.81 0.50
1936 45–28 2.94 2.00
1937 50–20 2.07 1.25
1938 25–14 0.84 0.50
ATCHISON, TOPEKA, AND SANTA FE RAILWAY COMPANY
Year Range of stock Earned per share Paid per share
1904 89–64 $ 9.47* $ 4.00
1905 93–78 5.92* 4.00
1906 111–85 12.31* 4.50
1907 108–66 15.02* 6.00
1908 101–66 7.74* 5.00
1909 125–98 12.10* 5.50
1910 124–91 8.89* 6.00
1911 117–100 9.30* 6.00
1912 112–103 8.19* 6.00
1913 106–90 8.62* 6.00
1923 105–94 15.48 6.00
1924 121–97 15.47 6.00
1925 141–116 17.19 7.00
1926 172–122 23.42 7.00
1927 200–162 18.74 10.00
1928 204–183 18.09 10.00
1929 299–195 22.69 10.00
1930 243–168 12.86 10.00
1931 203–79 6.96 10.00
1932 94–18 0.55 2.50
1933 80–35 1.03(d) Nil
1934 74–45 0.33 2.00
1935 60–36 1.38 2.00
1936 89–59 1.56 2.00
1937 95–33 0.60 2.00
1938 45–22 0.83 Nil
* Fiscal years ended June 30.
American Can was a typical example of a prewar speculative stock. It was speculative f |
106–90 8.62* 6.00
1923 105–94 15.48 6.00
1924 121–97 15.47 6.00
1925 141–116 17.19 7.00
1926 172–122 23.42 7.00
1927 200–162 18.74 10.00
1928 204–183 18.09 10.00
1929 299–195 22.69 10.00
1930 243–168 12.86 10.00
1931 203–79 6.96 10.00
1932 94–18 0.55 2.50
1933 80–35 1.03(d) Nil
1934 74–45 0.33 2.00
1935 60–36 1.38 2.00
1936 89–59 1.56 2.00
1937 95–33 0.60 2.00
1938 45–22 0.83 Nil
* Fiscal years ended June 30.
American Can was a typical example of a prewar speculative stock. It was speculative for three good and sufficient reasons: (1) It paid no divi- dend; (2) its earnings were small and irregular; (3) the issue was “watered,” i.e., a substantial part of its stated value represented no actual investment in the business. By contrast, Pennsylvania, Atchison, and National Biscuit were regarded as investment common stocks—also for three good and sufficient reasons: (1) They showed a satisfactory record of continued
dividends; (2) the earnings were reasonably stable and averaged substan- tially in excess of the dividends paid; and (3) each dollar of stock was backed by a dollar or more of actual investment in the business.
NATIONAL BISCUIT COMPANY
Year Range for stock Earned per share Paid per share
1909 120–97 $ 7.67* $ 5.75
1910 120–100 9.86* 6.00
1911 144–117 10.05* 8.75
1912 161–114 9.59* 7.00
1913 130–104 11.73* 7.00
1914 139–120 9.52* 7.00
1915 132–116 8.20* 7.00
1916 131–118 9.72* 7.00
1917 123–80 9.87† 7.00
1918 111–90 11.63 7.00
(old basis)‡ (old basis)‡ (old basis)‡
1923 370–266 $35.42 $21.00
1924 541–352 38.15 28.00
1925 553–455 40.53 28.00
1926 714–518 44.24 35.00
1927 1,309–663 49.77 42.00
1928 1,367–1,117 51.17 49.00
1929 1,657–980 57.40 52.50
1930 1,628–1,148 59.68 56.00
1931 1,466–637 50.05 49.00
1932 820–354 42.70 49.00
1933 1,061–569 36.93 49.00
1934 866–453 27.48 42.00
1935 637–389 22.93 31.50
1936 678–503 30.28 35.00
1937 584–298 28.35 28.00
1938 490–271 30.80 28.00
* Earnings for the year ended Jan. 31 of the following year.
† Eleven months end |
‡
1923 370–266 $35.42 $21.00
1924 541–352 38.15 28.00
1925 553–455 40.53 28.00
1926 714–518 44.24 35.00
1927 1,309–663 49.77 42.00
1928 1,367–1,117 51.17 49.00
1929 1,657–980 57.40 52.50
1930 1,628–1,148 59.68 56.00
1931 1,466–637 50.05 49.00
1932 820–354 42.70 49.00
1933 1,061–569 36.93 49.00
1934 866–453 27.48 42.00
1935 637–389 22.93 31.50
1936 678–503 30.28 35.00
1937 584–298 28.35 28.00
1938 490–271 30.80 28.00
* Earnings for the year ended Jan. 31 of the following year.
† Eleven months ending Dec. 31, 1917.
‡ Stock was split 4 for 1 in 1922, followed by a 75% stock dividend. In 1930 it was again split 21/2 for 1. Published figures applicable to new stock were one-seventh of those given above for 1923–1929. Likewise the foregoing figures for 1930–1938 are 171/2 times the published figures for those years.
If we study the range of market price of these issues during the decade preceding the World War (or the 1909–1918 period for National Biscuit), we note that American Can fluctuated widely from year to year in the fashion regularly associated with speculative media but that Pennsylva- nia, Atchison, and National Biscuit showed much narrower variations and evidently tended to oscillate about a base price (i.e., 97 for Atchison, 64 for Pennsylvania, and 120 for National Biscuit) that seemed to repre- sent a well-defined view of their investment or intrinsic value.
AMERICAN CAN COMPANY
Year Range for stock Earned per share Paid per share
1904 ............... $ 0.51* 0
1905 ............... 1.39(d)† 0
1906 ............... 1.30(d)‡ 0
1907 8–3 0.57(d) 0
1908 10–4 0.44(d) 0
1909 15–8 0.32(d) 0
1910 14–7 0.15(d) 0
1911 13–9 0.07 0
1912 47–11 8.86 0
1913 47–21 5.21 0
1923 108–74 19.64 $ 5.00
1924 164–96 20.51 6.00
1925 297–158 32.75 7.00
(old basis)§ (old basis)§ (old basis)§
1926 379–233 26.34 13.25
1927 466–262 24.66 12.00
1928 705–423 41.16 12.00
1929 1,107–516 48.12 30.00
1930 940–628 48.48 30.00
1931 779–349 30.66 30.00
1932 443–178 19.56 24.00
1933 603–297 30.2 |
05 ............... 1.39(d)† 0
1906 ............... 1.30(d)‡ 0
1907 8–3 0.57(d) 0
1908 10–4 0.44(d) 0
1909 15–8 0.32(d) 0
1910 14–7 0.15(d) 0
1911 13–9 0.07 0
1912 47–11 8.86 0
1913 47–21 5.21 0
1923 108–74 19.64 $ 5.00
1924 164–96 20.51 6.00
1925 297–158 32.75 7.00
(old basis)§ (old basis)§ (old basis)§
1926 379–233 26.34 13.25
1927 466–262 24.66 12.00
1928 705–423 41.16 12.00
1929 1,107–516 48.12 30.00
1930 940–628 48.48 30.00
1931 779–349 30.66 30.00
1932 443–178 19.56 24.00
1933 603–297 30.24 24.00
1934 689–542 50.32 24.00
1935 898–660 34.98 30.00
1936 825–660 34.80 36.00
1937 726–414 36.48 24.00
1938 631–425 26.10 24.00
* Fiscal year ended Mar. 31, 1905.
† Nine months ended Dec. 31, 1905.
‡ Excluding fire losses of 58 cents a share.
§ Stock was split 6 for 1 in 1926. Published figures applicable to new stock were one-sixth of those given for 1926–1938.
Prewar Conception of Investment in Common Stocks. Hence the prewar relationship between analysis and investment on the one hand and price changes and speculation on the other may be set forth as follows: Investment in common stocks was confined to those showing sta- ble dividends and fairly stable earnings; and such issues in turn were expected to maintain a fairly stable market level. The function of analysis was primarily to search for elements of weakness in the picture. If the earn- ings were not properly stated; if the balance sheet revealed a poor current position, or the funded debt was growing too rapidly; if the physical plant was not properly maintained; if dangerous new competition was threat- ening, or if the company was losing ground in the industry; if the man- agement was deteriorating or was likely to change for the worse; if there was reason to fear for the future of the industry as a whole—any of these defects or some other one might be sufficient to condemn the issue from the standpoint of the cautious investor.
On the positive side, analysis was concerned with finding those issues which met |
physical plant was not properly maintained; if dangerous new competition was threat- ening, or if the company was losing ground in the industry; if the man- agement was deteriorating or was likely to change for the worse; if there was reason to fear for the future of the industry as a whole—any of these defects or some other one might be sufficient to condemn the issue from the standpoint of the cautious investor.
On the positive side, analysis was concerned with finding those issues which met all the requirements of investment and in addition offered the best chance for future enhancement. The process was largely a matter of comparing similar issues in the investment class, e.g., the group of divi- dend-paying Northwestern railroads. Chief emphasis would be laid upon the relative showing for past years, in particular the average earnings in relation to price and the stability and the trend of earnings. To a lesser extent, the analyst sought to look into the future and to select the indus- tries or the individual companies that were likely to show the most rapid growth.
Speculation Characterized by Emphasis on Future Prospects. In the prewar period it was the well-considered view that when prime emphasis was laid upon what was expected of the future, instead of what had been accomplished in the past, a speculative attitude was thereby taken. Spec- ulation, in its etymology, meant looking forward; investment was allied to “vested interests”—to property rights and values taking root in the past. The future was uncertain, therefore speculative; the past was known, therefore the source of safety. Let us consider a buyer of American Can common in 1910. He may have bought it believing that its price was going to advance or be “put up” or that its earnings were going to increase or that it was soon going to pay a dividend or possibly that it was destined to develop into one of the country’s strongest industrials. From the pre-
war standpoint, although one of these reaso |
g root in the past. The future was uncertain, therefore speculative; the past was known, therefore the source of safety. Let us consider a buyer of American Can common in 1910. He may have bought it believing that its price was going to advance or be “put up” or that its earnings were going to increase or that it was soon going to pay a dividend or possibly that it was destined to develop into one of the country’s strongest industrials. From the pre-
war standpoint, although one of these reasons may have been more intel- ligent or creditable than another, each of them constituted a speculative motive for the purchase.
Technique of Investing in Common Stocks Resembled That for Bonds. Evidently there was a close similarity between the technique of investing in common stocks and that of investing in bonds. The common-stock investor, also, wanted a stable business and one showing an adequate mar- gin of earnings over dividend requirements. Naturally he had to content himself with a smaller margin of safety than he would demand of a bond, a disadvantage that was offset by a larger income return (6% was stan- dard on a good common stock compared with 41/2% on a high-grade bond), by the chance of an increased dividend if the business continued to prosper, and—generally of least importance in his eyes—by the possi- bility of a profit. A common-stock investor was likely to consider himself as in no very different position from that of a purchaser of second-grade bonds; essentially his venture amounted to sacrificing a certain degree of safety in return for larger income. The Pennsylvania and Atchison exam- ples during the 1904–1913 decade will supply specific confirmation of the foregoing description.
Buying Common Stocks Viewed as Taking a Share in a Business. Another useful approach to the attitude of the prewar common-stock investor is from the standpoint of taking an interest in a private business. The typical common-stock investor was a business man, and it seemed sen |
is venture amounted to sacrificing a certain degree of safety in return for larger income. The Pennsylvania and Atchison exam- ples during the 1904–1913 decade will supply specific confirmation of the foregoing description.
Buying Common Stocks Viewed as Taking a Share in a Business. Another useful approach to the attitude of the prewar common-stock investor is from the standpoint of taking an interest in a private business. The typical common-stock investor was a business man, and it seemed sensible to him to value any corporate enterprise in much the same man- ner as he would value his own business. This meant that he gave at least as much attention to the asset values behind the shares as he did to their earnings records. It is essential to bear in mind the fact that a private busi- ness has always been valued primarily on the basis of the “net worth” as shown by its statement. A man contemplating the purchase of a partner- ship or stock interest in a private undertaking will always start with the value of that interest as shown “on the books,” i.e., the balance sheet, and will then consider whether or not the record and prospects are good enough to make such a commitment attractive. An interest in a private business may of course be sold for more or less than its proportionate asset value; but the book value is still invariably the starting point of the calculation, and the deal is finally made and viewed in terms of the pre- mium or discount from book value involved.
Broadly speaking, the same attitude was formerly taken in an invest- ment purchase of a marketable common stock. The first point of depar- ture was the par value, presumably representing the amount of cash or property originally paid into the business; the second basal figure was the book value, representing the par value plus a ratable interest in the accu- mulated surplus. Hence in considering a common stock, investors asked themselves: “Is this issue a desirable purchase at the premium above b |
roadly speaking, the same attitude was formerly taken in an invest- ment purchase of a marketable common stock. The first point of depar- ture was the par value, presumably representing the amount of cash or property originally paid into the business; the second basal figure was the book value, representing the par value plus a ratable interest in the accu- mulated surplus. Hence in considering a common stock, investors asked themselves: “Is this issue a desirable purchase at the premium above book value, or the discount below book value, represented by the market price?” “Watered stock” was repeatedly inveighed against as a deception practiced upon the stock-buying public, who were misled by a fictitious statement of the asset values existing behind the shares. Hence one of the protective functions of security analysis was to discover whether or not the value of the fixed assets, as stated on the balance sheet of a company, fairly represented the actual cost or reasonable worth of the properties.
Investment in Common Stocks Based on Threefold Concept. We thus see that investment in common stocks was formerly based upon the threefold concept of: (1) a suitable and established dividend return, (2) a stable and adequate earnings record, and (3) a satisfactory backing of tan- gible assets. Each of these three elements could be made the subject of careful analytical study, viewing the issue both by itself and in compari- son with others of its class. Common-stock commitments motivated by any other viewpoint were characterized as speculative, and it was not expected that they should be justified by a serious analysis.
THE NEW-ERA THEORY
During the postwar period, and particularly during the latter stage of the bull market culminating in 1929, the public acquired a completely differ- ent attitude towards the investment merits of common stocks. Two of the three elements above stated lost nearly all their significance, and the third, the earnings record, took on an entire |
vated by any other viewpoint were characterized as speculative, and it was not expected that they should be justified by a serious analysis.
THE NEW-ERA THEORY
During the postwar period, and particularly during the latter stage of the bull market culminating in 1929, the public acquired a completely differ- ent attitude towards the investment merits of common stocks. Two of the three elements above stated lost nearly all their significance, and the third, the earnings record, took on an entirely novel complexion. The new theory or principle may be summed up in the sentence: “The value of a common stock depends entirely upon what it will earn in the future.”
From this dictum the following corollaries were drawn:
1. That the dividend rate should have slight bearing upon the value.
2. That since no relationship apparently existed between assets and earning power, the asset value was entirely devoid of importance.
3. That past earnings were significant only to the extent that they indi- cated what changes in the earnings were likely to take place in the future.
This complete revolution in the philosophy of common-stock invest- ment took place virtually without realization by the stock-buying public and with only the most superficial recognition by financial observers. An effort must be made to reach a thorough comprehension of what this changed viewpoint really signifies. To do so we must consider it from three angles: its causes, its consequences and its logical validity.
Causes for This Changed Viewpoint. Why did the investing public turn its attention from dividends, from asset values, and from average earn- ings to transfer it almost exclusively to the earnings trend, i.e., to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, sec- ond, that the rewards offered by the future had become irresistibly alluring. The new-era concepts had their root first of all in |
uses for This Changed Viewpoint. Why did the investing public turn its attention from dividends, from asset values, and from average earn- ings to transfer it almost exclusively to the earnings trend, i.e., to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, sec- ond, that the rewards offered by the future had become irresistibly alluring. The new-era concepts had their root first of all in the obsolescence of the old-established standards. During the last generation the tempo of economic change has been speeded up to such a degree that the fact of being long established has ceased to be, as once it was, a warranty of stability. Corporations enjoying decade-long prosperity have been pre- cipitated into insolvency within a few years. Other enterprises, which had been small or unsuccessful or in doubtful repute, have just as quickly acquired dominant size, impressive earnings, and the highest rating. The major group upon which investment interest was chiefly concentrated, viz., the railroads, failed signally to participate in the expansion of national wealth and income and showed repeated signs of definite retro- gression. The street railways, another important medium of investment prior to 1914, rapidly lost the greater portion of their value as the result of the development of new transportation agencies. The electric and gas companies followed an irregular course during this period, since they were harmed rather than helped by the war and postwar inflation, and their impressive growth was a relatively recent phenomenon. The history of industrial companies was a hodge-podge of violent changes, in which the benefits of prosperity were so unequally and so impermanently dis- tributed as to bring about the most unexpected failures alongside of the
most dazzling successes.
In the face of all this instability it was inevitable that the threefold basis of common-stock |
this period, since they were harmed rather than helped by the war and postwar inflation, and their impressive growth was a relatively recent phenomenon. The history of industrial companies was a hodge-podge of violent changes, in which the benefits of prosperity were so unequally and so impermanently dis- tributed as to bring about the most unexpected failures alongside of the
most dazzling successes.
In the face of all this instability it was inevitable that the threefold basis of common-stock investment should prove totally inadequate. Past earnings and dividends could no longer be considered, in themselves, an index of future earnings and dividends. Furthermore, these future earn-
ings showed no tendency whatever to be controlled by the amount of the actual investment in the business—the asset values—but instead depended entirely upon a favorable industrial position and upon capable or fortunate managerial policies. In numerous cases of receivership, the current assets dwindled, and the fixed assets proved almost worthless. Because of this absence of any connection between both assets and earn- ings and between assets and realizable values in bankruptcy, less and less attention came to be paid either by financial writers or by the general pub- lic to the formerly important question of “net worth,” or “book value”; and it may be said that by 1929 book value had practically disappeared as an element in determining the attractiveness of a security issue. It is a significant confirmation of this point that “watered stock,” once so burn- ing an issue, is now a forgotten phrase.
Attention Shifted to the Trend of Earnings. Thus the prewar approach to investment, based upon past records and tangible facts, became outworn and was discarded. Could anything be put in its place? A new conception was given central importance—that of trend of earn- ings. The past was important only in so far as it showed the direction in which the future could be expected to move. A continuo |
confirmation of this point that “watered stock,” once so burn- ing an issue, is now a forgotten phrase.
Attention Shifted to the Trend of Earnings. Thus the prewar approach to investment, based upon past records and tangible facts, became outworn and was discarded. Could anything be put in its place? A new conception was given central importance—that of trend of earn- ings. The past was important only in so far as it showed the direction in which the future could be expected to move. A continuous increase in profits proved that the company was on the upgrade and promised still better results in the future than had been accomplished to date. Con- versely, if the earnings had declined or even remained stationary during a prosperous period, the future must be thought unpromising, and the issue was certainly to be avoided.
The Common-stocks-as-long-term-investments Doctrine. Along with this idea as to what constituted the basis for common-stock selection emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based upon a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past. The figures indicated that such diversified common-stock holdings yielded both a higher income return and a greater principal profit than purchases of standard bonds.
The combination of these two ideas supplied the “investment theory” upon which the 1927–1929 stock market proceeded. Amplifying the prin- ciple stated on page 356, the theory ran as follows:
1. “The value of a common stock depends on what it can earn in the future.”
2. “Good common stocks are those which have shown a rising trend of earnings.”
3. “Good common stocks will prove sound and profitable investments.”
These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses that could and did result |
supplied the “investment theory” upon which the 1927–1929 stock market proceeded. Amplifying the prin- ciple stated on page 356, the theory ran as follows:
1. “The value of a common stock depends on what it can earn in the future.”
2. “Good common stocks are those which have shown a rising trend of earnings.”
3. “Good common stocks will prove sound and profitable investments.”
These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses that could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether or not it was a desirable purchase.
New-era Investment Equivalent to Prewar Speculation. A moment’s thought will show that “new-era investment,” as practiced by the public and the investment trusts, was almost identical with specula- tion as popularly defined in preboom days. Such “investment” meant buying common stocks instead of bonds, emphasizing enhancement of principal instead of income, and stressing the changes of the future instead of the facts of the established past. It would not be inaccurate to state that new-era investment was simply old-style speculation confined to common stocks with a satisfactory trend of earnings. The impressive new concept underlying the greatest stock-market boom in history appears to be no more than a thinly disguised version of the old cynical epigram: “Investment is successful speculation.”
Stocks Regarded as Attractive Irrespective of Their Prices. The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a public-utility stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the preboom standard, the conclusion to be drawn was not that the stock was now too h |
ynical epigram: “Investment is successful speculation.”
Stocks Regarded as Attractive Irrespective of Their Prices. The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a public-utility stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the preboom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell but even upon the price at which it would deserve to sell. This fantas- tic reasoning actually led to the purchase at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceiv- able price.
An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only neces- sary to buy “good” stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic. Countless people asked themselves, “Why work for a living when a fortune can be made in Wall Street without working?” The ensuing migration from business into the financial district resembled the famous gold rush to the Klondike, except that gold was brought to Wall Street instead of taken from it.
Investment Trusts Adopted This New Doctrine. An ironical side- light is thrown on this 1928–1929 theory by the practice of the invest- ment trusts. These were formed for the purpose of giving the untrained public the benefit of expert administration of its funds—a plausible idea and one that had been working reasonably w |
ensuing migration from business into the financial district resembled the famous gold rush to the Klondike, except that gold was brought to Wall Street instead of taken from it.
Investment Trusts Adopted This New Doctrine. An ironical side- light is thrown on this 1928–1929 theory by the practice of the invest- ment trusts. These were formed for the purpose of giving the untrained public the benefit of expert administration of its funds—a plausible idea and one that had been working reasonably well in England. The earliest American investment trusts laid considerable emphasis upon certain time-tried principles of successful investment, which they were much bet- ter qualified to follow than the typical individual. The most important of these principles were:
1. To buy in times of depression and low prices and to sell out in times of prosperity and high prices.
2. To diversify holdings in many fields and probably in many countries.
3. To discover and acquire undervalued individual securities as the result of comprehensive and expert statistical investigations.
The rapidity and completeness with which these traditional principles disappeared from investment-trust technique is one of the many marvels of the period. The idea of buying in times of depression was obviously inapplicable. It suffered from the fatal weakness that investment trusts could be organized only in good times, so that they were virtually com- pelled to make their initial commitments in bull markets. The idea of world-wide geographical distribution had never exerted a powerful appeal upon the provincially minded Americans (who possibly were right in this respect), and with things going so much better here than abroad this principle was dropped by common consent.
Analysis Abandoned by Investment Trusts. But most paradoxical was the early abandonment of research and analysis in guiding investment-
trust policies. However, since these financial institutions owed their exis- tence to the new-era philoso |
f world-wide geographical distribution had never exerted a powerful appeal upon the provincially minded Americans (who possibly were right in this respect), and with things going so much better here than abroad this principle was dropped by common consent.
Analysis Abandoned by Investment Trusts. But most paradoxical was the early abandonment of research and analysis in guiding investment-
trust policies. However, since these financial institutions owed their exis- tence to the new-era philosophy, it was natural and perhaps only just that they should adhere closely to it. Under its canons investment had now become so beautifully simple that research was unnecessary and elabo- rate statistical data a mere incumbrance. The investment process con- sisted merely of finding prominent companies with a rising trend of earnings and then buying their shares regardless of price. Hence the sound policy was to buy only what every one else was buying—a select list of highly popular and exceedingly expensive issues, appropriately known as the “blue chips.” The original idea of searching for the under- valued and neglected issues dropped completely out of sight. Investment trusts actually boasted that their portfolios consisted exclusively of the active and standard (i.e., the most popular and highest priced) common stocks. With but slight exaggeration, it might be asserted that under this convenient technique of investment, the affairs of a ten-million-dollar investment trust could be administered by the intelligence, the training and the actual labors of a single thirty-dollar-a-week clerk.
The man in the street, having been urged to entrust his funds to the superior skill of investment experts—for substantial compensation—was soon reassuringly told that the trusts would be careful to buy nothing except what the man in the street was buying himself.
The Justification Offered. Irrationality could go no further; yet it is important to note that mass speculation can flourish only |
ministered by the intelligence, the training and the actual labors of a single thirty-dollar-a-week clerk.
The man in the street, having been urged to entrust his funds to the superior skill of investment experts—for substantial compensation—was soon reassuringly told that the trusts would be careful to buy nothing except what the man in the street was buying himself.
The Justification Offered. Irrationality could go no further; yet it is important to note that mass speculation can flourish only in such an atmosphere of illogic and unreality. The self-deception of the mass spec- ulator must, however, have its element of justification. This is usually some generalized statement, sound enough within its proper field, but twisted to fit the speculative mania. In real estate booms, the “reasoning” is usually based upon the inherent permanence and growth of land val- ues. In the new-era bull market, the “rational” basis was the record of long-term improvement shown by diversified common-stock holdings.
A Sound Premise Used to Support an Unsound Conclusion. There was, however, a radical fallacy involved in the new-era application of this historical fact. This should be apparent from even a superficial examination of the data contained in the small and rather sketchy vol- ume from which the new-era theory may be said to have sprung. The book is entitled Common Stocks as Long Term Investments, by Edgar
Lawrence Smith, published in 1924.1 Common stocks were shown to have a tendency to increase in value with the years, for the simple reason that they earned more than they paid out in dividends and thus the reinvested earnings added to their worth. In a representative case, the company would earn an average of 9%, pay 6% in dividends, and add 3% to sur- plus. With good management and reasonable luck the fair value of the stock would increase with its book value, at the annual rate of 3% com- pounded. This was, of course, a theoretical rather than a standard pattern, but the |
to increase in value with the years, for the simple reason that they earned more than they paid out in dividends and thus the reinvested earnings added to their worth. In a representative case, the company would earn an average of 9%, pay 6% in dividends, and add 3% to sur- plus. With good management and reasonable luck the fair value of the stock would increase with its book value, at the annual rate of 3% com- pounded. This was, of course, a theoretical rather than a standard pattern, but the numerous instances of results poorer than “normal” might be off- set by examples of more rapid growth.
The attractiveness of common stocks for the long pull thus lay essen- tially in the fact that they earned more than the bond-interest rate upon their cost. This would be true, typically, of a stock earning $10 and sell- ing at 100. But as soon as the price was advanced to a much higher price in relation to earnings, this advantage disappeared, and with it disap- peared the entire theoretical basis for investment purchases of common stocks. When in 1929 investors paid $200 per share for a stock earning
$8, they were buying an earning power no greater than the bond-inter- est rate, without the extra protection afforded by a prior claim. Hence in using the past performances of common stocks as the reason for paying prices 20 to 40 times their earnings, the new-era exponents were starting with a sound premise and twisting it into a woefully unsound conclusion. In fact their rush to take advantage of the inherent attractiveness of common stocks itself produced conditions entirely different from those which had given rise to this attractiveness and upon which it basically depended, viz., the fact that earnings had averaged some 10% on market price. As we have seen, Edgar Lawrence Smith plausibly explained the growth of common-stock values as arising from the building up of asset values through the reinvestment of surplus earnings. Paradoxically enough, the new-era theory that expl |
dvantage of the inherent attractiveness of common stocks itself produced conditions entirely different from those which had given rise to this attractiveness and upon which it basically depended, viz., the fact that earnings had averaged some 10% on market price. As we have seen, Edgar Lawrence Smith plausibly explained the growth of common-stock values as arising from the building up of asset values through the reinvestment of surplus earnings. Paradoxically enough, the new-era theory that exploited this finding refused to accord the slightest importance to the asset values behind the stocks it favored. Furthermore, the validity of Mr. Smith’s conclusions rested necessarily upon the assumption that common stocks could be counted on to behave
1 The reader is referred to Chelcie C. Bosland, The Common Stock Theory of Investment, Its Development and Significance, New York, 1937, for a survey of the literature on the com- mon-stock theory. Common Stock Indexes by Alfred Cowles 3d and associates, Bloomington, Ind., 1939, is a significant work on this subject which has appeared since publication of Pro- fessor Bosland’s book.
in the future about as they had in the past. Yet the new-era theory threw out of account the past earnings of corporations except in so far as they were regarded as pointing to a trend for the future.
Examples Showing Emphasis on Trend of Earnings. Take three com- panies with the following exhibits:
EARNINGS PER SHARE
Year Company A (Electric Power & Light) Company B (Bangor & Aroostook R. R.) Company C (Chicago Yellow Cab)
1925 $1.01 $6.22 $5.52
1926 1.45 8.69 5.60
1927 2.09 8.41 4.54
1928 2.37 6.94 4.58
1929 2.98 8.30 4.47
5-year average $1.98 $7.71 $4.94
High price, 1929 865/8 903/8 35
The 1929 high prices for these three companies show that the new- era attitude was enthusiastically favorable to Company A, unimpressed by Company B, and definitely hostile to Company C. The market consid- ered Company A shares worth more than twice as much a |
ght) Company B (Bangor & Aroostook R. R.) Company C (Chicago Yellow Cab)
1925 $1.01 $6.22 $5.52
1926 1.45 8.69 5.60
1927 2.09 8.41 4.54
1928 2.37 6.94 4.58
1929 2.98 8.30 4.47
5-year average $1.98 $7.71 $4.94
High price, 1929 865/8 903/8 35
The 1929 high prices for these three companies show that the new- era attitude was enthusiastically favorable to Company A, unimpressed by Company B, and definitely hostile to Company C. The market consid- ered Company A shares worth more than twice as much as Company C shares, although the latter earned 50% more per share than Company A in 1929 and its average earnings were 150% greater.2
Average vs. Trend of Earnings. These relationships between price and earnings in 1929 show definitely that the past exhibit was no longer a measure of normal earning power but merely a weathervane to show which way the winds of profit were blowing. That the average earnings had ceased to be a dependable measure of future earnings must indeed be admitted, because of the greater instability of the typical business to which we have previously alluded. But it did not follow at all that the trend of earnings must therefore be a more dependable guide than the average; and even if it were more dependable, it would not necessarily provide a safe basis, entirely by itself, for investment.
2 See Appendix Note 44, p. 778 on accompanying CD, for a discussion of the subsequent performance of these three companies.
The accepted assumption that because earnings have moved in a cer- tain direction for some years past they will continue to move in that direc- tion is fundamentally no different from the discarded assumption that because earnings averaged a certain amount in the past they will continue to average about that amount in the future. It may well be that the earn- ings trend offers a more dependable clue to the future than does the earn- ings average. But at best such an indication of future results is far from certain, and, more important still, th |
moved in a cer- tain direction for some years past they will continue to move in that direc- tion is fundamentally no different from the discarded assumption that because earnings averaged a certain amount in the past they will continue to average about that amount in the future. It may well be that the earn- ings trend offers a more dependable clue to the future than does the earn- ings average. But at best such an indication of future results is far from certain, and, more important still, there is no method of establishing a log- ical relationship between trend and price.3 This means that the value placed upon a satisfactory trend must be wholly arbitrary, and hence speculative, and hence inevitably subject to exaggeration and later collapse.
Danger in Projecting Trends into the Future. There are several reasons why we cannot be sure that a trend of profits shown in the past will con- tinue in the future. In the broad economic sense, there is the law of dimin- ishing returns and of increasing competition which must finally flatten out any sharply upward curve of growth. There is also the flow and ebb of the business cycle, from which the particular danger arises that the earnings curve will look most impressive on the very eve of a serious setback. Considering the 1927–1929 period we observe that since the trend-of-earnings theory was at bottom only a pretext to excuse rank speculation under the guise of “investment,” the profit-mad public was quite willing to accept the flimsiest evidence of the existence of a favor- able trend. Rising earnings for a period of five, or four, or even three years only, were regarded as an assurance of uninterrupted future growth and a warrant for projecting the curve of profits indefinitely upward.
3 The new-era investment theory was conspicuously reticent on the mathematical side. The relationship between price and earnings, or price and trend of earnings was anything that the market pleased to make it (note the price of Elect |
flimsiest evidence of the existence of a favor- able trend. Rising earnings for a period of five, or four, or even three years only, were regarded as an assurance of uninterrupted future growth and a warrant for projecting the curve of profits indefinitely upward.
3 The new-era investment theory was conspicuously reticent on the mathematical side. The relationship between price and earnings, or price and trend of earnings was anything that the market pleased to make it (note the price of Electric Power and Light compared with its earnings record given on p. 363). If an attempt were to be made to give a mathematical expression to the underlying idea of valuation, it might be said that it was based on the derivative of the earnings, stated in terms of time. In recent years more serious efforts have been made to establish a mathematical basis for discounting expected future earnings or div- idends. See Gabriel Preinreich, The Theory of Dividends, New York, 1935; and J. B. Williams, The Theory of Investment Value, Cambridge, Mass., 1938. The latter work is built on the premise that the value of a common stock is equal to the present value of all future divi- dends. This principle gives rise to an elaborate series of mathematical equations designed to calculate exactly what a common stock is worth, assuming certain vital facts about future earnings, distribution policy and interest rates.
Example: The prevalent heedlessness on this score was most evident in connection with the numerous common-stock flotations during this period. The craze for a showing of rising profits resulted in the promo- tion of many industrial enterprises that had been favored by temporary good fortune and were just approaching, or had already reached, the peak of their prosperity. A typical example of this practice is found in the offer- ing of preferred and common stock of Schletter and Zander, Inc., a man- ufacturer of hosiery (name changed later to Signature Hosiery Company). The company wa |
numerous common-stock flotations during this period. The craze for a showing of rising profits resulted in the promo- tion of many industrial enterprises that had been favored by temporary good fortune and were just approaching, or had already reached, the peak of their prosperity. A typical example of this practice is found in the offer- ing of preferred and common stock of Schletter and Zander, Inc., a man- ufacturer of hosiery (name changed later to Signature Hosiery Company). The company was organized in 1929, to succeed a company organized in 1922, and the financing was effected by the sale of 44,810 shares of $3.50 convertible preferred shares at $50 per share and 261,349 voting-trust cer- tificates for common stock at $26 per share. The offering circular pre- sented the following exhibit of earnings from the constituent properties:
Year Net after federal taxes Per share of preferred Per share of common
1925 $ 172,058 $ 3.84 $0.06
1926 339,920 7.58 0.70
1927 563,856 12.58 1.56
1928 1,021,308 22.79 3.31
The subsequent record was as follows:
1929 812,136 18.13 2.51
1930 179,875(d) 4.01(d) 1.81(d)
In 1931 liquidation of the company’s assets was begun, and a total of
$17 per share in liquidating dividends on the preferred had been paid up to the end of 1933. (Assets then remaining for liquidation were negligi- ble.) The common was wiped out.
This example illustrates one of the paradoxes of financial history, viz., that at the very period when the increasing instability of individual com- panies had made the purchase of common stocks far more precarious than before, the gospel of common stocks as safe and satisfactory invest- ments was preached to and avidly accepted by the American public.
Chapter 28
NEWER CANONS OF COMMON-
STOCK INVESTMENT
OUR EXTENDED discussion of the theory of common-stock investment has thus far led only to negative conclusions. The older approach, centering upon the conception of a stable average earning power, appears to have been |
of individual com- panies had made the purchase of common stocks far more precarious than before, the gospel of common stocks as safe and satisfactory invest- ments was preached to and avidly accepted by the American public.
Chapter 28
NEWER CANONS OF COMMON-
STOCK INVESTMENT
OUR EXTENDED discussion of the theory of common-stock investment has thus far led only to negative conclusions. The older approach, centering upon the conception of a stable average earning power, appears to have been vitiated by the increasing instability of the typical business. As for the new-era view, which turned upon the earnings trend as the sole cri- terion of value, whatever truth may lurk in this generalization, its blind adoption as a basis for common-stock purchases, without calculation or restraint, was certain to end in an appalling debacle. Is there anything at all left, then, of the idea of sound investment in common stocks?
A careful review of the preceding criticism will show that it need not be so destructive to the notion of investment in common stocks as a first impression would suggest. The instability of individual companies may conceivably be offset by means of thoroughgoing diversification. More- over, the trend of earnings, although most dangerous as a sole basis for selection, may prove a useful indication of investment merit. If this approach is a sound one, there may be formulated an acceptable canon of common-stock investment, containing the following elements:
1. Investment is conceived as a group operation, in which diversifica- tion of risk is depended upon to yield a favorable average result.
2. The individual issues are selected by means of qualitative and quan- titative tests corresponding to those employed in the choice of fixed-value investments.
3. A greater effort is made, than in the case of bond selection, to deter- mine the future outlook of the issues considered.
Whether or not a policy of common-stock acquisition based upon the foregoing princi |
stment is conceived as a group operation, in which diversifica- tion of risk is depended upon to yield a favorable average result.
2. The individual issues are selected by means of qualitative and quan- titative tests corresponding to those employed in the choice of fixed-value investments.
3. A greater effort is made, than in the case of bond selection, to deter- mine the future outlook of the issues considered.
Whether or not a policy of common-stock acquisition based upon the foregoing principles deserves the title of investment is undoubtedly open to debate. The importance of the question, and the lack of well-defined
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and authoritative views thereon, compel us to weigh here the leading arguments for and against this proposition.
THREE GENERAL APPROACHES
Secular Expansion as Basis. May the ownership of a carefully selected, diversified group of common stocks, purchased at reasonable prices, be characterized as a sound investment policy? An affirmative answer may be developed from any one of three different kinds of assumptions relating to the future of American business and the policy of selection that is followed. The first will posit that certain basic and long-established elements in this country’s economic experience may still be counted upon. These are (1) that our national wealth and earning power will increase, (2) that such increase will reflect itself in the increased resources and profits of our important corporations, and (3) that such increases will in the main take place through the normal process of investment of new capital and reinvestment of undistributed earnings. The third part of this assumption signifies that a broad causal connection exists between accumulating surplus and future earning power, so that common-stock selection is not a matter purely of chance or guesswork but should be governed by an analysis of past record |
itself in the increased resources and profits of our important corporations, and (3) that such increases will in the main take place through the normal process of investment of new capital and reinvestment of undistributed earnings. The third part of this assumption signifies that a broad causal connection exists between accumulating surplus and future earning power, so that common-stock selection is not a matter purely of chance or guesswork but should be governed by an analysis of past records in relation to cur- rent market prices.
If these fundamental conditions still obtain, then common stocks with suitable exhibits should on the whole present the same favorable oppor- tunities in the future as they have for generations past. The cardinal defect of instability may not be regarded, therefore, as menacing the long-range development of common stocks as a whole. It does indeed exert a pow- erful temporary effect upon all business through the variations of the eco- nomic cycle, and it has permanently adverse effects upon individual enterprises and single industries. But of these two dangers, the latter may be offset in part by careful selection and chiefly by wide diversification; the former may be guarded against by unvarying insistence upon the rea- sonableness of the price paid for each purchase.
They would be rash authors who would express themselves unequiv- ocably for or against this basic assumption that American business will develop in the future pretty much as in the past. In our Introduction we point out that the experience of the last fifteen years weighs against this
proposition. Without seeking to prophesy the future, may it not suffice to declare that the investor cannot safely rely upon a general growth of earnings to provide both safety and profit over the long pull? In this respect it would seem that we are back to the investor’s attitude in 1913— with the difference that his caution then seemed needlessly blind to the powerful evidences of secu |
he past. In our Introduction we point out that the experience of the last fifteen years weighs against this
proposition. Without seeking to prophesy the future, may it not suffice to declare that the investor cannot safely rely upon a general growth of earnings to provide both safety and profit over the long pull? In this respect it would seem that we are back to the investor’s attitude in 1913— with the difference that his caution then seemed needlessly blind to the powerful evidences of secular growth inherent in our economy. Our cau- tion today would appear, at least, to be based on bitter experience and on the recognition of some newer and less promising factors in the whole business picture.
Individual Growth as Basis of Selection. Those who would reject the suggestion that common-stock investment may be founded securely on a general secular expansion may be attracted to a second approach. This stresses the element of selectivity and is based on the premise that certain favored companies may be relied on to grow steadily. Hence such companies, when located, can be bought with confidence as long-term investments. This philosophy of investment is set forth at some length in the 1938 report of National Investors Corporation, an investment trust, from which we quote as follows:
The studies by this organization, directed specifically toward improved pro- cedure in selection, afford evidence that the common stocks of growth com- panies—that is, companies whose earnings move forward from cycle to cycle, and are only temporarily interrupted by periodic business depressions—offer the most effective medium of investment in the field of common stocks, either in terms of dividend return or longer term capital appreciation. We believe that this general conclusion can be demonstrated statistically and is supported by economic analysis and practical reasoning.
In considering this statement critically, we must start with the emphatic but rather obvious assertion that the inv |
forward from cycle to cycle, and are only temporarily interrupted by periodic business depressions—offer the most effective medium of investment in the field of common stocks, either in terms of dividend return or longer term capital appreciation. We believe that this general conclusion can be demonstrated statistically and is supported by economic analysis and practical reasoning.
In considering this statement critically, we must start with the emphatic but rather obvious assertion that the investor who can success- fully identify such “growth companies” when their shares are available at reasonable prices is certain to do superlatively well with his capital. Nor can it be denied that there have been investors capable of making such selections with a high degree of accuracy and that they have benefited hugely from their foresight and good judgment. But the real question is whether or not all careful and intelligent investors can follow this policy with fair success.
Three Aspects of the Problem. Actually the problem falls into three parts: First, what is meant by a “growth company”? Second, can the investor identify such concerns with reasonable accuracy? Third, to what extent does the price paid for such stocks affect the success of the program?
1. What Are Growth Companies? The National Investors Corporation discussion defined growth companies as those “whose earnings move for- ward from cycle to cycle.” How many cycles are needed to meet this def- inition? The fact of the matter seems to be that prior to 1930 a large proportion of all publicly owned American businesses grew from cycle to cycle. The distinguishing characteristic of growth companies, as now understood, developed only in the period between 1929 and 1936–1937. In this one cycle we find that most companies failed to regain their full depression losses. The minority that did so stand out from the rest, and it is these which are now given the complimentary title of “growth com- panies.” But since thi |
he matter seems to be that prior to 1930 a large proportion of all publicly owned American businesses grew from cycle to cycle. The distinguishing characteristic of growth companies, as now understood, developed only in the period between 1929 and 1936–1937. In this one cycle we find that most companies failed to regain their full depression losses. The minority that did so stand out from the rest, and it is these which are now given the complimentary title of “growth com- panies.” But since this distinction is in reality based on performance dur- ing a single cycle, how sure can the investor be that it will be maintained over the longer future?
It is true, from what we have previously said, that many of the com- panies that expanded from 1929 to 1937 had participated in the general record of growth prior to 1929, so that they combine the advantages of a long period of upbuilding and an exceptional ability to expand in the last decade. The following are examples of large and well-known companies of this class:
Air Reduction Monsanto Chemical
Allis Chalmers Owens-Illinois Glass
Coca-Cola J. C. Penney
Commercial Credit Procter & Gamble
Dow Chemical Sherwin-Williams Paint
Du Pont Standard Oil of New Jersey International Business Machines Scott Paper
International Nickel Union Carbide and Carbon Libbey-Owens-Ford
2. Can the Investor Identify Them? But our natural enthusiasm for such excellent records is tempered somewhat by a sobering considera- tion. This is the fact that, viewed historically, most successful companies
of the past are found to have pursued a well-defined life cycle, consisting first of a series of struggles and setbacks; second, of a halcyon period of prosperity and persistent growth; which in turn passes over into a final phase of supermaturity—characterized by a slackening of expansion and perhaps an actual loss of leadership or even profitability.1 It follows that a business that has enjoyed a very long period of increasing earnings may ipso facto |
d historically, most successful companies
of the past are found to have pursued a well-defined life cycle, consisting first of a series of struggles and setbacks; second, of a halcyon period of prosperity and persistent growth; which in turn passes over into a final phase of supermaturity—characterized by a slackening of expansion and perhaps an actual loss of leadership or even profitability.1 It follows that a business that has enjoyed a very long period of increasing earnings may ipso facto be nearing its own “saturation point.” Hence the seeker for growth stocks really faces a dilemma; for if he chooses newer companies with a short record of expansion, he runs the risk of being deceived by a temporary prosperity; and if he chooses enterprises that have advanced through several business cycles, he may find this apparent strength to be the harbinger of coming weakness.
We see, therefore, that the identification of a growth company is not so simple a matter as it may at first appear. It cannot be accomplished solely by an examination of the statistics and records but requires a con- siderable supplement of special investigation and of business judgment. Proponents of the growth-company principle of investment are wont cur- rently to lay great emphasis on the element of industrial research. In the absence of general business expansion, exceptional gains are likely to be made by companies supplying new products or processes. These in turn are likely to emerge from research laboratories. The profits realized from cellophane, ethyl gas and various plastics, and from advances in the arts of radio, photography, refrigeration, aeronautics, etc., have created a nat- ural enthusiasm for research as a business asset and a natural tendency to consider the possession of research facilities as the sine qua non of industrial progress.
Still here, too, caution is needed. If the mere ownership of a research laboratory could guarantee a successful future, every company in the lan |
aboratories. The profits realized from cellophane, ethyl gas and various plastics, and from advances in the arts of radio, photography, refrigeration, aeronautics, etc., have created a nat- ural enthusiasm for research as a business asset and a natural tendency to consider the possession of research facilities as the sine qua non of industrial progress.
Still here, too, caution is needed. If the mere ownership of a research laboratory could guarantee a successful future, every company in the land would have one. Hence, the investor must pay heed to the kind of facili- ties owned, the abilities of the researchers and the potentialities of the field under investigation. It is not impossible to study these points suc- cessfully, but the task is not easy, and the chance of error is great.
3. Does the Price Discount Potential Growth? The third source of dif- ficulty is perhaps the greatest. Assuming a fair degree of confidence on
1 This characteristic pattern of successful enterprise is discussed at length in the 1938 report of National Investors Corporation, pp. 4–6.
the part of the investor that the company will expand in the future, what price is he justified in paying for this attractive element? Obviously, if he can get a good future for nothing, i.e., if the price reflects only the past record, he is making a sound investment. But this is not the case, of course, if the market itself is counting on future growth. Characteristically, stocks thought to have good prospects sell at relatively high prices. How can the investor tell whether or not the price is too high? We think that there is no good answer to this question—in fact we are inclined to think that even if one knew for a certainty just what a company is fated to earn over a long period of years, it would still be impossible to tell what is a fair price to pay for it today. It follows that once the investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risk; vi |
ell at relatively high prices. How can the investor tell whether or not the price is too high? We think that there is no good answer to this question—in fact we are inclined to think that even if one knew for a certainty just what a company is fated to earn over a long period of years, it would still be impossible to tell what is a fair price to pay for it today. It follows that once the investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risk; viz., that the growth will be less than he anticipates, that over the long pull he will have paid too much for what he gets, that for a considerable period the market will value the stock less optimistically than he does.
On the other hand, assume that the investor strives to avoid paying a high premium for future prospects by choosing companies about which he is personally optimistic, although they are not favorites of the stock market. No doubt this is the type of judgment that, if sound, will prove most remunerative. But, by the very nature of the case, it must represent the activity of strong-minded and daring individuals rather than invest- ment in accordance with accepted rules and standards.2
May Such Purchases Be Described as Investment Commitments? This has been a longish discussion because the subject is important and not too well comprehended in Wall Street. Our emphasis has been laid more on the pitfalls of investing for future growth than on its advantages. But we repeat that this method may be followed successfully if it is pursued with skill, intelligence and diligent study. If so, is it appropriate to call such purchases by the name of “investment”? Our answer is “yes,” provided that two factors are present: the first, already mentioned, that the elements affecting the future are examined with real care and a wholesome
2 The “expanding-industry” criterion of common-stock investment is vigorously champi- oned in an arresting book The Ebb and Flow of Investment V |
t this method may be followed successfully if it is pursued with skill, intelligence and diligent study. If so, is it appropriate to call such purchases by the name of “investment”? Our answer is “yes,” provided that two factors are present: the first, already mentioned, that the elements affecting the future are examined with real care and a wholesome
2 The “expanding-industry” criterion of common-stock investment is vigorously champi- oned in an arresting book The Ebb and Flow of Investment Values, New York, 1939, by Edward S. Mead and J. Grodinsky. For a consideration of their views in some detail see Appendix Note 71, p. 845 on accompanying CD.
scepticism, rather than accepted quickly via some easy generalization; the second, that the price paid be not substantially different from what a pru- dent business man would be willing to pay for a similar opportunity pre- sented to him to invest in a private undertaking over which he could exercise control.
We believe that the second criterion will supply a useful touchstone to determine whether the buyer is making a well-considered and legiti- mate commitment in an enterprise with an attractive future, or instead, under the guise of “investment,” he is really taking a flier in a popular stock or else letting his private enthusiasm run away with his judgment. It will be argued, perhaps, that common-stock investments such as we have been discussing may properly be made at a considerably higher price than would be justified in the case of a private business, first, because of the great advantage of marketability that attaches to listed stocks and, second, because the large size and financial power of publicly owned com- panies make them inherently more attractive than any private enterprise could be. As to the second point, the price to be paid should suitably reflect any advantages accruing by reason of size and financial strength, but this criterion does not really depend on whether the company is publicly or private |
he case of a private business, first, because of the great advantage of marketability that attaches to listed stocks and, second, because the large size and financial power of publicly owned com- panies make them inherently more attractive than any private enterprise could be. As to the second point, the price to be paid should suitably reflect any advantages accruing by reason of size and financial strength, but this criterion does not really depend on whether the company is publicly or privately owned. On the first point, there is room for some difference of opinion whether or not the ability to control a private business affords a full counterweight (in value analysis) to the advantage of marketability enjoyed by a listed stock. To those who believe marketability is more valu- able than control, we might suggest that in any event the premium to be paid for this advantage cannot well be placed above, say, 20% of the value otherwise justified without danger of introducing a definitely speculative
element into the picture.
Selection Based on Margin-of-safety Principle. The third approach to common-stock investment is based on the margin-of-safety principle. If the analyst is convinced that a stock is worth more than he pays for it, and if he is reasonably optimistic as to the company’s future, he would regard the issue as a suitable component of a group investment in common stocks. This attack on the problem lends itself to two possi- ble techniques. One is to buy at times when the general market is low, measured by quantitative standards of value. Presumably the purchases would then be confined to representative and fairly active issues. The
other technique would be employed to discover undervalued individual common stocks, which presumably are available even when the general market is not particularly low. In either case the “margin of safety” resides in the discount at which the stock is selling below its minimum intrinsic value, as measured by the analyst. But |
en the general market is low, measured by quantitative standards of value. Presumably the purchases would then be confined to representative and fairly active issues. The
other technique would be employed to discover undervalued individual common stocks, which presumably are available even when the general market is not particularly low. In either case the “margin of safety” resides in the discount at which the stock is selling below its minimum intrinsic value, as measured by the analyst. But with respect to the hazards and the psychological factors involved, the two approaches differ considerably. Let us discuss them in their order.
Factors Complicating Efforts to Exploit General Market Swings. A glance at the chart on page 6, showing the fluctuations of common-stock prices since 1900, would suggest that prices are recurrently too high and too low and that consequently there should be repeated opportunities to buy stocks at less than their value and to sell them out later at fair value or higher. A crude method of doing this—but one apparently encouraged by the chart itself—would consist simply of drawing a straight line through the approximate midpoints of past market swings and then planning to buy somewhere below this line and to sell some- where above it.
Perhaps such a “system” would be as practical as any, but the analyst is likely to insist on a more scientific approach. One possible refinement would operate as follows:
1. Select a diversified list of leading industrial common stocks.
2. Determine a base or “normal” value for the group by capitalizing their average earnings at some suitable figure, related to the going long- term interest rate.
3. Determine a buying point at some percentage below this normal value and a selling point above it. (Or buying and selling may be done “on a scale down” and “on a scale up.”)
A method of this kind has plausible logic to recommend it, and it is favored also by an age-old tradition that success in the stock market i |
trial common stocks.
2. Determine a base or “normal” value for the group by capitalizing their average earnings at some suitable figure, related to the going long- term interest rate.
3. Determine a buying point at some percentage below this normal value and a selling point above it. (Or buying and selling may be done “on a scale down” and “on a scale up.”)
A method of this kind has plausible logic to recommend it, and it is favored also by an age-old tradition that success in the stock market is gained by buying at depressed levels and selling out when the public is optimistic. But the reader will suspect at once that there is a catch to it somewhere. What are its drawbacks?
As we see it, the difficulties attending this idea are threefold: First, although the general pattern of the market’s behavior may be properly anticipated, the specific buying and selling points may turn out to have been badly chosen, and the operator may miss his opportunity at one extreme or the other. Second, there is always a chance that the character
of the market’s behavior may change significantly, so that a scheme of operation that would have worked well in the past will cease to be prac- ticable. Third, the method itself requires a considerable amount of human fortitude. It generally involves buying and selling when the prevalent psy- chology favors the opposite course, watching one’s shares go lower after purchase and higher after sale and often staying out of the market for long periods (e.g., 1927–1930) when most people are actively interested in stocks. But despite these disadvantages, which we do not minimize, it is our view that this method has a good deal to commend it to those tem- peramentally qualified to follow it.
The Undervalued-individual-issue Approach. The other application of the principle of investing in undervalued common stocks is directed at individual issues, which upon analysis appear to be worth substantially more than they are selling for. It is rare that a c |
., 1927–1930) when most people are actively interested in stocks. But despite these disadvantages, which we do not minimize, it is our view that this method has a good deal to commend it to those tem- peramentally qualified to follow it.
The Undervalued-individual-issue Approach. The other application of the principle of investing in undervalued common stocks is directed at individual issues, which upon analysis appear to be worth substantially more than they are selling for. It is rare that a common stock will appear satisfactory from every qualitative angle and at the same time will be found to be selling at a low price by such quantitative standards as earn- ings, dividends, and assets. Issues of this type would undoubtedly be eli- gible for a group purchase that would fulfill our supplementary criterion of “investment” given in Chap. 4. (“An investment operation is one that can be justified on both qualitative and quantitative grounds.”)
Of more practical importance is the question whether or not invest- ment can be successfully carried on in common stocks that appear cheap from the quantitative angle and that—upon study—seem to have average prospects for the future. Securities of this type can be found in reasonable abundance, as a result of the stock market’s obsession with companies con- sidered to have unusually good prospects of growth. Because of this empha- sis on the growth factor, quite a number of enterprises that are long established, well financed, important in their industries and presumably destined to stay in business and make profits indefinitely in the future, but that have no speculative or growth appeal, tend to be discriminated against by the stock market—especially in years of subnormal profits—and to sell for considerably less than the business would be worth to a private owner.3
3 Note that we have applied the touchstone of “value to a private investor” to justify two differ- ent types of investment in common stocks: (1) purchase of issue |
n their industries and presumably destined to stay in business and make profits indefinitely in the future, but that have no speculative or growth appeal, tend to be discriminated against by the stock market—especially in years of subnormal profits—and to sell for considerably less than the business would be worth to a private owner.3
3 Note that we have applied the touchstone of “value to a private investor” to justify two differ- ent types of investment in common stocks: (1) purchase of issues thought to have exceptional prospects at no higher price than would be paid for a corresponding interest in a private busi- ness, and (2) purchase of issues with good records and average prospects at a much lower price than the business is worth to a private owner. See Appendix Note 45, p. 778 on accompanying CD, for the exhibit of an issue of the latter type (Swift and Company).
We incline strongly to the belief that this last criterion—a price far less than value to a private owner—will constitute a sound touchstone for the discovery of true investment opportunities in common stocks. This view runs counter to the convictions and practice of most people seeking to invest in equities, including practically all the investment trusts. Their emphasis is mainly on long-term growth, prospects for the next year, or the indicated trend of the stock market itself. Undoubtedly any of these three viewpoints may be followed successfully by those especially well equipped by experience and native ability to exploit them. But we are not so sure that any of these approaches can be developed into a system or technique that can be confidently followed by everyone of sound intelli- gence who has studied it with care. Hence we must raise our solitary voice against the use of the term investment to characterize these methods of operating in common stocks, however profitable they may be to the truly skillful. Trading in the market, forecasting next year’s results for various businesses, selec |
ve ability to exploit them. But we are not so sure that any of these approaches can be developed into a system or technique that can be confidently followed by everyone of sound intelli- gence who has studied it with care. Hence we must raise our solitary voice against the use of the term investment to characterize these methods of operating in common stocks, however profitable they may be to the truly skillful. Trading in the market, forecasting next year’s results for various businesses, selecting the best media for long-term expansion—all these have a useful place in Wall Street. But we think that the interests of investors and of Wall Street as an institution would be better served if operations based primarily on these factors were called by some other name than investment.
Whether or not our own concept of common-stock investment is a valid one may be more intelligently considered after we have given extended treatment to the chief factors that enter into a statistical analy- sis of a stock issue. The need for such analysis is quite independent of our investment philosophy. After all, common stocks exist and are actively dealt in by the public. Those who buy and sell will properly seek to arm themselves with an adequate knowledge of financial practice and with the tools and technique necessary for an intelligent analysis of corporate statements.
Such information and equipment for the common-stock investor form the subject matter of the following chapters.
Chapter 29
THE DIVIDEND FACTOR IN COMMON-
STOCK ANALYSIS
A NATURAL classification of the elements entering into the valuation of a common stock would be under the three headings:
1. The dividend rate and record.
2. Income-account factors (earning power).
3. Balance-sheet factors (asset value).
The dividend rate is a simple fact and requires no analysis, but its exact significance is exceedingly difficult to appraise. From one point of view the dividend rate is all-important, but from another and equally |
HE DIVIDEND FACTOR IN COMMON-
STOCK ANALYSIS
A NATURAL classification of the elements entering into the valuation of a common stock would be under the three headings:
1. The dividend rate and record.
2. Income-account factors (earning power).
3. Balance-sheet factors (asset value).
The dividend rate is a simple fact and requires no analysis, but its exact significance is exceedingly difficult to appraise. From one point of view the dividend rate is all-important, but from another and equally valid standpoint it must be considered an accidental and minor factor. A basic confusion has grown up in the minds of managements and stockholders alike as to what constitutes a proper dividend policy. The result has been to create a definite conflict between two aspects of common-stock own- ership: one being the possession of a marketable security, and the other being the assumption of a partnership interest in a business. Let us consider the matter in detail from this twofold approach.
Dividend Return as a Factor in Common-stock Investment. Until recent years the dividend return was the overshadowing factor in common-stock investment. This point of view was based on simple logic. The prime purpose of a business corporation is to pay dividends to its owners. A successful company is one that can pay dividends regularly and presumably increase the rate as time goes on. Since the idea of investment is closely bound up with that of dependable income, it follows that invest- ment in common stocks would ordinarily be confined to those with a well-established dividend. It would follow also that the price paid for an investment common stock would be determined chiefly by the amount of the dividend.
[376]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
We have seen that the traditional common-stock investor sought to place himself as nearly as possible in the position of an investor in a bond or a preferred stock. He |
n stocks would ordinarily be confined to those with a well-established dividend. It would follow also that the price paid for an investment common stock would be determined chiefly by the amount of the dividend.
[376]
Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use.
We have seen that the traditional common-stock investor sought to place himself as nearly as possible in the position of an investor in a bond or a preferred stock. He aimed primarily at a steady income return, which in general would be both somewhat larger and somewhat less certain than that provided by good senior securities. Excellent illustrations of the effect of this attitude upon the price of common stocks are afforded by the records of the earnings, dividends and annual price variations of American Sugar Refining between 1907 and 1913 and of Atchison, Topeka, and Santa Fe Railway between 1916 and 1925 presented herewith.
AMERICAN SUGAR REFINING COMPANY
Year Range for stock Earned per share Paid per share
1907 138–93 $10.22 $7.00
1908 138–99 7.45 7.00
1909 136–115 14.20 7.00
1910 128–112 5.38 7.00
1911 123–113 18.92 7.00
1912 134–114 5.34 7.00
1913 118–100 0.02(d) 7.00
ATCHISON, TOPEKA, AND SANTA FE RAILWAY COMPANY
Year Range for stock Earned per share Paid per share
1916 109–100 $14.74 $6
1917 108–75 14.50 6
1918 100–81 10.59* 6
1919 104–81 15.41* 6
1920 90–76 12.54* 6
1921 94–76 14.69† 6
1922 109–92 12.41 6
1923 105–94 15.48 6
1924 121–97 15.47 6
1925 141–116 17.19 7
* Results for these years based on actual operations. Results of federal operation were: 1918—$9.98; 1919—$16.55; 1920—$13.98.
† Includes nonrecurrent income. Excluding the latter the figure for 1921 would have been $11.29.
The market range of both issues is surprisingly narrow, considering the continuous gyrations of the stock market generally during those peri- ods. The most striking feature of the exhibit is the slight influence exer- cised both by the irregula |
15.47 6
1925 141–116 17.19 7
* Results for these years based on actual operations. Results of federal operation were: 1918—$9.98; 1919—$16.55; 1920—$13.98.
† Includes nonrecurrent income. Excluding the latter the figure for 1921 would have been $11.29.
The market range of both issues is surprisingly narrow, considering the continuous gyrations of the stock market generally during those peri- ods. The most striking feature of the exhibit is the slight influence exer- cised both by the irregular earnings of American Sugar and by the exceptionally well-maintained and increasing earning power on the part of Atchison. It is clear that the price of American Sugar was dominated throughout by its $7 rate and that of Atchison by its $6 rate, even though the earnings records would apparently have justified an entirely different range of relative market values.
Established Principle of Withholding Dividends. We have, there- fore, on the one hand an ingrained and powerfully motivated tradition which centers investment interest upon the present and past dividend rate. But on the other hand we have an equally authoritative and well- established principle of corporate management which subordinates the current dividend to the future welfare of the company and its sharehold- ers. It is considered proper managerial policy to withhold current earn- ings from stockholders, for the sake of any of the following advantages:
1. To strengthen the financial (working-capital) position.
2. To increase productive capacity.
3. To eliminate an original overcapitalization.
When a management withholds and reinvests profits, thus building up an accumulated surplus, it claims confidently to be acting for the best interests of the shareholders. For by this policy the continuance of the established dividend rate is undoubtedly better assured, and furthermore a gradual but continuous increase in the regular payment is thereby made possible. The rank and file of stockholders will give such policies th |
e productive capacity.
3. To eliminate an original overcapitalization.
When a management withholds and reinvests profits, thus building up an accumulated surplus, it claims confidently to be acting for the best interests of the shareholders. For by this policy the continuance of the established dividend rate is undoubtedly better assured, and furthermore a gradual but continuous increase in the regular payment is thereby made possible. The rank and file of stockholders will give such policies their support, either because they are individually convinced that this proce- dure redounds to their advantage or because they accept uncritically the authority of the managements and bankers who recommend it.
But this approval by stockholders of what is called a “conservative div- idend policy” has about it a peculiar element of the perfunctory and even the reluctant. The typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself. No instances are on record in which the withholding of dividends for the sake of future prof- its has been hailed with such enthusiasm as to advance the price of the
stock. The direct opposite has invariably been true. Given two companies in the same general position and with the same earning power, the one pay- ing the larger dividend will always sell at the higher price.
Policy of Withholding Dividends Questionable. This is an arresting fact, and it should serve to call into question the traditional theory of corpo- rate finance that the smaller the percentage of earnings paid out in divi- dends the better for the company and its stockholders. Although investors have been taught to pay lip service to this theory, their instincts—and per- haps their better judgment—are in revolt against it. If we try to bring a fresh and critical viewpoint to bear upon this subject, we shall find that weighty objections may be leveled against the accepted dividend policy of American corporations.
Examining this po |
of corpo- rate finance that the smaller the percentage of earnings paid out in divi- dends the better for the company and its stockholders. Although investors have been taught to pay lip service to this theory, their instincts—and per- haps their better judgment—are in revolt against it. If we try to bring a fresh and critical viewpoint to bear upon this subject, we shall find that weighty objections may be leveled against the accepted dividend policy of American corporations.
Examining this policy more closely, we see that it rests upon two quite distinct assumptions. The first is that it is advantageous to the stockhold- ers to leave a substantial part of the annual earnings in the business; the second is that it is desirable to maintain a steady dividend rate in the face of fluctuations in profits. As to the second point, there would be no ques- tion at all, provided the dividend stability is achieved without too great sacrifice in the amount of the dividend. Assume that the earnings vary between $5 and $15 annually over a period of years, averaging $10. No doubt the stockholder’s advantage would be best served by maintaining a stable dividend rate of $8, sometimes drawing upon the surplus to maintain it, but on the average increasing the surplus at the rate of $2 per share annually.
This would be an ideal arrangement. But in practice it is rarely fol- lowed. We find that stability of dividends is usually accomplished by the simple expedient of paying out a small part of the average earnings. By a reductio ad absurdum it is clear that any company that earned $10 per share on the average could readily stabilize its dividend at $1. The ques- tion arises very properly if the shareholders might not prefer a much larger aggregate dividend, even with some irregularity. This point is well illustrated in the case of Atchison.
The Case of Atchison. Atchison maintained its dividend at the annual rate of $6 for the 15 years between 1910 and 1924. During this time the avera |
the average earnings. By a reductio ad absurdum it is clear that any company that earned $10 per share on the average could readily stabilize its dividend at $1. The ques- tion arises very properly if the shareholders might not prefer a much larger aggregate dividend, even with some irregularity. This point is well illustrated in the case of Atchison.
The Case of Atchison. Atchison maintained its dividend at the annual rate of $6 for the 15 years between 1910 and 1924. During this time the average earnings were in excess of $12 per share, so that the stability was attained by withholding over half the earnings from the stockholders. Eventually this policy bore fruit in an advance of the dividend to $10,
which rate was paid between 1927 and 1931, and was accompanied by a rise in the market price to nearly $300 per share in 1929. Within six months after the last payment at the $10 rate (in December 1931) the dividend was omitted entirely. Viewed critically, the stability of the Atchi- son dividend between 1910 and 1924 must be considered as of dubious benefit to the stockholders. During its continuance they received an unduly small return in relation to the earnings; when the rate was finally advanced, the importance attached to such a move promoted excessive speculation in the shares; finally, the reinvestment of the enormous sums out of earnings failed to protect the shareholders from a complete loss of income in 1932. Allowance must be made, of course, for the unprece- dented character of the depression in 1932. But the fact remains that the actual operating losses in dollars per share up to the passing of the divi- dend were entirely insignificant in comparison with the surplus accumu- lated out of the profits of previous years.
United States Steel, Another Example. The Atchison case illustrates the two major objections to what is characterized and generally approved of as a “conservative dividend policy.” The first objection is that stock- holders receive both |
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