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Title: How to Invest Money

Author: George Garr Henry

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Language: English

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*** START OF THE PROJECT GUTENBERG EBOOK HOW TO
INVEST MONEY ***

HOW TO INVEST
MONEY
BY

GEORGE GARR HENRY
Vice-President Guaranty Trust Company, of New York.

FUNK & WAGNALLS COMPANY

NEW YORK AND LONDON
1908

Copyright, 1908, by

FUNK & WAGNALLS COMPANY
[Printed in the United States of America]
Published April, 1908

CONTENTS
CHAPTER PAGE
I. General Principles of 7
Investment
II. Railroad Mortgage 23
Bonds
III. Railroad Equipment 40
Bonds
IV. Real-Estate Mortgages 51
V. Industrial Bonds 63
VI. Public-Utility Bonds 76
VII. Municipal Bonds 91
VIII. Stocks 100
IX. Market Movements of 108
Securities

PREFACE
The aim of this book is to present in clear form the simple principles of
investment, and to afford the reader a working knowledge of the various
classes of securities which are available as investments and their relative
adaptability to different needs. The book is an outgrowth of the writer's
personal experience as an investment banker. Most of the matter which is
presented has appeared in the pages of "System" Magazine, through the
courtesy of whose editors it is now rearranged and consolidated for
publication in book form.
G. G. H.

HOW TO INVEST MONEY

I
GENERAL PRINCIPLES OF INVESTMENT

With the immense increase in wealth in the United States during the last
decade and its more general distribution, the problem of investment has
assumed correspondingly greater importance. As long as the average
business man was an habitual borrower of money and possest no private
fortune outside of his interest in his business, he was not greatly concerned
with investment problems. The surplus wealth of the country for a long time
was in the hands of financial institutions and a few wealthy capitalists.
These men, the officers and directors of banks, savings-banks, and
insurance companies, and the possessors of hereditary wealth, were
thoroughly equipped by training and experience for the solving of
investment problems and needed no help in the disposition of the funds
under their control. During the last ten years, however, these conditions
have been greatly altered. The number of business men to-day in possession
of funds in excess of their private wants and business requirements is far
greater than it was ten years ago, and is constantly increasing. These men
are confronted with a real investment problem.
While they have not always recognized it, the problem which they are
called upon to solve is really twofold—it concerns the safeguarding of their
private fortune and the wise disposition of their business surplus. They have
usually seen the first part of this problem, but not all have succeeded in
clearly understanding the second. When the treatment of a man's business
surplus is spoken of as an investment problem, it is meant, of course, not his
working capital, which should be kept in liquid form for immediate needs,
but that portion of his surplus which is set aside for emergencies. It is
coming to be a recognized principle that every business enterprise of
whatever kind or size should establish a reserve fund. It is felt that the
possession of a reserve fund puts the business upon a secure foundation,
adds to its financial strength and reputation, and greatly increases its credit
and borrowing capacity. The recognition of this fact, combined with the
ability to set aside a reserve fund, has brought many men to a consideration

of the best way in which to dispose of it. It is obviously a waste of income
to have the surplus in bank-accounts; more than that, there would be a
constant temptation to use it and to confuse it with working capital. Its best
disposition is plainly in some safe interest-bearing security, which can be
readily sold, so that it will be available for use if necessity demands.
Confronted with the double problem thus outlined, what measure of success
has attended the average business man in its solution?
It is safe to say that the average man has found it easier to make money than
to take care of it. Money-making, for him, is the result of successful activity
in his own line of business, with which he is thoroughly familiar; while the
investment of money is a thing apart from his business, with which he is not
familiar, and of which he may have had little practical experience. His
failure to invest money wisely is not due to any want of intelligence or of
proper care and foresight on his part, as he sometimes seems to believe, but
simply because he is ignorant of the principles of a business which differs
radically from his own.
The investment of money is a banker's business. When the average man has
funds to invest, whether he be a business man or a pure investor, he should
consult some experienced and reliable investment banker just as he would
consult a doctor or a lawyer if he were in need of medical or legal advice.
This book is not intended to take the place of consultation with a banker,
but to supplement it.
The advantage of such consultation is shown by the fact that if a man
attempts to rely on his own judgment, he is almost certain not to do the best
thing, even if his business instinct leads him to avoid those enterprises
which are more plainly unpromising or fraudulent. It should be
remembered, however, that widows and orphans are not the only ones
ensnared by attractive advertisements and the promise of brilliant returns. In
most cases, widows' and orphans' funds are protected by conscientious and
conservative trustees, and it is the average business man who furnishes the
money which is ultimately lost in all propositions which violate the
fundamental laws of investment.
The average man is led into these unwise investments through a very
natural error of judgment. Accustomed to take reasonable chances and to

make large returns in his own business, he fails to detect anything
fundamentally wrong in a proposition simply because it promises to pay
well. He forgets that the rate of interest on invested money, or pure interest,
is very small, and that anything above that can only come as payment for
management, as he makes in his own business, or at the sacrifice of some
essential factor of safety which will usually lead to disaster.
For the successful investment of money, however, a good deal more is
required than the mere ability to select a safe security. That is only one
phase of the problem. Scientific investment demands a clear understanding
of the fundamental distinctions between different classes of securities and
strict adherence to the two cardinal principles, distribution of risk and
selection of securities in accordance with real requirements.
One of the most important distinctions is that between promises to pay and
equities. Bonds, real-estate mortgages, and loans on collateral represent
somebody's promise to pay a certain sum of money at a future date; and if
the promise be good and the security ample, the holder of the promise will
be paid the money at the time due. On the other hand, equities, such as the
capital stocks of banking, railway, and industrial corporations, represent
only a certain residuary share in the assets and profits of a working concern,
after payment of its obligations and fixt charges. The value of this residuary
share may be large or small, may increase or diminish, but in no case can
the holder of such a share require any one, least of all the company itself, to
redeem the certificate representing his interest at the price he paid for it, nor
indeed at any price. If a man buys a $1,000 railroad bond, he knows that the
railroad, if solvent, will pay him $1,000 in cash when the bond is due. But if
he buys a share of railroad stock, his only chance of getting his money
back, if he should wish it, is that some one else will want to buy his share
for what he paid for it, or more. In one case he has bought a promise to pay,
and in the other an equity.
It is not the intention, from the foregoing, to draw the conclusion that
equities under no circumstances are to be regarded as investments, because
many of our bank and railroad stocks, and even some of our public-utility
and industrial stocks, have attained a stability and permanence of value and
possess sufficiently long dividend records to justify their consideration

when investments are contemplated; but it is essential that the investor
should have a thorough understanding of the distinction involved.
The principle of distribution of risk is a simple one. It involves no more
than obedience to the old rule which forbids putting all one's eggs in the
same basket. The number of men who carry out this principle with any
thoroughness, however, is very small. Proper distribution means not only
the division of property among the various forms of investment, as railroad
bonds, municipals, mortgages, public-utility bonds, etc., but also the
preservation of proper geographical proportions within each form.
Adherence to this principle is perhaps not so important for private investors
as for institutions. A striking instance of the need for insistence upon its
observance in the institutional field was furnished by one of the fire-
insurance companies of San Francisco after the earthquake. It appeared that
the company's assets were largely invested in San Francisco real estate and
in local enterprises generally, where the bulk of its fire risks were
concentrated. As a result, the very catastrophe which converted its risks into
actual liabilities deprived its assets of all immediate value. This instance
serves to show the importance of the principle and the necessity for its
observance.
The principle of selection in accordance with real requirements is more
complex. It involves a thorough understanding of the chief points which
must be considered in the selection of all investments. These are five in
number: (1) Safety of principal and interest, or the assurance of receiving
the principal and interest on the dates due; (2) rate of income, or the net
return which is realized on the actual amount of money invested; (3)
convertibility into cash, or the readiness with which it is possible to realize
on the investment; (4) prospect of appreciation in value, or that growth in
intrinsic value which tends to advance market price; and (5) stability of
market price, or the likelihood of maintaining the integrity of the principal
invested.
The five qualities above enumerated are present in different degrees in
every investment, and the scientific investor naturally selects those
securities which possess in a high degree the qualities upon which he
wishes to place emphasis. A large part of the problem of investment lies in
the careful selection of securities to meet one's actual requirements. The

average investor does not thoroughly understand this point. He does not
realize that a high degree of one quality involves a lower degree of other
qualities. He may have a general impression that a high rate of income is
apt to indicate less assurance of safety, but he rarely applies the same
reasoning to other qualities. When he buys securities, he is quite likely to
pay for qualities which he does not need. It is very common, for example,
when he wishes to make a permanent investment and has no thought of
reselling, to find him purchasing securities which possess in a high degree
the quality of convertibility. From his point of view, this is pure waste. A
high degree of convertibility is only obtained at the sacrifice of some other
quality—usually rate of income. If he were to use more care in his
selections, he could probably find some other security possessing equal
safety, equal stability, and equal promise of appreciation in value, which
would yield considerably greater revenue, lacking only ready convertibility.
Thus he would satisfy his real requirements and obtain a greater income, at
the expense only of a quality which he does not need.
The quality of convertibility divides investors into classes more sharply
than any other quality. For some investors convertibility is a matter of small
importance; for others it is the paramount consideration. Generally
speaking, the private investor does not need to place much emphasis upon
the quality of convertibility, at least for the larger part of his estate. On the
other hand, for a business surplus, ready convertibility is an absolute
necessity, and in order to secure it, something in the way of income must
usually be sacrificed.
Again, some investors are so situated that they can insist strongly upon
promise of appreciation in value, while others can not afford to do so. Rich
men whose income is in excess of their wants, can afford to forego
something in the way of yearly return for the sake of a strong prospect of
appreciation in value. Such men naturally buy bank and trust-company
stocks, whose general characteristic is a small return upon the money
invested, but a strong likelihood of appreciation in value. This is owing to
the general practise of well-regulated banks to distribute only about half
their earnings in dividends and to credit the rest to surplus, thus insuring a
steady rise in the book value of the stock. Rich men, again, can afford to
take chances with the quality of safety, for the sake of greater income, in a
way which poor men should never do. In practise, however, if the writer's

observation can be depended upon, it is usually the poor men who take the
chances—and lose their money.
In the quality of safety, there is a marked difference between safety of
principal and safety of interest. With some investments the principal is
much safer than the interest, and vice versa. This can best be illustrated by
examples. The bonds of terminal companies, which are guaranteed as to
interest, under the terms of a lease, by the railroads which use the terminal,
are usually far safer as to interest than as to principal. While the lease lasts,
the interest is probably perfectly secure, but when the lease expires and the
bonds mature, the railroads may see fit to abandon the terminal and build
one elsewhere, if the city has grown in another direction, and the terminal
may cease to have any value except as real estate. On the other hand, a new
railroad, built in a thinly settled but rapidly growing part of the country,
may have difficulty in bad years in meeting its interest charges, and may
even go into temporary default, but if the bonds are issued at a low rate per
mile and the management of the road is honest and capable, the safety of
the principal can scarcely be questioned.
Stability of market price is frequently a consideration of great importance.
This quality should never be confused with the quality of safety. Safety
means the assurance that the maker of the obligation will pay principal and
interest when due; stability of market price means that the investment shall
not shrink in quoted value. These are very different things, tho frequently
identified in people's minds. An investment may possess assured safety of
principal and interest and yet suffer a violent decline in quoted price, owing
to a change in general business and financial conditions. In times of
continued business prosperity very high rates are demanded for the use of
money, because the liquid capital of the country, to a large extent, has been
converted into fixt forms, in the development of new mines, the building of
new factories and railroads, and in the improvement and extension of
existing properties. These high rates have the effect of reducing the price
level of investment securities because people having such securities are apt
to sell them in order to lend the money so released, thus maintaining the
parity between the yields upon free and invested capital.
As an illustration of this tendency, within the last few years New York City
3½-per-cent bonds have declined from 110 to 90, without the slightest

suspicion of their safety. Their inherent qualities have changed in no respect
except that their prospect of appreciation in quoted price has become
decidedly brighter. Their fall in price has been due to two factors, one
general and the other special—first, the absorption of liquid capital and
consequent rise in interest rates, occasioned by the unprecedented business
activity of the country, and, second, to the unfavorable technical position of
the bonds, due to an increased supply in the face of a decreased demand.
It will be seen that the question of maintaining the integrity of the money
invested is a matter of great importance and deserves to rank as a fifth
factor in determining the selection of investments, altho it is not an inherent
quality of each investment, but is dependent for its effect upon general
conditions. If it is essential to the investor that his security should not shrink
in quoted price, his best investment is a real-estate mortgage, which is not
quoted and consequently does not fluctate. For the investment of a business
surplus, however, where a high degree of convertibility is required, real-
estate mortgages will not answer, and the best way to guard against
shrinkage is to purchase a short-term security, whose approach to maturity
will maintain the price close to par.
The foregoing comments, in a brief and imperfect way, serve to indicate the
main points which should be considered in the selection of securities for
investment. The considerations advanced will be amplified as occasion
demands in the following pages. For the present, the main lesson which it is
sought to draw is the necessity that a man should have a thorough
understanding of his real requirements before he attempts to make
investments. For a private investor to go to a banker and ask him to suggest
a security to him without telling him the exact nature of his wants is about
as foolish as it would be for a patient to go to a physician and ask him to
give him some medicine without telling him the symptoms of the trouble
which he wished cured. In neither case can the adviser act intelligently
unless he knows what end he is seeking to accomplish.
It is plainly impossible within the limits of a small volume to consider the
needs of all classes of investors. Special attention will be paid to the
requirements of a business surplus and of the private investor. In the field of
private investment two distinct classes can be recognized—those who are
dependent upon income from investments and those who are not. Both

classes will be considered. For the investment of a business surplus, safety,
convertibility, and stability of price are the qualities to be emphasized; for
investors dependent upon income, safety and a high return; and for those
not dependent upon income, a high return and prospect of appreciation in
value. In the following chapters railroad bonds, real-estate mortgages,
industrial, public-utility, and municipal bonds and stocks will be considered
in turn; their advantages and disadvantages will be analyzed in accordance
with the determining qualities above enumerated, and their adaptability to
the requirements of a business surplus and of private investment will be
discust.

II
RAILROAD MORTGAGE BONDS

A railroad bond is an obligation of a railroad company (usually secured by
mortgage upon railroad property) which runs for a certain length of time at
a certain rate of interest. It is apparent, from this definition, that the price of
a railroad bond, as distinct from its value, is affected by two accidental
conditions quite apart from the five determining qualities described in the
preceding chapter.
These accidental conditions are the length of time that the bond has to run
and the rate of interest that it bears. To understand clearly the influence of
these accidental conditions is a matter of the utmost importance. It is
evident, for instance, that a 5-per-cent fifty-year bond, based on a given
security, will sell at a widely different price from a 3½-per-cent twenty-year
bond, based on the same security; yet the only difference is in the accidental
conditions which are under the control of the board of directors.
In order to eliminate these accidental features from the situation, it is
customary for bond-dealers to classify bonds purely on the basis of their
yield, or net income return. As a thorough understanding of this point is
essential to an accurate judgment of bond values, whether railroad bonds or
otherwise, it must be developed in detail, even at the risk of carrying the
reader over familiar ground.
If a bond sells above par, it does not yield its purchaser a net return as great
as the rate of interest which the bond bears, for two reasons: first, because
the loss in principal, represented by the premium which the purchaser pays,
must be distributed over the number of years which the bond has to run, and
operates to reduce the rate of interest which the holder receives; and,
secondly, because the rate is paid only on the par value of the bond instead
of on the actual money invested. Thus, if a 6-percent bond with eight years
to run sells at 110¾, it will yield only 4.40 per cent, which means that if the
holder spends more than $48.73 (4.40 per cent of $1,107.50) out of the $60

which he receives annually, he is spending the excess out of principal, and
not out of income. Conversely, if a bond sells below par, it yields more than
the rate of interest which the bond bears.
These yields have been calculated with the utmost exactness for all bonds
paying from 2 per cent to 7 per cent and running from six months to one
hundred years, so that it is only necessary to turn to the tables to discover
what will be the net return upon a given bond at a given price. This net
return is generally known as the "basis," and bonds are spoken of as selling
upon a 3.80 per cent basis or a 4.65 per cent basis or whatever the figure
may be, with no reference whatever to the price or to the rate of interest
which the bond bears. Indeed, so exclusively is the basis considered by
bond-dealers that very often bonds are bought and sold upon a basis price,
and the actual figures at which the bonds change hands are not determined
until after the transaction is concluded.
It is not expected, of course, that the average business man will purchase
bonds in quite as scientific a way as this, but it is essential that he should
understand that while the intrinsic value of a bond is determined only by the
five general factors described, its money value, or price, is affected also by
these two accidental conditions. Exprest in other words, he must realize that
the general factor described as rate of income does not mean the coupon
rate of interest which the bond bears, but the scientific "basis," derived by
elimination of the accidental features.
Within the past year there has been a good deal of uninformed comment
about the safety of railroad bonds. Before the era of popular agitation and
governmental antagonism, railroad bonds enjoyed a large measure of public
confidence; but it can not be denied that some part of this confidence has
been shaken as a result of the recent exposures. Even clearheaded men have
exaggerated the importance of the developments; and too often railroad
officials, who should have insisted upon the soundness and stability of their
properties, when they elected to talk for publication, have given way instead
to dismal and unwarranted forebodings.
There is no mystery involved in determining the safety of railroad bonds.
Any man of business experience, keeping in mind the general principle
which measures the value of all obligations, can easily determine, with the

aid of two documents, the degree of safety which attaches to any particular
railroad bond. The general principle to be observed is that the safety of any
obligation depends upon the margin of security in excess of the amount of
the loan; and the two documents to be consulted are the mortgage or trust
indenture securing the bonds, which describes the property mortgaged, and
the last annual report of the railroad, which shows its financial condition.
Confining the analysis, for the present, to mortgage bonds upon the general
mileage of a railroad, the following points should be considered:
(1) Rate per mile at which the bond is issued. Applying the general
principle indicated above, it must be learned what proportion the bonded
debt of a railroad bears to the total market value of the property. It is much
easier to make this comparison on a per-mile basis. In determining whether
the rate per mile is excessive, reference must be made not so much to the
particular bond in question as to the total bonded debt per mile of the
railroad, and to the relation which that figure bears to the total market value
of the property per mile. The total market value per mile is obtained by
adding the market value of the stock per mile to the par value of the bonded
debt per mile. A single issue of bonds varies all the way from $5,000 to
$100,000 per mile, according to the location of the railroad. Total
capitalization per mile—stocks and bonds at par—varies in about the same
proportion, from $35,000 to $300,000. The average for all the railroads of
the United States is $67,936 per mile. The actual cost of the railroad, as
shown by the balance-sheet, must be taken into consideration, and also the
estimated cost of duplicating the property. Physical difficulties of
construction must be weighed, for a railroad through a flat, sandy country
should not be bonded for as much, other things being equal, as a railroad
through a mountainous country, where much cutting, filling, and bridging
are required. The section of country in which the railroad is located must be
considered, for $35,000 per mile on a single-track line in a poor country
may be higher than $300,000 per mile on a four-track trunk line which
owns valuable terminals and rights of way through several large cities.
(2) Amount of prior lien bonds outstanding per mile. The amount of bonds
which come ahead of the bond in question on the same mileage is a matter
of great importance and works directly against the security of the bond.
Purchasing a bond which is preceded by a prior line bond is like taking a

real-estate mortgage on property already encumbered. If the bond is not
followed by other bonds, then the margin of security in the property is
represented wholly by the market value of the stock per mile, and the
investor must figure carefully the value of this equity.
(3) Amount of junior lien bonds outstanding per mile. The amount of bonds
which come after the bond in question, on the other hand, works directly in
favor of the bond, for it increases the margin of security. It shows also that
other people have had sufficient confidence in the property to invest their
money in obligations subject to the one in question. In the event of a
receivership this is often a matter of great importance; for if a foreclosure
sale is ordered the junior bondholders, in order to protect their own interest,
must buy in the property for an amount at least equal to the par value of the
prior lien bonds.
The foregoing considerations apply particularly to the safety of the
principal invested in railroad bonds; the following points affect the safety of
interest:
(4) Gross earnings per mile. The gross earnings of a railroad must be
compared with those of other roads occupying the same field, and the
returns for a number of years must be examined to determine whether such
earnings have increased or decreased. The position in which the railroad
stands for obtaining new traffic must be noted. This is dependent somewhat
upon the railroad's ability to take traffic from other railroads, but more upon
the probable growth and development of the territory which the railroad
serves, and the increased traffic which will probably be offered. In this
connection the rate of increase in population in the road's territory is
important. The proportion between passenger and freight earnings, the
diversity and density of freight traffic, and passenger and freight rates
should be examined. The reputation of the management for ability and
integrity should be considered. Gross earnings run from about $3,000 to
$40,000 per mile with the average $10,460.
(5) Net income per mile. Net income is obtained by subtracting from gross
earnings operating expenses (and sometimes taxes) and adding to the net
earnings so obtained whatever income from other sources the railroad may
derive. This is a very important figure. As with gross earnings, the reports

should be examined to determine whether net income is on the increase or
the decrease, and it should be compared with the net income of other
railroads occupying the same field. It involves a criticism of operating
expenses. The payments of the railroad must be analyzed to determine
whether the proper sums have been expended for maintenance of way,
replenishment of rolling stock, and other improvements sufficient to keep
the road in good physical condition. Normally speaking, operating expenses
should absorb about 65 per cent of gross earnings. If it is found that a
railroad operates for 60 per cent, however, it does not always follow that its
operating officials are exceptionally efficient, so that the cost of conducting
transportation is relatively small; it may mean that the physical condition of
the property is being neglected, or that ordinary improvements, which
should be charged to maintenance, are being paid for by increase in
capitalization. It is very important for the investor to find out which is the
case. If analysis leads to the suspicion that the earnings result from
neglecting the property or capitalizing every trivial improvement, the
railroad's bonds should be rejected. Net income varies from $1,500 to
$12,000 per mile, with an average of $4,702.
(6) Fixt charges per mile. The fixt charges of a railroad include interest on
its bonds, rentals, and taxes (when the last-named are not reported with
operating expenses). The importance of this figure lies in its relation to net
income. If a railroad does not earn well over double its fixt charges, its
obligations can not be regarded as in the first investment rank. Of course,
when a railroad earns more than twice the interest requirement upon its
entire bonded debt, it is probable that some of the underlying bonds are
protected by three, four, or five times the interest requirement upon them,
and their position is correspondingly strengthened.
The foregoing analysis applies particularly to mortgage bonds upon the
general mileage of a railroad and not to such special issues as collateral
trust, terminal, bridge, or guaranteed bonds. It will not be necessary,
however, to lay down any rules as to these classes of bonds, for the general
principles outlined above, with slight modifications of detail, will be found
equally applicable to a judgment of their value. Equipment bonds, on the
other hand, owing to their want of similarity to any other railroad issues,
will receive separate treatment later.

It is of interest, in view of the present diminished confidence in railroad
securities, to advance certain considerations touching upon the safety of
railroad bonds in general.
The last published report of the Inter-State Commerce Commission, year
1906, furnishes interesting testimony on this subject. A table on page 60
shows that the total railroad capital of the United States for that year was
$14,570,421,478, of which $7,766,661,385, or 53.31 per cent, was in the
form of bonded debt, and the rest in capital stock.
These figures indicate a substantial equity, but are somewhat misleading
because they refer to par value. A fair estimate of the market value of this
stock equity, which is the margin of security in the properties from the
bondholder's point of view, can be obtained from a table on page 82, which
shows a balance available for dividends, after paying all operating expenses
and fixt charges, of all the railroads of the United States for the year ended
June 30, 1906, of $457,060,326. This amount is equivalent to nearly 7 per
cent upon the total par value of the stocks.
Estimating that a railroad stock should earn 10 per cent upon its market
price—and even the most prejudiced will admit that a stock earning 10 per
cent is worth par—the total market value of American railroad stocks would
be $4,570,603,260, or more than half the par value of the bonds. In other
words, the bonded debt would represent something less than 63 per cent of
the total market value of the property. This compares favorably with the
security of first mortgages upon real estate.
When the safety of interest is considered, the showing made is equally
strong. Page 82 of the report above quoted shows that the net income of the
railroads of the United States for the year ended June 30, 1906, after
payment of all operating expenses, was $848,836,771, and the total fixt
charges, including interest on bonds, interest on current liabilities, and
taxes, amounted to $391,776,445, leaving a balance available for dividends
of $457,060,326. It is apparent, therefore, that the net earnings of the
railroads of the United States, considered as one system, could be cut in half
without affecting the payment of interest upon the railroad's obligations.
This affords a large measure of protection.

The following analysis shows that the actual market value of the railroads is
probably greater than the estimate made above.

The table shows the percentage of bonded debt to total market value of
some of the more important railroad systems. Two trunk lines in the
East, a north and south line in the middle West, and two
transcontinental have been chosen. No attempt has been made to select
railroads which would make a favorable showing. Indeed
Pennsylvania, and Union Pacific, by reason of their recent heavy bond
issues, probably compare unfavorably with others which might have
been chosen. The figures showing the par value of bonds outstanding
have been taken from last annual reports, with additions made for
recent issues. The figures showing the market value of stocks are based
on the amounts outstanding April 1st, 1908, at the market price.

Par value of Approx. Per cent
bonds market of
outstanding value of stock bonds to
outstanding total
value

Pennsylvania $270,974,645 $361,000,000 42.8
New York 255,414,845 174,000,000 59.4
Central
Illinois Central 156,053,275 120,000,000 56.6
Great Northern 207,517,939 260,000,000 44.3
Union Pacific 274,827,000 324,000,000 45.9
In view of the enormous decline which has occurred in railroad stocks
during the past eighteen months, the showing above is truly remarkable. It
is plain that the entire bonded debt of any of these standard railroads is less
than 60 per cent of the total market value of the property, while in the cases
of the Pennsylvania, Great Northern, and Union Pacific, more than half of
the present market value of the property could be erased before the lien of
the bonds least well secured would be impaired.

Of course, where the entire bonded debt is protected by such a margin, it is
evident that the underlying bonds (the prior liens and first mortgages) are
protected by several times as great a margin and their position is
correspondingly strengthened.
The foregoing analysis, in the judgment of the writer, affords convincing
proof not only that the prevailing want of confidence in railroad obligations
is without foundation, but that railroad bonds compare favorably in point of
safety with any other form of investment.
It remains to point out the amount of income and degree of convertibility
which they afford and the extent of appreciation in value which they
promise. It is impossible to do more than indicate the general characteristics
of railroad bonds in these particulars.
Railroad bonds cover a wide range of income return. They yield all the way
from 3¾ per cent to 9 per cent, the general average being from 4 per cent to
6 per cent. As a class they yield more than government or municipal bonds,
and less than public-utility or industrial bonds. With equal security they
probably yield less than real-estate mortgages. Compared with stocks they
return more than bank stocks, average about the same as railroad stocks,
and yield less than public-utility, industrial, or mining stocks. These
comparisons are intended to apply to the classes as a whole, and remain
generally true in spite of specific cases to the contrary.
Convertibility is the distinguishing mark of railroad bonds. Generally
speaking they may be more easily marketed than any other class of bonds.
Compared with stocks they exceed public-utility, mining, and bank stocks
in point of convertibility, and yield only to railroad stocks. It is hard to say
whether or not they possess greater convertibility than industrial stocks, but
it is probable that they do, allowing for the fact that an undue impression is
created by the activity of certain prominent shares.
Railroad bonds as a class possess great promise of appreciation in value.
American railroads, generally speaking, have adopted the conservative
policy of putting a considerable part of their annual earnings back into the
property in the form of improvements. To the extent to which this policy is
followed, an equity is created back of the bonds which raises their intrinsic
value. This policy contrasts favorably with the general practise of English

roads to pay out all their earnings in dividends, and to capitalize their
improvements. In addition, new capital for American railroads is largely
raised by stock issues, which further increases the margin of security for the
bondholders. Taken together these facts insure a steady enhancement in the
intrinsic value of railroad bonds, which is bound to be reflected, other
things being equal, in higher prices.
We shall not attempt to discuss at this time the degree of stability of market
price which railroad bonds enjoy. As explained in the first chapter, stability
of market price is dependent upon general financial and business
conditions. It is sufficient to point out here that the maintenance intact of
the principal sum invested can only be rendered certain by the purchase of
short-time securities whose near approach to maturity will keep their price
close to par. In a later chapter the general principles which determine this
question will be elucidated.
The ideal investment may be defined as one combining ample security of
principal and interest, a good rate of income, ready convertibility into cash,
and reasonable promise of appreciation in value. Measured by the
requirements of this definition, the conclusion seems justified that well-
selected railroad bonds, if purchased under favorable money-market
conditions, afford a highly desirable form of investment.

III
RAILROAD EQUIPMENT BONDS

As its name implies, an equipment bond is one issued by a railroad to
provide funds with which to pay for new rolling stock—cars and
locomotives. The issues are variously described as car trust certificates,
equipment bonds, or equipment notes. They conform in general to one of
two standard forms: (1) The conditional sale plan: In accordance with
specifications furnished by the railroad, the trustee selected (usually a trust
company) contracts with the builders for the purchase of the equipment.
From 10 to 20 per cent of the cost of the equipment is paid in cash by the
railroad and the rest is represented by the equipment bonds. The bonds are
the direct obligation of the railroad company. They are secured by a first
lien upon the entire equipment purchased. The title to the equipment
remains in the trustee for the benefit of the bondholders until the last bond
has been paid, so that under no circumstances can the general mortgages of
the railroad attach as a first lien on the equipment ahead of the car trust
obligations. After the final payment, the trustee assigns title to the railroad
company, which thereupon becomes the owner in fee of the equipment.
Under the terms of the deed of trust the railroad is always obliged to keep
the equipment fully insured, in good order and complete repair, and to
replace any equipment which may become worn out, lost, or destroyed. The
bonds are usually issued in coupon form, $1,000 each, bearing semiannual
interest, with provision for registration. They are generally paid off in
semiannual or annual instalments of substantially equal amounts, the last
instalment usually falling due in ten years, a period well within the life of
the equipment as estimated under the master car builder's rules.
Occasionally this method of payment is altered by the substitution of a
sinking fund, the bonds having a uniform fixt maturity, but subject to the
operation of a sinking fund which is sufficient to retire the entire issue well
within the life of the equipment. In either case the security, ample at the
outset, increases proportionally with the reduction in obligations
outstanding against it.

(2) The so-called "Philadelphia plan." Under this plan the equipment is
purchased by an individual, association, or corporation which leases the
equipment to the railroad for a term of years at a rental equivalent to the
interest and maturing instalments of the bonds. The contract of lease is then
assigned to a trust company as trustee, which thereupon issues its
certificates in substantially the form described in the plan above, these
representing a beneficial interest in the equipment, which are usually
guaranteed both principal and interest by the railroad. The lease runs until
the last bond has been paid, after which the trustee assigns title to the
railroad as above. The chief advantage of this plan over the other is that in
some States, notably Pennsylvania, certificates issued in accordance with its
terms are exempt from taxation, whereas under the conditional sale plan, as
the direct obligation of the railroad, the bonds would be taxable.
It is evident from the foregoing description that equipment bonds differ in
two important respects from all other classes of railroad issues. First, the
title to the property which secures the bonds does not vest in the railroad;
and, secondly, the property is movable and not fixt in any one locality.
By virtue of these two points, the holders of equipment bonds possess a
great advantage over the holders of mortgage bonds in the event of a
railroad's becoming bankrupt.
If a railroad is unable to meet its interest charges, the mortgage bondholders
can rarely do better than have a receiver appointed who will operate the
railroad in their interest; but if, with honest and efficient management, the
railroad can not be made to earn its interest charges, the mortgage
bondholders usually have to consent to the scaling of their bonds to a point
where the railroad can operate upon a paying basis.
With the holders of equipment bonds the case is quite different. If the
receiver defaults upon their bonds they have only to direct the trustee to
enter upon possession of the equipment and sell it or lease it to some other
railroad. The knowledge that they possess this power renders its exercise
generally unnecessary. The equipment of a railroad is essential to its
operation. It is the tool with which the railroad handles its business. If the
receiver were deprived of the equipment it would be impossible for him to
operate the road, and so he could never satisfy its creditors. Consequently

the courts, both State and Federal, have ruled that the necessary equipment
of a bankrupt railroad must be preserved, and have placed the charges for
principal and interest of equipment obligations upon an equality with
charges for wages, materials, and other operating expenses, and in priority
to interest of even first-mortgage bonds.
These points sufficiently explain the remarkable record which equipment
bonds have made during reorganizations. Careful investigation has been
made of the various railroads which were reorganized, either with or
without foreclosure, between the years 1888 and 1905. This covers the chief
period of railroad receivership. It was discovered that sixteen different
railroads, aggregating nearly one hundred thousand miles and located in
widely different parts of the country, had outstanding equipment bonds at
the time of default. In every case the principal and interest of equipment
bonds were paid in full, while all other securities, with a few exceptions,
were reduced in rate or amount or both. Two of these railroads offered to
the holders of equipment bonds the option of an advantageous exchange of
securities, which amounted to more than payment in full.
The foregoing facts justify the conclusion that equipment bonds possess
security equal or superior to that of any other form of railroad bonds.
Let us now consider their remaining characteristics—their rate of income,
convertibility, prospect of appreciation in value, and stability of market
price.
One of the strongest features of equipment bonds is the relatively high rate
of income which they yield. The amount realized varies in accordance with
the financial strength and credit of the issuing railroad, and the margin of
security in the equipment itself. As a general rule, the net return on the
equipment bonds of a given railroad is usually from ½ per cent to ¾ per
cent greater than on the first-mortgage bonds of the same railroad. This is
owing to the fact that while banks and scientific investors have bought
equipment bonds for many years, the general public is not sufficiently
familiar with the inherent strength of these issues to create much of a
demand for them. This insures a good return.
Equipment bonds vary in point of convertibility. The reader will remember
from the description above that equipment bonds are usually issued in serial

form, with instalments maturing semiannually from six months to ten years.
By confining purchases to the shorter maturities, say within two or three
years, a high degree of convertibility may usually be obtained because the
short maturities are greatly sought by banks and other financial institutions
which regard equipment bonds in much the same light as merchant's paper
or time loans secured by collateral. At a price equivalent to the rate which
the best commercial paper commands, there is always a good demand from
the banks. Many banks prefer equipment bonds to loans or paper on account
of their greater convertibility. As the length of maturity increases, the
degree of convertibility generally decreases, because the chief demand for
the longer dates comes from insurance companies, which do not, in the
aggregate, constitute as great a demand as the banks. When the demand
from private investors increases, as it undoubtedly will when they become
more familiar with the desirable points of these issues, all maturities will
probably possess ready convertibility.
In the same way, equipment bonds vary as to stability of market price.
Compared with other classes of railroad issues, equipment bonds are all
relatively stable, but the stability is especially marked in the shorter
maturities.
Equipment bonds possess little prospect of appreciation in value.
The attentive reader who has carefully followed the foregoing description
of equipment bonds, may have noticed a special adaptability on their part to
the requirements of a business surplus. Broadly speaking, for such
investment, a security is required which will combine perfect safety of
principal and interest, a good rate of income, ready convertibility into cash,
and unyielding stability of market price. The necessity for insistence upon
these requirements in the investment of a business surplus will appear upon
a moment's reflection. Safety is required in all forms of investment, but is
particularly important in the handling of business funds; a good rate of
income is always desirable; convertibility is necessary for a business
surplus so that the reserve funds may be converted into cash at any time;
and it is of the utmost importance that the security should not shrink
materially in quoted price, no matter what changes may take place in
financial and business conditions, so that if the need should arise for
realizing on the reserve fund, it would be found unimpaired in amount. As

explained in a former chapter, this point can not be covered by the selection
of securities perfectly safe as to principal and interest, but only by the
purchase of short-term obligations.
The point may be illustrated as follows: Let it be supposed that a firm or
company has decided to invest $100,000 in the 5-per-cent equipment bonds
of a good railroad maturing in three years, which can be obtained at par,
merchant's paper then commanding about 5½ per cent. After two years it
becomes necessary for the firm to realize on its investment at a time when
commercial paper is floated with difficulty on a 6½-per-cent or 7-per-cent
basis. Under such money conditions the equipment bonds could be sold on
about a 6-per-cent basis, which would mean a price of 99 for a 5-per-cent
bond with one year to run. The firm, in liquidating its investment, would
therefore lose 1 per cent in principal, but would have received 5 per cent
interest for two years, making the net return 4½ per cent. Compare this
showing with the result if the bonds when originally bought had had ten
years to run instead of three.
After two years, when the firm wished to dispose of its bonds it might
experience some difficulty in doing so in the stringent money market which
has been supposed, but even if it succeeded in selling them upon a 6-per-
cent basis, that would mean a price of only 93¾ and would represent 6¼-
per-cent loss in principal. If it were necessary to sell the bonds upon a
higher basis or if the firm had purchased a bond with more than ten years to
run, the relative disadvantage of the longer bond would be still more
apparent. These points sufficiently demonstrate the importance of buying
only short-term securities for the investment of a business surplus. Of
course, if money conditions improve instead of becoming worse between
the dates of purchase and sale, then a greater profit would be made with the
longer-term bond. This, however, should not be allowed to influence the
choice, first because it is not the object of a reserve fund to make a
speculative profit, and secondly because a firm or corporation is only likely
to want to realize upon its reserve fund when money is hard to obtain
otherwise, and that is precisely the time when any long-term bond would be
apt to show considerable depreciation.
The foregoing considerations indicate a special adaptability on the part of
equipment bonds to the usual requirements of a business surplus. The points

have been brought out at some length because of the importance of the
subject to the average business man. The purpose in concentrating attention
upon a single instance has been to illustrate more clearly the principles
involved and at the same time to acquaint the business man with details of a
highly desirable and somewhat unfamiliar form of security.

IV
REAL-ESTATE MORTGAGES

In the preceding chapter the discussion of railroad bonds was brought to a
close. Before passing to the consideration of real-estate mortgages, which is
the next form of investment to be taken up, it may be well to review briefly
the general principles advanced in the first chapter of this book, in order
that the reader may have clearly in mind the main points upon which
judgment of the value of investments should be based.
There are five chief points to be considered in the selection of all forms of
investment. These are: (1) safety of principal and interest; (2) rate of
income; (3) convertibility into cash; (4) prospect of appreciation in intrinsic
value; (5) stability of market price.
Keeping these five general factors in mind, the present chapter will discuss
real-estate mortgages as a form of investment, both as adapted to the
requirements of private funds and of a business surplus.
The average American business man is so familiar with real-estate
mortgages that the details may be passed over briefly. A real-estate
mortgage, or a bond and mortgage, as it is sometimes called, consists
essentially of two parts, a bond or promise to pay a certain sum of money at
a future date with interest at a certain rate per annum, and a mortgage or
trust deed transferring title and ownership in a piece of real estate, with the
provision that the transfer shall be void if the interest is regularly paid and
the bond redeemed at maturity. Before advancing money on the security of
a mortgage it is necessary to determine whether the title to the property
legally vests in the maker of the mortgage; and during the continuance of
the mortgage it is necessary to have proof that the taxes and assessments are
being regularly paid, and, in the case of improved property, the fire-
insurance as well.
The safety of real-estate mortgages, in common with the safety of all
obligations, depends upon the margin of security in excess of the amount of

the loan. In the case of real-estate mortgages the amount of this margin may
be determined without great difficulty. It is only necessary to have the
property carefully appraised by an expert in real-estate values. It does not
follow, however, because a mortgage has been shown to possess substantial
equity, that it is perfectly safe as an investment, unless it satisfies also
another condition of great importance. A mortgage may not exceed 50 per
cent of the selling value of the real estate pledged, and yet be a poor
investment. This point involves a serious objection to real-estate mortgages
which sometimes escapes notice.
The holder of a mortgage is at a great disadvantage in regard to the
changing value of real estate. If the value of the property upon which he
holds a mortgage increases, the additional value enhances the security of
the loan, but does not add to the principal which he has invested, while if
the value of the property diminishes, not only is the security proportionately
lessened, but if the impairment be great, the holder is frequently compelled
to take over the property and may suffer loss of principal. In other words, he
receives no direct benefit from an increase in the value of the property, but
has to stand the larger part of the risk of a decline in its value.
This is not the case with investments represented by negotiable securities
subject to changing market quotations. All such securities, railroad bonds
for example, are acted on equally by changes in the value of the property
which secures them. Except for the influences of money-market conditions,
railroad bonds advance with an increase in the value of the property and
decline with a decrease in its value. Well-selected bonds usually increase in
value with time, and all such increase goes directly to the benefit of the
holder. The failure of real-estate mortgages to respond similarly to changes
in the value of property places the holder of a mortgage at a great
disadvantage.
Owing to this characteristic, real-estate mortgages should be purchased only
when general conditions in the real-estate market are distinctly favorable.
Not only should the purchaser of a mortgage have sufficient margin of
security in the particular piece of property upon which he is loaning money,
but he should also be satisfied that general real-estate values are relatively
low, that there has been no undue speculation, and that conditions favor an
advance rather than a decline in real-estate prices.

No class of property is subject to more rapid changes in value than real
estate. After an extensive advance the holder of a mortgage may be
insufficiently protected by the equity in the property, even if his mortgage
represents only 60 per cent of the current appraised value of the real estate
pledged. It may be that the 60 per cent which he has loaned represents the
total value or more than the total value a few years before. When a rapid
advance in values occurs, tho it may be largely justified by the growth and
development of the territory, there is sure to be present an element of
speculation which is likely to carry prices beyond the point of reason. When
the turn comes and a severe collapse takes place, its effects are extremely
disastrous, because, unlike speculation in stocks or commodities, no short
selling exists in real estate to temper the fall, and the immobile form of
capital makes liquidation impossible. These considerations serve to show
the need for great prudence in the purchase of real-estate mortgages. If the
investor exercises due care in these particulars, he is reasonably sure of
obtaining a very high-grade security; if he neglects these precautions, he
may suffer severe loss of principal.
No general figures are available which would indicate the degree of
certainty attaching to the payment of interest upon real-estate mortgages.
Certain classes of mortgages, such as those secured by unimproved real
estate or dwellings, afford no direct security of interest payment other than
the threat of foreclosure. Other classes, such as mortgages upon stores,
hotels, or office-buildings, are often protected by a large income from the
direct operation of the mortgaged premises, thus furnishing a security for
the annual interest payment. The margin of protection in these cases varies
greatly, so that no general conclusion can be drawn.
The other characteristics of real-estate mortgages may be passed over more
briefly. It is generally conceded that mortgages return a higher rate of
income than can be obtained upon any other form of investment which
affords equal security. This constitutes their chief advantage.
Their chief disadvantage, on the other hand, lies in their entire want of
convertibility. There is no market for real-estate mortgages, and except in
special instances they can not be readily sold. The fact that they are not
subject to quotation prevents them also from holding out any prospect of
appreciation in value. Their very deficiency in this respect, however,

constitutes an important advantage from another point of view. Since they
are not quoted they can not shrink in market price in obedience to changes
in financial and business conditions. The buyer of a mortgage is assured
that he can carry his mortgage at par through periods when it may be
necessary to mark down all negotiable securities subject to changing market
quotations. This is frequently a matter of great importance.
The general characteristics of real-estate mortgages may be summarized as
follows: (1) When carefully selected and purchased under favorable
conditions, great safety of principal and interest; (2) a relatively high return;
(3) a low degree of convertibility; (4) no prospect of appreciation in value;
and (5) the practical certainty of maintaining the integrity of the principal
invested.
Is a security possessing these characteristics a suitable investment for a
business surplus? Only to a limited extent. The safety, high return, and
assurance against loss in quoted value of principal are all highly desirable
qualities for this purpose, but the lack of convertibility is a fatal defect. No
consideration is of greater importance in the investment of a business
surplus than a high degree of convertibility, so that if the need should arise
the investment may be instantly liquidated. The fact that real-estate
mortgages can not be readily disposed of makes it practically impossible to
employ them for the investment of a business surplus.
Where convertibility is not an essential requirement, and where the want of
promise of appreciation in value is not a serious matter, mortgages afford a
very desirable form of investment. The characteristics which they possess in
an eminent degree—safety, high return, and assurance against loss in
quoted value of principal—are exactly suited to the ordinary requirements
of savings-banks. Generally speaking, only a small proportion of a savings-
bank's assets need be kept in liquid form or readily convertible, and
accordingly they find mortgages highly desirable.
For the purpose of private investment the attractiveness of mortgages is not
so easy to determine. Ordinarily, fluctations in quoted values are of no great
importance to the private investor, so that the absence of quotation which
mortgages enjoy is not especially valuable. Their safety and high return are
attractive qualities, but their want of convertibility and of prospect of

appreciation in value are drawbacks. On the whole, the private investor may
probably employ with advantage a certain part, but not too much of his
estate in mortgage investments.
As part of a scientific and comprehensive scheme of investment, the special
advantages of real-estate mortgages appear most prominently in the years
following a business depression. During such a period real-estate values are
usually relatively low, but beginning to advance, so that mortgages present
their maximum margin of security. At such a time they compare most
favorably with bonds and other investment securities which are subject to
changing quotations, because such securities are then apt to be at their
highest point under the combined influence of restored confidence and the
low money rates which usually prevail. After several years of continued and
increasing business prosperity the positions are just reversed.
No discussion of real-estate mortgages would be complete without allusion
to the guaranteed mortgages which have been placed upon the market in
great quantities within the past few years. Guaranteed mortgages are real-
estate mortgages guaranteed as to principal and interest by substantial
companies having large capital and surplus. In addition to the guaranty, the
companies usually search and guarantee the title, see to it that the taxes,
assessments, and insurance are paid, and perform the other services of a
real-estate broker. Their compensation varies somewhat, but probably
averages ½ per cent—that is, for example, they loan at 5 per cent and sell
guaranteed mortgages to the investor at 4½.
The value of the guaranty may be considered from two points of view—
first, in the event of a general decline in real-estate values, and, secondly,
when a fall occurs in a particular piece of property or in a particular locality.
If a severe decline in real-estate values takes place, affecting all localities, it
might become necessary for the holders of guaranteed mortgages to test the
value of their guaranties. In such a case the question would arise how far
the capital and surplus of the guaranteeing companies would extend in
liquidating the mortgages which they had guaranteed. This would depend
entirely upon the proportion between the capital and surplus of the
companies and the total amount of outstanding mortgages guaranteed.
Ordinarily the capital and surplus do not exceed 5 per cent of the

mortgages, so that the average guaranty is good for about 5 per cent
additional equity. On a piece of property worth $100,000, upon which a
guaranteed mortgage of $60,000 exists, the guaranty would be worth
$3,000, and would margin the property down to $57,000. This additional
equity is of little value. It is probably unlikely that a 40-per-cent
depreciation in value will take place, but the guaranty is not needed unless
it does, and if it should occur, the depreciation is quite as likely to go to 50
per cent or more as to stop at 43.
From the second point of view the value of the guaranty is much greater.
The distribution of risk, as in the case of fire-insurance, protects the holder
against loss in the event of a fall in the particular piece of property upon
which he holds a mortgage, or even in a particular locality. It can not be
said, however, that the records are yet sufficiently complete to form a
conclusion as to what is a safe proportion between capital and surplus and
outstanding mortgages. Further than that the guaranteeing companies,
generally speaking, have been operating since their inception upon a rising
market, so that their success hitherto has not been remarkable. Allowing for
these drawbacks, however, the private investor, unless so situated as to give
personal attention to the details of his investments, will probably do well to
purchase his mortgages in guaranteed form.

V
INDUSTRIAL BONDS

Industrial bonds include the obligations of all manufacturing and mercantile
companies, and miscellaneous companies of a private character. They form
a class quite distinct from railroad bonds or public-utility bonds.
I. Safety of Principal and Interest. The safety of industrial bonds, in
common with the safety of all forms of investment, depends upon the
margin of security in excess of the amount of the obligation. In the case of
industrial bonds the amount of this margin is not always easy to determine.
Even when determined, the rule is difficult of application because a margin
which may seem insufficient from the point of view of physical valuation
may be satisfactory when considered as the equity of a working concern.
The indications most to be relied upon in estimating the safety of industrial
bonds are as follows:
(a) Value of real estate. The first point to be determined in considering the
purchase of an industrial bond is the value of the real estate upon which it is
a first mortgage. If the appraised value of the ground, irrespective of the
buildings and machinery upon it, is greater by a substantial sum than the
amount of the bond issue, the obligation is practically a real-estate
mortgage. In such a case, while possibly "slow," i.e., secured by an assets
difficult to realize upon—the safety of the bond can hardly be questioned.
In judging a bond upon its real-estate value, it is not always safe to take the
cost price of the land as shown by the company's books, because frequently
the cost upon the books is artificially raised by payment having been made
in securities whose market value is less than par, or in other ways. As stated
above, judgment should be based upon the appraised value of the land.
If the bond meets this test satisfactorily, the prospective investor may feel
reasonably sure that the safety of his principal is not in question, and may
buy the bond without anxiety if it satisfies his other requirements. On the
other hand, if the bond only partially meets this test, and it appears that

some part of its value comes from plant and equipment and from the
strength of the company as a working concern, then it is necessary for the
investor to consider carefully several other factors.
(b) Net quick assets. The balance-sheet of every industrial company can be
divided horizontally into two parts. Its assets are of two kinds—property
assets, which are fixt, and current assets, which are fluid. Similarly, its
liabilities are of two kinds—capital liabilities and current liabilities. It
requires no very extended business experience to pick out the items which
make up these totals. Plant and property assets are usually lumped together
under the head, "Cost of Property." Current assets include inventories, bills
and accounts receivable, agents' balances, marketable securities, and cash
on hand and in banks—everything, in short, which can be quickly converted
into cash. On the other side of the balance-sheet, capital liabilities are easily
determined. They consist of the par amounts of bonds and stocks
outstanding. Current liabilities comprise bills and accounts payable,
including borrowed money, pay-rolls, and interest and taxes accrued but not
due.
The real strength of every industrial concern is to be learned from the
figures relating to its current accounts. Property assets and capital liabilities
are not of the same significance. If the cost of plant and equipment as
shown by the books exceeds its real value, the market usually makes the
necessary adjustment by putting a price less than par upon the bonds and
stocks.
No such process is possible in the case of the current accounts. If the
current liabilities exceed the current assets the company shows a deficit,
whatever its surplus may show on the books. On the other hand, if the
current assets are greater than the current liabilities, the company possesses
a working capital, represented by the difference between the two, and
known as net quick assets.
There are three things to consider in connection with net quick assets: First,
the proportion between current assets and current liabilities. To put a
company in good shape its current assets should be at least twice as great as
its current liabilities. Two for one is a fair proportion, tho some companies

show as much as six to one. The stronger a company is in this proportion
the better.
Secondly, the proportion between net quick assets and bonded debt. The
bonded debt should never exceed net quick assets, except when the
company possesses real estate, in which case two-thirds of the real-estate
value plus the net quick assets should cover the bonds. Some companies do
much better than that. One prominent company in this country, altho it
possesses real estate of considerable value, has agreed in the indenture
securing its bonds to keep net quick assets at all times greater by a
substantial margin than the amount of bonds outstanding.
Thirdly, the proportion between net quick assets and the surplus as shown in
the balance-sheet. If the capital liabilities exactly balance the property
assets, it is plain that the surplus will exactly balance the net quick assets. If
the surplus is smaller than net quick assets, it is usually a sign that capital
liabilities have been created to provide working capital. Opinions differ as
to the wisdom of this course. Generally speaking, it is better to provide
working capital by means of a stock issue than to depend upon the banks
for accommodation. The exception to this rule occurs in the case of
companies that require a great deal of working capital for part of the year
and only a little at other times. If they have the best banking connections,
such companies may be safe in depending upon their banks to carry them,
but if they do so, they should have no bonded or other fixt indebtedness
which would prevent their paper from being a first lien upon their entire
assets.
If working capital is to be created by the issue of capital liabilities, it is
much better that it should be done by stocks than by bonds. The ideal
method, however, is to provide only such an amount of working capital at
the organization of a company as is necessary for the conduct of its
business, and then, as the volume of its business grows, to accumulate the
additional amount necessary out of earnings, refraining from the payment of
dividends until the fund is complete.
Before leaving the subject of net quick assets, it is well to note the
importance of the figure showing the actual amount of current liabilities. If
a company has outstanding large amounts of bills and notes payable, it

occupies a vulnerable position. Inability to renew maturing notes was the
cause of most of the industrial failures of last year.
(c) Net Earnings. The amount of net earnings is of great importance in
estimating the strength of an industrial company. The figures for a number
of years should be examined to determine whether the earnings are
increasing or decreasing, and to discover whether or not the earning power
of the company is stable. This will depend largely upon the nature of the
article which the company produces or trades in. If its product enjoys a
steady demand at a fairly uniform price, it is justifiable that some of its
capital should be in the form of bonds; but if its earnings are subject to
violent fluctuations due to rapid changes in the price of its product, there is
little justification for conducting the business on borrowed money.
In this connection it should always be considered how greatly a falling off
in gross earnings will affect net earnings; and the proportion between net
earnings and fixt charges should be carefully noted.
In order for an industrial bond to receive favorable consideration, the
average yearly net earnings of the company should amount to about three
times the annual bond interest, taxes, and sinking funds. The greater the
protection is in this respect the better.
(d) Form of Issue. The form in which an industrial bond is issued is a matter
of some importance. If the principal of the bond does not become due for a
number of years, there is danger that the property will depreciate so far in
value as to leave the bond without sufficient margin of protection. There are
two ways to overcome this difficulty. One way is to establish a sinking-fund
which will retire a certain proportion of the bonds by lot each year. Another
way is to issue the bonds in serial form, with a definite instalment maturing
every year. In either case the annual sinking-fund or annual instalment
should be greater than the probable depreciation so that the margin of
security will be constantly increasing.
(e) Management and Control. No question is of greater importance in
estimating the strength of an industrial company than the reputation of the
men in charge. The ability and integrity of the men who control the policy
of the company and the efficiency of the operating officials are the principal
factors in the success of an industrial undertaking. Vacillating policies,

weakly executed, will ruin the most promising enterprise. This is
particularly true in the case of small companies. Every man of business
experience will understand the importance of this factor and be guided by it
in the selection of industrial securities.
Based upon the foregoing considerations it is of interest to inquire what
degree of safety really attaches to the average industrial bond? How far
does it meet the foregoing requirements? The question is difficult to answer.
Industrial bonds vary greatly in point of safety, some issues possessing
great strength and others being highly speculative. No general conclusions
can be depended upon, and the investor is forced to consider each issue
upon its own merits.
II. Rate of Income. The average net return upon industrial bonds is probably
higher than upon any other form of funded corporate obligation. This
constitutes one of the chief advantages of industrial bonds.
III. Convertibility. It is impossible to make any general statement in regard
to the convertibility of industrial bonds. Some industrial bonds, notably the
larger issues of well-known trusts, command a broad and active market.
Such bonds can be sold in large amounts at almost any time without
seriously affecting the price. On the other hand, small underlying issues of
such companies, usually high-grade in point of security, or the obligations
of smaller companies, are almost as unmarketable as real-estate mortgages.
Between these two extremes all varieties of industrial bonds are to be
found. The degree of convertibility which a security possesses is usually a
matter of some importance, and the investor should make a careful
examination of each bond in this respect.
IV. Prospect of Appreciation in Value. To what extent a bond may improve
in security during the time that an investor holds it is of little importance
unless the improvement be reflected in the market price of the bond. Only
so can the investor take advantage of its appreciation in value. In order for
the improvement in security to be reflected in market price and thus add to
the principal invested, it is necessary that a bond should possess a fairly
active market. For this reason the industrial bonds which hold out the
greatest promise of appreciation in value are the larger, more speculative

issues, which possess the greatest convertibility. The purchase of such
bonds frequently results in substantial profits.
V. Stability of Market Price. The four points above touched upon—safety,
rate of income, convertibility, and likelihood of improvement in intrinsic
value—are all inherent characteristics of every bond. The likelihood of
favorable or unfavorable fluctation in market price is largely external in its
nature and depends upon general financial and business conditions.
As a class, industrial bonds can not be said to possess much stability of
market price. Some of the smaller issues enjoy a fictitious stability because
of their inactivity, but generally speaking industrial bonds are subject to
wide fluctations in accordance with changes in the business outlook.
The foregoing is a summary, necessarily brief and imperfect, of the main
points to be considered in judging the value of industrial bonds. The
question remains whether such securities are desirable for the investment of
a business surplus and of private funds.
Except in special cases industrial bonds are not suitable for a business
surplus. It is impossible to find an industrial bond which combines all the
characteristics necessary for that purpose. The requirements are great safety
of principal and interest, a relatively high return, ready convertibility, and
stability of market price. Many industrial bonds can be found which
combine two of these requirements, some even which combine three, but
the full combination, if it exists at all, is unknown to the writer.
In addition, the principle of distribution of risk should prevent one
industrial company from investing its reserve funds in the securities of
another industrial company.
For private investment the case is somewhat different. A man of good
business judgment, who desires to obtain a high yield for which he is
prepared to sacrifice something in the way of convertibility and prospect of
appreciation in value, may buy the underlying issues of strong companies
with every confidence in the safety of his principal. Again, the investor who
wants a high yield and quick convertibility, who is prepared to take a
business man's risk and to sacrifice stability of market price, may make a
large profit by buying second-grade industrial bonds. No investor, however,

should deceive himself with the idea that any industrial bond will satisfy all
the requirements of the ideal investment.

VI
PUBLIC-UTILITY BONDS

It was a common saying among bond-dealers a few years ago that the day
of the municipal bond had passed, the day of the railroad bond was passing,
and the day of the public-utility bond was to be. Municipal bonds were
selling at fancy prices in consequence of the low rates for money which
then prevailed, and railroad bonds appeared to be following in their wake.
Public-utility bonds alone afforded a satisfactory yield, and it was felt that
the investing public would be forced to turn to them.
This prediction, like many others which were based upon the assumption of
continued ease in money, was destined to be unfulfilled. Almost
immediately there appeared an added demand for capital, and in the face of
this demand, supplies of capital which had before seemed ample became
suddenly scarce. Money rates rose rapidly and as a necessary consequence
municipal and railroad bonds fell in price to a point where their net return
was commensurate with that obtained from the loaning of free capital. The
investment situation was thus completely reversed. It was no longer a
question as to what form of security investors must seek in order to obtain a
satisfactory yield, but rather could the highest grade of municipal and
railroad bonds be floated at any price. Under these circumstances the
contemplated necessity of turning to public-utility bonds never arose, and
the general investing public remains for the most part unfamiliar with their
elements of strength and of weakness.
The term "public-utility company" denotes a private corporation supplying
public needs under authority of a public franchise. The franchise may be of
definite date or perpetual, and may be partial or exclusive.
Public-utility companies include street-railway, gas, electric-light and
power, and water companies. Properly speaking, telephone companies
should also be included, but they are not usually regarded as belonging to
the class of public-service corporations.

It is impossible, within the limits of a single chapter, to discuss each kind of
company separately. The investment value of street-railway bonds will be
here considered, and it is felt that the general principles advanced, with
slight modifications of detail, will be found equally applicable to a
judgment of other forms of public-service securities.
I. Safety of Principal and Interest. In order to determine the safety of a
street-railway company's bonds, the company must be subjected to a
threefold examination, physical, financial, and political.
An examination must be made into the extent and condition of the physical
property in order to ascertain whether the bonded debt is secured by
property having a real market value in excess of the face amount of bonds
issued. The first point to be determined is the extent and valuation of the
company's real estate. If the appraised value of the land upon which power-
houses and car-barns have been erected is alone greater than the amount of
bonds outstanding, the investigation need go no further, for the bonds, in
such a case, would be practically a real-estate mortgage. In most instances,
however, this is very far from being the case; and after careful appraisal of
the real estate it is then necessary to make a careful valuation of the other
physical property; namely, power-plants, depots, car-sheds, roadway, and
equipment.
It is usually impossible for the average investor to make such an
examination himself, nor is it likely that he would possess sufficient
technical knowledge to render his investigation of much value. For an
accurate estimate of the value of a street-railway's physical property, it is
usually necessary to depend upon the expert opinion of a trained engineer. It
is a matter of regret that the average street-railway report can not be relied
upon to furnish an accurate valuation of the physical property; and it is
accordingly customary for careful bond-dealers, when they contemplate
taking an issue of street-railway bonds for distribution among their clients,
to have the property examined by a competent engineer, whose report then
determines for them the question of taking the issue.
Disregarding the figures which show the cost of property and equipment
upon the company's books, the engineer proceeds to make a careful
estimate of the replacement value of the property, including real estate. If

the result of the examination shows that the property could not be
duplicated for the amount of the bond issue, the company occupies an
unusually strong position—altho even in such a case some part of the value
of the bonds comes from the strength of the company as a going concern.
In most cases, however, it is probably found that the bond issue is in excess
of the value of real estate and the replacement value of the physical
property, the balance representing a capitalization of the franchise.
To determine the real value of the franchise or franchises is a difficult
matter and involves the whole question of the company's relations with the
community which it serves and with the local lawmaking bodies.
The first question which arises is whether the franchise is perpetual or for a
definite time, and the second whether it is partial or exclusive. Franchises
vary greatly in these respects. Sometimes a franchise, apparently partial, is
practically exclusive, owing to the fact that all the available space in the
streets is already occupied by the company's own tracks. If the franchises of
a company are limited as to time, it is expedient, if not imperative, that the
bonds should mature before the expiration of the franchises.
If the company whose bonds are under examination satisfactorily passes
this physical test—if it possesses real estate of considerable value, if the
replacement value of the property is as great or nearly as great as the
amount of the bonds, and if the franchises, while perhaps not perpetual or
exclusive, are yet of longer duration than the bonds and render successful
competition unlikely—the next step may then be taken; that is to say, an
examination of the company's financial condition and earning capacity may
be made.
The amount of its gross earnings should be examined and the figures
scrutinized for a number of years back to discover whether its earnings are
increasing or decreasing. The position in which the company stands for
obtaining new traffic must be noted, and some estimate must be made of the
stability of its earning power. In this connection the relations of the
company to the public are of great importance. It must be learned whether
the company follows the policy of conciliating or ignoring public sentiment.

The net earnings of the company must then be examined. This involves a
criticism of operating expenses. The payments of the road must be analyzed
to determine whether the proper amounts have been expended for renewal
of track, replenishment of rolling stock, and other improvement sufficient to
keep the property in good physical condition. This is the most intricate
subject in the investigation of a street-railway property. Unless proper
allowance be made for depreciation, in addition to the expenses of direct
operation, it is only a question of time before the strongest company will
become bankrupt.
Deterioration of plant and equipment, which goes on constantly, can only be
offset in two ways: one is out of earnings and the other is out of the
security-holders—that is, by decreases in the market value of the securities.
The first takes prosperity or courage; the second leads to bankruptcy. It is
difficult to measure depreciation accurately, but a safe rule is to write off
ten per cent of gross earnings each month for depreciation. In this way the
charge for depreciation will be proportionate to the traffic, which provides
automatic adjustment.
If the net earnings, after making this allowance for depreciation, and after
providing all expenses of operation including ordinary repairs, amount to as
much as twice the interest charges upon the bonds outstanding, it is
probable that the bonds may be taken with safety.
Before finally determining the question, however, certain political factors
must be taken into consideration. The relations of the company to the
leaders of the dominant political party must be investigated. The likelihood
of agitation looking toward a reduction of fares must be considered and the
possibility of increase in taxes (if below the legal limit) must be weighed.
The probable attitude of the legislature on the question of renewing the
franchises when they expire must be considered. In general, it must be
learned whether any real ground of contention exists between the company
on the one hand and the public and its representatives on the other, because
it is inevitable that the company will weaken its independence of position
by too close a connection with politics, and that the physical property will
suffer if there is any lack of uninterrupted attention to it.

Finally one other thing should be investigated—the amount of the accident
account and its proportion to the net earnings of the company. On small
lines a single case of heavy damages will sometimes make serious inroads
upon the earnings.
The foregoing is a summary, necessarily brief and imperfect, but true in its
essential outlines, of the main points which should be considered in judging
the safety of street-railway bonds. The question remains, how far does the
average street-railway company satisfy these requirements? Broadly
speaking, street-railway bonds are not yet to be classed in the first rank of
investment securities. The troubles which have come to a head in the
financial operations of the traction systems in New York and Chicago are
typical of troubles which are likely to occur elsewhere from the same
general causes—overcapitalization in the first place and insufficient
allowance for depreciation in the second place. In both New York and
Chicago the crisis was hastened by open and obvious overcapitalization,
which is almost inevitable when many independent lines are merged into
one system. The same trouble, however, is apt to occur in other traction
systems where this evil appeared less flagrant at the outset.
The advantages of electricity over horsepower naturally led to the
multiplication of electric street lines, as the system ten or fifteen years ago
passed beyond the experimental stage. As in all new enterprises, speculation
ran ahead of the reality and financing built upon oversanguine calculations
has too often had difficulty in squaring accounts when brought face to face
with facts. In most of the calculations insufficient allowance was made for
the wear and tear of service; in other words, for renewal of road and
equipment. After a few years' test of earnings against expenses, it became
evident that a proper allowance for depreciation of plant would show a
heavy deficit in the income account. In most cases therefore no allowance
or only a meager one was made. For a time this method of bookkeeping
proved less disastrous than might have been expected owing to the rapid
growth of population and business in American cities. It was possible in
many cases to consider the enhanced value given to the franchise by growth
of business as an offset to the depreciation of tracks and equipment. In so
far also as the plant was kept up to a high degree of efficiency by charging
the expense of repairs to operating expenses, the absence of a depreciation
account was partially offset.

With the progress of recent years, however, a new factor has been entering
into the problem which promises to make the situation still more serious for
the traction systems. This new factor is the rise in prices and wages.
Temporarily the influence of this factor may be checked by diminished
business activity, but when normal conditions are restored, it will
commence to act again upon the railways with accumulated effect.
In most cases a proposition to increase the standard street-railway fare
above five cents as an offset to the increased operating expenses would be
so revolutionary a proposal that it could hardly be carried through. With the
line of cost converging upon the line of receipts and with no proper
allowance made for depreciation, the traction systems of the country seem
to be facing a difficult problem. In the long run it can not be doubted that
the problem will be met and solved in a way to afford justice alike to the
public who use the cars and to the capitalists who have made street traction
on a large scale possible, but in the meantime the investor who desires
perfect safety should exercise great care and discrimination in his purchases
of street-railway obligations.
II. Rate of Income. As a general rule, street-railway bonds in common with
the obligations of all public-service corporations sell upon about the same
income basis as high-grade industrial bonds—that is to say, under normal
conditions they return considerably more than railroad or municipal bonds.
III. Convertibility. It is difficult to speak of the convertibility of public-
utility bonds as a class for the reason that they differ widely from one
another in this respect. In general, it is certainly more difficult to dispose of
public-utility bonds than railroad bonds. They do not possess sufficient
convertibility to justify their purchase by any one who may need to realize
quickly on his holdings.
IV. Prospect of Appreciation in Value. Public-utility bonds, except such
issues as are convertible into stock, possess little prospect of appreciation in
value. It was pointed out above that depreciation is not properly allowed
for, and it is very difficult for the securities to advance in the face of this
obstacle.
V. Stability of Market Price. The bonds of public-service corporations are
relatively more stable than railroad bonds because their earnings are not

subject to the fluctations which occur in railroad properties between years
of prosperity and years of depression. At the same time, it should be pointed
out that their stability of price is largely fictitious, owing to the comparative
inactivity of the issues. In other words, while the quotation may be
maintained, it is usually difficult to sell any large quantity of a public-
service corporation's bonds in a period of financial disturbance, while
railroad bonds are more easily liquidated even if at a sacrifice.
The question remains, do public-utility bonds afford a desirable security for
the investment of a business surplus and of private funds? In regard to the
former, it may be said at once that public-utility bonds do not meet the
necessary conditions. The security is too doubtful, the convertibility is too
small, and the stability of price too uncertain.
For private investment the case is somewhat different. Keeping in mind the
desirability of diversifying investments and admitting the attractiveness of
investing in a class of property whose earnings are comparatively stable, it
seems clear that public-utility bonds can not be dismissed without
consideration. When a company is found whose property is substantially
equal in real value to its bonded debt, whose allowance for depreciation is
ample, whose franchises are satisfactory, whose earning capacity is large,
and whose management is capable and upright, the investor is justified in
giving careful consideration to its issues. Unless all these points are found
to be satisfactory, however, the investor should content himself with some
other form of security. For some years to come it is to be feared that many
of our public-service corporations will suffer from the war of discordant
elements—disregard of the rights of the public on the part of the
management and socialistic agitation for control on the part of the
community. Until these warring factions are reconciled and the questions at
issue adjusted with fairness to the security-holders and the public, the
investor should be most prudent in his purchases of public-utility
obligations.

VII
MUNICIPAL BONDS

The previous chapters have considered, in turn, the investment value of
railroad bonds, real-estate mortgages, industrial bonds, and public-utility
bonds. The desirability of each of these different classes of security has
been judged in accordance with the general principles laid down in the
introductory chapter; that is to say, each class has been analyzed in relation
to safety, rate of income, convertibility, prospect of appreciation in value
and stability of market price. The same determining factors must now be
applied to a judgment of government, State, and municipal bonds.
Bonds issued by a national government, by a State, or by a municipality are
based primarily on some form of the power of taxation, tho the bonds are
usually tax exempt within the political unit which creates them.
When the power of taxation is unlimited, as in the case of the national
government and the sovereign States, there can be no question as to the
ability of the political unit to meet its obligation, and the question becomes
entirely one of good faith. It is probable that the obligations of the United
States Government, by reason of the fact that the per-capita debt of the
country is so small, the wealth of the country so great, and the good faith of
the American people so clearly established, represent the highest type of
security to be found in the world. It is quite possible, therefore, that the 2-
per-cent United States Consols would sell in any case at a relatively higher
price than the obligations of any other country, but it can not be denied that
the chief reason which causes them to sell at the remarkably high price
which they have attained is the fact that they are required by national banks
as security for circulation. This fact is doubtless the controlling element in
their market position, and at once accounts for their special strength and
removes them from the field of private investment.
Only less secure than United States bonds are the obligations of the
sovereign States of the Union. State bonds usually sell upon a basis which

may be taken as the equivalent of pure interest, with no element of risk or
speculation involved. The obligations of different States sell at different
prices, in accordance with market conditions and the relations of supply and
demand, but there can be no question of the equal ability of all States to pay
their obligations. Repudiation of State debts has occurred in our history, but
only in cases where an overwhelming majority of the citizens were opposed
to the creation of the debt at the time of its issue, but lacked the means to
control the situation. Such instances are chiefly to be found in the case of
the so-called carpet-bag governments of the Southern States after the Civil
War.
Municipal bonds—i.e., the bonds of cities, counties, and townships—are
indirectly a first lien upon all taxable property in the municipality, and take
precedence of every form of mortgage or judgment lien. This lien is
enforced through a tax levy to meet interest and principal, and this tax levy
the courts will compel in the rare cases in which a municipality attempts to
repudiate a valid bond. This priority of the tax lien is the foundation of the
prime position of municipal bonds. The case rarely occurs where a bond
held valid by the courts proves uncollectable if sufficient taxing power
existed when the bond was issued to provide for its redemption. It is only
when the municipality itself diminishes in population and taxable property
to the vanishing-point that such a default can occur. An investor can judge
for himself as to the likelihood of such a catastrophe in any particular
community, and can feel sure that his bond, if valid and protected by a
sufficient taxing power, is as secure in its principal and interest as the
municipality which issues it is secure in its continued existence. The
following are the chief points which should be considered in the
investigation of a municipal bond: (1) The proportion which the total debt
of the municipality bears to the assessed valuation of the property subject to
taxation. Usually a maximum rate is fixt by constitutional provision which
rarely exceeds 10 per cent. (2) The purpose of issue. This must be a proper
and suitable one. (3) The proceedings under which the bonds were issued.
These proceedings, the form of bonds, their execution, and their legal
details must be in full compliance with the law.
If these points are found to be satisfactory, the investor may rest content
that no other form of security is so greatly safeguarded and that his bond
ranks upon a substantial equality with government and State obligations.

The rate of income to be derived from investment in municipal bonds varies
in accordance with the obligations selected. Like other forms of security,
municipal bonds are controlled by market conditions, and their price is
determined by the relations of supply and demand, and by adjustment to
prevailing money rates. While differing only moderately from one another
in point of safety and income return, municipal bonds may be divided into
two distinct classes in accordance with the degree of convertibility which
they possess. Some municipal bonds possess great convertibility; others
almost none. The feature which chiefly determines the activity or inactivity
of a municipal issue is the size and importance of the municipality, together
with the amount of bonds which it has outstanding. The bonds of large and
important cities, whose outstanding debt reaches considerable proportions,
usually possess great activity. They are constantly traded in and command a
broad market because dealers are willing to buy or sell them in blocks at
prices within a fraction of 1 per cent apart.
On the other hand, the bonds of counties, townships, and small cities are
usually quite inactive. Transactions rarely occur in them, dealers do not
make a market in them, and they can be sold only to genuine investors. It is
often impossible to have them even quoted.
At first sight, it would appear that active municipal bonds would be much
more desirable, but inactive municipals possess a special advantage which
the active ones do not enjoy. They possess more stability of market price. It
is true that their stability of value is due to the fact that they are not traded
in or quoted and is, therefore, largely fictitious, but nevertheless it
accomplished a useful purpose. It enables the investor to carry inactive
municipals at cost price upon his books through periods in which active
market bonds would require to be marked down in conformity with
prevailing market prices. No other class of investment except real-estate
mortgages possesses to the same degree this quality of price stability. For
many classes of buyers—savings-banks, for example—stability of price is a
consideration of prime importance. The preservation of the savings-bank's
surplus and, indeed, the continued solvency of the institution depend upon
maintaining the integrity of the principal which it has invested. A savings-
bank requires, also, great safety of principal and interest; i.e., the certainty
that principal and interest instalments will be paid at maturity. It needs only
a fair but not high yield, and it does not need to place emphasis upon

convertibility or prospect of appreciation in value. Comparison of these
requirements with the characteristics of inactive municipal bonds discloses
a striking adaptability on their part to the real needs of the case. As a
consequence, it is not surprizing to discover that inactive municipals are
greatly sought by savings-banks.
The desirability of inactive municipals for savings-bank investment was
never more forcibly illustrated than on the first of last January, when the
savings-banks came to make up their annual statements. Broadly speaking,
there can be no doubt that they were saved by the large quantity of inactive
municipals and real-estate mortgages which they carried. Had any
considerable portion of their assets consisted of railroad bonds and active
municipals, upon which they should have had to write off a loss of ten to
fifteen points, their solvency would almost certainly have been impaired.
But we are chiefly concerned in these pages with the advantages and
disadvantages of different forms of investment from the point of view of a
business man, both for the investment of his business surplus and of his
private funds. Do municipal bonds, either active or inactive, conform to the
requirements of the business surplus? It can not be said that they do.
Municipal bonds possess either convertibility without stability of price or
stability of price without convertibility. Both qualities are necessary for a
business surplus. The only form of municipal security which is at all
adapted for the investment of a business surplus is a short-term issue of an
active municipal bond. If it has only a very few years to run, its constant
approach to maturity will invest it with the necessary stability of price. But
even in this case equal safety and equal stability of price combined with a
higher yield can probably be found in some high-grade railroad issue—
either a short-term mortgage or equipment bond.
For private investment the case is somewhat different. Enough has been
said in the preceding chapters to impress upon the reader the importance of
buying securities only in accordance with his real requirements. If any
investor, after careful comparison of the characteristics of municipal bonds,
either active or inactive, with his necessities, decides that he can more
closely satisfy his requirements with municipals than with any other form of
security, he should not hesitate to purchase them. It is the opinion of the
writer, however, that a thorough survey of the field of investment will

generally disclose to the investor some security in either the railroad or
corporation field which will suit his requirements as well as the municipal
bond and at the same time provide him with a greater income.

VIII
STOCKS

Passing to the consideration of stocks as investments, it is necessary at the
outset that the reader should have clearly in mind the fundamental
difference between stocks and bonds. This distinction was drawn in the
introductory chapter, but it will be well to amplify it here, even at the risk of
carrying the reader over familiar ground.
The distinction between bonds and stocks is that between promises to pay
and equities. Bonds, loans on collateral, and real-estate mortgages represent
some one's promise to pay a sum of money at a future date; and if the
promise be valid and the security ample, the holder of the promise will be
paid the money on the date due. Stocks, on the other hand, represent only a
beneficial interest or residuary share in the assets and profits of a working
concern after payment of its obligations and fixt charges. The value of the
residuary share may be large or small, may increase or diminish, but in no
case can the holder of such a share require any one, least of all the company
itself, to take his share off his hands at the price he paid for it, or, indeed, at
any price. If a man buys a $1,000 railroad bond, he knows that the railroad,
if solvent, will pay him $1,000 in cash when the bond matures, but if he
buys a share of railroad stock his only chance of getting his money back, if
he should wish it, is that some one else will want to buy his share from him
at the price he paid for it or more. If he buys a bond he becomes a creditor
of the company, without voice in its management, but entitled to receive his
principal and interest when due under pain of forfeiture of the security
which the company made over to the trustee to insure payment. If he buys
stock, he becomes a partner in a business enterprise, exercising his
proportionate share in the direction of the company's affairs, and sharing
ratably in its profits and losses. In the one case he buys a promise to pay
and in the other an equity.
This distinction, which appears plainly marked in theory, has been much
obscured in recent years by the influence of two factors. As the country

grew in size, the large corporations—the railroads, for example—required
greater capital in order to provide facilities for the handling of their growing
business. It was impossible to provide this capital wholly by means of bond
issues without destroying the proportion between bonds and stocks, which
alone could give to the bondholders the protection of a substantial equity. It
was therefore necessary to obtain a large part of the capital required in the
form of stock. The railway-managers were thus confronted with a difficult
problem. It was imperative that they should obtain more capital, and it was
impossible to dispose of sufficient stock on the basis of a speculative risk in
a business venture. It was therefore necessary for the railway-managers to
emphasize, as far as possible, the investment character of their stock, and
various expedients were adopted to accomplish this purpose. In some cases
preferred stocks were created or resulted from reorganizations, which
possest a first lien upon the assets after payment of the obligations, and
which were entitled to a certain stipulated dividend before the common
stock obtained any distribution from the earnings. In this way the railway-
managers created a compromise security which could be regarded as a
stock, and would thus provide equity from the bondholders' point of view,
and, at the same time, one which could be disposed of to investors. In other
cases, which were probably more numerous, railway-managers attempted to
give their stock an investment value through stability of income return. In
good years when the company earned 10 or 15 per cent on its stock, their
policy was to pay only 5 or 6 per cent in dividends, and hold the rest in their
surplus fund in order to have the means of paying the same dividends the
next year if only 2 or 3 per cent should be earned. By giving their stock
stability of income return they hoped and expected to give it some stability
of market price, and thus make it attractive to genuine investors. The effect
of this policy was unquestionably successful, and one after another the
stocks of our more important transportation systems and other large
undertakings passed into the hands of investors.
The successful adoption of this policy on the part of the railway-managers
and other captains of industry has had one curious effect which was not
contemplated by the originators of the movement, and which brings us to
the second influence mentioned above as having tended to obscure the
distinction between bonds and stocks. When a case has been brought before
the courts in which the contention was advanced that the charges of the

railway or public-service corporation were too high, the courts appear to
have taken the ground that stocks and bonds should be classed together in
order to determine the aggregate capitalization of the company, and that the
justice or injustice of the contention that the charges are too high should be
determined by ascertaining whether if the charges were made lower the net
earnings would still be sufficient to pay a fair return on the total capital
invested. This is the general line of reasoning pursued by the courts, both in
the case of the Consolidated Gas Company in New York and the
Pennsylvania Railroad in Pennsylvania. The effect of this attitude on the
part of the courts has been to obscure still more greatly the real distinction
between bonds and stocks. It is too early as yet to judge what will be the
final outcome of the changed attitude toward stocks, but it can not be
doubted that the present tendency of opinion on the subject, so far as large
corporations are concerned, is to limit the return on stocks to a strictly
investment basis, instead of leaving the stockholders free to reap all
possible profit from their business venture subject to the restraints of
competition.
The adoption of this attitude by the courts should be a matter for serious
consideration on the part of present and prospective stockholders. If the
maximum return on stock is to be limited to 6 per cent, or any fair
investment basis, and charges reduced to consumers so that they obtain the
benefit of any greater earning power, it would appear that the stockholders
occupy an undesirable position. With their possible profits limited, but with
no fixt return insured to them and no guaranty against possible loss, it can
not be held that the purchase of stock seems attractive.
These questions, however, will doubtless be settled in the long run in justice
both to the public and to the stockholders, and in the meantime the stocks of
our large and successful railway and industrial corporations, which have
attained a certain stability and permanence of value, are entitled to
consideration when investments are contemplated. It is not worth while to
lay down rules for judging the investment value of such stocks, because the
general principles advanced in the preceding chapters will be found
sufficient for a judgment of their values.
One class of stocks, however, deserves special mention. Bank and trust-
company stocks possess one characteristic in higher degree than other

classes of stock. Owing to the general practise of self-regulated banking
institutions to distribute only about one-half their earnings in dividends and
to credit the rest to surplus account, a steady rise is assured in the book
value of the stock. No other class of stock possesses quite the same promise
of appreciation in value. Bank and trust-company stocks are especially
sought by wealthy men, who can forego something in the way of income
return for the sake of increasing the amount of their principal. The general
characteristics of bank stocks are great safety, a low rate of income, limited
convertibility, and practical certainty of appreciation in value.
With the present chapter the discussion of specific forms of investments has
come to an end. The next and concluding chapter will explain the general
principles which control the market movements of all negotiable securities,
and will endeavor to point out the indications which may be relied upon in
determining whether or not given conditions are favorable for the purchase
of securities.

IX
MARKET MOVEMENTS OF SECURITIES

There is no question connected with the investment of money more
important than the ability to judge whether general market conditions are
favorable for the purchase of securities.
After learning how to judge the value of every form of investment, a man
may still be unsuccessful in the investment of money unless he acquires
also a firm grasp upon the general principles which control the price
movements of securities. By this it is not meant that a man needs to have an
intimate knowledge of technical market conditions whereby to estimate
temporary fluctations of minor importance, but rather that he should have
clearly in mind the causes which operate to produce the larger swings of
prices. If an investor acquires such a knowledge, he is enabled to take
advantage of large price movements in such a way as materially to increase
his income, and, at the same time, avoid carrying upon his books securities
which may have cost much more than their current market quotations. If he
can recognize the indications which point to the beginning of a pronounced
upward swing in securities, and if he can equally recognize the signs which
indicate that the movement has culminated, he can liquidate the securities
which he bought at the inception of the rise or transfer them to some short-
term issues whose near approach to maturity will render them stable in
price, allowing the downward swing to proceed without disturbing him. It is
not expected, of course, that the average business man will be able to
realize completely this ideal of investment, but it is hoped that the following
analysis will give him a clearer conception of the principles involved.
Broadly speaking, the market movements of all negotiable securities are
controlled by two influences, sometimes acting in opposition to each other
and sometimes in concert. One of these influences is the loaning rate of free
capital; the other is the general condition of business. A low rate of interest
or the likelihood of low rates has the effect of stimulating security prices,
because banks and other money-lending institutions are forced into the

investment market when they can not loan money to advantage. Conversely,
a high rate of interest or the prospect of high rates has the effect of
depressing prices, because banking institutions sell their securities in order
to lend the money so released. The automatic working of this process tends
to produce a constant adjustment between the yields upon free and invested
capital. When money rates are low, securities tend to advance to the point
where the return upon them is no greater than that derived from the loaning
of free capital. When rates are high, securities tend to decline to a point
where the return is as great. This explains the influence of the first factor.
The other factor is the general condition of business. Good business
conditions, or the promise of good conditions, tend to advance security
prices, because they indicate larger earnings and a stronger financial
condition. Poor business conditions, or an unpromising outlook, have the
reverse effect.
The larger movements of security prices are always the resultant of the
interaction of these two forces. When they work together the effect is
irresistible, as when low interest rates and the prospect of good business
conditions occur together, or when high money rates occur in the face of an
indicated falling off in business activity. At such times all classes of
securities swing together. For the most part, however, money rates and
business conditions are opposed in their influence, rates being low when
business is bad and high when business is good. Usually the worse business
conditions become, the easier money grows; while the more active business
becomes, the higher money rates rise. The effect of this antagonism
between the controlling causes is to produce movements of different
proportions and sometimes in different directions in different classes of
securities. High-grade bonds may be declining, middle-grade bonds
remaining stationary, and poor bonds advancing, all at the same time. This
serves to give a very irregular appearance to the security markets, and
appears to justify the widely held opinion that security prices are a pure
matter of guesswork, and that they are controlled only by manipulation and
special influences. A clear conception of the nature of the influences which
are always silently at work reconciles these apparent inconsistencies and
makes it plain that general price movements are determined by laws as
certain in their operation as the laws of nature.

This may be illustrated by a single example. Let us assume that interest
rates are low and business conditions bad with prospect of still lower
interest rates and still more unpromising business conditions. What will be
the effect upon different classes of securities? High-grade bonds, such as
choice municipals, whose safety can not be impaired by any extent of
depression in business, will advance because their market price is
influenced almost wholly by money rates. If their interest is certain to be
paid, no matter what business conditions may become, they can not be
greatly affected by a reduction of earnings, and consequently the influence
of low money rates is left to act practically alone. Middle-grade bonds, such
as second-class railroad issues, will remain almost stationary, low money
rates tending to advance their price and the fear of decreased earnings
tending to depress them. The lowest grade of bonds and stocks, whose
margin of security even in good times is not very great, will probably suffer
in price because the fear of default in interest and of reduction in dividends
will operate much more strongly than the mere stimulus of low interest
rates. Of course, securities can not be clearly separated into these three
classes, but shade imperceptibly into one another. The classification is
adopted only for purposes of illustration.
Up to this point we have been concerned merely in showing that the market
movements of negotiable securities are controlled by the influence of
certain factors. A more important question now remains to be considered,
viz.: whether the effect of these two influences is to produce general swings
in prices which may be depended upon with comparative certainty, and, if
so, what indications are afforded to the investor of the commencement or
culmination of such a movement. The answer must be that the combined
effect of the two influences described is to produce definite and regular
swings in prices, and that the indications which define the movements are
not difficult to follow.
A general survey of the history of every industrial nation reveals the fact
that business conditions undergo alternate periods of prosperity and
depression extending in clearly defined cycles of substantially uniform
length. By tracing the usual course of interest rates and of business
conditions throughout one of these cycles, a general idea can be formed of
the way in which the joint influences operate to produce price movements.
To what extent the course of interest rates is a cause as well as a result of

changing business conditions, we shall not attempt here to estimate, but will
be content to note carefully the general course which rates for money
pursue throughout the cycles. Immediately after a financial crisis, which
usually closes an era of great business prosperity, money rates become
abnormally easy. Within a few months from the climax of the crisis, money
accumulates in enormous volume in financial centers. This is caused by the
great diminution of business activity which renders unnecessary a large part
of the circulating medium that was formerly required to transact the greater
volume of business. To the extent to which this accumulation of money
merely reflects a redundancy of currency as distinguished from real liquid
capital, it can have little effect in encouraging the resumption of business
activity. As time passes, however, and economies in operation commence to
make themselves manifest, and especially as waste and extravagance are
curtailed, the country as a whole commences to accumulate real liquid
capital; that is to say, its total production leaves a surplus over the amount
of consumption. In the state of business feeling which has been pictured,
the undertaking of new business ventures or additions to existing properties
would not be approved, so that the surplus wealth created finds its way into
bank deposits as liquid capital. The competitive attempt to loan this capital
at a time when borrowers are few produces merely nominal interest rates.
This continues for some time. It is only gradually as confidence returns and
as the spirit of initiative begins to reassert itself that some part of the liquid
capital created each year is diverted into fixt forms. Here and there some
enterprising group of men will develop a mine, lay a new piece of railway,
or make some addition to an existing undertaking. For some length of time,
however, the liquid capital of the country not only remains unimpaired, but
is continually increasing. After a time a change comes. The annual surplus
of production, tho larger than before, is only sufficient to provide for the
new undertakings which the growing optimism demands. Interest rates rise
moderately in response to the added demand for capital. A few years further
along, as business activity increases and success appears plainly to wait
upon new ventures, the demand for new capital with which to develop
increased facilities and new enterprises exceeds the annual supply of wealth
created. Prosperity having increased, another factor commences to assert
itself. The spirit of economy and thrift which had prevailed throughout the
years of depression gives place to extravagance, the demand for luxuries,
and other unproductive forms of expenditure. While the total production is

much greater than in the lean years, the margin of production is not
proportionately as great, and this amount is insufficient to meet the
demands upon it. The supplies of liquid capital stored up during the years of
depression are resorted to, and they serve to provide the new capital for a
few additional years. Interest rates at once reflect the encroachment upon
stored-up capital, and their rise gives the first real warning of the country's
true position. The optimistic business men do not heed the warning. After
exhausting all the real capital available in the country, they proceed to
borrow extensively from foreigners or from government banks—in this
country from the national government through bank deposits. Every step
which can be taken to induce foreigners to part with their capital is resorted
to. If foreigners will not buy long-term bonds, short-term notes are created.
If the foreigners refuse these, they are asked to make loans secured by the
new bonds and notes. The rates of interest offered are so attractive that
considerable sums are usually obtained, and the pressure of business
activity continues further. Finally the day of reckoning arrives when some
incident, usually unimportant in itself, first suggests to the lenders of money
that their debtors whom they know to be overextended may not be able to
pay their loans. The attempt to collect their loans produces a financial crisis
which brings to an end the period of prosperity.
The foregoing is a description of the more important stages through which
business conditions pass from crisis to crisis. Different cycles vary in
particular details, but all agree in essential outlines. Sometimes special
influences are at work which operate to shorten or prolong the cycle. The
approach of a crisis will be retarded by inflation of the currency, for the
excess finds its way into bank vaults and increases the volume of loanable
credit. The effect of such inflation, however, is wholly disastrous, because
the addition to the supply of capital is fictitious, not real, and only defers
the day of reckoning for a greater catastrophe. On the other hand, the
approach of a crisis can be greatly hastened by wars, conflagrations, and
other agencies which destroy capital, and by attacks upon capital and the
conduct of corporate business, for such attacks tend to render capital timid
and produce the same effect as a violent curtailment of the supply. These
are only some of the many influences which might become operative, but
they serve to show the necessity for careful consideration of all the factors

at work if a true conception of the condition and tendencies of business is to
be formed.
From the general account given above of the successive phases of a credit
cycle, it is possible to summarize the course of interest rates and the course
of business conditions. Money rates become suddenly easy after a crisis,
remain low or grow easier for a period of several years, and then rise
continuously until the next crisis, advancing with great rapidity toward the
close of the cycle. Business conditions remain poor or grow worse a few
years after a crisis. Liquidation is taking place, prices are going down, and
the uncertainty of the outlook causes diminished activity. Thereafter,
however, conditions improve and activity increases with fair uniformity
until it reaches the high tension of the period immediately preceding the
crisis. The course of interest rates and the course of business conditions
may both be deflected by the operation of special influences, but the general
tendencies are substantially as outlined. The result of the operation of these
joint factors may be traced in the market movements of any class of security
desired. For the sake of simplicity, let us consider their effect in producing
the market swings of the highest grade of investment issues and of the
lowest grade, those which are affected only by money rates and those which
are affected almost wholly by business conditions.
Emerging from the strain of the crisis at their lowest point, high-grade
bonds, such as the best municipal and railroad issues, advance rapidly as
interest rates decline, continuing their advancing tendency throughout the
period of business depression which follows upon the heels of the crisis. As
business conditions improve, their position, while perfectly secure before, is
further strengthened and an added stimulus is given to their rise. About the
middle of the cycle when the business outlook is very promising, and before
interest rates have sustained any material advance, the prices of high-grade
bonds are usually at their highest point. From that time forward they
commence to decline, in spite of the increasing prosperity of the country,
under the influence of rising money rates. They make their lowest prices in
the midst of the crisis, when the strain upon capital is greatest and the
outlook for business most unpromising.
The lowest grade of bonds, on the other hand (whose margin of security is
least), do not commence to recover materially in price, in spite of the

influence of low money rates during the hard times which follow the crisis,
the influence of reduced earnings and the fear of default of interest holding
them in check. As the outlook becomes brighter, they advance rapidly and
continue to improve in price so long as they yield more than current money
rates. At some point, difficult to determine in advance but usually well
along toward the end of the cycle, they reach their high point and thereafter
decline under the influence of the growing stringency in money.
Between these two extremes, every class of security is to be found. The
better ones will tend to resemble, in their market movements, the course
pursued by the choicest bonds; the poorer ones will approximate the lowest
class. In every case, however, unless special influences operate to produce
variations, the market swing of a given security should be easily
conjectured by an investor who gives careful attention to the relative weight
which is likely to attach to each determining influence.

Transcriber's Note:
Spelling remains as in the original except "qualities to be emphasied; for investors" has been
changed to "emphasized".

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