Hints About Investments/Chapter 11
Public Debts, the first form of Stock Exchange investment that we considered, were to this extent simple, that they all implied a contract by which the investor became a creditor entitled to a fixed rate of interest and usually a capital sum to be some day repaid by the debtor.
Company securities, as a preliminary to the consideration of which we have been looking for a meaning in company accounts, are complicated in that they give the investor the choice of creditorship or ownership.
For those who like to be creditors, companies provide debts, in the form of bonds, debentures and debenture stocks, similar to the bonds and stocks issued by Governments and public bodies and, occasionally, interest bearing notes, usually with an early date of maturity, similar to the Treasury bills and Exchequer bonds with which Governments cater for the appetite that likes to see its money back soon.
For those who like ownership with the greater risk and more luxurious prizes that are its lot, companies provide ordinary, or common, shares and stocks.
For those who love compromise and a via media—less risk than is run by the ordinary shareholder and a higher yield than is given to the debtholder—companies provide preference or preferred shares and stocks.
These are the three main divisions, and, though there are many intermediate varieties with fancy names, they nearly all fall in fact into one of these classes. The debtholder takes the first bite out of the revenue of the company (after wages, salaries, taxes and other expenses have been met): the preference holder comes next and the ordinary shareholder takes such share of the balance as is not kept in hand by the directors or placed to reserve fund.
The position of the company debtholder is, usually, much the same as that of the holder of public debts—he is entitled to a fixed rate of interest, either for all time or up to the date at which his bond or stock is due for repayment. This date is either definitely fixed, or may be determined by the hazard of a draw, when the securities are numbered and part of them is drawn yearly or half-yearly for repayment. Payment is usually at par or the face value of the bond, but sometimes a small bonus is thrown in on redemption, and £105 or so is paid for the £100 stock or bond. This is usually confined to cases in which the debtor has a right of redeeming at an early date, as when a company issues bonds redeemable, at its option, at £105 in ten years or at £100 in thirty years. In the case of Bass & Co. the 4½ and 3½ per cent. Debentures are redeemable at the option of the company at 117 and 110 respectively.
In addition to these rights and frillings, holders of company debts, such as are described as mortgage bonds or mortgage debentures, have the right of foreclosure over part or all of the company's property in the event of its defaulting in the interest payments or redemption service. The value of this right evidently depends on the price at which the property pledged could, in case of foreclosure, be sold for the benefit of the creditors. And so here we find ourselves back in the region of guesswork. And very often we do not even know the book values of the assets that we are trying to guess about. Prospectuses frequently offer notes or debentures, with the label "first mortgage" attached, and say, for example, that they are specifically charged on the freehold and leasehold property, and then give a statement of assets in which the said freeholds and leaseholds are jumbled up with the machinery and plant under one heading, so that it is not possible to tell even what is the balance-sheet value of the property specifically charged. And even if we knew that, the price that would be secured by a sale, at a time when the company was in difficulties, is still a matter of surmise. As to the "first floating charge" on all the assets, with a pledge that the Board will not put any charge ahead of it, except if necessary for "advances in the ordinary course of business"—and some such phrase is often found when debentures are issued—this protection is not a very sure shield for holders, since advances in the ordinary course of business would be more than likely, if the enterprise were straitened for funds, to be on a considerable scale.
An additional protection is secured for industrial debenture holders by the appointment of trustees to watch over their interest. The efficiency of their vigilance, however, is likely to be impaired if, as often happens, one or more of the trustees is also a member of the Board. If all goes well there is no objection, because the trustees only become important when all is not well; then, the interests of the creditors and those of the shareholders are likely to clash, and it is not right for one man to represent them both.
In the case of railways, mortgage rights are often of great value, especially when the property pledged to the bond or debenture issue is in a position that is of importance to the working of the whole property. In England, railway debenture stocks do not carry mortgage rights. But the first mortgages granted by the American railroads have been, in the past, a source of great strength to the holders of bonds issued under them, whose rights have been respected at times of most ruthless reconstruction. At the same time, it must not be supposed that because a bond has a first mortgage it is therefore a sound security. Mr. John Moody, that eminent authority on American and other investments, says that: "Another false notion regarding the genuineness of a given railroad bond is the theory that a bond secured by a mortgage is always better than one which is not so secured. Of course in the majority of cases this is true, but there are numerous instances where a debenture bond, which is a mere promissory note, is a far better security than one which is protected by a direct mortgage lien. For a case in point, one might mention the New York Central Railroad Debenture Sixes. These bonds were not secured by any mortgage whatever on the property, and they were subject to a great mass of other obligations of prior security. And yet they were a far higher grade investment . . . than hundreds of first mortgage bonds of various other railroads throughout the country."[1]
Then there are the income bonds or income debentures, a form of security that is rare and generally unsatisfactory because it is usually nothing but a preference share trying to look impressive by calling itself a bond. On them interest is paid if it be earned during the year or period for which it is due. On bonds and debentures it is nearly always the rule that interest, whether earned or not, has to be paid somehow sometime; it cannot be "passed" and forgotten.
But one of the most important things that an investor has to learn and to keep remembering always is not to take the names attached to securities at their face value; not to think, for instance, that because a stock is called a first mortgage bond or debenture it therefore necessarily is a first charge on the property that has issued it. If he jumps to this conclusion and acts on it he may find when it is too late that the stock once carried a first charge but that in the course of a period of misfortune the Board found it necessary to raise funds by an issue ranking ahead of the first charge and probably described as a "prior lien."
Of course the consent of the first mortgage holders was required before this could be done, and no doubt they only granted it because after many meetings of protest and much correspondence in the press, they were convinced that if they did not do so any attempt to enforce their rights would lead to results disastrous to themselves. Every security has to be tested not by the names attached to it but by its actual position with regard to a share in the revenue of the concern which has issued it, and in its assets in the event of liquidation.
Preference shares are a compromise, dear to minds that love this refuge, despised by the hearty whole-hogger who says: "Give me one thing or the other." The objection to them is that if fortune frowns on the enterprise the rights of the preference holders are apt to be set aside. As we have seen this sometimes happens even to first mortgage debenture holders, in spite of the weight of their legal rights and the special protection that is given them by the existence of trustees specially appointed to watch over their interests; much more is it likely when it is a matter of preference holders who are not creditors at all but only what may be called limited partners in the ownership of the concern.
A preference holder who has not a right to a "cumulative" dividend—which has to be paid, if not this year next year or some other year before the ordinary holders get anything—has, indeed, very little right that is worth assailing. He takes his fixed dividend if earned and goes without it if it is not. It is the cumulative right that makes the preference worth having, and it is the one that the holder is likely to be asked to forego if a series of bad years has piled up arrears of dividend due to him that put the resumption of dividends on the ordinary shares into the dim future. In such a case a threat of immediate liquidation held at the heads of the preference holders and an intimation that liquidation will mean that little or nothing will be saved for them from the wreck, leaves them little choice about accepting any scheme of reconstruction involving the sacrifice of all or part of their arrears of dividend, a lower rate in future and possibly the surrender for the future of their cumulative "privilege." The directors represent the ordinary shareholders and the preference holders have only themselves to take care of them.
Such things happen when things go wrong. But then, when things go wrong, all the investors in all the securities of the company concerned are bound to be affected. They are like a row of ninepins—if the first one hit by misfortune, the ordinary shareholder, is hit hard enough to fall over he will hit the preference holder; and if he does so hard enough to knock him over, the debenture holder will not escape without a blow; if he still gets his interest he will not be feeling nearly so comfortable about his investment, and if he happens to want to sell, the fact the preference and ordinary are paying nothing will make a serious difference to the price that he will get in the market.
Nevertheless the right to take interest or dividend ahead of somebody else is always a comfort to those who like the safe side and are ready to pay for it by taking a lower rate of interest. When things go wrong the other fellow is hit first, and if they go only a little wrong the preference holder is not hit at all. Many investors look with satisfaction on a nice collection of well-chosen preference shares; they are confined to their fixed rate—or usually so—and may sometimes look with envy at the swelling dividends of the ordinary holders who come after them. But the fact of increased dividends for ordinary shareholders makes the preference holders' dividend more certain, gives them sounder sleep on their security and enables them to sell it better if they want to turn it into cash. Preference shares in a good and successful industrial concern are, as long as it is successful, as comfortable an investment as anyone can desire, especially when there is no debenture debt ahead of them.
Moreover financial ingenuity has devised a kind of preference share which combines all the advantages of a fixed preferential and sometimes cumulative rate with a share in profits after a certain rate has been paid on the ordinary. This is the "participating" preference share. Its holder gets all the security that his position can provide and at the same time has some share in prosperity if prosperity is abundant enough to give the ordinary shareholder an adequate return for his greater risk, and leave a divisible balance over. There is a good deal of equity in this principle, and it frees the preference holder's position from the objection that is often raised against it, namely that when things go wrong his rights are invaded and that when they go right he gets his fixed rate and no more.
Hitherto the participating preference share has been issued almost solely by companies which, from the nature of the enterprise conducted, are more liable to fluctuations of fortune than those which are engaged in transport or industry in the narrower sense of the word. It is a pity that this is so, because a participating preference has thus acquired a slightly speculative association, which is an obstacle in the way of its wider adoption.
Some preference shares and stocks are called "guaranteed," and get from this high-sounding name more consideration than they deserve from investors. This was shown when the real nature of the guarantee of the Grand Trunk Railway of Canada's guaranteed stock was revealed in the strong light of disaster. All that it meant was that the company guaranteed to pay the interest if it could, just as it promised to pay, if it could, the dividends on the various preference issues. Investors are apt to assume that a guaranteed stock is necessarily guaranteed by some outside authority which is not affected by the fortunes of the company, and sometimes this is so, but by no means always. The guaranteed stocks of the British railway companies rank before the preferences and the dividend on them is cumulative, but the guarantee is merely that of the companies. "Guaranteed" is thus a label that needs careful scrutiny when attached to a security.
Such are the securities—giving the rights and limitations of creditorship and limited ownership—which rank ahead of the real out-and-out owner, the ordinary shareholder, who takes what is left when these limited claims have been met. He takes it either in the form of dividend paid into his pocket, or in the form of reserve funds built up by the directors to increase his property and his future dividends; or he takes it with the best grace that he can muster if it be a minus quantity or a profit too small to make a dividend. He is the "functionless" person who takes the first risk and the last profit, but the last profit, how great so ever it be, is his.
Simple as his position is, as compared with the precedences and differences by which the prior charges are distinguished, it is sometimes subject to complications. One we have seen in examining the participating preference. Where it exists the ordinary divides with it—in proportions that vary according to the terms on which the participating preference is issued—any surplus left after a fixed rate has been paid to itself.
Then there is the deferred or management or founders' share, usually of quite nominal face value, which also takes a share of the profits after a certain rate has been paid on the ordinary. It used to be fashionable to denounce these shares as necessarily a wicked feature of company finance, but they are not necessarily so. When issued to those who have been, or are, helpful in organizing or carrying on the company, they may be a quite legitimate form of payment for highly important services.
And occasionally—such is the incorrigible habit of using words in different senses in which finance insists on indulging—shares are called ordinary which are really preferences, entitled to a fixed rate of dividend and no more, with a deferred share behind them enjoying the real rights and risks of ownership. But this arrangement is rare. As a rule the ordinary or common shareholder is the real owner to whom the property belongs, subject to the limited claims of the creditors and preferred partners.
As has been already indicated, old-fashioned investment doctrine looked on the ordinary share as so risky that anyone who held it became a speculator; those who upheld it confined the attention of seekers after a safe income to bonds, debentures and preferences, regarding preferences as a doubtful concession. Sound as this doctrine undoubtedly is, since the first and second charges on income are evidently safer than the third and last, it is possible to doubt whether comparative safety with fixed rate is necessarily and always preferable to comparative risk with possibility of expansion of income. If we could know that a company is going to be highly successful, we should certainly take its ordinary shares rather than the prior charge securities. If we have good reason to expect, from its past performances, that it is likely to be so, the question arises whether the chance of expanding success cannot fairly be weighed against the limitation imposed on the income of the debenture and preference holder.
For safety, such as is given by the best industrial debenture, is only relative. If misfortune does happen, debenture holders will be affected, directly by loss of interest and capital, or remotely by anxiety and a lower price for the security if it has to be sold. This relative safety is accompanied by an absolute limit on the income. The owner or ordinary shareholder, on the other hand, is relatively less certain to get any income, but no limit is imposed, by the terms of his holding, on the possibility of its expansion, and this possibility, as we have seen, is favoured by the reserve fund policy, which continually expands the earning power of any business to which it is consistently and successfully applied.
There is thus a good deal to be said for the view that, if one goes into industrial investments at all, the greater risk plus possible expansion carried by the ordinary share is a sounder business proposition, if adequate skill and knowledge can be applied to selection, than the smaller risk plus limit on income carried by the debenture and preference.
This view has been supported by the striking results of investigations lately carried out in America and referred to on page 14 of Chapter I. It is time to examine them more closely.
- ↑ Profitable Investing, by John Moody, B. C. Forbes Publishing Company, New York, p. 36.