How to invest money wisely

Preface

In the following chapters the proper methods for investing money in standard securities are outlined and discussed. An attempt has been made to treat this important subject in a practical and concrete way. and thus enable the investor to feel that he is getting something more than a mere statement of principles. The great weakness with most books on investment subjects is that they generalize too much, without presenting practical suggestions for the investor to adopt.

The whole plan of this little book is based on the ideas of Diversified Investing which the writer has for many years been making a careful study of in his work as an analyst and adviser for bankers, financial institutions and individual investors both at home and abroad. These principles for wisely and intelligently investing money under diversified plans have within the past few years been adopted by numerous institutions and several thousand individual investors with satisfaction and profit.

It will of course be recognized that within the limited scope of a small volume of this kind, the subject can be covered only in outline. But it is hoped that those who read this book with care will desire to have the subject further elucidated, with the idea of applying the method of investment themselves. For all such as these, our large statistical and analytical organization is operated, further details regarding which will be furnished upon request.

John Moody.

35 Nassau Street, New York.

Note.— In the back pages of this book will be found a detailed description of our Investment Service.

Part One: Diversifying En VESTMENT J PAGES

I. Selection of Investments 11

II. Mistaken Investment Methods 17

III. Unsound Theories g]

IV. Proper Principles for Diversifying Investments... 25 V. Applying the Principles

VI. Further Application of Sound Principles A[)

VII. The Factor of Maturity in Bonds 49

Part Two: Investing for Profit

VIII. Taking Advantage of Potential Possibilities 59

IX. Investment Cycles 67

X. Distribution and Profit Combined 75

XI. Plans for Investment of Moderate Sums 81

XII. Plans for Investing Larger Sums 87

Part Three: Classes of Investments

XIII. Some Typical Industrial Bonds 99

XIV. Selected Public Utility Bonds 109

XV. Railroad Stocks as Investments L2fl

XVI. Guaranteed Railroad Stocks as Investments

XVII. Industrial Preferred Stocks as Investments 145

XVIII. Unlisted Industrial Preferred Stocks 155

XIX. Public Utility Preferred Stocks as Investments... 157

XX. Short Term Investments 163

XXI. Investing in Convertible Bonds 167

PART ONE DIVERSIFYING INVESTMENTS Selection of Investments

THE sound principle for properly distributing investment capital has been a puzzle to investors for many years. This is not only true of the person whose investment capital is small and limited to a fewthousand dollars, but it is just as fully the case with the large investor whose capital runs up into the millions. As a general thing those who desire to have their principal thoroughly safe have endeavored to confine themselves to the higher grade bond issues of railroads and municipalities, and in some cases have made an effort at distribution by spreading their investments over wide sections of the country and among a considerable number of different issues. But in spite of this effort at distribution, such investors usually find themselves facing losses in principal even in periods of prosperity when they naturally would expect profits on this principal. In fact, the method employed by such investors has often resulted in permanently impairing their capital rather than adding it. Many cases can be poinded out where an investment fund of $500,000 has been reduced from ten to twenty per cent in the short period of ten years and this lias hap-

(ii)

pened when no undue risks have been taken and no ordinary speculation whatever has been indulged in. Of course, where an investor attempts to add to his income by investing a part of his principal in speculative stocks or bonds, the dangers of loss under certain conditions seem apparent enough. But when his entire effort has been directed to the conservation of his principal and he has consistently avoided investment in any stocks or bonds of a doubtful or speculative nature, it seems on the surface quite surprising that such losses should be incurred.

But when we turn to the small investor whose capital is limited in amount, and whose securities are usually confined to only two or three issues, we find that the danger of loss in principal is even far greater. I have known of many instances where an investor with a capital of from two to five thousand dollars, after exerting the greatest possible care in placing his money safely and avoiding every kind of a speculative proposition, has found himself at the end of two or three years with a loss of from twenty to forty per cent and with no possibility of recovering this loss except by taking unreasonable risks.

The kind of advice which is generally regarded as the most conservative for the investor who does not wish to risk his principal is the following: "Think first of your capital and pay no attention to the amount of interest return until the intrinsic value back of the investment has been thoroughly demonstrated. Confine your investments to first mortgages in railroads or other successful undertakings which have back of them a heavy earning

Selection of Investments 13

power and on which the interest has been earned for a long series of years at least three or four times over. ( )r, select municipal bonds which arc hacked by the credit of prosperous American cities and about which there is no doubt whatever of a permanent maintenance of high credit."

Now suppose an investor with a capital of $20,000 acted on the foregoing advice in the year 1902 and put half of his principal into Lake Shore & Michigan Southern Railroad 3y2% bonds and the other half into Xew York City 4% bonds. In the year 1902 lie would have found that among railroad bonds there was nothing which stood higher than Lake Shore 3j4s. These bonds answered the test of security to the fullest extent. They had back of them an enormous equity in railroad property with great earning power, and for a long series of y< the earnings had been sufficient to cover the interest on the bonds at least half a dozen times over. The issue was of such high standing that it became a savings bankinvestment in New York and other Eastern states, and in every sense of the word was practically as secure as a government bond.

As for Xew York City 4% bonds, nothing of higher type could have been selected in the municipal field. The credit of Xew York City was unsurpassed and the general strength of its obligation- seemed quite equal in security to those of the United State- I lovernment

But where would this investor find himself today had he followed this advice ten years ago?' In the ca^e of the railroad bonds, he would find that his principal had depredated more than twenty per cent. In the year 1902 the Lake Shore 3y2s sold steadily between 110 and 112. In the latter part of 1912 they were quoted at 86 and during this entire period of ten years they had been quite steadily declining from the high figures at the beginning of the decade.

The record of the New York City bonds is somewhat similar. In this case the investor would find that over ten per cent of his principal had gone forever. These bonds sold steadily well above 110 in 1902, but today are quoted considerably below par.

In both of these cases the equity or strength back of the principal of these issues has been fully maintained during the past ten years. The earning power of the Lake Shore & Michigan Southern Railroad has greatly increased since 1902 and the margin of safety on the 3y2% bonds has grown almost every year. The standing and credit of New York City has also been maintained and the assessed valuation of property is enormously greater today than ever before.

But in spite of these facts the investor who had put $20,000 into these securities in 1902 would find himself today with his capital contracted to less than $17,500 with no apparent hope of being able to get this loss back within his lifetime. While it is true that a part of the loss on a bond like the Lake Shore Zy2s will finally be recovered eighty years hence, when the bonds mature, yet at no time during the man's life would he be able to turn this investment into cash without accepting a very large part of this loss.

Selection of Investments 15

It will thus be seen that the principle outlined for the safe investment of capital, as mentioned above, does not work out in practice. In fact, any sound method for the safe investment of funds must he planned on entirely different lines from that which is ordinarily stated.

II Mistaken Investment Methods

IT has often been said that it is far easier to make money than to save it. Thousands of invests large and small, will attest to the truth of this axiom. For show me an investor, who, without special and expert experience, can safely and intelligently invest $50,000 or $100,000, and keep it safely and intelligently, invested, on a basis to yield normal rates of return, and not jeopardize his principal, and I will show you a hundred who are in constant danger of losing or seriously risking at least a part of both interest and principal. And in saying this I do not refer to the speculator, nor even to the "semi-investor" who seeks "a little more than the average return," but exclusively to the man, woman or institution who may be well satisfied with genuine safety of principal, combined with an interest yield of from 4% to 6% on the invested capital.

As I intimated in the first chapter, one of the causes of investment loss is the adherence to some crude principle in investing money, which, while sound enough in its does not go far enough to offset the many pitfalls which confront the average person who wishes to set his m< actively at work in good securities. The most conspicuous of those investment principles which I would designate as "crude" is that one which is based on the theory that only "high grade or first mortgage bonds, legal for savings banks," and a few high grade stocks of equal security, so far as principal is concerned, should be included in a sound investment scheme.

To show the unsoundness of this bare theory if taken by itself alone (and it is so taken in thousands of cases), I present on page 19 a concrete example of the ordinary method of "conservative" investment, as applied to a capital sum of about $100,000. The assumed date of this investment is 1902, ten years ago. I show the cost of the bonds selected at that time, the yield on the cost, the low value in 1907, the high value in 1909, and the value in the month of May, 1912.

The investment scheme here presented is confined entirely to "high grade" railroad issues, most of them savings banks investments, and all recommended in the strongest terms as "seasoned" issues. As far as security of principal is concerned, nothing could be better; there are enormous assets back of every one of the issues, and at the end of the decade, these assets were in every case much greater than at the beginning. And further than this, the sum is distributed in very small lots, showing an attempt at diversification. And yet, as the example shows, the outcome has been most unsatisfactory to the investor. Not only has the yield been low from the start (disregarding amortization, which would make it very much lower), but the holder has actually suffered a heavy loss in present capital value. At the low prices

Mistaken Investment Methods

L9 o^-^j ocoooooooorr P ^ S-5 o«oooo»ooQiowac 4

•S 2 o i* K} H lO <D M) h

OOOOOOOQOOCTC S

*C o "f

OOOOQOOOOOO *o©©©©©*nm©i- »fl eo o co © © w >o x © pfl — ■ r o

c

G ©

o

1 ' !3

3'

o

O O O O o o © © © CO

CM -**" CM

© © © *o o •o o o t- t-

CM CM CO H »-t

+j »rs © o o o to o © o ta o ©

O M irt N O M

O w r: C c O O

»o

-

O

fc«

f-

G

CM

—

cm

M

CI

CO

~

O a

_

o

S

o

~ w

r-

t-

«o o

M3 o

X

CO

O

K3

—

C

a

— H

a a

T-l i-< i-H OJ i-H t-1 i-l cm

f-

f

OC

ri

a iH

~

r.

— a m

L> pH

•O

0 0

~

•d

OJ

O

CO

cm

r/T

-r

C

CO

u

ryf

*0 rH

OJ r

CO

PC

a

y to c

CO

PQ

c^

C/f O

u

'7)

co s

c

c

-z C

'J

CO

CO

1— (

CO

•d

r

CO

~

Ih

a

- be

— .

u u-

> 1

"3 b c c

B

1 z

. 0

•u

: 0

•1

* 0 pq u

L

c -

! C

O

si x a^

u ri * r=

r «J pq ^

aUUL i fi

—

U

M

'o

u u

C

J

C u

U

In

G

a H

Ej * PL4 u

P CL

U x 5

u

CO

CO

c ^

O

P In

g

c

-

e

Q

O

1 0

G

3 3

> 0

O

3 3 of 1907 (the panic year) his principal showed a depreciation of $16,600 or 18% ; at the high prices of 1909 (the best seen since the panic) he still had a loss of $5,450 or over 51/2(/o ) while at present prices he has a loss of $11,350, or 11^%.

The truth is that the theory on which this man invested his money is not only inadequate for modern times, but unscientific and unsound. He supposed that in spreading his principal among many companies, in small lots, and diversifying it to all parts of the country, he was spreading his risk and keeping his eggs out of one basket. But as a matter of fact, all his eggs were in one basket and that basket was tied to one string, and is still so tied. He might just as well have put all his capital into one bond issue of the high grade seasoned class; the result would have been essentially the same.

In future chapters I shall attempt to point out some of the real principles which should be adopted in a safe and sane investment program.

Ill

Unsound Theories

AS pointed out on the previous pages, the theory of investment followed in the example shown is not only inadequate for modern times, but unscientific and unsound. With the rapid and unusual changes in business enterprise and industry during the past quarter century the field for investment has not only broadened vastly, but has become immeasurably complicated. Where, in 1885, there were but few fields in which the careful investor could safely place his funds, with only half a dozen types of high class security issues, today there are many dozens of such. In those earlier days, money could be invested with safety, and on a satisfactory basis of yield (outside of real estate mortgages), only in Government issues of the United States, carefully selected bonds of States, Cities and Towns, and still more carefully selected issues of steam railroads. But nowadays, not only has the field for government, municipal and railroad issues vastly broadened, but entirely new fields for safe and profitable investment have come into existence. The change of manufacturing enterprise into corporate forms, and the consolidation into vast units of industrial undertakings of every type has enlarged the investment field within recent years to the extent of probably ten billions of dollars in this one direction alone. The development of electrical power and light, with the growth and expansion of the great public utility undertakings of the country, has also broadened the field enormously in which capital can safely be set to work without danger to either principal or yield. The growth and expansion in the use of the telephone; the opening up of natural resources; the increases in the possibilities of water power and water supply ; the growth in commercial use of gas and oil ; the increases in population which have steadily raised the values of utilities in our cities; — all have opened new avenues for the safe investment of capital which were not dreamed of a generation ago. And within the past ten years, the trend toward consolidation of retail businesses in many lines, including the remarkable growth of the mail order business, has brought into existence a new class of security issues of safety and promise. Furthermore, the steady increase of wealth throughout the American continent has constantly contributed to enlarged size and stability for institutions engaged in the business of banking and insurance, and many stocks of National and State banks, trust companies, safe deposit and insurance organizations have, within recent years, come to be classed among strong and desirable investment issues.

It is probably largely because of the very multiplicity of these investment possibilities that the problem of safe selection of investments has become so difficult in modern times. No one but he who has made a careful study,

Unsound Theories 23 not merely of particular investments, but also of general business conditions, can be regarded as qualified to select the best issues with entire assurance of safety. For the pitfalls are many and dangerous; and while, among all the classes of enterprise referred to above, money can be discriminatingly placed, the fact remains that danger stalks in every direction for the person who has not the facts at hand or who does not possess the experience t«> pick the wheat from the chaff. Thus, while one can safely select bond issues secured on trolley lines which are, for all practical purposes, "as good as gold," he can also lose his money by buying worthless trolley bonds or stocks. He can select "seasoned" railroad issues, and he can lose his money with great ease in this same field. lie can buy industrial investments which will pay him handsomely ; but he also has full opportunity to lose his all in this same type of security. If he goes in for bank or trust company stocks, he may fare well or he may do worse than anywhere else; and he can also find plenty of weak or bad municipal bonds as well as good ones.

Because of the existence of so many pitfalls, many investors adhere to the theory that it is still the wisest plan to stick exclusively to the few old line investments, such as municipals, governments, and the underlying bonds of railroads, and not attempt to go into the new and less mature investment fields. But against this theory stands the undeniable fact that the investor must attempt t<> conserve his full principal and at the same time get at least a fair return on his capital. Unless he he a very rich man, he cannot afford to allow all hi- capital n> he concentrated in government issues, yielding 2 to 3 per cent, nor in high grade municipal bonds, which will return him but little more. If he selects a large proportion of underlying railroad bonds in order to bring his income up to a moderately higher plane, he cannot hope to secure an average yield of over 3% to 4% per cent in any event.

But there is a still stronger reason than this why he cannot afford to concentrate his capital entirely in security issues of this type. Such bonds, whether they be governments, municipals or railroads, often prove, when held over long periods of time, very unsatisfactory investments indeed. As I pointed out in the first chapter, he who bought New York City bonds five or six years ago, finds himself in a very unenviable position with his holdings today. If he had bought English consols, French rentes, or the bonds of any strong government or strong municipality on this or any other continent, he would have fared the same. If he had selected underlying railroad bonds, with enormous equities and vast earning capacities back of them, he would have done no better . Ten years ago, English consols would have cost him 98; today the same bonds are selling at 74 ; Illinois Central 3s, in 1899, sold at 96; now they are quoted at 75. No matter how carefully he had selected issues of this type a few years ago, he would today be facing a serious depreciation in the value of his capital.

IV Proper Principles for Diversifying Investments

IN recent chapters I have been pointing out the mistaken ideas regarding proper investment distribution, which so many investors have followed to their sorrow in modern times. I shall now submit some constructive suggestions regarding scientific investment distribution and try to lay down some fundamental principles which all investors should recognize when placing their capital in bond and stock issues.

There is a distinct divisional line running across the entire field of corporate investments. This line of demarkation does not follow any superficial division such as we find distinguishes a stock issue from a bond obligation. A bond per se, is not always necessarily any better than a stock ; nor is it sometimes as secure as a stock. Many stock issues are far superior in strength and value to many bond issues, and the mere fact that the bond is a mortgage, and that the holder thereof is legally entitled to a fixed return on the mortgage, will not of itself ne. sarily put him in a position of better security than that occupied by one who holds common stock in a corporation or railroad which is not a mortgage and which has no prior claim on income. This is simply another way of saying that, after all, the real element back of the average security is the earning power or income producing capacity of the property. A first mortgage on a railroad which is earning little or no money is not in any sense so desirable as a common stock on a railroad or industrial corporation which is earning and paying a good dividend on that stock.

The relative position of different securities in relation to earning power, results in dividing them into two great classes. These two classes are briefly defined as follows :

1. Securities, the investment values of which are beyond or above the influences of fluctuating earning power; and

2. Securities, the values of which are almost exclusively affected by changes in earning power.

Among the former are such issues as underlying bonds of railroad systems on which, over a long period of years the interest has been earned many times over, and back of which there are vast equities which are of such size that no possible doubt could arise regarding the practically complete security of the issue. Such are many of the bond issues secured on the Pennsylvania, the Illinois Central, the Chicago & Northwestern, the Burlington, the Lake Shore, etc. Preferred stock issues of some railroads are also to be regarded as in this class, although this does not generally hold true. Guaranteed stocks also are in many cases in the same general class as high grade seasoned bonds and the higher grade preferred stocks. Guaranteed issues like Morris & Essex stock, New York, Lackawanna & Western stock, and Pitts-

Proper Principles for Diversifying Investments Ti

burg, Fort Wayne & Chicago stock, arc all issues of this type.

The primary factor affecting the prices oi this first class of securities is the money market. The price i bond like the Lake Shore first 3l/2s or the Illinois Cen tral 3V2s is not materially (if at all) affected by the changing results from year to year in the income of th properties. The price of Northern Pacific fir>t 4s is not so affected. These properties might double their earnings within a given time and this fact would have no ap preciable effect on the prices of these bonds. The same thing is true of the Union Pacific first 4s, the Pennsylvania Railroad underlying issues, or the underlying bonds or strongly guaranteed issues of the Delaware & Hudson, the Reading or the New York Central. Consequently, if the investor confines his selections to high grade issues of this type he need give little concern to changes and fluctuations in earning power. It will not hurt him if earnings on his particular property fall off quite radically ; and conversely, it will not help him if earning- rise very rapidly. Even should his particular property come upon evil days and default on some of its junior obligations his position will be practically the same. In the year 1908 the Erie Railroad failed to earn the interest on its junior bond issues and came perilously near a receivership, but the underlying bonds on the system, such as the old Eric Railway 4s and 5s, secured by first lien on the main line, were not affected in value or price by this condition of things. In fact, they were selling at better pi the company was so near bankruptcy, than they were two years before, when the road was reporting a large surplus and paying a dividend on its first preferred stock. The reason for this was that, no matter what may have happened to the Erie system, the equity back of these particular issues was so heavy that troubles could never reach them. The Erie might have been reorganized in a very drastic fashion, and yet these mortgages could not have been disturbed. Consequently, they are in the first class mentioned above, and depend for their value, not on specific factors affecting the earnings or financial condition of the Erie Railroad, but on the general money rate factor almost exclusively.

To take a more extreme case. The Wheeling & Lake Erie Railroad has been in receivers' hands for several years, but the Lake Erie division bonds of this company sold higher in 1909 than in 1908 and have never declined in response to the fact that the company went bankrupt.

The true line of demarkation between "high grade" issues, so called, and those of any other "grade" is the one we have indicated. The phraseology on the instrument has its place and meaning, of course; but no legal lore or high sounding phrases can give a bond value if its position in the income results of the property is not secure. If a given railroad is earning an average of $5,000 per mile net, and a bond issue on the property has the first claim on that income, the immediate question will be, how much of that $5,000 per mile is required to meet the interest on the issue? If $4,000 per mile is so required, then the bond is in no sense "high grade ;" for a 20 per cent decline in net receipts would wipe out all the

Proper Principles* for Diversifying Investments 89

margin of safety. But if the amount required for interest is $400 per mile or less and the net earnings are $4,000 per mile, then the bond is removed entirely beyond the influence of changing earnings, and even a 50 per cent fall in net receipts would not jeopardize its position to any great extent. In fact, the road would have to go through an almost unheard-of period of bad results to affect the value of this issue.

But sufficient has been said to indicate that any sound and rational distribution of investment funds must cover a broader field than that of the merely "high grade issues," so called. In brief, it should include not merely issues which are primarily responsive to the current rates for money and credit, but also such issues as are more directly responsive to earning power. The latter type of securities can easily be included in a sound selection of investments without going into the field of speculation. It is not necessary for a man to buy speculative bonds or non-dividend-paying and doubtful dividend-paying stocks to get the benefit of improving earning power and growing equities in railroads and other properties, which transpire over reasonable lengths of time. But it is necessary that he should invest to some extent in the types of securities which have a potential interest in the expansion of the property. If he buys an ordinary bond he has a limited interest only ; if the bond is thoroughly seasoned and he has paid the prevailing rate for it, then there is no chance whatever of future benefit from expansion in values of the property; if the bond is low grade and not yet secure, then he is merely speculating. If, however, he can make careful selections of securities which participate in some way in increasing earnings, either directly or indirectly, then as the business and profits of the company grow, the value of his investment and the income on it will also grow. If he purchases, at the proper periods, stocks of railroads like the Illinois Central or the Pennsylvania, which have long records for steady payment of dividends, he may be able to put himself in a stronger position to meet changing conditions in industry and in the money market, than if he confines himself to bond issues alone. It is just as reasonable that intelligent selections of high grade stocks can be made as high grade bonds. It would not have been wise for an investor seeking security of principal and permanency of income to have bought Missouri Pacific stock or Toledo, St. Louis & Western preferred in 1908, merely because they were dividend payers and looked "cheap," but there would have been no mistake at that time in buying Louisville & Nashville, Norfolk & Western or Southern Pacific stocks. While such stocks as the latter fluctuate to considerable extent and rise too high during periods of speculation, they have back of them enormous equities and growing earning power, and as this earning power improves from decade to decade, the equities and income of such stocks improve in logical ratio.