The careful investor

Preface

American investors, under our crude and careless methods of finance, have lost incalculable amounts of money by purchasing bad securities. Not alone has the "get-rich-quick" company preyed upon the investor, but hundreds of millions have been lost in the bonds and stocks of railroad, public-service, and industrial corporations — securities often issued under the auspices of responsible and respected banking houses, but which, either because of defects in the securities which a careful preliminary examination would have disclosed, or because of bad financial management, have failed to come up to expectation.

Made wise by costly experience, the American investor has grown critical in recent years. He is disinclined to speculate. He looks for security before income. He asks many questions concerning assets, earnings, the quality of management, the strength of franchises, the extent of monopoly control possessed by the companies into which he puts his money. It is no longer easy to victimize

PREFACE

him with junior Hen mortgage bonds or with inflated stocks.

Investment bankers have also learned that a reputation for sound judgment as to the value of the securities which they offer is their greatest asset. Competition for the investors' money is growing constantly more strenuous. Salesmen are quick to seize upon the weak points in the securities offered by other houses. The banker cannot afford to take chances by selling bonds of whose merits he has not thoroughly satisfied himself.

Out of the growing caution of the investor in buying securities, and the desire of the investment banker to take no chances as to the quality of what he offers, has been developed a body of sound financial knowledge which is constantly being utilized to increase the security of investments. Improvement has proceeded so far that it is now possible to offer the investor thoroughly safe bonds which will yield a much higher rate of interest than was, until recent years, thought consistent with security.

This book, the outgrowth of a series of magazine articles which has followed a fairly consistent plan of arrangement, aims to present some of the

PREFACE

accepted opinions as to what constitutes a safe investment. The author claims no special ability in indicating soimd investments, but he is confident that close adherence to the cautions laid down in the following pages will keep the investor from buying investments which are unsound.

Edward Sherwood Mead

Philadelphia, 19 14

Contents

CHAPTER PAGE

I. The Chances of a Lamb in the Stock Market. . ii II. Stocks or Bonds 36

III. The Corporation Mortgage and the Deed of

II

We turn now from the subject of speculation, the purchase or sale of securities to make a profit from their rise or fall, to the subject of investment, the purchase of securities to receive the interest or dividends which they pay, and the first question which we encounter is the choice of securities. Shall the investor buy stocks or bonds ?

"Give me a seat in the front row," said an investor to his banker. *'No stock, no real estate, no equities, for me. I do not want to look over the shoiilders of the audience. I want the front row. Put my money into bonds."

This is the richest nation in the world, and, next to France, the most thrifty. In a normal year the net income of the American people, after paying most liberal living expenses, is far in excess of their operating expenses . An enormous amoimt remains for investment. What becomes of this money? A large amount of this money is put into savings banks. A large amotmt goes into insurance. A still larger sum is put into enterprises of various kinds which have stock for sale. Some goes into real estate, and a constantly increasing fraction into bonds.

It has been estimated that on the average a quarter of a billion dollars a year, and the real figures are probably higher, is lost in bad investments; sunk in margins on the stock exchange; donated to the brood of mining and industrial schemes whose promises are gold, and whose performances are chaff and stubble ; invested in town lots in some ''thriving industrial suburb " ; or even used to purchase on margin standard railway and industrial stocks, which seem to advance only long enough to inflict heavy losses upon those who purchase them for still further gains. These are the vast losses in the game of business hazard, where the dice are always loaded and the cards are always marked.

On the other hand are the timid ones, who buy

the obligations of the government, who put their

money into savings banks or into life insurance,

whose most daring flights are the ptirchases of the

homes in which they live. These are recruited

either from the anaemic or the dyspeptic, or from

the burnt children who, as a result of sad experience, dread the fire. Between these two classes are the institutional buyers of bonds; the insurance companies; savings and commercial banks, who purchase as trustees for their policy-holders and depositors, taking a liberal toll for their service ; and the individual bond-buyer, the man who is intelligent enough to buy his investments at first hand, and, at the same time, sufficiently conservative to decHne to participate in the risks of business.

"What is a bond? How does it differ from a share of stock? Why does it offer a safer place for my savings than a savings bank or a trust company, while at the same time allowing me a moderate share in the profits of business?" These are questions often heard, but seldom clearly answered.

A bond is a promissory note, a contract to pay money, executed and issued by a corporation, either public or engaged in private business, and bearing interest at 4, 5, or 6 per cent., according to the location of the borrowing company or the business in which the corporation is engaged. The payment of this promissory note is usually secured, principal and interest, by a second agreement, executed between the borrowing company and a trustee for the lender, usually a trust company, by which the property of the buyer is transferred to the trustee, in trust, to secure the punctual performance by the corporation of all its agreements, including not merely the payment of interest and of principal when the note matures, but the keeping of the property in good repair, and the performance of many other covenants which increase the safety of the loan. The corporation bond is, therefore, not only protected like any other promissory note by all the property of the borrower which can be sold for the lender's benefit if default is made on either interest or principal, but it is safer than an unsecured promissory note in that the property of the borrower is formally set aside as security for the loan. The borrowing company can neither sell the property nor place any additional incumbrance upon it, nor increase the amount of its indebtedness secured by existing incumbrances, without the consent of every bondholder, which is, of course, seldom given.

And this is not all. If only the bonds of ' ' going concerns" are purchased — that is, the bonds of corporations doing a profitable and increasingly prosperous business — the security of the investor

whose bonds are protected by a first lien on all the property of the corporation, is not merely the property which is purchased with the money which he pays for his bonds, and which he is safe in supposing will earn more than enough to pay his interest, but, in addition, all the previously existing property of the company. In other words, if the investor exercises that degree of care in the selection of his bonds which any prudent man will naturally give to the conduct of affairs in which he is interested, both his principal and his interest are secured and secure.

Now contrast the position of the corporation bond-holder, the creditor of the company, with the position of the stock-holder. A share of stock is a certificate of part ownership in a corporation. A corporation is an association of persons to which the law gives the right, after certain simple formalities have been complied with, to own property, and to carry on certain kinds of business. It is the association which owns the property, which borrows, buys, and sells. The association issues stock which represents its ownership, in exchange for money or property.

This stock is divided into shares. It comes into possession of those who expect through its means to share in the profits of the company. The stockholder is the owner of the corporation, as the corporation is the owner of the property. The stockholder does not own any part of the factory, or mine, or railroad. He owns a part of the company, and the company owns the property.

As the stock-holder does not own the property of his company, so he does not manage the company's business. That is done for him by trustees called directors, whom the law makes him elect. Each share of stock counts as one vote at the election, and a majority of the stock can elect the entire board. For example, a corporation capitaHzed at $10,000,000 may have 100,000 shares of stock. An investor has purchased 100 shares. At the election he has 100 votes out of 100,000, or one thousandth part of the total. So the "right to vote," which is one of the privileges of the stock-holder, not enjoyed by the bond-holder, amounts to little.

The small stock-holders in the best managed, largest, and soundest American corporations, either singly or in combination, have, practically speaking, no influence upon the election of directors. Where the officers care to take the trouble they may send out proxies, blank powers of attorney for

stock-holders to sign, but in only the most exceptional cases can an individual stock-holder, who has, in theory, the same right to solicit proxies as the officers, gain sufficient support to influence the election.

So well is this powerlessness of the stock-holder recognized, that some of the largest railway systems in the United States are dominated down to the last director and the last official by men who own only a few shares of stock, but who, in case of need, can secure by sending out requests for proxies, the cooperation of a sufficient number of stock-holders to enable them to control a disputed election. The late Henry 0. Havemeyer, who was in absolute control of the American Sugar Refining Company to the day of his death, held about 2/100 of one per cent, of its stock when he passed away. Elections are seldom disputed. Stock-holders are too widely scattered and too apathetic to take much interest in the way their company's affairs are conducted. While they receive dividends, they are content, and when dividends are reduced or suspended, their dissatisfaction seldom rises above sleepy growls of irritation and disgust.

The stock-holder also has the right to participate in profits, when, and only when, these are distributed by the Board of Directors. If the profits are not earned, he receives no dividends.

Even when large profits have been earned, he cannot obtain any share in them, unless the directors declare a dividend, and there is no power to force the directors to take such action. They can decide to pile up profits, and the stock-holders, unless they are able to put the directors out, which seldom happens, are helpless to interfere. They own shares in the company, it is true, but often this does them little good.

Of course, there is a brighter side to the picture. Sometimes profits are very large, and the stockholder gets large dividends, but he must always bear in mind that the bond-holder's interest must first be paid, and that any losses which the company may sustain must first fall upon its owners. And how numerous those losses are! Within a few months in 1908, the United States plunged from prosperity into depression, and down went the dividends of many of the strongest railroads and industries ; some of them suspended altogether, others seriously reduced.

The stock-holder has no assurance, moreover,

that the amount of stock outstanding will remain

where it is. He may be called upon to authorize a

doubHng of the capital stock, raising the number of

shares from 100,000 to 200,000. The new stock may be issued for property or for money, and the investment may be profitable, but there are now twice as many shares, and the universal practice of increasing stock capital keeps down the dividend rates of even the most prosperous companies to 6 or 7 per cent.

It is a hard saying, but a true one, that the small stock-holder in American business corporations has no influence in selecting the directors, no voice in the management, and but little power to protect himself against the directors should they decide to keep him out of his profits for the purpose of depressing the value of his holdings, so that they may purchase it from him at low figures, or practice upon him simdry other arts of the stock manipulator. He is powerless to prevent an imlimited increase in the amoim.t of stock, if made for lawful purposes and in a lawful manner. He has no claim upon the company to pay him dividends, and if he is dissatisfied with the way his business is conducted, his only remedy, in the language of a famous legal decision, is either "to elect new directors" — a manifest impossibility for the small investor — or '*to sell his stock and withdraw," which he frequently does at a considerable

discoimt from the price he paid.

How different and how vastly superior is the position of the investor who has purchased from reputable and responsible bankers the mortgage bonds of the same enterprises whose stock-holders are liable to so many hardships and mishaps. In common with the stock-buyer, the bond-buyer contributes money to construct and extend the plant of the corporation. They are both interested in its property and its profits. But here the resemblance between the position of the two investors abruptly ends. The bond-holder must be paid his interest regtdarly or the company becomes a bankrupt. The stock-holder's dividends need not be paid at all, unless the directors so decide, and they may be lowered or raised at the directors* pleasure. There is no certainty about them.

The bond-holder knows that his money has

gone into some kind of property — ^his trustee sees

to that. The stock of the same company may have

been originally issued for the *' good- will'' — often

the *'good will" of those who receive the stock.

The money which he pays very often goes not to

the company, but to its promoters, and those who

have sold property to it. The money which is

paid for stock takes the forms, not of rails, ties,

and power-houses, but of automobiles, horses and yachts. The bond-holder does not own any part of the corporation, as does the stock-holder, but, on the other hand, the stock-holder does not control any part of the property, while all the property is conveyed to a trustee for the safeguarding of the bond-holder's interests. The bond-holder knows how much of a particular issue he owns, and he knows that the total amount of this debt may not be increased unless he gives his consent. Before the stock-holder, on the other hand, stretches an endless vista of new issues, whose amount he is powerless to regulate or limit.

The bond-holder has a first claim upon earnings. In very few cases will they ever fall so far as to endanger his interest. Even in those cases where bonds of inferior security, or which have been issued in excessive amounts, are purchased without proper investigation, from bankers who valued immediate profits above the permanent confidence of satisfied customers — and most of these bankers belong to a past generation — and when these bonds have been in default, the investor has seldom sxiffered any permanent damage if he has held on to his security. These companies have been reorganized; new bonds or preferred stock are issued for

the bonds in default; and, in the great majority of cases, all the losses have been regained, sometimes with a large profit. The stock-holder, on the other hand, takes what is left after interest is paid, be that remainder much or little. He comes after the bond-holder. He sits in the lowest room, eats at the second table, occupies a seat in the back row. Long before the bond-holder*s interest is reached by the decline in earnings, the stock-holder's dividends are suspended, and the reorganization which passes lightly over the creditors falls upon the owners with crushing force.

As a final difference between stock and bonds, the value of a first mortgage bond, because of all the advantages and points of superiority which have been mentioned, changes very little in comparison with the value of the stock of the same company. The stocks of even the safest and best managed companies show the most astonishing gyrations, the wildest fluctuations. They fall $io, $20, $30, $50, a share, within a few months, while the bonds, securely protected by their position as first and fixed claimants to income, rise and fall very slowly and within very narrow limits. The owner can usually be certain of realizing on his investment with but trifling loss. What the

stock-holder will get may depend on the honesty of some New York bank president, the digestion of a high government officer or the success of the advertising campaign of some stock-manipiilator. Whether to sell or to pledge as security for loans, bonds are conspicuously better than stocks.

Now, then, if bonds are so much better than stocks, that the wayfaring man, if not altogether a fool, cannot fail to appreciate their superiority, how shall bonds be bought? Shall the investor turn his money over to an insurance company in an "endowment" policy, or to a savings bank or trust company, or shall he buy bonds direct ? The answer is not difficult. It is his money which buys the bonds in any event, whether he deposits it in a bank or pays it as premiums to an insurance company, or whether he chooses the better plan, and himself buys the same bonds which these institutions piirchase with the money which he contributes.

Why should he not buy direct and obtain the higher interest of direct ownership? There is only one objection to direct bond-buying, the lack of the ability, or rather the lack of experience, of the private investor to select soimd investments. There are all sorts of bonds, good, bad, and indifferently poor. Great care and much intelligent investigation is required to choose good bonds for investment. The insurance companies and the savings banks pay high salaries to experienced men to make investments for these institutions. Their depositors and policy-holders reap the benefit in perfect security, to obtain which they sacrifice a part of the money which is earned on the investment of their money by these institutions. The investor does not possess this ability. Left to himself in his bond-buying, he may go badly astray. Nor can he afford to pay adequate fees to expert advisers.

Into this situation comes the bond-house, with its organization of experienced investigators, far superior to those employed by the insurance company or savings bank, its large capital and still larger credit. The bond-house buys the bonds of enterprises in which it has confidence with its own money, purchasing them not as a broker or agent, but as an investor, and then resells them at a small profit to private investors, who are in this way able to purchase, with perfect security in both interest and principal, bonds which pay them much higher returns than they can receive from any institution to which they may entrust their

savings.

4 49

Ill

THE CORPORATION MORTGAGE AND THE DEED OF TRUST

Most people who have saved money are acquainted with the nattire of a mortgage. They understand it as a lien upon property, given to secure a debt. The conditions of the lien are that, in case the debt is not paid at maturity, the lender who holds the lien can force a sale of the property by judicial process, having his own debt paid out of the proceeds, and returning any balance to the borrower.

While the operation and effect of the real-estate mortgage are generally familiar, the nature of the lien conferred by the mortgage is not equally well imderstood. A mortgage is a conveyance of property by the owner to the lender. It is in form and in effect a deed similar to the ordinary deed by which property is conveyed from one person to another. The conveyance is, however, coupled with the condition that the creditor holds the title to the property, as trustee for the owner. The

conditions of the trust are as follows. If the debt to secure which the conveyance is made is not paid at maturity, or if any other covenant in the mortgage is broken by the lender, the trust, which up to that time has been a "passive " trust, becomes active, and the lender, known as the mortgagee, asserts his title to the property and forces its sale. The agreement between the parties binds the borrower, the owner of the property, not only to the payment of interest and principal, but also to the performance of certain other covenants of great importance to the security of the debt. For example, the owner must insure the property and make the policies payable to the lender; he must also pay the taxes and deliver the tax receipts to the holder of the mortgage, since a failiu-e to pay taxes might result in a sale of the property by the State, which would deprive the lender of his security. The borrower agrees to keep the property in good repair. He further agrees not to sell any portion of the mortgaged property without the consent of the lender, who will, of coxirse, not allow such a sale to be made unless the proceeds are applied either to the liquidation of the debt or to the piu-chase of new property of equal value to that sold.

This mortgage or conditional deed which con- 51 veys the title to real property to the lender is given to sectire a debt in the form of a bond. This bond is a simple promise to pay a definite sum of money, with interest, at a certain date in the future. It is signed by the owner of the property. The real-estate mortgage therefore comprises two contracts : first, a contract to pay money, and, second, a conveyance of real estate to secure the fulfilment of a contract to pay money.

When the conveyance, otherwise known as the mortgage, is copied into a book of record kept in a public ofiice for the inspection of all those who may be interested, it fixes the title of the mortgageholder as against all the world. The owner of the property, who is left in possession so long as he carries out his agreements with the lender, is free to sell his interest in the property. He must sell it, however, subject to the right of the lender to enforce the provisions of his contract. It is impossible, in any other way than by a tax sale, to separate the interest of the lender from the property to which that interest attaches.

We have these principles carried out in the corporation mortgage bond, the universal form of safe investment. There is, first, a promise to pay $1,000,000, $5,000,000, or $100,000,000 in ten, twenty, or fifty years from date. This promise to pay, executed by the officers of the corporation, is not expressed in the form of a single note, but is divided into i,ooo, 10,000, or 100,000 notes, numbered serialty from one to the total number, and all identical in form, with the single difference in the numbers. This division of the corporate debt into "pieces" is for purposes of convenience in marketing. It is unusual for one investor to take more than a small portion of a large loan. By dividing a large debt into a number of identical notes, each of small denomination, it is possible for the company to make a wide distribution of its bonds and gather funds from a great number of private investors and institutions.

Just as the corporation bond differs but slightly from the bonds executed in connection with the real-estate mortgage, so the corporation mortgage is practically identical with the more familiar real-estate mortgage. Because the creditors of the corporation are ntimerous, it is impossible to make the conveyance to the lenders — there are too many lenders. It is necessary, therefore, that a trustee should be appointed to act for the lenders, and to hold the property in trust for the securing of these

various obligations. Sometimes an individual trustee is named for this ptirpose. The usual practice, however, is to designate a trust company, which, because of its large capital, and its administrative organization experienced in the conduct of matters of this kind, makes a more satisfactory trustee than an individual. A corporation mortgage is, therefore, usually known as a deed of trust, or sometimes as a mortgage deed of trust.

The form of the corporation deed of trust follows the usual outline of real-estate mortgages. There is first a description of the bond to secure which the mortgage is executed. Then comes the detailed description of the property. This property is next conveyed to the trustee in a form of which the following is a type :

NOW, THEREFORE, THIS INDENTURE WITNESS- ETH that, for and in consideration of the premises and of the acceptance of the refunding bonds by the holders thereof, and of the sum of one himdred dollars, lawful money of the United States of America, to it diily paid by the Trustee at or before the ensealing and delivery of these presents, the receipt whereof is hereby acknowledged, and for other good and valuable considerations, Rogers-Brown Iron Company has granted, bargained, sold, aliened, remised, released, conveyed, confirmed, assigned, transferred and set over, and by these presents does grant, bargain, sell, alien, remise, release, convey, confirm, assign, transfer and set over irnto the Trustee, its successors in the trust and its and their assigns, forever, all and singular the following described or mentioned property, rights and franchises, which collectively are hereinafter generally called the trust estate, to wit:

Then follows a detailed description of the property, the same description that is contained in the original deeds by which the borrowing and pledging corporation took title to the various properties named in the mortgage.

The nature of the conveyance is, however, not absolute, but conditional. This appears in the following clause ; respectively called the Habendum Clause and the Grant in Trust:

TO HAVE AND TO HOLD all and singular the said property, rights and franchises unto the Trustee, its successors in the trust and its and their assigns, forever: —

IN TRUST, NEVERTHELESS, for the equal and proportionate benefit and security of all holders and registered owners of refunding bonds and coupons and, ... for the enforcement of the payment of the principal . . . and interest of all such bonds when payable, according to the tenor, purport and effect of such bonds and coupons, and to secure the performance and observance of and compliance with the covenants and conditions of this indenture, without preference, priority, or distinction as to lien or otherwise of one bond over any other bond by reason of priority in the issue, sale or negotiation thereof . . . and so that the principal, premium and interest of every such bond shall, subject to the terms hereof, be equally and proportionately secured hereby as if all had been duly issued, secured, and negotiated simultaneously with the execution and delivery hereof.

Up to this point, there is no substantial difference to be observed between the wording of the real-estate mortgage and the wording of the corporate mortgage. The only points of variance of the corporation mortgage are the greater complexity, and the fact that in the corporation mortgage the conveyance is not to the lender direct, but to the lender's representative.

From this point, however, the corporate mortgage differs from the real-estate mortgage in that it contains a variety of covenants entered into by the company which owns the property, with the trustee who holds the property in trust for the security of the debt. These covenants are calculated to maintain the value of the security.

In addition to a repetition of the agreements contained in the bond to pay principal and interest, the company which owns the property agrees with the trustee in the mortgage that it will pay the taxes ; that it will pay all claims for labor and materials out of which mechanic's liens might arise, which might precede the claim of the trustee to the property; that the company will maintain the property in good condition and repair, and will continue to operate the property in the conduct of the business to which it is specifically devoted, as, for example, the production of pig iron or the business of transportation ; that any property which they may thereafter acquire, they will, by

supplementary deeds, convey to the trustee as additional security to that already conveyed; that they will not, without the consent of the trustee, sell any portion of the property, and that this consent will be given only on condition that the proceeds of the sale represent a fair price for the property disposed of, and that these proceeds are invested in new property to take the place of that withdrawn; that the company will keep all property subject to the danger of fire damage fully insured, and that, if the trustee desires, the policies of insurance shall be made payable to the order of the trustee, so that the money will come into his hands, in order that he may superintend its disbursement; that, in so far as the company operates any franchises granted by municipalities, the obligations of these franchises will be faithftdly observed; that, in so far as it holds any property imder lease, it will faithftdly carry out the covenants of these leases ; and, in general, that the company executing the mortgage and owning the property will carefully conserve and protect the physical condition and the value of the business as a going concern, so that the bond-holders may have at all times adequate security for their debt.