The art of Wall Street investing

Preface

ALTHOUGH the popular impression is probably the reverse, it is certainly a fact that a greater sum of money is annually lost in this country through unwise investment in Wall Street, than through pure speculation. While fortunes are daily jeopardized and dissipated through speculation in stocks, bonds, grain-futures and like ventures, yet the many sums, large and small, which annually leave the pockets of actual investors are far greater in amount. Indeed, I would almost say that the losses incurred through "unwise Wall Street investing" are easily tenfold the losses occasioned through mere speculation on the exchanges.

And furthermore, the losses resulting from unwise investing are far more important to the community at large; for while speculative losses are in a sense anticipated, the losses through mistaken investments are usually unexpected and unprepared for. Speculative

iii iv PREFACE

losses often represent the loss of money easily gained, either through former speculations or from other sources, but the average loss of the investing public is generally a loss of hardearned or industriously accumulated savings; and therefor such losses are felt more deeply by the community.

The Art of Wall Street Investing involves two important primary principles. The first is to place one's principal where it will be entirely secure, and the second, to gain as large a percentage of return as possible without in the least disturbing or lessening the security of the principal. The moment the status of the principal is changed for the purpose of enhancing the rate of return, the transaction ceases to be a pure investment and becomes more or less of a speculation. Thus, analyzed in its simplest form, we may put it down as axiomatic that only those are legitimate investments where the primary motive is the safe securing of one's principal and the rate of return thereon is looked upon as secondary. A speculation, on the other hand, is where the desire for large profit is so strong that the safety of the principal becomes in effect a minor consideration. That is to say, the person investing or speculating may regard his principal as secure but is

PREFACE v

willing to place it at considerable risk in order to increase his profit. The securing of the principal, therefor, is the first and chief matter to be considered in investing money.

Looked upon in this light, it will be seen that the matter of investing money wisely is a most important as well as a most difficult art, and therefor well worthy of careful examination. The ideas and suggestions embraced in the following pages are the concrete result of sixteen years' experience and study of Wall Street conditions and methods ; and while it may appear to some that the writer is too conservative in his attitude towards investing methods in general, yet careful thought should convince every reader that it is the part of safety and prudence to be securely on the side of conservatism in Wall Street investing, rather than the reverse.

In the following chapters the general subject of Wall Street investing is treated in as practical a way as possible. The fundamental principles of investing are carefully examined, and their importance emphasized. It is intended that the book shall not be merely a treatise on the abstract or theoretical side of investing, nor that it shall merely give a surface view of the investment field. Rather is it vi PREFACE

intended to make the book of general use as a practical hand-book or guide for those who wish to place their money in legitimate corporate enterprises of the several kinds, through the purchase of stocks and bonds. Not only are the different classes of securities themselves described, but careful explanations are given of the machinery and methods of investing throughout the various Wall Street channels.

In the general arrangement and composition the valuable co-operation of Mr. John F. Hume, author of a book now long out of print, entitled "The Art of Investing," is hereby publicly acknowledged.

JOHN MOODY

Contents

Chapter Page

I. Safety and Security 9

II. Bonds and What They Represent . 33

II

T5 ONDS are issued on all kinds of property *^ and are usually secured by a mortgage of some kind. There are, however, certain classes of bonds, such as "governments" and "municipals," the principal of which is secured entirely in other ways. It will be of interest and profit to briefly point out the earmarks of these different classes of bonds.

Bonds are usually issued in denominations of $1,000 each, though sometimes issued for a larger or smaller amount. Some bonds bear coupons and some are what are known as registered bonds. The interest on the latter is always paid directly to the registered owner by check, in the same manner that dividends are paid.

A first mortgage bond is always secured by a deed of trust, and directly covers the property on which it is secured, without being subject to any other lien. There may be other bond issues secured on the same property, but their lien is entirely subsequent to the first mortgage. Because a bond is a "first mortgage" one should not necessarily assume that it is a "gilt-edged" security. True, it is bound to be better than any other bonds secured on the same property, but the property itself may not be worth the amount of the mortgage, or the business may not be earning enough to pay the interest as it falls due.

A second mortgage bond, is, as its name indicates, always secured subsidiary to the prior, or first mortgage. If the first mortgage completely covers the value of the property, then of course, the second mortgage has an inferior standing only. But many first mortgages amount to only a portion of the value of a property, and in these cases a second mortgage is frequently well secured and attractive as an investment. To illustrate: A property worth $10,000,000 and earning $800,000 per year may have issued a first mortgage amounting to $1,000,000, and carrying an interest charge of $60,000 per year. Such a first mortgage bond would be regarded as high grade. The company may then have issued a second mortgage amounting to $2,000,000, and carrying an interest charge of $120,000 per annum.

In this case the second mortgage bond would be high grade also, as the aggregate amount of both mortgages would be but $3,000,000 on a property valued at $10,000,000, and the total interest charge of $180,000 would leave a surplus, (based on earnings of $800,000 per year) aggregating $620,000, or more than 3^2 time:: the interest charge itself. On the other hand, if a property, the value of which was but $4,000,000, with annual earnings of but $240,- 000, should issue first and second mortgages of the character and amounts mentioned above » not only would the second mortgage bond be of doubtful quality, but the first mortgage itself would be regarded as very far from "high-grade."

Third, fourth and fifth mortgages, etc., are ; as their names indicate, secured subsequent to the several preceding issues and require no separate comment, except that the mere fact of their being subsidiary to several issues does not of itself make them inferior in value. Other things being equal, the title of a bond signifies very little. The fifth mortgage bond o£ the old New York & Erie Railroad (now assumed by the Erie Railroad S3^stem) and of which there are outstanding $700,000, are not any the less valuable because they are secured as a "fifth" mortgage only, but on the other hand they are decidedly high-grade in respect to security, as they are a lien (subject to four prior mortgages aggregating $13,500,000) on 446 miles of the Erie main lines. As these main lines are easily worth ten times the amount of all five mortgages, it will be seen at a glance that they are all securities of a most desirable kind.

A consolidated mortgage bond is generally created as a result of a reorganization, a readjustment of finances, or for the purpose of providing new capital where a property is already mortgaged to some extent, and a second or third mortgage would not be well enough secured to warrant a ready sale. To cite an instance, let us take the First Consolidated 5% bonds of the Southern Railway Company. This Company was formed in 1894 as suc " cessor to a large number of other railroad corporations operating throughout the South. It was necessary to finance the new company with liberal capital, to spend a large amount of money on the properties, and in these and other ways to increase the earning power of the company. As the properties were already mortgaged in various ways for more than $60,000,000, it was not found practicable for the company to issue an independent mortgage. They therefore authorized a "consolidated" mortgage, one of the cardinal features being the authorization of a very large issue, of which a sufficient amount were held in reserve to retire the various prior divisional mortgages as they matured. This consolidated issue runs 100 years, and as the many divisional and prior bonds mature at different dates and some very quickly, it follows that the "consolidated" bonds grow in security and value as the old issues are cancelled. In this particular case every prior issue will be retired by 1938 and most of them much sooner, whereupon the consolidated issue will become a first mortgage.

A general mortgage bond is of the same class as a consolidated mortgage. This is sometimes called a "blanket" mortgage, and is frequently issued when there is but a single first mortgage on the property. It is sometimes partly secured by second mortgage and partly by first mortgage, but usually it is merely subsequent to two or more first and sometimes even consolidated or less well secured liens. When this is the case a sufficient amount is generally reserved to take care of the other bonds as they mature. In some cases the prior liens, or portions of them, are exchanged for the "generals" on a mutually satisfactory basis.

A prior lien bond is not necessarily a bond of prior security at all, except in a qualified sense. The term "prior lien" as applied to railroad bonds nowadays, connotes something entirely different from what would naturally be supposed. The Erie Railroad "prior lien" fours, for instance, are simply prior to the "general lien" fours, and both are part of an issue of a first consolidated mortgage which was authorized at the time of the reorganization in 1895 to provide new capital, take care of old mortgages, etc. The prior lien issue, therefore, simply has preference over the general lien portion of the same mortgage. The Northern Pacific, Baltimore and Ohio, and a number of other large railroad companies have adopted a similar device.

A debenture bond is not a mortgage, but simply a promissory note, or promise to pay. It is usually issued in the same form as other bonds, sometimes carrying coupons and sometimes appearing in registered form. While both principal and interest are an obligation of the company issuing the bond, yet in the case of a default the holder cannot foreclose as he can in the case of a mortgage bond. In this respect the deoenture is in very much the same position as a cumulative preferred stock, with the important exception that the latter usually carries a voting power, while the former does not. But debenture bonds, like all the rest, get their investment status largely through the character of the corporation issuing them. Some debenture issues, like those on the Chicago & Northwestern system, are in such high standing (because of the vastness and general solidity of the company) as to be quoted at a very high premium, the fives selling at over 115— while others are in the category of third-rate stocks.

A collateral trust bond is an indirect mortgage on a piece of property, made through the deposit with a trustee of other securities which are usually directly secured. Sometimes, however, the collateral so deposited consists of both stocks and bonds, and in same cases, of stocks 'only. Like other kinds of bonds, there are "ail sorts and conditions" of collateral issues, some being secured by one collateral only and others being secured by a heterogeneous variety of good, bad and indifferent stocks and bonds. In some cases bonds are secured partly by deposit of collateral and partly by mortgage on some property. In such instances they are described as "mortgagecollateral trust bonds," etc.

A convertible bond is an issue which carries a right or privilege for conversion into some other issue of bonds or stocks. There are many kinds of convertible bonds, and they carry convertible clauses for many and diverse reasons. Thus, United States Steel Corporation second fives were convertible into preferred stock at par; Erie Railroad four per cent, convertibles are convertible into common stock on the basis of $200 in stock for $100 in bonds before April 1, 1915; Baltimore & Ohio convertible debentures are convertible into common stock at par on any interest day, etc. Sometimes these clauses are inserted in mortgages to give them a speculative value; in other cases to provide for the retirement of the debt by its conversion into stock. Usually the act of converting is optional with the holder.

A joint bond is one issued or assumed by two or more corporations. Thus, the Great Northern-Northern Pacific joint collateral trust fours, secured by deposit of Chicago, Burlington & Quincy Railroad stock are the joint obligation of the two controlling companies.

There are not a great many issues of such joint-bonds, although there are many cases where independent bond issues are jointly guaranteed, either by two or more separate corporations.

A guaranteed bond is one the payment of which is specifically "guaranteed" by endorsement or otherwise by another corporation. There are many guaranteed bond issues in the railroad field, carrying guarantees of various kinds. In some cases the interest only is guaranteed; in others, both the principal and interest. Guarantees often come about as the result of a consolidation, lease or absorption of some kind, altho there are many cases in which bonds are guaranteed for other reasons. The Delaware, Lackawanna & Western Railway specifically guarantees the Morris & Essex refunding 3^2% bonds. But the Morris & Essex is a constituent part of the Delaware* Lackawanna & Western system, and the bonds would be equally as valuable without the guarantee as they are with it. The guarantee, however, makes them a direct obligation of the Delaware, Lackawanna & Western Railway, There are many guaranteed issues, which are, of course, materially improved by their guarantee, and which without it would not only be unattractive, but would be entirely unsalable, for the reason that the property on which they are directly secured is not valuable enough in itself or has not the necessary earning power. It must not be assumed, however, that the mere formal guarantee gives the bond its value. This latter depends entirely upon the standing and financial strength of the guarantor. Thus, a bond issue guaranteed by the New York Central system will have a far better standing than one guaranteed by a company like the Denver & Southwestern, the standing of which has been of a more or less uncertain and speculative nature.

Investors in guaranteed bonds should examine their security very closely to ascertain whether the guarantee can be abrogated in any way, and whether it actually covers both principal and interest. If the guaranteeing company itself seems likely to ever repudiate the bond, its entire value will then, of course, revert back to the standing of the mortgage itself, and in any event, this latter should be investigated with care. The guarantee of a bond is usually embraced in the phraseology of the bond itself, or else is specifically stated by the actual endorsement of the guarantor.

An assumed bond is in some respects similar to a guaranteed bond, being an issue, the payment of which, both principal and interest, is "assumed" by the controlling company. The effect is in some sense the same as a guarantee and the bond becomes, as a result, a direct obligation of the assuming corporation. There are many hundreds of "assumed" bonds dealt in in Wall Street, of every kind and description. Great care should be taken, however, in examining a so-called assumed bond. Many large railroad corporations have acquired control of other properties without actually assuming their obligations. Frequently the acquiring company, for strategic or other reasons, voluntarily takes care of these obligations, without being legally obligated to do so. But unless a bond issue has been definitely and formally assumed by the controlling company, its standing as an investment must depend chiefly on the actual property itself and not on the standing of the controlling corporation. Instances of assumed bonds are such as the Kentucky Central; Atlantic, Knoxville & Northern and the Evansville, Henderson & Nashville issues in the Louisville & Nashville system. The payment of both principal and interest of these issues has been made an obligation of the controlling company. On the same system we find several mortgages of the Nashville, Chattanooga & St. Louis Railway which have not been "assumed" at all. These issues stand entirely on their own merits, and are an obligation of the Nashville, Chattanooga & St. Louis Railway only, the latter being controlled through stock ownership, by the Louisville & Nashville Railroad.

A divisional bond is usually an obligation of a large railroad which is secured on some specific division of the property. On the Chicago, Milwaukee & St. Paul Railway all the bond issues, outside of the general mortgage, are divisional liens. Thus, the Iowa & Dakota Division 7s are a direct obligation, but secured by mortgage on the division extending from Algoma, Iowa, to Chamberlain, South Dakota, consisting of 355 miles. The Chicago & Lake Superior Division first 5s are a direct obligation, but secured by direct mortgage on 75 miles of road extending from Rockland, Illinois, to Portage City, Michigan. The cardinal distinction between a divisional and an assumed bond is that the former is a direct obligation and is usually issued by the main corporation, while the latter is (or originally was) the obligation of a subsidiary corporation, the owner-

BONDS AND WHAT THEY REPRESENT 45 ship or control of the stock or property of which has been acquired, or is possessed by the main company. Assumed bonds are sometimes spoken of as divisional issues, and in a broad sense they are, but the specific meaning cf the term is as explained above.

An income bond is one on which the payment of the interest is dependent on income. That is to say, while the principal is a mortgage and legally must be taken care of at maturity, the interest rate is not a "fixed charge," and no foreclosure proceedings can be instituted in case the interest is not paid. The payment of the latter is entirely dependent on the earnings of the company, it being generally agreed that if the interest is earned it shall be paid; otherwise, not. There are several classes of income bonds. Some are not a mortgage. These are usually known as "debenture incomes." Others bear a cumulative clause which provides that interest when unpaid, shall accrue, and all accrued interest be paid or satisfied before the current interest is paid. These are known as cumulative income bonds. Still others are convertible into securities of another class, such as preferred stock, and are known as convertible incomes. Others have preference over inferior issues and are known as preference incomes. Thus on the Central of Georgia Railway there are issues of first, second and third incomes, all carrying the right to 5% interest per annum, when earned. In this instance 5% must be paid on the firsts before the seconds receive anything, and the seconds must of course receive their 5% before the thirds come in for any interest. If enough is earned to pay the full amount on the firsts, but not enough for the full amount on the seconds, then the latter usually receive whatever amount of the divisible income is left. This may amount to 1% or 3%% or 4%, being dependent on what the road may be currently earning.

It does not follow, however, that interest is always paid on income bonds, even when the property earns it. One frequently hears the remark, that such and such a company is "showing" the full interest on its incomes or the full dividend on its preferred shares. "Showing" is not necessarily paying, and payments depend not merely on the earnings, but also on the judgment of the management as to whether it is wise to make the payments. Some managements are far more conservative in this respect than others, and the most far-seeing and cautious men, who handle the finances of a large property, v/ill generally "go slow" in the matter of paying out money on incomes and dividends unless the company is earning a considerable surplus over the amount required for the payment, or has already accumulated a tangible surplus from earnings to fall back upon.

A sinking-fund mortgage is one which carries a provision setting aside a portion of earnings year by year for the purpose of retiring the bonds at or before maturity. There are many kinds of sinking-fund clauses in bonds and they act in several different ways. The best known form is a provision requiring the company to deposit with the trustee periodically a certain sum of money, sometimes a percentage of the gross or net earnings, sometimes a percentage of the outstanding issue, and sometimes simply a fixed sum of money each year; the trustee then either calling in by lot a sufficient number of the issue to exhaust the amount of money he has received, or, if more are offered at the callable price (this price is usually a premium figure, 102, 105, no, etc.), then buying the bonds in the open market at the lowest prices offered. The bonds so acquired are then cancelled and thus the issue is gradually reduced. Other forms of sinking-funds are where the bonds so acquired by the trustee are "kept alive," the interest which is paid thereon being added to the fund and used for the purpose of buying still more bonds. Still other funds require that the bond issue itself be allowed to run until maturity and that the money set aside in the fund be invested in other securities, and thus the whole fund is held intact until the entire bond issue actually matures.

There are a great many "sinking-fund" bonds in existence, but in the railroad investment field, they are not as popular nowadays as in former times. The permanent investor does not like a sinking-fund which may result in disturbing his investment at any time, even if he does receive a little premium, and this is especially true of savings banks and large corporate investors like insurance companies, large estates, etc. Furthermore, in the case of a bond which is subject to call, an artificial value is created; it will not sell much above the callable price, for the reason that it is callable at any time. On the other hand, if there is but little market for the bonds an artificial demand is created at the time of each sinking-fund purchase, and thus its attractions as an investment purchase are seriously interfered with. In the matter of municipal securities, however, the sinking-fund is far more logical and useful, and particularly is it necessary in bonds which are issued for the construction of public utilities such as water, electric light and gas plants, which (where owned by municipalities) are operated at approximate cost and are not supposed to set aside surplus earnings in other ways to cover depreciation, expansions and improvements. This is also true of the more speculative classes of bonds, such as those on public service corporations in private hands, industrial enterprises, etc. Such cannot, as a rule, have too much safe-guarding of this nature. Railway industries of all kinds which have not had the opportunity of demonstrating their permanency or soundness over long periods of time should always carry sinking-funds in their bond issues. This is particularly applicable to industrial enterprises, the property of which constantly tends to depreciate. The great United States Steel Corporation carries many kinds of sinking-funds, aggregating in total amount nearly $35,000,000 per annum, which at the present time is equal to more than 20% of the annual net income of all the plants. Bonds on coal mines and other mining properties also usually carry sinking-

5 o ART OF WALL STREET INVESTING

funds. In the case of the former the proviso usually is that a certain amount (often 2 or 3 cents) be set aside with every ton of coal mined, the accumulations being used in the usual ways for the retirement periodically of the issue.

An extended bond is an issue which has matured and by agreement with the owners has been extended for a further period, instead of a new issue being created to take its place. Often bonds are extended for a few years only, but sometimes the extension reaches on over several decades. Usually, in the case of railroad issues, the rate of interest is reduced at the time of the extension and sometimes new bonds of the same mortgage, but with sheets of coupons at reduced rates, are exchanged for the old ones. There have been instances where the old bonds have been retained and stamped with the "extension clause," and new sheets of coupons supplied separately.

There are several issues of extended bonds now running as divisional liens on the Erie Railroad system. These are the New York & Erie first, second, third, fourth and fifth mortgages. Originally issued in the '40s and '50s at 7%, they all matured in the '70s and '8os, and have been extended for forty to fifty years more at 4, 4^ and 5%. When they finally mature again they will this time be retired, and bonds of the Erie Railroad general lien issue, now held in reserve, will take their places.

An underlying bond is a general term describing any issue which precedes or is prior in mortgage security to some subsequent issue. When a bond is spoken of as underlying, it is generally so referred to in connection with some general or junior issue, which may or may not provide for retiring this issue at maturity. Thus any bond issue is "underlying" which has a junior security following it. Hence, a bond need not necessarily be a first mortgage to be described as "underlying." It may itself be subject to a further mortgage or mortgages which underlie it. On many railroad systems, and indeed in other corporations there are frequently several "layers" of underlying issues, and on portions of the Erie and of the Reading systems, there are as many as ten mortgages secured, "underlying," or, if you wish to reverse the viewpoint, "overlying" one another.

A refunding mortgage bond is an isssue especially created for taking care of maturing issues, supplying additional capital, etc., and for reducing fixed charges. The modern refunding bond on steam railroads is usually an issue running one hundred years, bearing a comparatively low rate of interest, and generally secured by a "blanket" mortgage on "all the property now owned or hereafter acquired," subject, of course, to the prior mortgages which are to be retired as they fall due. Often, a very large issue is authorized, in order that funds may be available for future acquisitions. One of the first large refunding issues was that of the New York Central 3%fo refunding mortgage issued in June, 1897. The authorized issue was $100,000,000, of which $70,- 397,333 were originally reserved to retire certain prior liens, with $14,622,667 for premiums on the bonds. The remaining $15,000,000 were to be issued for new construction or property, after Dec. 31, 1903, at a rate not exceeding $1,000,000 per annum.

In authorizing these bonds the maturity of several underlying liens was anticipated by a few years. It so happened that all the main-line mortgages on the New York Central system matured between 1897 and 1905, and in authorizing the new 3%% mortgage it was made a part of the plan to allow holders to exchange their old bonds at once, on an equitable basis, and without waiting for the dates of maturity. This exchange plan was made optional with the old bondholders, but a large proportion of them took advantage of it. Today all the prior liens have been retired and nearly $85,000,000 of the three and one-half per cents are today outstanding. It will be observed that they are now an actual first lien on the main lines of the system, and their refunding features have ceased to be a factor. There are today a large number of refunding issues, and because of their improving position, the length of time they run, and so forth, they are generally more popular with permanent investors than the prior issues which usually underlie them.

A participating bond is a modern term describing an issue which is entitled to participate in income or profits, under certain conditions, beyond its fixed rate of interest. The most notable instance of a participating bond were the Oregon Short Line Railroad participating fours, issued in 1902, but called for payment and cancelled on February 1, 1905. These bonds were issued to finance the purchase by the Union Pacific interests of Northern Securities Company stock, and the latter was deposited as collateral with the trustee. The mort-

54 ART OF V/ALL STREET INVESTING

gage required that in addition to receiving 4% interest, the bonds were to participate in any dividends over 4% that the Northern Securities Company stock might pay. Thus, when the Northern Securities Company dividend rate was increased to 5%, these bonds received a dividend of 1% in addition to their regular interest, and of course shared, to an extent, in the speculative value thus engendered by an additional division of profits. The Northern Securities merger being afterward set aside, these participating bonds were largely converted into a new refunding issue of fours, guaranteed by the Union Pacific Railroad, and the balance were called and paid off at the redemption price of one hundred and five.