How to Invest Money.

by George Garr Henry.

PREFACE

The aim of this book is to present in clear form the simple principles of investment, and to afford the reader a working knowledge of the various cla.s.ses of securities which are available as investments and their relative adaptability to different needs. The book is an outgrowth of the writer's personal experience as an investment banker. Most of the matter which is presented has appeared in the pages of "System"

Magazine, through the courtesy of whose editors it is now rearranged and consolidated for publication in book form.

G. G. H.

HOW TO INVEST MONEY

I

GENERAL PRINCIPLES OF INVESTMENT

With the immense increase in wealth in the United States during the last decade and its more general distribution, the problem of investment has a.s.sumed correspondingly greater importance. As long as the average business man was an habitual borrower of money and possest no private fortune outside of his interest in his business, he was not greatly concerned with investment problems. The surplus wealth of the country for a long time was in the hands of financial inst.i.tutions and a few wealthy capitalists. These men, the officers and directors of banks, savings-banks, and insurance companies, and the possessors of hereditary wealth, were thoroughly equipped by training and experience for the solving of investment problems and needed no help in the disposition of the funds under their control. During the last ten years, however, these conditions have been greatly altered. The number of business men to-day in possession of funds in excess of their private wants and business requirements is far greater than it was ten years ago, and is constantly increasing. These men are confronted with a real investment problem.

While they have not always recognized it, the problem which they are called upon to solve is really twofold--it concerns the safeguarding of their private fortune and the wise disposition of their business surplus. They have usually seen the first part of this problem, but not all have succeeded in clearly understanding the second. When the treatment of a man's business surplus is spoken of as an investment problem, it is meant, of course, not his working capital, which should be kept in liquid form for immediate needs, but that portion of his surplus which is set aside for emergencies. It is coming to be a recognized principle that every business enterprise of whatever kind or size should establish a reserve fund. It is felt that the possession of a reserve fund puts the business upon a secure foundation, adds to its financial strength and reputation, and greatly increases its credit and borrowing capacity. The recognition of this fact, combined with the ability to set aside a reserve fund, has brought many men to a consideration of the best way in which to dispose of it. It is obviously a waste of income to have the surplus in bank-accounts; more than that, there would be a constant temptation to use it and to confuse it with working capital. Its best disposition is plainly in some safe interest-bearing security, which can be readily sold, so that it will be available for use if necessity demands.

Confronted with the double problem thus outlined, what measure of success has attended the average business man in its solution?

It is safe to say that the average man has found it easier to make money than to take care of it. Money-making, for him, is the result of successful activity in his own line of business, with which he is thoroughly familiar; while the investment of money is a thing apart from his business, with which he is not familiar, and of which he may have had little practical experience. His failure to invest money wisely is not due to any want of intelligence or of proper care and foresight on his part, as he sometimes seems to believe, but simply because he is ignorant of the principles of a business which differs radically from his own.

The investment of money is a banker's business. When the average man has funds to invest, whether he be a business man or a pure investor, he should consult some experienced and reliable investment banker just as he would consult a doctor or a lawyer if he were in need of medical or legal advice. This book is not intended to take the place of consultation with a banker, but to supplement it.

The advantage of such consultation is shown by the fact that if a man attempts to rely on his own judgment, he is almost certain not to do the best thing, even if his business instinct leads him to avoid those enterprises which are more plainly unpromising or fraudulent. It should be remembered, however, that widows and orphans are not the only ones ensnared by attractive advertis.e.m.e.nts and the promise of brilliant returns. In most cases, widows' and orphans' funds are protected by conscientious and conservative trustees, and it is the average business man who furnishes the money which is ultimately lost in all propositions which violate the fundamental laws of investment.

The average man is led into these unwise investments through a very natural error of judgment. Accustomed to take reasonable chances and to make large returns in his own business, he fails to detect anything fundamentally wrong in a proposition simply because it promises to pay well. He forgets that the rate of interest on _invested money_, or pure interest, is very small, and that anything above that can only come as payment for management, as he makes in his own business, or at the sacrifice of some essential factor of safety which will usually lead to disaster.

For the successful investment of money, however, a good deal more is required than the mere ability to select a safe security. That is only one phase of the problem. Scientific investment demands a clear understanding of the fundamental distinctions between different cla.s.ses of securities and strict adherence to the two cardinal principles, distribution of risk and selection of securities in accordance with real requirements.

One of the most important distinctions is that between _promises to pay_ and _equities_. Bonds, real-estate mortgages, and loans on collateral represent somebody's promise to pay a certain sum of money at a future date; and if the promise be good and the security ample, the holder of the promise will be paid the money at the time due. On the other hand, _equities_, such as the capital stocks of banking, railway, and industrial corporations, represent only a certain residuary share in the a.s.sets and profits of a working concern, after payment of its obligations and fixt charges. The value of this residuary share may be large or small, may increase or diminish, but in no case can the holder of such a share require any one, least of all the company itself, to redeem the certificate representing his interest at the price he paid for it, nor indeed at any price. If a man buys a $1,000 railroad bond, he knows that the railroad, if solvent, will pay him $1,000 in cash when the bond is due. But if he buys a share of railroad stock, his only chance of getting his money back, if he should wish it, is that some one else will want to buy his share for what he paid for it, or more. In one case he has bought a _promise to pay_, and in the other an _equity_.

It is not the intention, from the foregoing, to draw the conclusion that _equities_ under no circ.u.mstances are to be regarded as investments, because many of our bank and railroad stocks, and even some of our public-utility and industrial stocks, have attained a stability and permanence of value and possess sufficiently long dividend records to justify their consideration when investments are contemplated; but it is essential that the investor should have a thorough understanding of the distinction involved.

The principle of distribution of risk is a simple one. It involves no more than obedience to the old rule which forbids putting all one's eggs in the same basket. The number of men who carry out this principle with any thoroughness, however, is very small. Proper distribution means not only the division of property among the various forms of investment, as railroad bonds, munic.i.p.als, mortgages, public-utility bonds, etc., but also the preservation of proper geographical proportions within each form. Adherence to this principle is perhaps not so important for private investors as for inst.i.tutions. A striking instance of the need for insistence upon its observance in the inst.i.tutional field was furnished by one of the fire-insurance companies of San Francisco after the earthquake. It appeared that the company's a.s.sets were largely invested in San Francisco real estate and in local enterprises generally, where the bulk of its fire risks were concentrated. As a result, the very catastrophe which converted its risks into actual liabilities deprived its a.s.sets of all immediate value. This instance serves to show the importance of the principle and the necessity for its observance.

The principle of selection in accordance with real requirements is more complex. It involves a thorough understanding of the chief points which must be considered in the selection of all investments. These are five in number: (1) _Safety of princ.i.p.al and interest_, or the a.s.surance of receiving the princ.i.p.al and interest on the dates due; (2) _rate of income_, or the net return which is realized on the actual amount of money invested; (3) _convertibility into cash_, or the readiness with which it is possible to realize on the investment; (4) _prospect of appreciation in value_, or that growth in intrinsic value which tends to advance market price; and (5) _stability of market price_, or the likelihood of maintaining the integrity of the princ.i.p.al invested.

The five qualities above enumerated are present in different degrees in every investment, and the scientific investor naturally selects those securities which possess in a high degree the qualities upon which he wishes to place emphasis. A large part of the problem of investment lies in the careful selection of securities to meet one's actual requirements. The average investor does not thoroughly understand this point. He does not realize that a high degree of one quality involves a lower degree of other qualities. He may have a general impression that a high rate of income is apt to indicate less a.s.surance of safety, but he rarely applies the same reasoning to other qualities. When he buys securities, he is quite likely to pay for qualities which he does not need. It is very common, for example, when he wishes to make a permanent investment and has no thought of reselling, to find him purchasing securities which possess in a high degree the quality of convertibility.

From his point of view, this is pure waste. A high degree of convertibility is only obtained at the sacrifice of some other quality--usually rate of income. If he were to use more care in his selections, he could probably find some other security possessing equal safety, equal stability, and equal promise of appreciation in value, which would yield considerably greater revenue, lacking only ready convertibility. Thus he would satisfy his real requirements and obtain a greater income, at the expense only of a quality which he does not need.

The quality of convertibility divides investors into cla.s.ses more sharply than any other quality. For some investors convertibility is a matter of small importance; for others it is the paramount consideration. Generally speaking, the private investor does not need to place much emphasis upon the quality of convertibility, at least for the larger part of his estate. On the other hand, for a business surplus, ready convertibility is an absolute necessity, and in order to secure it, something in the way of income must usually be sacrificed.

Again, some investors are so situated that they can insist strongly upon promise of appreciation in value, while others can not afford to do so.

Rich men whose income is in excess of their wants, can afford to forego something in the way of yearly return for the sake of a strong prospect of appreciation in value. Such men naturally buy bank and trust-company stocks, whose general characteristic is a small return upon the money invested, but a strong likelihood of appreciation in value. This is owing to the general practise of well-regulated banks to distribute only about half their earnings in dividends and to credit the rest to surplus, thus insuring a steady rise in the book value of the stock.

Rich men, again, can afford to take chances with the quality of safety, for the sake of greater income, in a way which poor men should never do.

In practise, however, if the writer's observation can be depended upon, it is usually the poor men who take the chances--and lose their money.

In the quality of safety, there is a marked difference between safety of princ.i.p.al and safety of interest. With some investments the princ.i.p.al is much safer than the interest, and _vice versa_. This can best be ill.u.s.trated by examples. The bonds of terminal companies, which are guaranteed as to interest, under the terms of a lease, by the railroads which use the terminal, are usually far safer as to interest than as to princ.i.p.al. While the lease lasts, the interest is probably perfectly secure, but when the lease expires and the bonds mature, the railroads may see fit to abandon the terminal and build one elsewhere, if the city has grown in another direction, and the terminal may cease to have any value except as real estate. On the other hand, a new railroad, built in a thinly settled but rapidly growing part of the country, may have difficulty in bad years in meeting its interest charges, and may even go into temporary default, but if the bonds are issued at a low rate per mile and the management of the road is honest and capable, the safety of the princ.i.p.al can scarcely be questioned.

Stability of market price is frequently a consideration of great importance. This quality should never be confused with the quality of safety. Safety means the a.s.surance that the maker of the obligation will pay princ.i.p.al and interest when due; stability of market price means that the investment shall not shrink in quoted value. These are very different things, tho frequently identified in people's minds. An investment may possess a.s.sured safety of princ.i.p.al and interest and yet suffer a violent decline in quoted price, owing to a change in general business and financial conditions. In times of continued business prosperity very high rates are demanded for the use of money, because the liquid capital of the country, to a large extent, has been converted into fixt forms, in the development of new mines, the building of new factories and railroads, and in the improvement and extension of existing properties. These high rates have the effect of reducing the price level of investment securities because people having such securities are apt to sell them in order to lend the money so released, thus maintaining the parity between the yields upon free and invested capital.

As an ill.u.s.tration of this tendency, within the last few years New York City 3-1/2-per-cent bonds have declined from 110 to 90, without the slightest suspicion of their safety. Their inherent qualities have changed in no respect except that their prospect of appreciation in quoted price has become decidedly brighter. Their fall in price has been due to two factors, one general and the other special--first, the absorption of liquid capital and consequent rise in interest rates, occasioned by the unprecedented business activity of the country, and, second, to the unfavorable technical position of the bonds, due to an increased supply in the face of a decreased demand.

It will be seen that the question of maintaining the integrity of the money invested is a matter of great importance and deserves to rank as a fifth factor in determining the selection of investments, altho it is not an inherent quality of each investment, but is dependent for its effect upon general conditions. If it is essential to the investor that his security should not shrink in quoted price, his best investment is a real-estate mortgage, which is not quoted and consequently does not fluctate. For the investment of a business surplus, however, where a high degree of convertibility is required, real-estate mortgages will not answer, and the best way to guard against shrinkage is to purchase a short-term security, whose approach to maturity will maintain the price close to par.

The foregoing comments, in a brief and imperfect way, serve to indicate the main points which should be considered in the selection of securities for investment. The considerations advanced will be amplified as occasion demands in the following pages. For the present, the main lesson which it is sought to draw is the necessity that a man should have a thorough understanding of his real requirements before he attempts to make investments. For a private investor to go to a banker and ask him to suggest a security to him without telling him the exact nature of his wants is about as foolish as it would be for a patient to go to a physician and ask him to give him some medicine without telling him the symptoms of the trouble which he wished cured. In neither case can the adviser act intelligently unless he knows what end he is seeking to accomplish.

It is plainly impossible within the limits of a small volume to consider the needs of all cla.s.ses of investors. Special attention will be paid to the requirements of a business surplus and of the private investor. In the field of private investment two distinct cla.s.ses can be recognized--those who are dependent upon income from investments and those who are not. Both cla.s.ses will be considered. For the investment of a business surplus, safety, convertibility, and stability of price are the qualities to be emphasized; for investors dependent upon income, safety and a high return; and for those not dependent upon income, a high return and prospect of appreciation in value. In the following chapters railroad bonds, real-estate mortgages, industrial, public-utility, and munic.i.p.al bonds and stocks will be considered in turn; their advantages and disadvantages will be a.n.a.lyzed in accordance with the determining qualities above enumerated, and their adaptability to the requirements of a business surplus and of private investment will be discust.

II

RAILROAD MORTGAGE BONDS

A railroad bond is an obligation of a railroad company (usually secured by mortgage upon railroad property) which runs for a certain length of time at a certain rate of interest. It is apparent, from this definition, that the price of a railroad bond, as distinct from its value, is affected by two _accidental conditions_ quite apart from the five determining qualities described in the preceding chapter.

These accidental conditions are the length of time that the bond has to run and the rate of interest that it bears. To understand clearly the influence of these accidental conditions is a matter of the utmost importance. It is evident, for instance, that a 5-per-cent fifty-year bond, based on a given security, will sell at a widely different price from a 3-1/2-per-cent twenty-year bond, based on the same security; yet the only difference is in the accidental conditions which are under the control of the board of directors.

In order to eliminate these accidental features from the situation, it is customary for bond-dealers to cla.s.sify bonds purely on the basis of their yield, or net income return. As a thorough understanding of this point is essential to an accurate judgment of bond values, whether railroad bonds or otherwise, it must be developed in detail, even at the risk of carrying the reader over familiar ground.

If a bond sells above par, it does not yield its purchaser a net return as great as the rate of interest which the bond bears, for two reasons: first, because the loss in princ.i.p.al, represented by the premium which the purchaser pays, must be distributed over the number of years which the bond has to run, and operates to reduce the rate of interest which the holder receives; and, secondly, because the rate is paid only on the par value of the bond instead of on the actual money invested. Thus, if a 6-percent bond with eight years to run sells at 110-3/4, it will yield only 4.40 per cent, which means that if the holder spends more than $48.73 (4.40 per cent of $1,107.50) out of the $60 which he receives annually, he is spending the excess out of princ.i.p.al, and not out of income. Conversely, if a bond sells below par, it yields more than the rate of interest which the bond bears.

These yields have been calculated with the utmost exactness for all bonds paying from 2 per cent to 7 per cent and running from six months to one hundred years, so that it is only necessary to turn to the tables to discover what will be the net return upon a given bond at a given price. This net return is generally known as the "basis," and bonds are spoken of as selling upon a 3.80 per cent basis or a 4.65 per cent basis or whatever the figure may be, with no reference whatever to the price or to the rate of interest which the bond bears. Indeed, so exclusively is the basis considered by bond-dealers that very often bonds are bought and sold upon a basis price, and the actual figures at which the bonds change hands are not determined until after the transaction is concluded.

It is not expected, of course, that the average business man will purchase bonds in quite as scientific a way as this, but it is essential that he should understand that while the intrinsic value of a bond is determined only by the five general factors described, its money value, or price, is affected also by these two accidental conditions. Exprest in other words, he must realize that the general factor described as _rate of income_ does not mean the coupon rate of interest which the bond bears, but the scientific "basis," derived by elimination of the accidental features.

Within the past year there has been a good deal of uninformed comment about the safety of railroad bonds. Before the era of popular agitation and governmental antagonism, railroad bonds enjoyed a large measure of public confidence; but it can not be denied that some part of this confidence has been shaken as a result of the recent exposures. Even clearheaded men have exaggerated the importance of the developments; and too often railroad officials, who should have insisted upon the soundness and stability of their properties, when they elected to talk for publication, have given way instead to dismal and unwarranted forebodings.

There is no mystery involved in determining the safety of railroad bonds. Any man of business experience, keeping in mind the general principle which measures the value of all obligations, can easily determine, with the aid of two doc.u.ments, the degree of safety which attaches to any particular railroad bond. The general principle to be observed is that the safety of any obligation depends upon the margin of security in excess of the amount of the loan; and the two doc.u.ments to be consulted are the mortgage or trust indenture securing the bonds, which describes the property mortgaged, and the last annual report of the railroad, which shows its financial condition.

Confining the a.n.a.lysis, for the present, to mortgage bonds upon the general mileage of a railroad, the following points should be considered:

(1) _Rate per mile at which the bond is issued._ Applying the general principle indicated above, it must be learned what proportion the bonded debt of a railroad bears to the total market value of the property. It is much easier to make this comparison on a per-mile basis. In determining whether the rate per mile is excessive, reference must be made not so much to the particular bond in question as to the total bonded debt per mile of the railroad, and to the relation which that figure bears to the total market value of the property per mile. The total market value per mile is obtained by adding the market value of the stock per mile to the par value of the bonded debt per mile. A single issue of bonds varies all the way from $5,000 to $100,000 per mile, according to the location of the railroad. Total capitalization per mile--stocks and bonds at par--varies in about the same proportion, from $35,000 to $300,000. The average for all the railroads of the United States is $67,936 per mile. The actual cost of the railroad, as shown by the balance-sheet, must be taken into consideration, and also the estimated cost of duplicating the property. Physical difficulties of construction must be weighed, for a railroad through a flat, sandy country should not be bonded for as much, other things being equal, as a railroad through a mountainous country, where much cutting, filling, and bridging are required. The section of country in which the railroad is located must be considered, for $35,000 per mile on a single-track line in a poor country may be higher than $300,000 per mile on a four-track trunk line which owns valuable terminals and rights of way through several large cities.

(2) _Amount of prior lien bonds outstanding per mile._ The amount of bonds which come ahead of the bond in question on the same mileage is a matter of great importance and works directly against the security of the bond. Purchasing a bond which is preceded by a prior line bond is like taking a real-estate mortgage on property already enc.u.mbered. If the bond is not followed by other bonds, then the margin of security in the property is represented wholly by the market value of the stock per mile, and the investor must figure carefully the value of this equity.