After two years, when the firm wished to dispose of its bonds it might experience some difficulty in doing so in the stringent money market which has been supposed, but even if it succeeded in selling them upon a 6-per-cent basis, that would mean a price of only 93-3/4 and would represent 6-1/4-per-cent loss in princ.i.p.al. If it were necessary to sell the bonds upon a higher basis or if the firm had purchased a bond with more than ten years to run, the relative disadvantage of the longer bond would be still more apparent. These points sufficiently demonstrate the importance of buying only short-term securities for the investment of a business surplus. Of course, if money conditions improve instead of becoming worse between the dates of purchase and sale, then a greater profit would be made with the longer-term bond. This, however, should not be allowed to influence the choice, first because it is not the object of a reserve fund to make a speculative profit, and secondly because a firm or corporation is only likely to want to realize upon its reserve fund when money is hard to obtain otherwise, and that is precisely the time when any long-term bond would be apt to show considerable depreciation.

The foregoing considerations indicate a special adaptability on the part of equipment bonds to the usual requirements of a business surplus. The points have been brought out at some length because of the importance of the subject to the average business man. The purpose in concentrating attention upon a single instance has been to ill.u.s.trate more clearly the principles involved and at the same time to acquaint the business man with details of a highly desirable and somewhat unfamiliar form of security.

IV

REAL-ESTATE MORTGAGES

In the preceding chapter the discussion of railroad bonds was brought to a close. Before pa.s.sing to the consideration of real-estate mortgages, which is the next form of investment to be taken up, it may be well to review briefly the general principles advanced in the first chapter of this book, in order that the reader may have clearly in mind the main points upon which judgment of the value of investments should be based.

There are five chief points to be considered in the selection of all forms of investment. These are: (1) safety of princ.i.p.al and interest; (2) rate of income; (3) convertibility into cash; (4) prospect of appreciation in intrinsic value; (5) stability of market price.

Keeping these five general factors in mind, the present chapter will discuss real-estate mortgages as a form of investment, both as adapted to the requirements of private funds and of a business surplus.

The average American business man is so familiar with real-estate mortgages that the details may be pa.s.sed over briefly. A real-estate mortgage, or a bond and mortgage, as it is sometimes called, consists essentially of two parts, a bond or promise to pay a certain sum of money at a future date with interest at a certain rate per annum, and a mortgage or trust deed transferring t.i.tle and ownership in a piece of real estate, with the provision that the transfer shall be void if the interest is regularly paid and the bond redeemed at maturity. Before advancing money on the security of a mortgage it is necessary to determine whether the t.i.tle to the property legally vests in the maker of the mortgage; and during the continuance of the mortgage it is necessary to have proof that the taxes and a.s.sessments are being regularly paid, and, in the case of improved property, the fire-insurance as well.

The safety of real-estate mortgages, in common with the safety of all obligations, depends upon the margin of security in excess of the amount of the loan. In the case of real-estate mortgages the amount of this margin may be determined without great difficulty. It is only necessary to have the property carefully appraised by an expert in real-estate values. It does not follow, however, because a mortgage has been shown to possess substantial equity, that it is perfectly safe as an investment, unless it satisfies also another condition of great importance. A mortgage may not exceed 50 per cent of the selling value of the real estate pledged, and yet be a poor investment. This point involves a serious objection to real-estate mortgages which sometimes escapes notice.

The holder of a mortgage is at a great disadvantage in regard to the changing value of real estate. If the value of the property upon which he holds a mortgage increases, the additional value enhances the security of the loan, but does not add to the princ.i.p.al which he has invested, while if the value of the property diminishes, not only is the security proportionately lessened, but if the impairment be great, the holder is frequently compelled to take over the property and may suffer loss of princ.i.p.al. In other words, he receives no direct benefit from an increase in the value of the property, but has to stand the larger part of the risk of a decline in its value.

This is not the case with investments represented by negotiable securities subject to changing market quotations. All such securities, railroad bonds for example, are acted on equally by changes in the value of the property which secures them. Except for the influences of money-market conditions, railroad bonds advance with an increase in the value of the property and decline with a decrease in its value.

Well-selected bonds usually increase in value with time, and all such increase goes directly to the benefit of the holder. The failure of real-estate mortgages to respond similarly to changes in the value of property places the holder of a mortgage at a great disadvantage.

Owing to this characteristic, real-estate mortgages should be purchased only when general conditions in the real-estate market are distinctly favorable. Not only should the purchaser of a mortgage have sufficient margin of security in the particular piece of property upon which he is loaning money, but he should also be satisfied that general real-estate values are relatively low, that there has been no undue speculation, and that conditions favor an advance rather than a decline in real-estate prices.

No cla.s.s of property is subject to more rapid changes in value than real estate. After an extensive advance the holder of a mortgage may be insufficiently protected by the equity in the property, even if his mortgage represents only 60 per cent of the current appraised value of the real estate pledged. It may be that the 60 per cent which he has loaned represents the total value or more than the total value a few years before. When a rapid advance in values occurs, tho it may be largely justified by the growth and development of the territory, there is sure to be present an element of speculation which is likely to carry prices beyond the point of reason. When the turn comes and a severe collapse takes place, its effects are extremely disastrous, because, unlike speculation in stocks or commodities, no short selling exists in real estate to temper the fall, and the immobile form of capital makes liquidation impossible. These considerations serve to show the need for great prudence in the purchase of real-estate mortgages. If the investor exercises due care in these particulars, he is reasonably sure of obtaining a very high-grade security; if he neglects these precautions, he may suffer severe loss of princ.i.p.al.

No general figures are available which would indicate the degree of certainty attaching to the payment of interest upon real-estate mortgages. Certain cla.s.ses of mortgages, such as those secured by unimproved real estate or dwellings, afford no direct security of interest payment other than the threat of foreclosure. Other cla.s.ses, such as mortgages upon stores, hotels, or office-buildings, are often protected by a large income from the direct operation of the mortgaged premises, thus furnishing a security for the annual interest payment.

The margin of protection in these cases varies greatly, so that no general conclusion can be drawn.

The other characteristics of real-estate mortgages may be pa.s.sed over more briefly. It is generally conceded that mortgages return a higher rate of income than can be obtained upon any other form of investment which affords equal security. This const.i.tutes their chief advantage.

Their chief disadvantage, on the other hand, lies in their entire want of convertibility. There is no market for real-estate mortgages, and except in special instances they can not be readily sold. The fact that they are not subject to quotation prevents them also from holding out any prospect of appreciation in value. Their very deficiency in this respect, however, const.i.tutes an important advantage from another point of view. Since they are not quoted they can not shrink in market price in obedience to changes in financial and business conditions. The buyer of a mortgage is a.s.sured that he can carry his mortgage at par through periods when it may be necessary to mark down all negotiable securities subject to changing market quotations. This is frequently a matter of great importance.

The general characteristics of real-estate mortgages may be summarized as follows: (1) When carefully selected and purchased under favorable conditions, great safety of princ.i.p.al and interest; (2) a relatively high return; (3) a low degree of convertibility; (4) no prospect of appreciation in value; and (5) the practical certainty of maintaining the integrity of the princ.i.p.al invested.

Is a security possessing these characteristics a suitable investment for a business surplus? Only to a limited extent. The safety, high return, and a.s.surance against loss in quoted value of princ.i.p.al are all highly desirable qualities for this purpose, but the lack of convertibility is a fatal defect. No consideration is of greater importance in the investment of a business surplus than a high degree of convertibility, so that if the need should arise the investment may be instantly liquidated. The fact that real-estate mortgages can not be readily disposed of makes it practically impossible to employ them for the investment of a business surplus.

Where convertibility is not an essential requirement, and where the want of promise of appreciation in value is not a serious matter, mortgages afford a very desirable form of investment. The characteristics which they possess in an eminent degree--safety, high return, and a.s.surance against loss in quoted value of princ.i.p.al--are exactly suited to the ordinary requirements of savings-banks. Generally speaking, only a small proportion of a savings-bank's a.s.sets need be kept in liquid form or readily convertible, and accordingly they find mortgages highly desirable.

For the purpose of private investment the attractiveness of mortgages is not so easy to determine. Ordinarily, fluctations in quoted values are of no great importance to the private investor, so that the absence of quotation which mortgages enjoy is not especially valuable. Their safety and high return are attractive qualities, but their want of convertibility and of prospect of appreciation in value are drawbacks.

On the whole, the private investor may probably employ with advantage a certain part, but not too much of his estate in mortgage investments.

As part of a scientific and comprehensive scheme of investment, the special advantages of real-estate mortgages appear most prominently in the years following a business depression. During such a period real-estate values are usually relatively low, but beginning to advance, so that mortgages present their maximum margin of security. At such a time they compare most favorably with bonds and other investment securities which are subject to changing quotations, because such securities are then apt to be at their highest point under the combined influence of restored confidence and the low money rates which usually prevail. After several years of continued and increasing business prosperity the positions are just reversed.

No discussion of real-estate mortgages would be complete without allusion to the guaranteed mortgages which have been placed upon the market in great quant.i.ties within the past few years. Guaranteed mortgages are real-estate mortgages guaranteed as to princ.i.p.al and interest by substantial companies having large capital and surplus. In addition to the guaranty, the companies usually search and guarantee the t.i.tle, see to it that the taxes, a.s.sessments, and insurance are paid, and perform the other services of a real-estate broker. Their compensation varies somewhat, but probably averages 1/2 per cent--that is, for example, they loan at 5 per cent and sell guaranteed mortgages to the investor at 4-1/2.

The value of the guaranty may be considered from two points of view--first, in the event of a general decline in real-estate values, and, secondly, when a fall occurs in a particular piece of property or in a particular locality.

If a severe decline in real-estate values takes place, affecting all localities, it might become necessary for the holders of guaranteed mortgages to test the value of their guaranties. In such a case the question would arise how far the capital and surplus of the guaranteeing companies would extend in liquidating the mortgages which they had guaranteed. This would depend entirely upon the proportion between the capital and surplus of the companies and the total amount of outstanding mortgages guaranteed. Ordinarily the capital and surplus do not exceed 5 per cent of the mortgages, so that the average guaranty is good for about 5 per cent additional equity. On a piece of property worth $100,000, upon which a guaranteed mortgage of $60,000 exists, the guaranty would be worth $3,000, and would margin the property down to $57,000. This additional equity is of little value. It is probably unlikely that a 40-per-cent depreciation in value will take place, but the guaranty is not needed unless it does, and if it should occur, the depreciation is quite as likely to go to 50 per cent or more as to stop at 43.

From the second point of view the value of the guaranty is much greater.

The distribution of risk, as in the case of fire-insurance, protects the holder against loss in the event of a fall in the particular piece of property upon which he holds a mortgage, or even in a particular locality. It can not be said, however, that the records are yet sufficiently complete to form a conclusion as to what is a safe proportion between capital and surplus and outstanding mortgages.

Further than that the guaranteeing companies, generally speaking, have been operating since their inception upon a rising market, so that their success. .h.i.therto has not been remarkable. Allowing for these drawbacks, however, the private investor, unless so situated as to give personal attention to the details of his investments, will probably do well to purchase his mortgages in guaranteed form.

V

INDUSTRIAL BONDS

Industrial bonds include the obligations of all manufacturing and mercantile companies, and miscellaneous companies of a private character. They form a cla.s.s quite distinct from railroad bonds or public-utility bonds.

I. _Safety of Princ.i.p.al and Interest._ The safety of industrial bonds, in common with the safety of all forms of investment, depends upon the margin of security in excess of the amount of the obligation. In the case of industrial bonds the amount of this margin is not always easy to determine. Even when determined, the rule is difficult of application because a margin which may seem insufficient from the point of view of physical valuation may be satisfactory when considered as the equity of a working concern. The indications most to be relied upon in estimating the safety of industrial bonds are as follows:

(_a_) _Value of real estate._ The first point to be determined in considering the purchase of an industrial bond is the value of the real estate upon which it is a first mortgage. If the appraised value of the ground, irrespective of the buildings and machinery upon it, is greater by a substantial sum than the amount of the bond issue, the obligation is practically a real-estate mortgage. In such a case, while possibly "slow," _i.e._, secured by an a.s.sets difficult to realize upon--the safety of the bond can hardly be questioned. In judging a bond upon its real-estate value, it is not always safe to take the cost price of the land as shown by the company's books, because frequently the cost upon the books is artificially raised by payment having been made in securities whose market value is less than par, or in other ways. As stated above, judgment should be based upon the _appraised_ value of the land.

If the bond meets this test satisfactorily, the prospective investor may feel reasonably sure that the safety of his princ.i.p.al is not in question, and may buy the bond without anxiety if it satisfies his other requirements. On the other hand, if the bond only partially meets this test, and it appears that some part of its value comes from plant and equipment and from the strength of the company as a working concern, then it is necessary for the investor to consider carefully several other factors.

(_b_) _Net quick a.s.sets._ The balance-sheet of every industrial company can be divided horizontally into two parts. Its a.s.sets are of two kinds--property a.s.sets, which are fixt, and current a.s.sets, which are fluid. Similarly, its liabilities are of two kinds--capital liabilities and current liabilities. It requires no very extended business experience to pick out the items which make up these totals. Plant and property a.s.sets are usually lumped together under the head, "Cost of Property." Current a.s.sets include inventories, bills and accounts receivable, agents' balances, marketable securities, and cash on hand and in banks--everything, in short, which can be quickly converted into cash. On the other side of the balance-sheet, capital liabilities are easily determined. They consist of the par amounts of bonds and stocks outstanding. Current liabilities comprise bills and accounts payable, including borrowed money, pay-rolls, and interest and taxes accrued but not due.

The real strength of every industrial concern is to be learned from the figures relating to its current accounts. Property a.s.sets and capital liabilities are not of the same significance. If the cost of plant and equipment as shown by the books exceeds its real value, the market usually makes the necessary adjustment by putting a price less than par upon the bonds and stocks.

No such process is possible in the case of the current accounts. If the current liabilities exceed the current a.s.sets the company shows a deficit, whatever its surplus may show on the books. On the other hand, if the current a.s.sets are greater than the current liabilities, the company possesses a working capital, represented by the difference between the two, and known as net quick a.s.sets.

There are three things to consider in connection with net quick a.s.sets: First, the proportion between current a.s.sets and current liabilities. To put a company in good shape its current a.s.sets should be at least twice as great as its current liabilities. Two for one is a fair proportion, tho some companies show as much as six to one. The stronger a company is in this proportion the better.

Secondly, the proportion between net quick a.s.sets and bonded debt. The bonded debt should never exceed net quick a.s.sets, except when the company possesses real estate, in which case two-thirds of the real-estate value plus the net quick a.s.sets should cover the bonds. Some companies do much better than that. One prominent company in this country, altho it possesses real estate of considerable value, has agreed in the indenture securing its bonds to keep net quick a.s.sets at all times greater by a substantial margin than the amount of bonds outstanding.

Thirdly, the proportion between net quick a.s.sets and the surplus as shown in the balance-sheet. If the capital liabilities exactly balance the property a.s.sets, it is plain that the surplus will exactly balance the net quick a.s.sets. If the surplus is smaller than net quick a.s.sets, it is usually a sign that capital liabilities have been created to provide working capital. Opinions differ as to the wisdom of this course. Generally speaking, it is better to provide working capital by means of a stock issue than to depend upon the banks for accommodation.

The exception to this rule occurs in the case of companies that require a great deal of working capital for part of the year and only a little at other times. If they have the best banking connections, such companies may be safe in depending upon their banks to carry them, but if they do so, they should have no bonded or other fixt indebtedness which would prevent their paper from being a first lien upon their entire a.s.sets.

If working capital is to be created by the issue of capital liabilities, it is much better that it should be done by stocks than by bonds. The ideal method, however, is to provide only such an amount of working capital at the organization of a company as is necessary for the conduct of its business, and then, as the volume of its business grows, to acc.u.mulate the additional amount necessary out of earnings, refraining from the payment of dividends until the fund is complete.

Before leaving the subject of net quick a.s.sets, it is well to note the importance of the figure showing the actual amount of current liabilities. If a company has outstanding large amounts of bills and notes payable, it occupies a vulnerable position. Inability to renew maturing notes was the cause of most of the industrial failures of last year.

(_c_) _Net Earnings._ The amount of net earnings is of great importance in estimating the strength of an industrial company. The figures for a number of years should be examined to determine whether the earnings are increasing or decreasing, and to discover whether or not the earning power of the company is stable. This will depend largely upon the nature of the article which the company produces or trades in. If its product enjoys a steady demand at a fairly uniform price, it is justifiable that some of its capital should be in the form of bonds; but if its earnings are subject to violent fluctations due to rapid changes in the price of its product, there is little justification for conducting the business on borrowed money.

In this connection it should always be considered how greatly a falling off in gross earnings will affect net earnings; and the proportion between net earnings and fixt charges should be carefully noted.

In order for an industrial bond to receive favorable consideration, the average yearly net earnings of the company should amount to about three times the annual bond interest, taxes, and sinking funds. The greater the protection is in this respect the better.

(_d_) _Form of Issue._ The form in which an industrial bond is issued is a matter of some importance. If the princ.i.p.al of the bond does not become due for a number of years, there is danger that the property will depreciate so far in value as to leave the bond without sufficient margin of protection. There are two ways to overcome this difficulty.

One way is to establish a sinking-fund which will retire a certain proportion of the bonds by lot each year. Another way is to issue the bonds in serial form, with a definite instalment maturing every year. In either case the annual sinking-fund or annual instalment should be greater than the probable depreciation so that the margin of security will be constantly increasing.