Industrial Securities as Investments

MUCH has been heard during the last five years of “industrials,” both as investments and as an economic and political problem. The organization of the Steel Corporation, with a capital of a billion dollars, made it the largest corporation in the world, but it has been hard pressed by other large combinations with capital running into the hundreds of millions. The American Tobacco Company has capital and bond obligations to the amount of $263,000,000; the American Smelting and Refining Company, $201,550,400; the Amalgamated Copper Company, $175,000,000; the American Sugar Refining Company, $90,000,000; the International Harvester Company, $120,000,000; the Standard Oil Company, $97,500,000; and eighteen other companies of $50,000,000 or more each, bring up the total capitalization and bonded debt of such corporations to a total of over $3,600,000,000. The total capital and bond obligations of all the “trusts ” is over $20,000,000,000, or more than one fifth the estimated wealth of the country.

Inevitably the creation of such corporations required the issue and sale of blocks of securities corresponding to their capital and bonded obligations. There had been for many years industrial securities on the market, representing woolen, cotton, and silk mills, other manufactures, and trading companies. The shares, indeed, of the Dutch East India Company were the subject of furious speculation on the Amsterdam Stock Exchange as early as 1602.¹ But industrial securities, down to within a few years, were in many cases closely held, and were not such an active factor in stock exchange speculation and investment as they have recently become. The principal classes of securities dealt in on the exchanges may be thrown into the following four general groups : —

(1) Government obligations.

(2) Railway and other transportation securities.

(3) Industrial securities.

(4) Mining securities.

To the novice it might not appear why securities of one of these classes, taken as a whole, should differ in stability and market value from those of other classes. There are reasons, however, why industrial securities have not yet attained the position of government or railway obligations, although they may fairly be said to rank above many types of mining stocks.

In discriminating between these different classes of investments, the reason why government obligations have a special standing does not require extended exposition. In a country like the United States, where the resources of the people are large, where taxation has not become unduly burdensome except in special cases, and where a high standard of public obligation exists, government securities have the advantage of being not only well known, but of unquestioned value. They have, moreover, in most cases, the technical position of bonds rather than stocks, — a bond representing a definite obligation to pay a fixed income, while stock is only a title to participation in profits, if they are earned. The obligations of a strong government, moreover, are less subject to the influence of prosperity or adversity than the obligations of corporations, whose earnings rise or fall with changing business conditions. Government finance is to a limited extent outside the scope of ordinary economic laws. If receipts fall off in periods of business depression, the individual or the corporation is obliged to diminish the distribution of profits, and may even have to suspend payment of interest on outstanding obligations; governments meet the emergency by imposing additional taxes or issuing new loans. Government securities thus stand in a class by themselves. It is with railway securities, therefore, rather than government obligations, that “industrials” may best be compared, for their parallelisms and their differences.

There is no reason why in course of time the best industrial securities should not acquire the same position as the best railway securities; but there are certain differences which will always exist and which are more important at the present time than they may be in future, because the modern type of industrial securities has not yet stood the test of many years of trial. The differences between railways and “industrials” from an investment point of view may be summed up under the following heads: —

(1) Railways have been longer tested as a means of earning income. Mistakes were made in the early history of railroad construction, as great and serious as any which have been made in the flotation of industrials. The reckless manipulation of Gould and Fiske, the issue of big blocks of stock without authority, new construction in sparsely-settled countries which could not for many years pay operating expenses, the commitment of half the roads of the country to the hands of receivers in 1893, and other experiences, as dishonest sometimes as they were hazardous, have resulted in a system of rules governing the construction of railways and the financing of their securities which have reduced them as investments to a comparatively uniform and conservative basis. The errors made in railway financing down to within a dozen years are not recalled, therefore, to arouse distrust of railway securities, many of which are now upon a basis as secure as government bonds. They are recalled to illustrate the point that industrials also, after passing through their period of experiment, error, and stress, may take their place by the side of the best railroad securities as conservative and well-tested investments. The question here discussed is chiefly that of time alone. Time permits the weeding out of unsound enterprises and the emergence upon firm ground of those only which are conducted by safe methods.

(2) Industrial securities usually depend upon the vicissitudes of a single industry. In this respect they might be considered inferior to railways, which depend for their freight earnings upon the movement of the products of many and diverse industries. On the other hand, it is conceivable that there might be industries ministering to permanent needs, whose earnings would be more uniform than those of a railway, subject to the ebb and flow of the tide of commercial prosperity. An industry the demand for whose product varies radically in periods of business activity and business depression, or which is influenced by sudden changes in fashions, would not prima facie afford as safe a basis of investment as one whose product was in nearly uniform demand. The objection might be overcome by setting aside a large portion of the profits of fat years to meet the deficits of lean years, but this is precisely one of those questions which for any given industry can be determined only by the test of time. Among the industrials which require the most careful management in this respect is steel, which Mr. Carnegie has aptly declared is “either prince or pauper,” — prince, when the extension of railways, the erection of steel buildings, and the call for new machinery pile up orders at the mills which cannot be filled, and make managers autocratic in dealing with new comers; pauper, when along the line of industrial activity passes the electric shock of depression, railways suspend extensions and postpone orders for new equipment, building ceases, mills have no occasion to order new machinery, and autocratic managers suddenly become pliant suitors for orders at cut prices.

In a sense, all industries, and railways themselves, are more or less subject to these changing conditions, but there are many industries ministering to permanent necessities whose product is not greatly reduced in periods of business depression. Among them, unfortunately perhaps for the moral sense of the people, are such articles as tobacco and whiskey. For these the demand is apt to be nearly constant, since in times of depression the diminished consumption of the provident will be offset by the increased consumption of those whom idleness or misery compels to seek relaxation or oblivion.

(3) The manner of formation of the industrial corporation differs from the organization of a railway. The industry may be itself one of those which minister to permanent wants, and which is assured of considerable earnings even in the dullest times. But its capital may have been unduly “watered,” by issuing so many bonds upon which interest has to be paid and so much preferred stock upon which dividends are guaranteed, that a slight falling off in earnings causes financial difficulties. In some of the great combinations made during the past few years the practice has prevailed of issuing bonds for the capital value of the visible assets of the combined companies; preferred stock upon earnings which were believed to be reasonably assured by economies and extensions; and common stock for the possibilities hanging at the end of the rainbow in the minds of enthusiastic promoters.

If the character of these securities were absolutely understood by every one dealing in them, not much harm would be done by over-issues of capital. Even under existing conditions the securities issued upon discounted hopes soon find their level in the stock market at quotations far below their par value. The mischief of such issues is in playing upon the hopes of persons unfamiliar with the brutal facts of business competition, and convincing them that the discounted hopes of the promoters are a safe and solid basis of investment. In railway financing there was much of this discounting of the future in early stock issues, but the crushing pressure of the reorganizations which followed the great panics squeezed out most of the water. Some of the industrials have already gone through this process, but others will probably have to submit to it in the future.

(4) In industrial enterprises the character of the management is important. Some of the greatest industrial combinations, which are paying interest and liberal dividends and piling up great surpluses, are subject to risk from this direction. A future which seems to be without a cloud may depend upon the constructive ability, the originality, and the aggressive force of the man at the head. It is true in a general sense that no man is indispensable, but the affairs of a great corporation are likely to fall into a routine which puts it at a disadvantage in the competition with new rivals if its directors cannot instantly put their hands in case of a vacancy upon a man of constructive ability and resource to take the place of one who retires.

In railway management individual initiative counts for much, but the entire railway service of the country is a training school for competent men who may be transferred from one railway system to another to meet new needs. The same is not so broadly true of the big industrial combinations. The American Tobacco Company is not training men able to take up at once the work of the Standard Oil combination, nor is “the rubber trust” training men familiar with the technique of the great smelting combination. It may be that men in the ranks of these companies are being trained to fill the vacancies which time will make among the men at the head, but the danger that the men in the business will fall into ruts and be unprepared to assume responsibilities is greater, and the field of selection is narrower, than in the railway system, which is of substantially a uniform character over two hundred thousand miles of line representing fourteen billions of capital.

The mere bigness of the industrial combinations involves something of an experiment. The corporate form of carrying on business was considered so stifling to individual initiative when Adam Smith wrote, that he believed it must necessarily be limited to a few simple industries. While this idea has been superseded by experience, there are many things in the management of corporations by boards of directors and their nominees which differ from the prompt initiative, the eye single to personal interest, and the ability to make quick and irrevocable decisions, which belong to the man in control of his own business. The scandals which have broken out in the life insurance companies are an illustration of a type of evil which would hardly be possible in a private establishment, however large, where the individual partners kept their hands firmly on the machinery and their eyes always open for opportunities for economy and improvement.

(5) The danger of competition is, in the nature of the case, not the same with industrial enterprises as with railways. The policy of constructing competing railway lines between similar points has now been almost abandoned. A given railway serves a certain community, and competition by another line can be introduced only by obtaining rights of way, land for terminals, and incurring other expenses which are rarely justified by the benefits of the competitive project. In the manufacture of industrial products, however, competing products can be moved from place to place at small cost. The location of the establishment, while one of the factors to be considered in its competitive power, is not usually the most important factor. Competitive products from abroad may face the products of a given mill in the very city of its establishment, having to meet in addition to cost of production only the ordinary costs of shipment by rail or by sea.

This is not the place to discuss the question how far competition has been destroyed in certain industries by the magnitude of the combinations made. But, however powerful these combinations may be at a given moment, and however completely they may seem to have absorbed or stifled competition, they are always subject to the menace that if they raise the charges for their products to a point which affords excessive profits, the whole fund of free capital in the world is liable to be directed to the erection of competing establishments. The lesson of prudence, therefore, for the great combinations is to keep their earnings within such a reasonable amount as not to afford a tempting mark for the competition of the accumulating millions of savings of the people of England, France, Belgium, and America.

(6) The danger of adverse legislation is a factor common alike, in a broad sense, to railways and industrial enterprises. In some ways it is an even greater menace to the railways, because their roadbeds are fixed. They cannot, like the Jewish money changers of the Middle Ages, turn their property into bills of exchange, conceal them about their persons, and flit quietly across the border, when they are threatened with confiscation or political regulation of rates. Industrial enterprises are in a better position in many cases to change their location to escape oppressive legislation. This has been especially the case thus far in this country, where severe restrictions and excessive taxation in a single state could be avoided by removal to an adjoining state. Federal restrictions are more far-reaching, but even they do not destroy the possibility of establishments in Canada or Mexico, whose younger enthusiasm to attract capital and develop industry keeps their doors wide open to welcome it, instead of reaching for its throat to throttle it.

This danger, so far as federal law is concerned, is still more or less speculative. A law which in its literal terms almost surpasses the espionage and savagery of the Middle Ages stands upon the statute books in the Sherman anti-trust law, but it remains to be seen how far the courts, in interpreting its provisions, will restrict them within the limits of established principles of law protecting the vested rights to labor and to transfer capital. For many years to come, if this law remains unchanged, the value of industrial securities will move up or down, under the influence of rumors and decisions from the court room, according as these decisions follow the literal terms of the law, making it a crime for two local grocers to agree upon a uniform price for meats; or give it the more reasonable interpretation that only combinations hostile to the public interest are intended to be included in its portentous catalogue of prosecutions, fines, and imprisonments.

What, then, after taking these various influences into consideration, are the merits of industrial securities as investments ?

The answer is that their value varies according to the particular security under consideration, in the same manner as other securities which have not acquired the definite and assured character of investments for trust funds. But securities which have reached the latter stage are only occasionally those upon which large profits can be made. It is those which have an element of uncertainty — at least, of speculative profits in the future — which afford the opportunity for anything beyond the three and a half or four per cent which can now be earned upon giltedged securities.

There cannot be large profits, especially for the outsider, without some risk. When the insider gets hold of a given property, with whose merits he is familiar, but which has not yet attained a high price on the market, he takes the risk that his judgment will be justified finally by that of the community. In many cases his conclusions are confirmed and great fortunes are made. But in all such ventures the insider, in addition to knowing the possibilities of the balance-sheet of the property in which he thus speculates, takes the risks also of competition, change of fashion, increase in the cost of raw material, and, in many cases, the creation of a demand which has not yet arisen. Some of these factors are what may be called natural economic factors; others — like the “strike bills,” against which the life insurance companies have spent their money profusely at Albany — are purely arbitrary, incapable of definite calculation in advance.

Some of the great industrial stocks have already passed through the preliminary tests of value, and may be considered on the road to the position of stable investment securities. This is particularly true of some bonds. There may still be some doubt, for instance, of the ability of the “Steel Trust” to continue through good times and bad to pay dividends on its seven per cent preferred stock or to resume dividends on its common stock, but hardly anything save a cataclysm can deprive it of the ability to pay the interest on its five per cent bonds. These bonds were quoted down to 65 in the crash of 1903, and remained as low as 683/4 during a part of 1904. They have since advanced, until the quotation is around 98. This does not put them on the same footing as a municipal three and a half or four per cent bond, or a first-class railroad bond paying the same rates; but a security paying five per cent, which is near par, may be considered a comparatively safe investment for a business man who keeps in touch with the market. Something of the same kind may be said of the four per cent bonds of the Consolidated Tobacco Company, which sagged to 511/2 in the break of 1903, and remained as low as 533/4 a part of the following year. After the conversion of half of them into six per cent preferred stock of the American Tobacco Company had been completed, in the autumn of 1904, they sold as low as 71 in January, 1905, but gradually climbed up to 80 in the autumn of that year. A four per cent bond at eighty is the same thing as a five per cent bond at par, so that Tobacco bonds stand practically upon the same basis as the Steel fives, or perhaps a shade better.

To the person speculatively inclined, the rise in some of these securities is seductive. The man who had the courage to buy Steel fives at 65, when the market was at its lowest in 1903, would have been able in two years to realize about $33 upon an investment of $65. Upon an original investment of $6500 he would have made a profit of $3300. In the case of the Tobacco bonds, he would have done still better under the conversion plan which was brought out in the autumn of 1904. This plan permitted him to exchange the old bonds of the Consolidated Tobacco Company, whose quotations have been given for 1903 and 1904, for fifty per cent of the amount in new four per cent bonds of the American Tobacco Company, and fifty per cent in six per cent preferred stock of the American company. The latter is now selling at about 105, so that upon his original investment of $52 he would now realize $40 for his bonds, and more than $50 for his stock, or a net profit approaching eighty per cent. These figures are based upon payment for the securities outright. Had he taken the risk of margins, he would, of course, have made a much larger percentage upon the money actually deposited with the broker.

There is another side, however, to the alluring spectacle of profits which these figures present. Few men have the courage to buy securities boldly and steadily in a falling market. Even if the would-be investor is familiar with the principle that he should buy when prices are low and sell when they are high (to which too many of the general public are strangely obtuse), yet he would be confronted from moment to moment by the doubt whether the securities were going lower. In other words, only hindsight, and not foresight, enables one to tell when the market has “touched bottom.”

A five per cent security which had fallen to 65, or a four per cent security which had fallen to 52, would be under suspicion by all but insiders, who knew exactly what assets were behind it. It would be a security which would not in any case be recommended by a careful broker or banker to a woman or a minor, whose sole dependence was on a small principal. To such persons honest brokers and bankers have no right to recommend risks. Even where they are reasonably confident of success, they usually learn by experience that a loss causes hard feelings and subjects them to the just criticisms of the courts. A man of intelligence who is willing to take moderate risks is justified in doing what he will with his own. His position should be very different towards trust funds in his custody, or any other funds towards which he exercises an informal trusteeship by acting as adviser for those who ought not to enter into speculation.

In buying industrial securities, as, indeed, in buying other types, patience is an important requisite. The man who becomes discouraged after buying a security at 90, because he sees it hanging about that quotation for several weeks or months, is not well fitted to buy securities for the rise. It is not often possible even for the most skillful speculators to buy at the lowest point. If they are sure that the securities they hold represent solid assets and steady earnings, they need not be frightened by a temporary gust of depression in the stock market. If they are satisfied that the properties are capable of progressive development and are under sound management, they must be willing to wait months, and sometimes years, for them to advance in value.

It is in this element of time, perhaps, that more mistakes are made than in almost any other element of the problem. The results may come eventually which the sanguine promoter and speculator anticipate. The logic of the situation may seem to exclude the possibility that such results shall not come. But it often happens that the patience and capital of the pioneers are exhausted before the fruition of logical reasoning and sound hopes is attained. Then others reap where the first have sown. This has been the case over and over again with railways, whose profits have finally gone into the hands of those who have acquired them under foreclosure or reorganization, and with some of the great trusts, from which the water has been squeezed by unexpected changes in general trade and financial conditions, even when the enterprise itself was sound.

Some of the greatest fortunes have been made by those who have selected good securities when the properties were undeveloped or the general market was depressed, and have stuck by them until their value came to be appreciated by the public. Reading Railroad stock is a case in point. Its minimum quotation in 1901 was 241/2; in the big crash of 1902, 321/4; in 1903, 371/2; and in 1904, 383/4. In the autumn of the latter year, its merits began to dawn upon the investing public. It was advanced rapidly to a high price of 70, and a low price of 611/2 in September; a high price of 781/2 in November; 825/8 in December; 903/8 in January, 1905; 971/8 in February; 1003/4 in June, and later in the year, by successive stages, to 1291/8 at the close of October, and finally to 140 early in November. Good industrial securities have gone through this experience to a larger degree than railways, because it has been only recently that their merits have come to be recognized. United States Steel preferred, as already pointed out, was below 50 in the crash of 1903. It gradually emerged from the cloud to a maximum price in 1904 of 955/8. It was not until April, 1905, however, that its substantial solidity as a seven per cent stock carried it to 1047/8 and later in the autumn to 1053/4. The preferred stock of the United States Rubber Company also required several years to reach its strong position around 110 in 1905. Being an eight per cent stock, it is likely to go still higher and to carry with it the second preferred, which pays six per cent, and was quoted at the close of last year around 80.

To hold stock for a rise requires thorough knowledge of the property represented, certainty that its merits are such as to carry it eventually to a higher value, and a mind sufficiently serene and firm to witness undisturbed the ebb and flow of market prices. It is by this policy of patience and serenity that the Rothschilds and others have made great fortunes, by locking up stocks when they were cheap and awaiting the progress of the years to give them value. How much can sometimes be made in this way may be judged from the fact that an investor who had put $36,875 (including commissions) into 1000 shares of American Smelting common stock when it was selling for 363/4 in October, 1903, would have been able to realize $157,000, or a profit of $120,000, in November, 1905. Yet it is doubtful if one man in America — outside of original holders, who were unmoved by market fluctuations — had the patience and foresight to pursue this course.

There is no doubt that the purchaser of some of the industrial stocks now on the market will realize a large profit on them some time. The difficulty is to be certain that the ones which he selects for investment are those which have a substantial value which will not be impaired by any of the influences which have been suggested in discussing the character and position of industrial securities. That some of these stocks are relatively worthless has been the sad experience of the last few years, but this very experience has been in the nature of a winnowing process, and has given a higher average value to those which have withstood the stress and storm of disturbed markets.

It is not intended here to recommend speculation on margins under any circumstances. Such speculation is a legitimate trade, but can be practiced with safety only by those who make it a trade and who are in daily touch with the market. The outsider who plunges into speculation on margins upon the strength of some “straight tip” usually ends by seeing his margins wiped out. A temporary gain is likely, as at the gaming table, to tempt him to larger ventures, and, ultimately, to larger losses. It is as foolish for the outsider to expect to make money against the sharp wits of the professional speculators as it would be for a man without expert training to stand up against Jeffries or “Kid” McCoy, or to take the place of the engineer on the “Twentieth Century Limited.” Speculation is a trade at which lifelong practice does not master all the possibilities, and which requires, in addition to profound study and accurate knowledge, a temperament which is swayed by neither optimism nor pessimism. Such a temperament must never be carried along by hopes which are not justified by facts, but must see facts in their true proportions, and draw inferences from them which are accurate not only from the qualitative, but also from the quantitative standpoint.

The general public who are not professional speculators usually buy on a rising market. " Bringing the public into the market” is sought by advancing prices. If the public come in freely at high prices, they can then be “shaken out” by allowing the market to go down. The professional speculator knows by both processes how to shear the wool from the “lambs” who venture into Wall Street. Such speculation cannot be recommended to any person who does not make it his profession. To the investor, who hopes occasionally to make a profit by good judgment, it can only be recommended to study properties carefully before investing in them, to buy in periods of depression, when the excited and panicstricken are selling, and to hold on patiently to a property he is assured is good until the general public come to realize the soundness of his judgment by paying the price which he demands.