Buying and Selling Income

This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.

by HOWARD DOUGLAS DOZIER

NOT so many years ago a philanthropist and former member of the United States Senate, who was born poor, died rich. Everybody knew that he came by his wealth honestly, for his character was irreproachable. Yet people wondered, for it was common knowledge that he had begun his career as a teacher on meagre pay and had never in his life earned an annual salary greater than that of a Senator.

He early learned the truth of the old adage that not all is gold that glitters, and he followed, with unusual singleness, the purpose of first improving the quality of his income and then increasing its quantity. He schooled himself to measure wealth in terms of its income and had the tenacity to continue doing so when his contemporaries came to think of it in terms of paper profits. As a result, appreciation in his income-producing assets took care of itself, and, as paradoxical as it may seem, it was that which he ignored, rather than that which he attended, that gave bulk to his estate.

Whenever he bought, he bought income because it was cheap; whenever he sold, he sold income because it was dear. He bought interest when it was cheaper than dividends, sold out and bought dividends when they became the cheaper. He shifted his funds from stocks to bonds and from bonds back to stocks when the time was ripe. ‘But how, pray, did he know when the time was ripe?‘ somebody asks. It is the purpose of this paper to give a general answer to that question.

Let Smith and Jones be two reasonably prudent and conservative income buyers possessed of funds seeking investment on January 1, 1924. A little calculation, hardly ranking as statistical and by no means as technical, would have revealed to them that at the prices then prevailing on the New York Stock Exchange the bond interest being paid by such industrial corporations as bad both bonds and common stocks outstanding could have been bought at the rate of about $5.25 to the hundred dollars of investment and their cash current common dividends at about the rate of $7.00 to the hundred of investment.

Now as to their commitments — what shall each do with his money? Smith, who is slightly more conservative, let us say, buys interest. Jones on the other hand, who we may suppose is slightly less so, but by no means speeulativeminded, buys common dividends of the self-same corporations. Jones gets some $2.00 more per year in common dividend income than Smith gets in interest income on an equal investment in bonds. But Jones merits this, for he has relieved Smith of some of the risk. Under the conditions which then prevailed, the programme of neither would have smacked of imprudence. But conditions did not remain stable; they never do.

Within the short period of eight months — that is, by mid-August — the investment situation had greatly changed. Dividend income and interest income from identical corporations were selling at the same price — namely, at about $5.25 to the hundred. Those who then bought dividends carried their portion of industrial risk for nothing. Speculation had set in. What should our income buyers do? Smith would be foolish to sell $5.25 good interest and use the proceeds to buy only a like amount of dividends which are less certain, and that is what he would have done had he sold his bonds and bought stocks. The quality of his income would have deteriorated, but its quantity would not have increased by way of compensation.

Jones’s choice was not so simple: he could sell his $7.00 of dividends for enough to buy a like amount of interest, thus maintaining the quantity of his income and at the same time improving its quality. To have done so would have been wise. But, on the other hand, not to have done so would not have been foolish, for he was already enjoying a yield on his original investment in dividends commensurate with the risk involved.

As matters turned out, the chance to change remained open to Jones from August. 1924 to November 1931. The least favorable results of a shift from stocks to bonds during this period would have been to exchange, without an additional in vestment of funds, a less secure for a more secure income of the same amount. .Had lie been fortunate enough to shift at the most opportune time, he would have increased his income by slightly less than three fold and improved its quality as well. It is hardly likely, however, that he would have been so lucky. But, guided solely by income consideration, the hypothesis here, he certainly would have shifted from stocks to bonds sometime prior to September 1929, when the same amount of money would buy less than half the amount of dividends that it would of interest. Had Jones shifted, both our income buyers would have been receiving interest income at the time of the break in the stock market in the fall of 1929 and both would have been standing by ready to sell interest when it again became cheap in comparison with dividends.

At intervals between June 1931 and March 1932, these two types of income sold at about the same relative prices at which they were selling when our two investors embarked upon their undertaking at the beginning of 1924. During these six or eight months, interest sold at a little above $5.00 to the hundred and dividends at around $7.00. Smith, the more conservative, would have had no more reason to shift at this time than he originally had for buying interest in preference to dividends. We may suppose, therefore, that he would have retained his bonds for a time. The same motives which influenced Jones to buy stocks originally would now operate to lead him to shift.

During the few months following March 1932, another change in the investment situation occurred. Dividends became so cheap in comparison with interest that both Smith and Jones would have had to consider a shift, Jones presumably transferring his funds first, Smith later. During this interval they could have bought dividends of $7.50 to $10.00 for the same amount as $5.25 in interest would have cost them. A differential of over $2.00 to $4.50 would have been more than sufficient to compensate them for carrying the additional risk inherent in dividends. They would not, however, have held their industrial stocks long after April 1933, for by that time industrial dividend income and interest income were again selling at the same price, and at no time since then would our investors have had to consider a change, inasmuch as dividend income has remained high in comparison with the interest income of the same corporations.

It should be emphasized, of course, that this paper is addressed to the single question of determining, from income analysis, during what periods a prudent investor would consider shifting funds from bonds to stocks or the reverse. The decision as to what bonds or stocks to buy is for the investor’s own determination. But, assuming that he owns common stock in a corporation paying dividends and that the public is offering more for the dividends than it is willing to pay for the interest of the same corporation, it is high time for the individual to consider selling his dividends to the public which is clamoring for his stock and buying interest on bonds.

The individual must also decide for himself how much he will let the differential of stock yield fall below the bond yield before he sells stocks and buys bonds, or how much he will let the differential of stock yield rise above the bond yield before selling out his bonds and buying in stocks.

Nevertheless, tor the benefit of those who are guided by income in making their commitments, I will add that from the beginning of 1925 to the middle of 1934 the maximum differential of industrial stock yields below industrial bond yields, both averaged at the beginning of each month for the previous six, was 2 3/4 per cent, and that the maximum differential of stock yield above bond yield during the same period was 4 1/2 per cent,

reached as a result of the demoralized stock market of 1932. Except during this debacle, the differential of stock yield above bond wield rarely if ever exceeded 2 per cent during the wildest speculative period in the history of America and its aftermath. With respect to public utilities, the maximum differential betw een the middle of 1927 and the middle of 1934 was a stock yield of 2 per cent below the bond yield and 3 1/2 per cent above, a figure reached as a result of the debacle.

Much of the same information which lies before me now as I write was in front of me when I suggested in the Atlantic for June 1929 that in my opinion we were in for an unprecedented washout in the stock market because millions were then borrowing at exorbitantly high interest rates to raise funds for “investment’ in excessively low dividend yields. Had we all remained income buyers, as our philanthropist and ex-Senator did, and followed blindly the rule of thumb of never buying stocks of corporations when their dividends were selling at fewer dollars to the hundred of investment than their interest was selling for, never holding stocks when it took a hundred dollars to buy one dollar less in dividends than in interest, and never considering selling bonds until the same amount of money would buy at least $2.00 more of dividends per hundred of investment than of interest, we should now be, as compared with what we are, a happy and contented people.