The Future of Bonds Versus Stocks

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 GILBERT HAROLD

DURING the period known as the ‘Coolidge boom’ two investment analysts — Edgar Lawrence Smith and Kenneth S. Van Strum—published books proving that diversified portfolios of common stocks had been better investments during the past half century than high-grade bonds. Based upon these findings and other data, Messrs. Smith and Van Strum enunciated the principle which later became known as the common-stock theory. This is the theory that, granted a continuing upward trend in industry, diversified portfolios of the common stocks of leading companies, chiefly industrials, are more remunerative and safer investments than high-grade bonds.

Much to-do was made over the common-stock theory in the decade following the Smith and Van Strum publications. Investment trusts, banks, trust companies, and insurance companies adopted its philosophy. Investment counselors pointed to it in selling their services to the investing public. And, most of all, individual investors espoused it with the gusto which characterized the period.

Following the crash of 1929, very little was heard of this theory. In 1932 and 1933, in the troughs of depression, many observers claimed that recent market history had proved the theory invalid. Not until 1934, however, did any further statistical data appear. At this time, data of Mr. Smith’s were carried by me first through 1932 (‘A Reconsideration of the Common Stock Theory,’ in the .Journal of Business of the University of Chicago, Jaunary 1934) and then through 1934 (’King Midas and His Common Stocks.’ in Barron’s, April 30, 1934), and it was shown that, assuming the validity of Mr. Smith’s data, common stocks were still in the lead, both as to income and as to principal.

It has been shown, therefore, that the record of common stocks has been one of eminence. It has been a history of the almost continuous advance of technological improvement, of industrial expansion on so wide a front and of such magnitude that an investment in diversified equities in leading companies was a commitment in practically certain growth with its attendant profits. It has been a triumph of ownership over creditorship.

In the articles above referred to, the question of bonds versus common stocks was treated from an historical point of view. No attempt was made to prognosticate, or even to consider the factors entering into the investment processes of the future. The point of view was entirely historical. In the present brief discussion the author will attempt to outline the considerations which may make the future of different hue than the past.

It is widely recognized that the accumulated facilities of the past are a factor of some importance in the probabilities of the future. There is another factor, however, of perhaps equal importance: namely, the desire’ of the present administration to curb what may be considered excessive speculation, to effect a more equal distribution of income.

Standing on the threshold of a New Deal with its manifold implications and complications, the investor of to-day faces multivious forces hardly approached by those which confronted his father three decades ago. He who eagerly scans the financial news in the present era must weigh the probable relative effects of such multipotent devices as the NRA. the AAA, the PWA, the CWA, and all the other industrial renovators created during the past year or so. He is forced to consider the influences of such activities as the gold-buying programme, the monetization of silver, the devaluation of the dollar, and many forms of inflation, reflation, and deflation. He is compelled to take account of such interrogations as the possible effects of new and sundry Senate investigations, of new laws such as the Securities Act of new drafts of income taxation as well as sales taxes — or, summarily, of new phases, extensions, and ramifications of social control.

Perhaps one of the most important factors on the financial horizon is the possible limitation of corporate profits envisioned in present and proposed legislation. Unless there is a reversal of present political sentiment it is credible that premature industrial expansion will be disouraged, restricted, or confined within certain limits. It is possible that the tendency of labor toward shorter hours, higher wages, pensions, and insurance will have so much effect that ‘excess profits will become unlikely or that taxation will discourage their genesis. It should be understood, of course, that those possibilities are really possibilities and that there is no implication that they are probabilities. It should also be understood that there is no implication that a reversal of sentiment is either desirable or undesirable. That is a matter clearly beyond the scope of this discussion.

If and when these postulates are definitely shown to be applicable, il will follow that common stocks are again junior securities in every sense of the word. It follows that corporate bonds will return to their former position as prime media for the lodgment of investment funds in business enterprise.

If the investor is convinced of a basic change in the direction of corporate expansion, he should make at least a substantial proportion of his commitments in mediumand high-grade bonds. If, on the other hand, he leans to the belief that present indicators are of only passing nature, he should recognize opportunities in the realm of common stocks. There are some factors, however, which he should not overlook.

Specifically, more attention will need be pain to the character of the industry, its stability, its likelihood of continuance, its possibilities and probabilities of development.

More attention will be paid to the position of the company within the industry. Granted certain types of legislation, such as corporate income taxation, it is conceivable that low-cost producers may lose some, even much, of their present profit advantages. It is conceivable that the common stocks of relatively high-cost producers may, under protective legislation, prove to be most attractive.

More attention will necessarily be paid by investors to developments within the industrial codes.

More attention will be given to the investor’s specialization within a few industries. If it has been impossible or impractical for the investor to maintain constant touch with the developments of many industries and many companies, it will be more so in the future. Therefore, one may look forward to a greater specialization in industries among investors.

One of the most misunderstood and overworked policies among present-day investors is diversification. Many security purchasers young in experience harbor the notion that perfect diversification would be effected in a commitment of an equal portion or even some portion of their funds to each company in which investment is justified or to each company listed on an exchange or exchanges. The fact is, however, that although there may be some faint theoretical ground for this supposition, such a conception has never been held by those who are well versed in investment procedure. The more accepted definition of diversification is that it should involve investment in a sufficient number of enterprises so that a loss in one venture will not seriously disturb the total fund. There is a difference between plain scatter and intelligent, limited, and discriminating diversification. It is to be expected that the truth of this principle will be recognized more in future than it has been in the past.

If a lapse in the application of the commonstock theory is to be anticipated, if the principle of the survival of the fittest is to be amended by political medicine and surgery, the results will apparently include a relative weakening of the common stocks of some companies and a relative strengthening of the bonds of practically all companies— especially in the cases of those bonds which are based upon good tangible assets.

Under such an order of things, some doubt may be expressed as to the market welfare of bonds issued against common stock collateral and, in some cases, against preferred stock collateral, and brighter days should be in store for bonds now regarded as middle or second grade.

No implication is made that common stocks will not rise in value. The proposition herein asserted is that if a change in the upward surge of industry is forthcoming, if ’excess profits are to be discouraged in one way or another, if the number of opportunities for gigantic expansion is to be severely limited, if the status quo of business men is to be protected, then a fundamental change in the application of the common-stock theory is in store. The exceptional common stock will prove to be a better investment than the general run of bonds, but no such random selection as was possible during the first quarter of the century will be practicable.

If this appraisal be sound, it follows that certain very special stocks will gain relatively, these being the stocks of companies whose portfolios are laden with corporate bonds. Such organizations include primarily bond investment trusts and insurance companies.

Summarily, if common stocks in general are to be regarded now as the desirable form of security, we must look forward to industrial expansion on a large scale. If the investor does not entertain such an outlook, he should make his commitments either in bonds alone or in bonds with a sprinkling of highly selected stocks. The future is likely to be more an era of selectivism than the past.