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a somewhat differ- ent angle, which will stress the fact that investment must always consider the price as well as the quality of the security. Strictly speaking, there can be no such thing as an “investment issue” in the absolute sense, i.e., imply- ing that it remains an investment regardless of price. In the case of high- grade bonds, this point may not be important, for it is rare that their prices are so inflated as to introduce serious risk of loss of principal. But in the common-stock field this risk may frequently be created by an undue advance in price—so much so, indeed, that in our opinion the great majority of common stocks of strong companies must be consid- ered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase. We must warn the reader that prevailing Wall Street opinion does not agree with us on this point; and he must make up his own mind which of us is wrong. Nevertheless, we shall embody our principle in the following addi- tional criterion of investment: An investment operation is one that can be justified on both qualitative and quantitative grounds. The extent to which the distinction between investment and specula- tion may depend upon the underlying facts, including the element of price, rather than on any easy generalization, may be brought home in somewhat extreme fashion by two contrasting examples based upon Gen- eral Electric Special (i.e., Preferred) stock, which occurred in successive months. Example 1: In December 1934 this issue sold at 123/4. It paid 6% on $10 par and was callable on any dividend date at 11. In spite of the pre- eminent quality of this issue, as far as safety of dividends was concerned, the buyer at 123/4 was speculating to the extent of more than 10% of his principal. He was virtually wagering that the issue would not be called for some years to come.6 As it happened, the issue was called that very month for redemptio

stock, which occurred in successive months. Example 1: In December 1934 this issue sold at 123/4. It paid 6% on $10 par and was callable on any dividend date at 11. In spite of the pre- eminent quality of this issue, as far as safety of dividends was concerned, the buyer at 123/4 was speculating to the extent of more than 10% of his principal. He was virtually wagering that the issue would not be called for some years to come.6 As it happened, the issue was called that very month for redemption at $11 per share on April 15, 1935. Example 2: After the issue was called, the price promptly declined to 11. At that time the issue offered an unusual opportunity for profitable short-term investment on margin. Brokers buying the shares at 11 (with- out paying commission), say on January 15, 1935, could have borrowed $10 per share thereon at not more than 2% per annum. This operation would have netted a sure return at the rate of 40% per annum on the capital invested—as shown by the following calculation: Cost of 1,000 shares at 11 net $11,000 Redeemed Apr. 15, 1935, at 11 plus dividend 11,150 Gross profit 150 Less 3 months’ interest at 2% on $10,000 50 Net profit 100 Net profit of $100 on $1,000 in 3 months is equivalent to annual return of 40%. Needless to say, the safety, and the resultant investment character, of this unusual operation derived solely from the fact that the holder could count absolutely on the redemption of the shares in April 1935. The conception of investment advanced above is broader than most of those in common use. Under it investment may conceivably—though not usually—be made in stocks, carried on margin, and purchased with the chief interest in a quick profit. In these respects it would run counter to the first four distinctions which we listed at the outset. But to offset this seeming laxity, we insist on a satisfactory assurance of safety based on adequate analysis. We are thus led to the conclusion that the view- point of analysis and the vie

advanced above is broader than most of those in common use. Under it investment may conceivably—though not usually—be made in stocks, carried on margin, and purchased with the chief interest in a quick profit. In these respects it would run counter to the first four distinctions which we listed at the outset. But to offset this seeming laxity, we insist on a satisfactory assurance of safety based on adequate analysis. We are thus led to the conclusion that the view- point of analysis and the viewpoint of investment are largely identical in their scope. 6 In recent years many United States Government short-term securities have been purchased at prices yielding less than nothing to maturity in the expectation that the holders would be given valuable exchange privileges into new issues. According to our definition all such pur- chases must be called speculative to the extent of the premium paid above par and interest to maturity. OTHER ASPECTS OF INVESTMENT AND SPECULATION Relation of the Future to Investment and Speculation. It may be said, with some approximation to the truth, that investment is grounded on the past whereas speculation looks primarily to the future. But this statement is far from complete. Both investment and speculation must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict. But what we have said about the analyst and the future applies equally well to the concept of investment. For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly—and often soundly—derive its basis and its justification from prospective developments that differ from past performance. Types of “Investment.” Assuming that the student has acquired a fairly clear concept of invest

ssentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly—and often soundly—derive its basis and its justification from prospective developments that differ from past performance. Types of “Investment.” Assuming that the student has acquired a fairly clear concept of investment in the distinctive sense that we have just developed, there remains the confusing effect of the prevalent use of the term in the broader meanings referred to at the beginning of this chap- ter. It might be useful if some descriptive adjective were regularly employed, when care is needed, to designate the particular meaning intended. Let us tentatively suggest the following: 1. Business investment Referring to money put or held in a business. 2. Financial investment or Referring to securities generally. investment generally 3. Sheltered investment Referring to securities regarded as subject to small risk by reason of their prior claim on earnings or because they rest upon an adequate taxing power. 4. Analyst’s investment Referring to operations that, upon thorough study, promise safety of principal and an adequate return. Evidently these different types of investment are not mutually exclu- sive. A good bond, for example, would fall under all four headings. Unless we specify otherwise, we shall employ the word “investment,” and its rel- atives, in the sense of “analyst’s investment,” as developed in this chapter. Types of Speculation. The distinction between speculation and gam- bling assumes significance when the activities of Wall Street are subjected to critical scrutiny. It is more or less the official position of the New York Stock Exchange that “gambling” represents the creation of risks not previ- ously existing—e.g., race-track betting—whereas “speculation” appl

ise, we shall employ the word “investment,” and its rel- atives, in the sense of “analyst’s investment,” as developed in this chapter. Types of Speculation. The distinction between speculation and gam- bling assumes significance when the activities of Wall Street are subjected to critical scrutiny. It is more or less the official position of the New York Stock Exchange that “gambling” represents the creation of risks not previ- ously existing—e.g., race-track betting—whereas “speculation” applies to the taking of risks that are implicit in a situation and so must be taken by someone. A formal distinction between “intelligent speculation” and “unin- telligent speculation” is no doubt open to strong theoretical objections, but we do think that it has practical utility. Thus we suggest the following: 1. Intelligent speculation The taking of a risk that appears justified after careful weighing of the pros and cons. 2. Unintelligent speculation Risk taking without adequate study of the situation. In the field of general business most well-considered enterprises would belong in the class of intelligent speculations as well as represent- ing “business investments” in the popular sense. If the risk of loss is very small—an exceptional occurrence—a particular business venture may qualify as an analyst’s investment in our special sense. On the other hand, many ill-conceived businesses must be called unintelligent speculations. Similarly, in the field of finance, a great deal of common-stock buying is done with reasonable care and may be called intelligent speculation; a great deal, also, is done upon inadequate consideration and for unsound reasons and thus must be called unintelligent; in the exceptional case a common stock may be bought on such attractive terms, qualitative and quantitative, as to set the inherent risk at a minimum and justify the title of analyst’s investment. Investment and Speculative Components. A proposed purchase that cannot qualify as an “analyst’s

n-stock buying is done with reasonable care and may be called intelligent speculation; a great deal, also, is done upon inadequate consideration and for unsound reasons and thus must be called unintelligent; in the exceptional case a common stock may be bought on such attractive terms, qualitative and quantitative, as to set the inherent risk at a minimum and justify the title of analyst’s investment. Investment and Speculative Components. A proposed purchase that cannot qualify as an “analyst’s investment” automatically falls into the speculative category. But at times it may be useful to view such a purchase somewhat differently and to divide the price paid into an investment and a speculative component. Thus the analyst, considering General Electric common at its average price of $38 in 1939, might conclude that up to, say, $25 per share is justified from the strict standpoint of investment value. The remaining $13 per share will represent the stock market’s average appraisal of the company’s excellent long-term prospects, including therein, perhaps, a rather strong psychological bias in favor of this outstanding enterprise. On the basis of such a study, the analyst would declare that the price of $38 for General Electric includes an investment component of some $25 per share and a speculative component of about $13 per share. If this is sound, it would follow that at a price of 25 or less, General Electric common would constitute an “analyst’s investment” com- pletely; but above that price the buyer should recognize that he is paying something for the company’s very real speculative possibilities.7 Investment Value, Speculative Value, and Intrinsic Value. The foregoing discussion suggests an amplification of what was said in Chap. 1 on the concept of “intrinsic value,” which was there defined as “value jus- tified by the facts.” It is important to recognize that such value is by no means limited to “value for investment”—i.e., to the investment component of to

but above that price the buyer should recognize that he is paying something for the company’s very real speculative possibilities.7 Investment Value, Speculative Value, and Intrinsic Value. The foregoing discussion suggests an amplification of what was said in Chap. 1 on the concept of “intrinsic value,” which was there defined as “value jus- tified by the facts.” It is important to recognize that such value is by no means limited to “value for investment”—i.e., to the investment component of total value—but may properly include a substantial component of spec- ulative value, provided that such speculative value is intelligently arrived at. Hence the market price may be said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation. Generally speaking, it is the function of the stock market, and not of the analyst, to appraise the speculative factors in a given common-stock picture. To this important extent the market, not the analyst, determines intrinsic value. The range of such an appraisal may be very wide, as illus- trated by our former suggestion that the intrinsic value of J. I. Case com- mon in 1933 might conceivably have been as high as 130 or as low as 30. At any point between these broad limits it would have been necessary to accept the market’s verdict—changeable as it was from day to day—as representing the best available determination of the intrinsic value of this volatile issue. 7 We have intentionally, and at the risk of future regret, used an example here of a highly controversial character. Nearly everyone in Wall Street would regard General Electric stock as an “investment issue” irrespective of its market price and, more specifically, would con- sider the average price of $38 as amply justified from the investment standpoint. But we are convinced that to regard investment quality as something independent of price is a funda- mental and dangerous error. As to the point at which the investment

at the risk of future regret, used an example here of a highly controversial character. Nearly everyone in Wall Street would regard General Electric stock as an “investment issue” irrespective of its market price and, more specifically, would con- sider the average price of $38 as amply justified from the investment standpoint. But we are convinced that to regard investment quality as something independent of price is a funda- mental and dangerous error. As to the point at which the investment value of General Elec- tric ceases and its speculative value begins, there is naturally room for a fairly wide difference of opinion. Our figure is only illustrative. Chapter 5 CLASSIFICATION OF SECURITIES SECURITIES ARE CUSTOMARILY divided into the two main groups of bonds and stocks, with the latter subdivided into preferred stocks and common stocks. The first and basic division recognizes and conforms to the funda- mental legal distinction between the creditors’ position and the partners’ position. The bondholder has a fixed and prior claim for principal and interest; the stockholder assumes the major risks and shares in the profits of ownership. It follows that a higher degree of safety should inhere in bonds as a class, while greater opportunity of speculative gain—to offset the greater hazard—is to be found in the field of stocks. It is this contrast, of both legal status and investment character, as between the two kinds of issues, which provides the point of departure for the usual textbook treat- ment of securities. Objections to the Conventional Grouping: 1. Preferred Stock Grouped with Common. While this approach is hallowed by tradi- tion, it is open to several serious objections. Of these the most obvious is that it places preferred stocks with common stocks, whereas, so far as investment practice is concerned, the former undoubtedly belong with bonds. The typical or standard preferred stock is bought for fixed income and safety of principal. Its owner cons

the usual textbook treat- ment of securities. Objections to the Conventional Grouping: 1. Preferred Stock Grouped with Common. While this approach is hallowed by tradi- tion, it is open to several serious objections. Of these the most obvious is that it places preferred stocks with common stocks, whereas, so far as investment practice is concerned, the former undoubtedly belong with bonds. The typical or standard preferred stock is bought for fixed income and safety of principal. Its owner considers himself not as a partner in the business but as the holder of a claim ranking ahead of the interest of the partners, i.e., the common stockholders. Preferred stockholders are part- ners or owners of the business only in a technical, legalistic sense; but they resemble bondholders in the purpose and expected results of their investment. 2. Bond Form Identified with Safety. A weightier though less patent objection to the radical separation of bonds from stocks is that it tends to identify the bond form with the idea of safety. Hence investors are led to believe that the very name “bond” must carry some especial [112] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. assurance against loss. This attitude is basically unsound, and on fre- quent occasions is responsible for serious mistakes and loss. The investor has been spared even greater penalties for this error by the rather accidental fact that fraudulent security promoters have rarely taken advantage of the investment prestige attaching to the bond form.1 It is true beyond dispute that bonds as a whole enjoy a degree of safety distinctly superior to that of the average stock. But this advantage is not the result of any essential virtue of the bond form; it follows from the circumstance that the typical American enterprise is financed with some honesty and intelligence and does not assume fixed obligations without a reasonable expectation of being able to

romoters have rarely taken advantage of the investment prestige attaching to the bond form.1 It is true beyond dispute that bonds as a whole enjoy a degree of safety distinctly superior to that of the average stock. But this advantage is not the result of any essential virtue of the bond form; it follows from the circumstance that the typical American enterprise is financed with some honesty and intelligence and does not assume fixed obligations without a reasonable expectation of being able to meet them. But it is not the obligation that creates the safety, nor is it the legal remedies of the bondholder in the event of default. Safety depends upon and is measured entirely by the ability of the debtor corporation to meet its obligations. The bond of a business without assets or earning power would be every whit as valueless as the stock of such an enterprise. Bonds repre- senting all the capital placed in a new venture are no safer than common stock would be, and are considerably less attractive. For the bondholder could not possibly get more out of the company by virtue of his fixed claim than he could realize if he owned the business in full, free and clear.2 This simple principle seems too obvious to merit statement; yet because of the traditional association of the bond form with superior safety, the investor has often been persuaded that by the mere act of limiting his return he obtained an assurance against loss. 3. Failure of Titles to Describe Issues with Accuracy. The basic classification of securities into bonds and stocks—or even into three main classes of bonds, preferred stocks, and common stocks—is open to the third objection that in many cases these titles fail to supply an accurate description of the issue. This is the consequence of the steadily mounting 1 For an example of fraudulent sales of bonds see Securities Act of 1933: Release No. 2112, dated Dec. 4, 1939, relating to conviction of various parties in connection with the sale of American Ter

e basic classification of securities into bonds and stocks—or even into three main classes of bonds, preferred stocks, and common stocks—is open to the third objection that in many cases these titles fail to supply an accurate description of the issue. This is the consequence of the steadily mounting 1 For an example of fraudulent sales of bonds see Securities Act of 1933: Release No. 2112, dated Dec. 4, 1939, relating to conviction of various parties in connection with the sale of American Terminals and Transit Company bonds and Green River Valley Terminal Company notes. 2 See Appendix Note 4, p. 736 on accompanying CD, for a phase of the liquidation of the United States Express Company illustrating this point and for the more recent example of Court-Livingston Corporation. percentage of securities which do not conform to the standard patterns, but instead modify or mingle the customary provisions. Briefly stated, these standard patterns are as follows: I. The bond pattern comprises: A. The unqualified right to a fixed interest payment on fixed dates. B. The unqualified right to repayment of a fixed principal amount on a fixed date. C. No further interest in assets or profits, and no voice in the management. II. The preferred-stock pattern comprises: A. A stated rate of dividend in priority to any payment on the com- mon. (Hence full preferred dividends are mandatory if the com- mon receives any dividend; but if nothing is paid on the common, the preferred dividend is subject to the discretion of the directors). B. The right to a stated principal amount in the event of dissolution, in priority to any payments to the common stock. C. Either no voting rights, or voting power shared with the common. III. The common-stock pattern comprises: A. A pro rata ownership of the company’s assets in excess of its debts and preferred stock issues. B. A pro rata interest in all profits in excess of prior deductions. C. A pro rata vote for the election of directors and for othe

ject to the discretion of the directors). B. The right to a stated principal amount in the event of dissolution, in priority to any payments to the common stock. C. Either no voting rights, or voting power shared with the common. III. The common-stock pattern comprises: A. A pro rata ownership of the company’s assets in excess of its debts and preferred stock issues. B. A pro rata interest in all profits in excess of prior deductions. C. A pro rata vote for the election of directors and for other purposes. Bonds and preferred stocks conforming to the above standard patterns will sometimes be referred to as straight bonds or straight pre- ferred stocks. Numerous Deviations from the Standard Patterns. However, almost every conceivable departure from the standard pattern can be found in greater or less profusion in the security markets of today. Of these the most frequent and important are identified by the following designations: income bonds; convertible bonds and preferred stocks; bonds and pre- ferred stocks with stock-purchase warrants attached; participating pre- ferred stocks; common stocks with preferential features; nonvoting common stock. Of recent origin is the device of making bond interest or preferred dividends payable either in cash or in common stock at the holder’s option. The callable feature now found in most bonds may also be termed a lesser departure from the standard provision of fixed maturity of principal. Of less frequent and perhaps unique deviations from the standard pat- terns, the variety is almost endless.3 We shall mention here only the glar- ing instance of Great Northern Railway Preferred Stock which for many years has been in all respects a plain common issue; and also the resort by Associated Gas and Electric Company to the insidious and highly objectionable device of bonds convertible into preferred stock at the option of the company which are, therefore, not true bonds at all. More striking still is the emergence of completely dis

from the standard pat- terns, the variety is almost endless.3 We shall mention here only the glar- ing instance of Great Northern Railway Preferred Stock which for many years has been in all respects a plain common issue; and also the resort by Associated Gas and Electric Company to the insidious and highly objectionable device of bonds convertible into preferred stock at the option of the company which are, therefore, not true bonds at all. More striking still is the emergence of completely distinctive types of securities so unrelated to the standard bond or stock pattern as to require an entirely different set of names. Of these, the most significant is the option warrant—a device which during the years prior to 1929 developed into a financial instrument of major importance and tremendous mis- chief-making powers. The option warrants issued by a single company— American and Foreign Power Company—attained in 1929 an aggregate market value of more than a billion dollars, a figure exceeding our national debt in 1914. A number of other newfangled security forms, bearing titles such as allotment certificates and dividend participations, could be mentioned.4 The peculiarities and complexities to be found in the present day secu- rity list are added arguments against the traditional practice of pigeon- holing and generalizing about securities in accordance with their titles. While this procedure has the merit of convenience and a certain rough validity, we think it should be replaced by a more flexible and accurate basis of classification. In our opinion, the criterion most useful for pur- poses of study would be the normal behavior of the issue after purchase— in other words its risk-and-profit characteristics as the buyer or owner would reasonably view them. New Classification Suggested. With this standpoint in mind, we suggest that securities be classified under the following three headings: 3 The reader is referred to Appendix Note 3 of the first edition of this wor

ced by a more flexible and accurate basis of classification. In our opinion, the criterion most useful for pur- poses of study would be the normal behavior of the issue after purchase— in other words its risk-and-profit characteristics as the buyer or owner would reasonably view them. New Classification Suggested. With this standpoint in mind, we suggest that securities be classified under the following three headings: 3 The reader is referred to Appendix Note 3 of the first edition of this work for a comprehen- sive list of these deviations, with examples of each. To save space that material is omitted from this edition. 4 In June 1939 the S.E.C. set a salutary precedent by refusing to authorize the issuance of “Capital Income Debentures” in the reorganization of the Griess-Pfleger Tanning Company, on the ground that the devising of new types of hybrid issues had gone far enough. See S.E.C. Corporate Reorganization Release No. 13, dated June 16, 1939. Unfortunately, the court failed to see the matter in the same light and approved the issuance of the new security. Class Representative Issue I. Securities of the fixed-value type. A high-grade bond or preferred stock. II. Senior securities of the variable- value type. A. Well-protected issues with profit A high-grade convertible bond. possibilities. B. Inadequately protected issues. A lower-grade bond or preferred stock. III. Common-stock type. A common stock. An approximation to the above grouping could be reached by the use of more familiar terms, as follows: I. Investment bonds and preferred stocks. II. Speculative bonds and preferred stocks. A. Convertibles, etc. B. Low-grade senior issues. III. Common stocks. The somewhat novel designations that we employ are needed to make our classification more comprehensive. This necessity will be clearer, per- haps, from the following description and discussion of each group. Leading Characteristics of the Three Types. The first class includes issues, of whatever titl

use of more familiar terms, as follows: I. Investment bonds and preferred stocks. II. Speculative bonds and preferred stocks. A. Convertibles, etc. B. Low-grade senior issues. III. Common stocks. The somewhat novel designations that we employ are needed to make our classification more comprehensive. This necessity will be clearer, per- haps, from the following description and discussion of each group. Leading Characteristics of the Three Types. The first class includes issues, of whatever title, in which prospective change of value may fairly be said to hold minor importance.5 The owner’s dominant interest lies in the safety of his principal and his sole purpose in making the commitment is to obtain a steady income. In the second class, prospective changes in the value of the principal assume real significance. In Type A, the investor hopes to obtain the safety of a straight investment, with an added possi- bility of profit by reason of a conversion right or some similar privilege. In Type B, a definite risk of loss is recognized, which is presumably offset 5 The actual fluctuations in the price of long-term investment bonds since 1914 have been so wide (see chart on p. 27) as to suggest that these price changes must surely be of more than minor importance. It is true, nonetheless, that the investor habitually acts as if they were of minor importance to him, so that, subjectively at least, our criterion and title are justified. To the objection that this is conniving at self-delusion by the investor, we may answer that on the whole he is likely to fare better by overlooking the price variations of high-grade bonds than by trying to take advantage of them and thus transforming himself into a trader. by a corresponding chance of profit. Securities included in Group IIB will differ from the common-stock type (Group III) in two respects: (1) They enjoy an effective priority over some junior issue, thus giving them a cer- tain degree of protection. (2) Their profit

lf-delusion by the investor, we may answer that on the whole he is likely to fare better by overlooking the price variations of high-grade bonds than by trying to take advantage of them and thus transforming himself into a trader. by a corresponding chance of profit. Securities included in Group IIB will differ from the common-stock type (Group III) in two respects: (1) They enjoy an effective priority over some junior issue, thus giving them a cer- tain degree of protection. (2) Their profit possibilities, however substan- tial, have a fairly definite limit, in contrast with the unlimited percentage of possible gain theoretically or optimistically associated with a fortunate common-stock commitment. Issues of the fixed-value type include all straight bonds and preferred stocks of high quality selling at a normal price. Besides these, there belong in this class: 1. Sound convertible issues where the conversion level is too remote to enter as a factor in the purchase. (Similarly for participating or warrant-bear- ing senior issues.) 2. Guaranteed common stocks of investment grade. 3. “Class A” or prior-common stocks occupying the status of a high-grade, straight preferred stock. On the other hand, a bond of investment grade which happens to sell at any unduly low price would belong in the second group, since the pur- chaser might have reason to expect and be interested in an appreciation of its market value. Exactly at what point the question of price fluctuation becomes mate- rial rather than minor is naturally impossible to prescribe. The price level itself is not the sole determining factor. A long-term 3% bond selling at 60 may have belonged in the fixed-value class (e.g., Northern Pacific Rail- way 3s, due 2047 between 1922 and 1930), whereas a one-year maturity of any coupon rate selling at 80 would not because in a comparatively short time it must either be paid off at a 20-point advance or else default and probably suffer a severe decline in market value. W

e- rial rather than minor is naturally impossible to prescribe. The price level itself is not the sole determining factor. A long-term 3% bond selling at 60 may have belonged in the fixed-value class (e.g., Northern Pacific Rail- way 3s, due 2047 between 1922 and 1930), whereas a one-year maturity of any coupon rate selling at 80 would not because in a comparatively short time it must either be paid off at a 20-point advance or else default and probably suffer a severe decline in market value. We must be pre- pared, therefore, to find marginal cases where the classification (as between Group I and Group II) will depend on the personal viewpoint of the analyst or investor. Any issue which displays the main characteristics of a common stock belongs in Group III, whether it is entitled “common stock,” “preferred stock” or even “bond.” The case, already cited, of American Telephone and Telegraph Company Convertible 41/2 s, when selling about 200, pro- vides an apposite example. The buyer or holder of the bond at so high a level was to all practical purposes making a commitment in the common stock, for the bond and stock would not only advance together but also decline together over an exceedingly wide price range. Still more definite illustration of this point was supplied by the Kreuger and Toll Participat- ing Debentures at the time of their sale to the public. The offering price was so far above the amount of their prior claim that their title had no significance at all, and could only have been misleading. These “bonds” were definitely of the common-stock type.6 The opposite situation is met when issues, senior in name, sell at such low prices that the junior securities can obviously have no real equity, i.e., ownership interest, in the company. In such cases, the low-priced bond or preferred stock stands virtually in the position of a common stock and should be regarded as such for purposes of analysis. A preferred stock selling at 10 cents on the dollar, for exa

could only have been misleading. These “bonds” were definitely of the common-stock type.6 The opposite situation is met when issues, senior in name, sell at such low prices that the junior securities can obviously have no real equity, i.e., ownership interest, in the company. In such cases, the low-priced bond or preferred stock stands virtually in the position of a common stock and should be regarded as such for purposes of analysis. A preferred stock selling at 10 cents on the dollar, for example, should be viewed not as a preferred stock at all, but as a common stock. On the one hand it lacks the prime requisite of a senior security, viz., that it should be followed by a junior investment of substantial value. On the other hand, it carries all the profit features of a common stock, since the amount of possible gain from the current level is for all practical purposes unlimited. The dividing line between Groups II and III is as indefinite as that between Groups I and II. Borderline cases can be handled without undue difficulty however, by considering them from the standpoint of either cat- egory or of both. For example, should a 7% preferred stock selling at 30 be considered a low-priced senior issue or as the equivalent of a common stock? The answer to this question will depend partly on the exhibit of the company and partly on the attitude of the prospective buyer. If real value may conceivably exist in excess of the par amount of the preferred stock, the issue may be granted some of the favored status of a senior security. On the other hand, whether or not the buyer should consider it in the same light as a common stock may also depend on whether he would be amply satisfied with a possible 250% appreciation, or is looking for even greater speculative gain.7 6 See Appendix Note 5, p. 737 on accompanying CD, for the terms of this issue. 7 There were many preferred stocks of this kind in 1932—e.g., Interstate Department Stores Preferred which sold at an average

anted some of the favored status of a senior security. On the other hand, whether or not the buyer should consider it in the same light as a common stock may also depend on whether he would be amply satisfied with a possible 250% appreciation, or is looking for even greater speculative gain.7 6 See Appendix Note 5, p. 737 on accompanying CD, for the terms of this issue. 7 There were many preferred stocks of this kind in 1932—e.g., Interstate Department Stores Preferred which sold at an average price of about 30 in 1932 and 1933 and then advanced to 107 in 1936 and 1937. A similar remark applies to low-priced bonds, such as those mentioned in the table on p. 330. From the foregoing discussion the real character and purpose of our classification should now be more evident. Its basis is not the title of the issue, but the practical significance of its specific terms and status to the owner. Nor is the primary emphasis placed upon what the owner is legally entitled to demand, but upon what he is likely to get, or is justified in expecting, under conditions which appear to be probable at the time of purchase or analysis. This page intentionally left blank PART II FIXED-VALUE INVESTMENTS Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. This page intentionally left blank I n tr oduc tion to P ar t II UNSHACKLING BONDS BY HOWARD S. MARKS y first exposure to Security Analysis came in 1965. As a Whar- ton undergraduate, I was assigned readings from the master- work of Benjamin Graham and David Dodd (joined by that time by editor Sidney Cottle). We’re talking about the early days, when a career in investment man- agement mostly meant working for a bank, a trust company, or an insur- ance company. The first institutional investment boutique that I remember—Jennison Associates—was still a few years away from its founding. Common stock investors referenced

urity Analysis came in 1965. As a Whar- ton undergraduate, I was assigned readings from the master- work of Benjamin Graham and David Dodd (joined by that time by editor Sidney Cottle). We’re talking about the early days, when a career in investment man- agement mostly meant working for a bank, a trust company, or an insur- ance company. The first institutional investment boutique that I remember—Jennison Associates—was still a few years away from its founding. Common stock investors referenced the Dow Jones Industrial Average, not the S&P 500, and there was no talk of quartiles or deciles. In fact, it was just a few years earlier, at the University of Chicago’s Center for Research in Security Prices, that daily stock prices since 1926 had been digitized, permitting calculation of the 9.2% historic return on equities. The term “growth stock investing” was relatively new (and in its absence, there was no need for the contrasting term “value investing”). The invention of the hedge fund had yet to be recognized, and I’m not sure the description even existed. No one had ever heard of a venture capital fund, a private equity fund, an index fund, a quant fund, or an emerging market fund. And, interestingly, “famous investor” was largely an oxymoron—the world hadn’t yet heard of Warren Buffett, for example, and only a small circle recognized his teacher at Columbia, Ben Graham. [123] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. The world of fixed income bore little resemblance to that of today. There was no way to avoid uncertainty regarding the rate at which inter- est payments could be reinvested because zero-coupon bonds had not been invented. Bonds rated below investment grade couldn’t be issued as such, and the fallen angels that were outstanding had yet to be labeled “junk” or “high yield” bonds. Of course, there were no leveraged loans, residential mortgage–backed securities (RMBSs), or collateral

erms of use. The world of fixed income bore little resemblance to that of today. There was no way to avoid uncertainty regarding the rate at which inter- est payments could be reinvested because zero-coupon bonds had not been invented. Bonds rated below investment grade couldn’t be issued as such, and the fallen angels that were outstanding had yet to be labeled “junk” or “high yield” bonds. Of course, there were no leveraged loans, residential mortgage–backed securities (RMBSs), or collateralized bond, debt, and loan obligations. And today’s bond professionals might give some thought to how their predecessors arrived at yields to matu- rity before the existence of computers, calculators, or Bloomberg terminals. But I’m lucky to have begun my studies in the mid-1960s because the finance and investment theory I would go on to learn at the University of Chicago Graduate School of Business was new and hadn’t yet spread broadly. Thus my college experience did not include exposure to the Effi- cient Market Hypothesis, which told the next few generations of students of finance that there was no use for Security Analysis: a guidebook to the impossible task of beating an inefficient market. * * * I learned a lot from this book, which was generally accepted in 1965 as the bible of security analysis. And yet I came away with a negative reac- tion as well, feeling that it contained too much dogma and too many for- mulas incorporating numerical constants like “multiply by x” or “count only y years.” My more recent reading of the chapters on fixed income securities in the 1940 edition of Security Analysis served to remind me of some of the rules I had found too rigid. But it also showed me the vast wealth of less quantitative and more flexible common sense contained in the book, as well as some of the forward-looking insights. To my mind, some of the most interesting aspects of the book—and of developments in the investment world over the last several decades— are seen in

t only y years.” My more recent reading of the chapters on fixed income securities in the 1940 edition of Security Analysis served to remind me of some of the rules I had found too rigid. But it also showed me the vast wealth of less quantitative and more flexible common sense contained in the book, as well as some of the forward-looking insights. To my mind, some of the most interesting aspects of the book—and of developments in the investment world over the last several decades— are seen in Graham and Dodd’s perspective on the evolution of invest- ment standards. • At least through 1940, there were well-accepted and very specific standards for what was proper and what was not, especially in fixed income. Rules and attitudes governed the actions of fiduciaries and the things they could and could not do. In this environment, a fiduci- ary who lost money for his beneficiaries in a nonqualifying investment could be “surcharged”—forced to make good the losses—without ref- erence to how well he did his job overall or whether the whole portfo- lio made money. • Then, there was the concept of the “prudent man,” based on a nineteenth-century court case. Was this something that a prudent per- son would do, judged in the light of the circumstances under which the decision was made and in the context of the portfolio as a whole? Thus individual losing investments need not give rise to penalties if the fiduciary’s decisions and results were acceptable in toto. • As part of the development of the finance theory that is attributed to the “Chicago School,” in the 1950s Harry Markowitz contributed the notion that, based on an understanding of correlation, the addition of a “risky asset” to a portfolio could reduce the portfolio’s overall riski- ness by increasing its diversification. • Finally, the ultimate contribution of the Chicago School came through the assertion that the “goodness” of an investment—and of a perform- ance record—had to be evaluated based on the relations

opment of the finance theory that is attributed to the “Chicago School,” in the 1950s Harry Markowitz contributed the notion that, based on an understanding of correlation, the addition of a “risky asset” to a portfolio could reduce the portfolio’s overall riski- ness by increasing its diversification. • Finally, the ultimate contribution of the Chicago School came through the assertion that the “goodness” of an investment—and of a perform- ance record—had to be evaluated based on the relationship between its risk and its return. A safe investment is not a good investment, and a risky investment is not a bad investment. Good-enough perform- ance prospects can compensate for the riskiness of a risky investment, rendering it attractive and prudent. Thus, today we see few absolute rules of investing. In fact, it’s hard to think of anything that’s off-limits, and most investors will do almost any- thing to make a buck. The 1940 edition of Security Analysis marks an interesting turn toward what we would consider very modern thinking— it references some absolute standards but dismisses many others and reflects an advanced attitude toward sensible fixed income investing. Investment Absolutes The 1940 edition certainly contains statements that seem definite. Here are some examples: Deficient safety cannot be compensated for by an abnormally high coupon rate. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests. (p. 144) If a company’s junior bonds are not safe, its first-mortgage bonds are not a desirable fixed-value investment. For if the second mortgage is unsafe the company itself is weak, and generally speaking there can be no high- grade obligations of a weak enterprise. (p. 148) Bonds of smaller industrial companies are not well qualified for consider- ation as fixed-value investments. (p. 161) When I began to manage high yield bonds in 1978, most institutional portfolios were governed by rules that li

4) If a company’s junior bonds are not safe, its first-mortgage bonds are not a desirable fixed-value investment. For if the second mortgage is unsafe the company itself is weak, and generally speaking there can be no high- grade obligations of a weak enterprise. (p. 148) Bonds of smaller industrial companies are not well qualified for consider- ation as fixed-value investments. (p. 161) When I began to manage high yield bonds in 1978, most institutional portfolios were governed by rules that limited bond holdings to either “investment grade” (triple B or better) or “A or better.” Rules like these that put certain securities off-limits to most buyers had the effect of mak- ing bargains available to those of us who weren’t so restricted. At first glance, Graham and Dodd’s proscriptions would seem to be among those rules. Investment versus Speculation As I reread the chapters that are the subject of this updating, I came across a number of statements like these, to the effect that some bond is or is not appropriate for investment. No mention of price or yield; just yes or no . . . good or bad. To someone whose career in portfolio manage- ment has dealt almost exclusively with speculative-grade assets, this would seem to rule out whole sections of the investment universe. The ideas that potential return can compensate for risk and that the debt of a financially troubled company can get so cheap that it’s a screaming buy appear to fight the authors’ principles. Then it dawned on me that Graham and Dodd were saying one thing and I was reading another. They didn’t mean that something shouldn’t be bought—but rather that it shouldn’t be bought, to use their phrase, “on an investment basis.” Today people attach the word “investment” to any- thing purchased for the purpose of financial gain—as opposed to some- thing bought for use or consumption. People invest today in not just stocks and bonds but also in jewelry, vacation-home timeshares, col- lectibles, and art. But 75 y

n me that Graham and Dodd were saying one thing and I was reading another. They didn’t mean that something shouldn’t be bought—but rather that it shouldn’t be bought, to use their phrase, “on an investment basis.” Today people attach the word “investment” to any- thing purchased for the purpose of financial gain—as opposed to some- thing bought for use or consumption. People invest today in not just stocks and bonds but also in jewelry, vacation-home timeshares, col- lectibles, and art. But 75 years ago, investing meant the purchase of financial assets that by their intrinsic nature satisfied the requirements of conservatism, prudence, and, above all, safety. Securities qualified for investment on the basis of quality, not prospective return. They either were eligible for investment or they were not. In the extreme, there were hard-and-fast rules, such as those promul- gated by each of the states for its savings banks. In New York, for exam- ple, savings banks could buy railroad, gas, and electric bonds but not the bonds of street railway or water companies. Bonds secured by first mort- gages on real estate qualified as investments, but—startlingly—industrial bonds did not. Investments that hewed to the accepted standards were “safe” (and probably litigation-proof for the fiduciary who bought them), while specu- lating was chancy. It was this rigid, exclusionary, black-and-white attitude toward investment propriety that likely led John Maynard Keynes to his trenchant observation that “a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.” Thus a more modern attitude—and, like Keynes’s, well ahead of its time—would be based on the notion that virtually any asset can be a good investment if bought knowledgeably and at a low-enough price. The opposite is also something that I insist is true: there’s no asset so good that it can’t be a bad investment if bought at too high a price. Everyone now realizes th

ion that “a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware.” Thus a more modern attitude—and, like Keynes’s, well ahead of its time—would be based on the notion that virtually any asset can be a good investment if bought knowledgeably and at a low-enough price. The opposite is also something that I insist is true: there’s no asset so good that it can’t be a bad investment if bought at too high a price. Everyone now realizes that membership on a list of “acceptable invest- ments” certainly doesn’t provide protection against loss. If you don’t agree with that statement, try looking for the bonds that were rated AAA a few decades ago or mortgage-backed securities that went from AAA to junk status in 2007. In Security Analysis, the principle is developed and reiterated that “a high coupon rate is not adequate compensation for the assumption of substantial risk of principal.” (p. 125 on accompanying CD) This statement would seem to rule out investing in high yield bonds, which has been successfully pursued over the last 30 years with absolute and risk- adjusted returns well above those on investment-grade bonds. A more thorough reading, however, shows that securities that the authors say should not be purchased “on an investment basis” can still be considered “for speculation.” Nevertheless, today Graham and Dodd’s blanket state- ment certainly seems doctrinaire—especially in that it implements a dis- tinction that has almost entirely ceased to exist. The statement that certain assets either are or aren’t appropriate for purchase on an investment basis is probably one of the dicta to which I reacted negatively 43 years ago. But now, in this rereading, I was able to see further. Investment Realism Over the last four or five decades, the investment world has seen what could be described as the development of a much more pragmatic approach to making money: judging investment merit not on absolute notion

hat has almost entirely ceased to exist. The statement that certain assets either are or aren’t appropriate for purchase on an investment basis is probably one of the dicta to which I reacted negatively 43 years ago. But now, in this rereading, I was able to see further. Investment Realism Over the last four or five decades, the investment world has seen what could be described as the development of a much more pragmatic approach to making money: judging investment merit not on absolute notions of quality and safety but rather on the relationship between expected return and expected risk. Alternatively, of course, this could be described as a lowering of standards; what ever happened to concepts like fiduciary duty and preservation of capital? Graham and Dodd seem to operate in something of a middle ground. They propound absolute requirements for purchases on an investment basis, but they also admit that apparent quality and safety alone shouldn’t be expected to make some things successful investments or rule out oth- ers. Here are several examples: [Given that fixed income securities lack the upside potential of equities,] the essence of proper bond selection consists, therefore, in obtaining specific and convincing factors of safety in compensation for the surren- der of participation in profits. (p. 143) The conception of a mortgage lien as a guaranty of protection independ- ent of the success of the business itself is in most cases a complete fal- lacy The established practice of stating the original cost or appraised value of the pledged property as an inducement to purchase bonds is entirely misleading. (p. 145) The debentures of a strong enterprise are undoubtedly sounder invest- ments than the mortgage issues of a weak company. (p. 148) It is clear that the investor who favors the Cudahy first-lien 5s [yield- ing 51⁄2 versus the junior 51⁄2’s yielding over 20%] is paying a premium of about 15% per annum (the difference in yield) for only a partial insur- a

ractice of stating the original cost or appraised value of the pledged property as an inducement to purchase bonds is entirely misleading. (p. 145) The debentures of a strong enterprise are undoubtedly sounder invest- ments than the mortgage issues of a weak company. (p. 148) It is clear that the investor who favors the Cudahy first-lien 5s [yield- ing 51⁄2 versus the junior 51⁄2’s yielding over 20%] is paying a premium of about 15% per annum (the difference in yield) for only a partial insur- ance against loss. On this basis he is undoubtedly giving up too much for what he gets in return. (p. 149) [On the other hand,] where the first-mortgage bond yields only slightly less, it is undoubtedly wise to pay the small insurance premium for pro- tection against unexpected trouble. (p. 149) [In reviewing bond collapses among railroads between 1931 and 1933,] the fault appears to be that the stability of the transportation industry was overrated, so that investors were satisfied with a margin of protec- tion which proved insufficient. It was not a matter of imprudently disre- garding old established standards of safety . . . but of being content with old standards when conditions called for more stringent requirements If [the investor] had required his railroad bonds to meet the same tests that he applied to industrial issues, he would have been compelled to confine his selection to a relatively few of the strongly situated lines. As it turned out, nearly all of these have been able to withstand the tremendous loss of traffic since 1929 without danger to their fixed charges. (p. 158, emphasis added) It is clear in these citations and many others that Graham and Dodd are insistent on substance over form, and on logic rather than rules. It’s how likely a bond is to pay that matters, not what it is labeled. Credit standards must not be fixed but instead must evolve. Mortgages are not automatically better than unsecured debentures. Safer bonds are not necessarily better buys

le to withstand the tremendous loss of traffic since 1929 without danger to their fixed charges. (p. 158, emphasis added) It is clear in these citations and many others that Graham and Dodd are insistent on substance over form, and on logic rather than rules. It’s how likely a bond is to pay that matters, not what it is labeled. Credit standards must not be fixed but instead must evolve. Mortgages are not automatically better than unsecured debentures. Safer bonds are not necessarily better buys than their juniors. Superior yield can render riskier issues more attractive. A thorough reading makes it clear that Graham and Dodd are true investment pragmatists. More echoing Keynes than diverging from him, they argue for thorough analysis followed by intelligent risk bearing (as opposed to knee-jerk risk avoidance). Our Methodology for Bond Investing To examine the relevance of Security Analysis to fixed income invest- ments, I reviewed Graham and Dodd’s process for bond investing, and I compared their approach to the one applied by my firm, Oaktree Capital Management, L.P. The bottom line is that, while Graham and Dodd’s thoughts may be expressed differently, most are highly applicable to today’s investment world. In fact, they strongly parallel the approach and methodology developed and applied in the area of high yield bonds over the last 30 years by my partner, Sheldon Stone, and me. 1. Our entire approach is based on recognition of the asymmetry that underlies all nondistressed bond investing. Gains are limited to the promised yield plus perhaps a few points of appreciation, while credit losses can cause the disappearance of most or all of one’s principal. Thus the key to success lies in avoiding losers, not in searching for winners. As Graham and Dodd note: Instead of associating bonds primarily with the presumption of safety— as has long been the practice—it would be sounder to start with what is not presumption but fact, viz., that a (straight) bond is an inve

essed bond investing. Gains are limited to the promised yield plus perhaps a few points of appreciation, while credit losses can cause the disappearance of most or all of one’s principal. Thus the key to success lies in avoiding losers, not in searching for winners. As Graham and Dodd note: Instead of associating bonds primarily with the presumption of safety— as has long been the practice—it would be sounder to start with what is not presumption but fact, viz., that a (straight) bond is an investment with limited return. . . . Our primary conception of the bond as a commitment with limited return leads us to another important viewpoint toward bond investment. Since the chief emphasis must be placed on avoidance of loss, bond selection is primarily a negative art. It is a process of exclusion and rejec- tion, rather than of search and acceptance. (p. 143) 2. Our high yield bond portfolios are focused. We work mostly in that part of the curve where healthy yields on B-rated bonds can be earned and where the risk of default is limited. For us, higher-rated bonds don’t have enough yield, and lower-rated bonds have too much uncertainty. This B zone is where our clients expect us to operate. It would be sounder procedure to start with minimum standards of safety, which all bonds must be required to meet in order to be eligible for further consideration. Issues failing to meet these minimum requirements should be automatically disqualified as straight investments, regardless of high yield, attractive prospects, or other grounds for partiality Essentially, bond selection should consist of working upward from definite minimum standards rather than working downward in haphazard fashion from some ideal but unacceptable level of maximum security. (pp. 167–168) 3. Credit risk stems primarily from the quantum of leverage and the firm’s basic instability, the interaction of which in tough times can erode the margin by which interest coverage exceeds debt service requirements. A

h yield, attractive prospects, or other grounds for partiality Essentially, bond selection should consist of working upward from definite minimum standards rather than working downward in haphazard fashion from some ideal but unacceptable level of maximum security. (pp. 167–168) 3. Credit risk stems primarily from the quantum of leverage and the firm’s basic instability, the interaction of which in tough times can erode the margin by which interest coverage exceeds debt service requirements. A company with very stable cash flows can support high leverage and a heavy debt service. By the same token, a company with limited lever- age and modest debt service requirements can survive severe fluctu- ations in its cash flow. But the combination of high leverage and undependable cash flow can result in a failure to service debt, as investors are reminded painfully from time to time. Graham and Dodd cite the very same elements. Studying the 1931–1933 record, we note that price collapses [among industrial bonds] were not due primarily to unsound financial structures, as in the case of utility bonds, nor to a miscalculation by investors as to the margin of safety needed, as in the case of railroad bonds. We are con- fronted in many cases by a sudden disappearance of earning power, and a disconcerting question as to whether the business can survive. (p. 157) 4. Analysis of individual issues calls for a multifaceted approach. Since 1985, my team of analysts has applied an eight-factor credit analysis process developed by Sheldon Stone. Most of the elements are reflected in—perhaps ultimately were inspired by—aspects of Gra- ham and Dodd’s thinking. Our concerns are with industry, company standing, management, interest coverage, capital structure, alterna- tive sources of liquidity, liquidation value, and covenants. Security Analysis reflects many of these same concerns. On company standing: “The experience of the past decade indicates that dominant or at least substantial siz

credit analysis process developed by Sheldon Stone. Most of the elements are reflected in—perhaps ultimately were inspired by—aspects of Gra- ham and Dodd’s thinking. Our concerns are with industry, company standing, management, interest coverage, capital structure, alterna- tive sources of liquidity, liquidation value, and covenants. Security Analysis reflects many of these same concerns. On company standing: “The experience of the past decade indicates that dominant or at least substantial size affords an element of protection against the hazards of instability.” (p. 178) On interest coverage: “The present-day investor is accustomed to regard the ratio of earnings to interest charges as the most impor- tant specific test of safety.” (p. 128 on accompanying CD) On capital structure: “The biggest company may be the weakest if its bonded debt is disproportionately large.” (p. 179) 5. “Buy-and-hold” investing is inconsistent with the responsibilities of the professional investor, and the creditworthiness of every issuer repre- sented in the portfolio must be revisited no less than quarterly. Even before the market collapse of 1929, the danger ensuing from neglect of investments previously made, and the need for periodic scrutiny or supervision of all holdings, had been recognized as a new canon in Wall Street. This principle, directly opposed to the former practice, is frequently summed up in the dictum, “There are no permanent investments.” (p. 253) 6. Don’t engage in market timing based on interest rate forecasts. Instead, we confine our efforts to “knowing the knowable,” which can result only from superior efforts to understand industries, companies, and securities. It is doubtful if trading in bonds, to catch the market swings, can be carried on successfully by the investor We are sceptical of the ability of any paid agency to provide reliable forecasts of the market action of either bonds or stocks. Furthermore we are convinced that any combined effort to advis

timing based on interest rate forecasts. Instead, we confine our efforts to “knowing the knowable,” which can result only from superior efforts to understand industries, companies, and securities. It is doubtful if trading in bonds, to catch the market swings, can be carried on successfully by the investor We are sceptical of the ability of any paid agency to provide reliable forecasts of the market action of either bonds or stocks. Furthermore we are convinced that any combined effort to advise upon the choice of individual high-grade investments and upon the course of bond prices is fundamentally illogical and confusing. Much as the investor would like to be able to buy at just the right time and to sell out when prices are about to fall, experience shows that he is not likely to be brilliantly successful in such efforts and that by injecting the trading element into his investment operations he will inevitably shift his inter- est into speculative directions. (p. 261) 7. Despite our best efforts, defaults will creep into our portfolios, whether due to failings in credit analysis or bad luck. In order for the incremental yield gained from taking risks to regularly exceed the losses incurred as a result of defaults, individual holdings have to be small enough so that a single default won’t dissipate a large amount of the portfolio’s capital. We have always thought of our approach to risk as being akin to that of an insurance company. In order for the actuarial process to work, the risk has to be spread over many small holdings and the expected return given a chance to prove out. Thus, you should not invest in high yield bonds unless you can be thoroughly diversified. The investor cannot prudently turn himself into an insurance company and incur risks of losing his principal in exchange for annual premiums in the form of extra-large interest coupons. One objection to such a policy is that sound insurance practice requires a very wide distribution of risk, in ord

work, the risk has to be spread over many small holdings and the expected return given a chance to prove out. Thus, you should not invest in high yield bonds unless you can be thoroughly diversified. The investor cannot prudently turn himself into an insurance company and incur risks of losing his principal in exchange for annual premiums in the form of extra-large interest coupons. One objection to such a policy is that sound insurance practice requires a very wide distribution of risk, in order to minimize the influence of luck and to allow maximum play to the law of probability. The investor may endeavor to attain this end by diversifying his holdings, but as a practical matter, he cannot approach the division of risk attained by an insurance company. (pp. 165–166) To wrap up on the subject of investment approach, we feel the suc- cessful assumption of credit risk in the fixed income universe depends on the successful assessment of the company’s ability to service its debts. Extensive financial statement analysis is not nearly as important as a few skilled judgments regarding the company’s prospects. The selection of a fixed-value security for limited-income return should be, relatively, at least, a simple operation. The investor must make certain by quantitative tests that the income has been amply above the interest charges and that the current value of the business is well in excess of its debts. In addition, he must be satisfied in his own judgment that the char- acter of the enterprise is such as to promise continued success in the future, or more accurately speaking, to make failure a highly unlikely occur- rence. (p. 160 on accompanying CD) In the end, though, we diverge from Graham and Dodd in one impor- tant way. In selecting bonds for purchase, we make judgments about the issuers’ prospects, and here’s why: When I began to analyze and manage high yield bonds in 1978, the widely held view was that investing in bonds and assessing the future are fundamen

r of the enterprise is such as to promise continued success in the future, or more accurately speaking, to make failure a highly unlikely occur- rence. (p. 160 on accompanying CD) In the end, though, we diverge from Graham and Dodd in one impor- tant way. In selecting bonds for purchase, we make judgments about the issuers’ prospects, and here’s why: When I began to analyze and manage high yield bonds in 1978, the widely held view was that investing in bonds and assessing the future are fundamentally incompatible, and that prudent bond investing must be based on solid inferences from past data as opposed to speculation regarding future events. But credit risk is prospective, and thus substantial credit risk can be borne intelligently only on the basis of skilled judgments about the future. In large part, the old position represented a prejudice: that buying stocks—an inherently riskier proposition—can be done intelligently on the basis of judgments regarding the future, but depending on those same judgments in the more conservative world of bond investing just isn’t right. Some of the greatest—and most profitable—market inefficien- cies I have encountered have been the result of prejudices that walled off certain opportunities from “proper investing” . . . and thus left them for flexible investors to pick off far below their fair value. This seems to be one of these prejudices. One of the reasons I started First National City Bank’s high yield bond portfolio in 1978 was my immediately prior experience as the bank’s director of research for equities. All I had to do, then, was apply the future-oriented process for analyzing common stocks to the universe of bonds rated below triple B. Few walls still stand in the investment world today, and it is widely understood that forward-looking analysis can be profitably applied to instruments of all sorts. That lesson remained to be learned in 1940. Common Sense Much of the value of Security Analysis lies not in its specific

immediately prior experience as the bank’s director of research for equities. All I had to do, then, was apply the future-oriented process for analyzing common stocks to the universe of bonds rated below triple B. Few walls still stand in the investment world today, and it is widely understood that forward-looking analysis can be profitably applied to instruments of all sorts. That lesson remained to be learned in 1940. Common Sense Much of the value of Security Analysis lies not in its specific instructions but in its common sense. Several of their lessons have specific relevance to the present. More importantly, Graham and Dodd’s insight and thought process show how investors should try to dig beneath custom- ary, superficial answers to investment questions. Security prices and yields are not determined by any exact mathematical calculation of the expected risk, but they depend rather upon the popular- ity of the issue. (p. 164) [Markets are not clinically efficient.] It may be pointed out further that the supposed actuarial computation of investment risks is out of the question theoretically as well as in practice. There are no experience tables available by which the expected “mortal- ity” of various types of issues can be determined. Even if such tables were prepared, based on long and exhaustive studies of past records, it is doubtful whether they would have any real utility for the future. In life insurance, the relation between age and mortality rate is well defined and changes only gradually. The same is true, to a much lesser extent, of the relation between the various types of structures and the fire hazard attaching to them. But the relation between different types of invest- ments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation. This is particularly true because investment losses are not distributed fairly evenly in point of time, but tend to be concentrated at int

and changes only gradually. The same is true, to a much lesser extent, of the relation between the various types of structures and the fire hazard attaching to them. But the relation between different types of invest- ments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation. This is particularly true because investment losses are not distributed fairly evenly in point of time, but tend to be concentrated at intervals, i.e., dur- ing periods of general depression. Hence the typical investment hazard is roughly similar to the conflagration or epidemic hazard, which is the exceptional and incalculable factor in fire or life insurance. (pp. 164–165, emphasis added) [So much for reliable quantitative models.] Among [the aspects of the earnings picture to which the investor would do well to pay attention] are the trend, the minimum figure, and the cur- rent figure. The importance of each of these cannot be gainsaid, but they do not lend themselves effectively to the application of hard and fast rules. (p. 133 on accompanying CD) The investor . . . will be attracted by: (a) a rising trend in profits; (b) an espe- cially good current showing; and (c) a satisfactory margin over interest charges in every year during the period studied. If a bond is deficient in any one of these three aspects, the result should not necessarily be to con- demn the issue but rather to exact an average earnings coverage well in excess of the minimum and to require closer attention to the general or qualitative elements in the situation. (pp. 133–134 on accompanying CD) If [a ratio of ] $1 of stock to $1 of bonds is taken as the “normal” require- ment for an industrial company, would it not be sound to demand, say, a $2-to-$1 ratio when stock prices are inflated, and conversely to be satisfied with a 50-cent-to-$1 ratio when quotations are far below intrinsic values? But this suggestion is impracticable for two

ell in excess of the minimum and to require closer attention to the general or qualitative elements in the situation. (pp. 133–134 on accompanying CD) If [a ratio of ] $1 of stock to $1 of bonds is taken as the “normal” require- ment for an industrial company, would it not be sound to demand, say, a $2-to-$1 ratio when stock prices are inflated, and conversely to be satisfied with a 50-cent-to-$1 ratio when quotations are far below intrinsic values? But this suggestion is impracticable for two reasons, the first being that it implies that the bond buyer can recognize an unduly high or low level of stock prices, which is far too complimentary an assumption. The second is that it would require bond investors to act with especial caution when things are booming and with greater confidence when times are hard. This is a counsel of perfection which it is not in human nature to follow. Bond buyers are people, and they cannot be expected to escape entirely either the enthusiasm of bull markets or the apprehensions of a severe depres- sion. (pp. 157–158 on accompanying CD) “In the purely speculative field the objection to paying for advice is that if the adviser knew whereof he spoke he would not need to bother with a consultant’s duties.” (p. 261) Not much different from Warren Buf- fett’s observation that “Wall Street is the only place that people ride to in a Rolls-Royce to get advice from those who take the subway.”1 There are many instances in which Graham and Dodd offer common- sense advice or, even more interestingly, in which they refute existing rules of investing, substituting common sense for “accepted wisdom,” that great oxymoron. To me, this represents the greatest strength of the section on fixed income securities. In the end, Graham and Dodd remind us, “Investment theory should be chary of easy generalizations.” (p. 171) Security Analysis through the Years Many of Graham and Dodd’s specific ideas have withstood the test of time and, in fact, been picked up

n- sense advice or, even more interestingly, in which they refute existing rules of investing, substituting common sense for “accepted wisdom,” that great oxymoron. To me, this represents the greatest strength of the section on fixed income securities. In the end, Graham and Dodd remind us, “Investment theory should be chary of easy generalizations.” (p. 171) Security Analysis through the Years Many of Graham and Dodd’s specific ideas have withstood the test of time and, in fact, been picked up and carried forward by others. • Their observation that “an investor may reject any number of good bonds with virtually no penalty at all” (p. 143) may have inspired War- ren Buffett, who draws a very apt comparison to batters in baseball. Buffett reminds us that a baseball hitter will be called out if he fails to 1 Los Angeles Times Magazine, April 7, 1991. swing at three pitches in the strike zone, while an investor can let any number of investment opportunities go by without being penalized. • Likewise, Graham and Dodd submitted that “the best criterion that we are able to offer [for the purpose of assessing the margin of assets over indebtedness] is the ratio of the market value of the capital stock to the total funded debt.” (p. 150 on accompanying CD) This was paralleled exactly by the market-adjusted debt (MAD) ratios popularized by Michael Milken when he pioneered the issuance of high yield bonds at Drexel Burnham Lambert in the 1970s and 1980s. Market values are far from perfect, but accounting data are purely historical and thus are often out-of-date at best and irrelevant at worst. • Importantly, Graham and Dodd highlight the importance of cash flow stability in a company’s ability to service its debts in an adverse envi- ronment. “Once it is admitted—as it always must be—that the indus- try can suffer some reduction in profits, then the investor is compelled to estimate the possible extent of the shrinkage and compare it with the surplus above the interest req

rfect, but accounting data are purely historical and thus are often out-of-date at best and irrelevant at worst. • Importantly, Graham and Dodd highlight the importance of cash flow stability in a company’s ability to service its debts in an adverse envi- ronment. “Once it is admitted—as it always must be—that the indus- try can suffer some reduction in profits, then the investor is compelled to estimate the possible extent of the shrinkage and compare it with the surplus above the interest requirements. He thus finds himself . . . vitally concerned with the ability of the company to meet the vicissi- tudes of the future.” (p. 155) This consideration contributed to the fact that, in its infancy in the mid-1970s, the leveraged buyout industry restricted its purchases to noncyclical companies. Of course, like all important investment principles, this one is often ignored in bullish periods; enthusiasm and optimism gain sway and the stable-cash-flow rule can be easily forgotten. A Few More Thoughts In considering the relevance 68 years later of the 1940 edition of Security Analysis, a number of additional observations deserve to be made. First, most of the timing that interested Graham and Dodd concerned “depressions” and their impact on creditworthiness. They cite three depressions—1920 to 1922, 1930 to 1933, and 1937 to 1938—whereas we talk today about there having been only one in this century: the Great Depression. Clearly, Graham and Dodd are talking about what we call “recessions.” Second, they were not concerned with predicting interest-rate fluctua- tions. The primary reason for this may be that interest rates didn’t fluctuate much in those days. A table on page 157 shows, for example, that in the 13 years from 1926 to 1938—a period that sandwiched a famous boom between two “depressions”—the yield on 40 utility bonds moved only between 3.9% and 6.3%. At the time the 1940 edition was published, then, interest rates were low and fairly steady. Third, it is imp

recessions.” Second, they were not concerned with predicting interest-rate fluctua- tions. The primary reason for this may be that interest rates didn’t fluctuate much in those days. A table on page 157 shows, for example, that in the 13 years from 1926 to 1938—a period that sandwiched a famous boom between two “depressions”—the yield on 40 utility bonds moved only between 3.9% and 6.3%. At the time the 1940 edition was published, then, interest rates were low and fairly steady. Third, it is important to note that several of Graham and Dodd’s warn- ings against risk taking are directed not at professionals but at the indi- vidual investors who appear to have been the authors’ target audience. As a practical matter it is not so easy to distinguish in advance between the underlying bonds that come through reorganization unscathed and those which suffer drastic treatment. Hence the ordinary investor may be well advised to leave such issues out of his calculations and stick to the rule that only strong companies have strong bonds. (p. 153) The individual is not qualified to be an insurance underwriter. It is not his function to be paid for incurring risks; on the contrary it is to his interest to pay others for insurance against loss Even assuming that the high coupon rates [on higher yielding securities] will, in the great aggregate, more than compensate on an actuarial basis for the risks accepted, such bonds are still undesirable investments from the personal standpoint of the average investor. (pp. 165–166) Thus concern for the safety of nonprofessional investors appears to be the source of many of Security Analysis’s most rigid dicta. I would not differ with the proposition that direct investment in distressed debt and high yield bonds should be left to professionals. Into the Future Few books can be read nearly 70 years after their publication with the reasonable expectation that everything they say—and the way they say it—will be thoroughly up-to-date. General

average investor. (pp. 165–166) Thus concern for the safety of nonprofessional investors appears to be the source of many of Security Analysis’s most rigid dicta. I would not differ with the proposition that direct investment in distressed debt and high yield bonds should be left to professionals. Into the Future Few books can be read nearly 70 years after their publication with the reasonable expectation that everything they say—and the way they say it—will be thoroughly up-to-date. General wisdom and occasional nuggets of insight are usually the most that can be hoped for. Anyone wondering how the 1940 edition of Security Analysis comes through in this regard needs only consider Graham and Dodd’s discussion of mort- gage investing in the light of the subprime and collateralized debt obli- gation (CDO) experience of 2007: During the great and disastrous development of the real estate mortgage- bond business between 1923 and 1929, the only datum customarily pre- sented to support the usual bond offering—aside from an estimate of future earnings—was a statement of the appraised value of the property, which almost invariably amounted to some 662⁄3% in excess of the mort- gage issue. If these appraisals had corresponded to the market values which experienced buyers of or lenders on real estate would place upon the properties, they would have been of real utility in the selection of sound real estate bonds. But unfortunately they were purely artificial valu- ations, to which the appraisers were willing to attach their names for a fee, and whose only function was to deceive the investor as to the protection which he was receiving. . . . This whole scheme of real estate financing was honeycombed with the most glaring weaknesses, and it is sad commentary on the lack of principle, penetration, and ordinary common sense on the part of all par- ties concerned that it was permitted to reach such gigantic proportions before the inevitable collapse. (p. 185) Paid-for home app

he appraisers were willing to attach their names for a fee, and whose only function was to deceive the investor as to the protection which he was receiving. . . . This whole scheme of real estate financing was honeycombed with the most glaring weaknesses, and it is sad commentary on the lack of principle, penetration, and ordinary common sense on the part of all par- ties concerned that it was permitted to reach such gigantic proportions before the inevitable collapse. (p. 185) Paid-for home appraisals (and security ratings) that led to undeserved confidence—and thus uninformed risk bearing—on the part of unknow- ing investors: what could better describe recent events? And what better evidence could there be of the relevance of the 1940 edition of Security Analysis to the decades since its writing . . . and the decades to come? Chapter 6 THE SELECTION OF FIXED-VALUE INVESTMENTS HAVING SUGGESTED a classification of securities by character rather than by title, we now take up in order the principles and methods of selection applicable to each group. We have already stated that the fixed-value group includes: 1. High-grade straight bonds and preferred stocks. 2. High-grade privileged issues, where the value of the privilege is too remote to count as a factor in selection. 3. Common stocks which through guaranty or preferred status occupy the position of a high-grade senior issue. Basic Attitude toward High-grade Preferred Stocks. By placing gilt-edged preferred stocks and high-grade bonds in a single group, we indicate that the same investment attitude and the same general method of analysis are applicable to both types. The very definite inferiority of the preferred stockholders’ legal claim is here left out of account, for the logical reason that the soundness of the best investments must rest not upon legal rights or remedies but upon ample financial capacity of the enterprise. Confirmation of this viewpoint is found in the investor’s atti- tude toward such an

high-grade bonds in a single group, we indicate that the same investment attitude and the same general method of analysis are applicable to both types. The very definite inferiority of the preferred stockholders’ legal claim is here left out of account, for the logical reason that the soundness of the best investments must rest not upon legal rights or remedies but upon ample financial capacity of the enterprise. Confirmation of this viewpoint is found in the investor’s atti- tude toward such an issue as National Biscuit Company Preferred, which for nearly 40 years has been considered as possessing the same essential investment character as a good bond.1 Preferred Stocks Not Generally Equivalent to Bonds in Invest- ment Merit. But it should be pointed out immediately that issues with the history and standing of National Biscuit Preferred constitute a 1 See Appendix Note 6, p. 737 on accompanying CD, for supporting data. [141] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. very small percentage of all preferred stocks. Hence, we are by no means asserting the investment equivalence of bonds and preferred stocks in general. On the contrary, we shall in a later chapter be at some pains to show that the average preferred issue deserves a lower rank than the average bond, and furthermore that preferred stocks have been much too readily accepted by the investing public. The majority of these issues have not been sufficiently well protected to assure continuance of divi- dends beyond any reasonable doubt. They belong properly, therefore, in the class of variable or speculative senior issues (Group II), and in this field the contractual differences between bonds and preferred shares are likely to assume great importance. A sharp distinction must, there- fore, be made between the typical and the exceptional preferred stock. It is only the latter which deserves to rank as a fixed-value investment and to be vie

ficiently well protected to assure continuance of divi- dends beyond any reasonable doubt. They belong properly, therefore, in the class of variable or speculative senior issues (Group II), and in this field the contractual differences between bonds and preferred shares are likely to assume great importance. A sharp distinction must, there- fore, be made between the typical and the exceptional preferred stock. It is only the latter which deserves to rank as a fixed-value investment and to be viewed in the same light as a good bond. To avoid awkward- ness of expression in this discussion we shall frequently use the terms “investment bonds” or merely “bonds” to represent all securities belong- ing to the fixed-value class. Is Bond Investment Logical? In the 1934 edition of this work we considered with some seriousness the question whether or not the extreme financial and industrial fluctuations of the preceding years had not impaired the fundamental logic of bond investment. Was it worth while for the investor to limit his income return and to forego all prospect of speculative gain, if despite these sacrifices he must still subject himself to serious risk of loss? We suggested in reply that the phenomena of 1927–1933 were so completely abnormal as to afford no fair basis for investment theory and practice. Subsequent experience seems to have borne us out, but there are still enough uncertainties facing the bond buyer to banish, perhaps for a long time, his old sense of complete security. The combination of a record high level for bonds (in 1940) with a history of two catastrophic price collapses in the preceding twenty years and a major war in progress is not one to justify airy confidence in the future. Bond Form Inherently Unattractive: Quantitative Assurance of Safety Essentials. This situation clearly calls for a more critical and exacting attitude towards bond selection than was formerly considered nec- essary by investors, issuing houses, or authors of textbook

e security. The combination of a record high level for bonds (in 1940) with a history of two catastrophic price collapses in the preceding twenty years and a major war in progress is not one to justify airy confidence in the future. Bond Form Inherently Unattractive: Quantitative Assurance of Safety Essentials. This situation clearly calls for a more critical and exacting attitude towards bond selection than was formerly considered nec- essary by investors, issuing houses, or authors of textbooks on investment. Allusion has already been made to the dangers inherent in the acceptance of the bond form as an assurance of safety, or even of smaller risk than is found in stocks. Instead of associating bonds primarily with the presump- tion of safety as has long been the practice—it would be sounder to start with what is not presumption but fact, viz., that a (straight) bond is an investment with limited return. In exchange for limiting his participation in future profits, the bondholder obtains a prior claim and a definite prom- ise of payment, while the preferred stockholder obtains only the priority, without the promise. But neither priority nor promise is itself an assurance of payment. This assurance rests in the ability of the enterprise to fulfill its promise, and must be looked for in its financial position, record, and prospects. The essence of proper bond selection consists, therefore, in obtaining specific and convincing factors of safety in compensation for the surrender of participation in profits. Major Emphasis on Avoidance of Loss. Our primary conception of the bond as a commitment with limited return leads us to another important viewpoint toward bond investment. Since the chief emphasis must be placed on avoidance of loss, bond selection is primarily a nega- tive art. It is a process of exclusion and rejection, rather than of search and acceptance. In this respect the contrast with common-stock selection is fundamental in character. The prospective buy

der of participation in profits. Major Emphasis on Avoidance of Loss. Our primary conception of the bond as a commitment with limited return leads us to another important viewpoint toward bond investment. Since the chief emphasis must be placed on avoidance of loss, bond selection is primarily a nega- tive art. It is a process of exclusion and rejection, rather than of search and acceptance. In this respect the contrast with common-stock selection is fundamental in character. The prospective buyer of a given common stock is influenced more or less equally by the desire to avoid loss and the desire to make a profit. The penalty for mistakenly rejecting the issue may conceivably be as great as that for mistakenly accepting it. But an investor may reject any number of good bonds with virtually no penalty at all, pro- vided he does not eventually accept an unsound issue. Hence, broadly speaking, there is no such thing as being unduly captious or exacting in the purchase of fixed-value investments. The observation that Walter Bagehot addressed to commercial bankers is equally applicable to the selection of investment bonds. “If there is a difficulty or a doubt the secu- rity should be declined.”2 Four Principles for the Selection of Issues of the Fixed-value Type. Having established this general approach to our problem, we may 2 Lombard Street, p. 245, New York, 1892. now state four additional principles of more specific character which are applicable to the selection of individual issues: I. Safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.3 II. This ability should be measured under conditions of depression rather than prosperity. III. Deficient safety cannot be compensated for by an abnormally high coupon rate. IV. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those pre- scribed by statute to gove

dual issues: I. Safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations.3 II. This ability should be measured under conditions of depression rather than prosperity. III. Deficient safety cannot be compensated for by an abnormally high coupon rate. IV. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those pre- scribed by statute to govern investments of savings banks. A technique of bond selection based on the above principles will differ in significant respects from the traditional attitude and methods. In departing from old concepts, however, this treatment represents not an innovation but the recognition and advocacy of viewpoints which have been steadily gaining ground among intelligent and experienced investors. The ensuing discussion is designed to make clear both the nature and the justification of the newer ideas.4 I. SAFETY NOT MEASURED BY LIEN BUT BY ABILITY TO PAY The basic difference confronts us at the very beginning. In the past the primary emphasis was laid upon the specific security, i.e., the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant ele- ment must be the strength and soundness of the obligor enterprise. There is here a clearcut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business. The older view was logical enough in its origin and purpose. It desired to make the bondholder independent of the risks of the business by 3 This is a general rule applicable to the majority of bonds of the fixed-value type, but it is subject to a number of exceptions which are discussed later. 4 These ideas are neither so new nor so uncommon in 1940 as they were in 1934, but we doubt whether they may be

is regarded as a claim against property; on the other hand, as a claim against a business. The older view was logical enough in its origin and purpose. It desired to make the bondholder independent of the risks of the business by 3 This is a general rule applicable to the majority of bonds of the fixed-value type, but it is subject to a number of exceptions which are discussed later. 4 These ideas are neither so new nor so uncommon in 1940 as they were in 1934, but we doubt whether they may be considered standard as yet. giving him ample security on which to levy in the event that the enter- prise proved a failure. If the business became unable to pay his claim, he could take over the mortgaged property and pay himself out of that. This arrangement would be excellent if it worked, but in practice it rarely proves to be feasible. For this there are three reasons: 1. The shrinkage of property values when the business fails. 2. The difficulty of asserting the bondholders’ supposed legal rights. 3. The delays and other disadvantages incident to a receivership. Lien Is No Guarantee against Shrinkage of Values. The concep- tion of a mortgage lien as a guaranty of protection independent of the success of the business itself is in most cases a complete fallacy. In the typical situation, the value of the pledged property is vitally dependent on the earning power of the enterprise. The bondholder usually has a lien on a railroad line, or on factory buildings and equipment, or on power plants and other utility properties, or perhaps on a bridge or hotel struc- ture. These properties are rarely adaptable to uses other than those for which they were constructed. Hence if the enterprise proves a failure its fixed assets ordinarily suffer an appalling shrinkage in realizable value. For this reason the established practice of stating the original cost or appraised value of the pledged property as an inducement to purchase bonds is entirely misleading. The value of pledged assets

er plants and other utility properties, or perhaps on a bridge or hotel struc- ture. These properties are rarely adaptable to uses other than those for which they were constructed. Hence if the enterprise proves a failure its fixed assets ordinarily suffer an appalling shrinkage in realizable value. For this reason the established practice of stating the original cost or appraised value of the pledged property as an inducement to purchase bonds is entirely misleading. The value of pledged assets assumes practical importance only in the event of default, and in any such event the book figures are almost invariably found to be unreliable and irrele- vant. This may be illustrated by Seaboard-All Florida Railway First Mort- gage 6s, selling in 1931 at 1 cent on the dollar shortly after completion of the road.5 Impracticable to Enforce Basic Legal Rights of Lien Holder. In cases where the mortgaged property is actually worth as much as the debt, the bondholder is rarely allowed to take possession and realize upon it. It must be recognized that the procedure following default on a corpora- tion bond has come to differ materially from that customary in the case of a mortgage on privately owned property. The basic legal rights of the lien holder are supposedly the same in both situations. But in practice we find a very definite disinclination on the part of the courts to permit 5 See Appendix Note 7, p. 738 on accompanying CD, for supporting data. corporate bondholders to take over properties by foreclosing on their liens, if there is any possibility that these assets may have a fair value in excess of their claim.6 Apparently it is considered unfair to wipe out stock- holders or junior bondholders who have a potential interest in the prop- erty but are not in a position to protect it. As a result of this practice, bondholders rarely, if ever, come into actual possession of the pledged property unless its value at the time is substantially less than their claim. In most

r properties by foreclosing on their liens, if there is any possibility that these assets may have a fair value in excess of their claim.6 Apparently it is considered unfair to wipe out stock- holders or junior bondholders who have a potential interest in the prop- erty but are not in a position to protect it. As a result of this practice, bondholders rarely, if ever, come into actual possession of the pledged property unless its value at the time is substantially less than their claim. In most cases they are required to take new securities in a reorganized company. Sometimes the default in interest is cured and the issue rein- stated.7 On exceedingly rare occasions a defaulted issue may be paid off in full, but only after a long and vexing delay.8 Delays Are Wearisome. This delay constitutes the third objection to relying upon the mortgaged property as protection for a bond investment. The more valuable the pledged assets in relation to the amount of the lien, the more difficult it is to take them over under foreclosure, and the longer the time required to work out an “equitable” division of interest among the various bond and stock issues. Let us consider the most favorable kind of situation for a bondholder in the event of receivership. He would hold a comparatively small first mortgage followed by a substantial junior lien, the requirements of which have made the company insolvent. It may well be that the strength of the first-mortgage bondholder’s position is such that at no time is there any real chance of eventual loss to him. Yet the financial difficulties of the company usually have a depressing effect on the market price of all its securities, even those presumably unimpaired in real value. As the receivership drags on, the market decline becomes accentuated, since investors are constitutionally averse to buying into a troubled situation. Eventually the first-mortgage bonds may come through the reorganization undisturbed, but during a wearisome and protrac

t no time is there any real chance of eventual loss to him. Yet the financial difficulties of the company usually have a depressing effect on the market price of all its securities, even those presumably unimpaired in real value. As the receivership drags on, the market decline becomes accentuated, since investors are constitutionally averse to buying into a troubled situation. Eventually the first-mortgage bonds may come through the reorganization undisturbed, but during a wearisome and protracted period the owners have faced a severe impairment in the quoted value of their holdings and at least some degree of doubt and worry as to the out- come. Typical examples of such an experience can be found in the case of Missouri, Kansas and Texas Railway Company First 4s and Brooklyn 6 The failure to foreclose on Interborough Rapid Transit Secured 7s for seven years after default of principal (discussed on p. 734) well illustrates this point. 7 See Appendix Note 8, p. 738 on accompanying CD, for supporting data. 8 See Appendix Note 9, p. 739 on accompanying CD, for supporting data. Union Elevated Railroad First 5s.9 The subject of receivership and reor- ganization practice, particularly as they affect the bondholder, will receive more detailed consideration in a later chapter. Basic Principle Is to Avoid Trouble. The foregoing discussion should support our emphatic stand that the primary aim of the bond buyer must be to avoid trouble and not to protect himself in the event of trouble. Even in the cases where the specific lien proves of real advantage, this benefit is realized under conditions which contravene the very mean- ing of fixed-value investment. In view of the severe decline in market price almost invariably associated with receivership, the mere fact that the investor must have recourse to his indenture indicates that his investment has been unwise or unfortunate. The protection that the mortgaged prop- erty offers him can constitute at best a mitigation of hi

uble. Even in the cases where the specific lien proves of real advantage, this benefit is realized under conditions which contravene the very mean- ing of fixed-value investment. In view of the severe decline in market price almost invariably associated with receivership, the mere fact that the investor must have recourse to his indenture indicates that his investment has been unwise or unfortunate. The protection that the mortgaged prop- erty offers him can constitute at best a mitigation of his mistake. Corollaries from This First Principle. 1. Absence of Lien of Minor Consequence. From Principle I there follow a number of corollaries with important practical applications. Since specific lien is of subordinate importance in the choice of high-grade bonds, the absence of lien is also of minor consequence. The debenture,10 i.e., unsecured, obligations of a 9 See Appendix Note 10, p. 739 on accompanying CD, for supporting data. On the subject of delays in enforcing bondholders’ claims, it should be pointed out that, with up to one-third of the country’s railroad mileage in bankruptcy, not a single road emerged from trusteeship in the six years following passage of the Sec. 77 amendment to the Bankruptcy Act in 1933— a step designed to accelerate reorganization. 10 The term “debenture” in American financial practice has the accepted meaning of “unse- cured bond or note.” For no good reason, the name is sometimes given to other kinds of securities without apparently signifying anything in particular. There have been a number of “secured debentures,” e.g., Chicago Herald and Examiner Secured Debenture 61/2s, due 1950, and Lone Star Gas Debenture 31/2s, due 1953. Also, a number of preferred issues are called debenture preferred stock or merely debenture stock, e.g., Du Pont Debenture Stock (called in 1939); General Cigar Company Debenture Preferred (called in 1927). Sometimes debenture issues, properly so entitled because originally unsecured, later acquire specific sec

anything in particular. There have been a number of “secured debentures,” e.g., Chicago Herald and Examiner Secured Debenture 61/2s, due 1950, and Lone Star Gas Debenture 31/2s, due 1953. Also, a number of preferred issues are called debenture preferred stock or merely debenture stock, e.g., Du Pont Debenture Stock (called in 1939); General Cigar Company Debenture Preferred (called in 1927). Sometimes debenture issues, properly so entitled because originally unsecured, later acquire specific security through the operation of a protective covenant, e.g., New York, New Haven and Hartford Railroad Company Debentures, discussed in Chap. 19. Another exam- ple was the Debenture 61/2s of Fox New England Theaters, Inc., reorganized in 1933. These debentures acquired as security a block of first-mortgage bonds of the same company, which were surrendered by the vendor of the theaters because it failed to meet a guarantee of future earnings. Observe that there is no clear-cut distinction between a “bond” and a “note” other than the fact that the latter generally means a relatively short-term obligation, i.e., one maturing not more than, say, ten years after issuance. strong corporation, amply capable of meeting its interest charges, may qualify for acceptance almost as readily as a bond secured by mortgage. Furthermore the debentures of a strong enterprise are undoubtedly sounder investments than the mortgage issues of a weak company. No first-lien bond, for example, enjoys a better investment rating than Stan- dard Oil of New Jersey Debenture 3s, due 1961. An examination of the bond list will show that the debenture issues of companies having no secured debt ahead of them will rank in investment character at least on a par with the average mortgage bond, because an enterprise must enjoy a high credit rating to obtain funds on its unsecured long-term bond.11 2. The Theory of Buying the Highest Yielding Obligation of a Sound Company. It follows also that if any obligation of

nvestment rating than Stan- dard Oil of New Jersey Debenture 3s, due 1961. An examination of the bond list will show that the debenture issues of companies having no secured debt ahead of them will rank in investment character at least on a par with the average mortgage bond, because an enterprise must enjoy a high credit rating to obtain funds on its unsecured long-term bond.11 2. The Theory of Buying the Highest Yielding Obligation of a Sound Company. It follows also that if any obligation of an enterprise deserves to qualify as a fixed-value investment, then all its obligations must do so. Stated conversely, if a company’s junior bonds are not safe, its first- mortgage bonds are not a desirable fixed-value investment. For if the second mortgage is unsafe the company itself is weak, and generally speaking there can be no high-grade obligations of a weak enterprise. The theoretically correct procedure for bond investment, therefore, is first to select a company meeting every test of strength and soundness, and then to purchase its highest yielding obligation, which would usu- ally mean its junior rather than its first-lien bonds. Assuming no error were ever made in our choice of enterprises, this procedure would work out perfectly well in practice. The greater the chance of mistake, however, the more reason to sacrifice yield in order to reduce the poten- tial loss in capital value. But we must recognize that in favoring the lower yielding first-mortgage issue, the bond buyer is in fact express- ing a lack of confidence in his own judgment as to the soundness of the business—which, if carried far enough, would call into question the advisability of his making an investment in any of the bonds of the particular enterprise. Example: As an example of this point, let us consider the Cudahy Packing Company First Mortgage 5s, due 1946, and the Debenture 51/2s of the same company, due 1937. In June 1932 the First 5s sold at 95 to yield about 51/2%, whereas the junior 51/2

r is in fact express- ing a lack of confidence in his own judgment as to the soundness of the business—which, if carried far enough, would call into question the advisability of his making an investment in any of the bonds of the particular enterprise. Example: As an example of this point, let us consider the Cudahy Packing Company First Mortgage 5s, due 1946, and the Debenture 51/2s of the same company, due 1937. In June 1932 the First 5s sold at 95 to yield about 51/2%, whereas the junior 51/2s sold at 59 to yield over 20% to 11 This point is strikingly substantiated by the industrial bond financing between 1935 and 1939. During these years, when only high-grade issues could be sold, by far the greater part of the total was represented by debentures. maturity. The purchase of the 5% bonds at close to par could only be jus- tified by a confident belief that the company would remain solvent and reasonably prosperous, for otherwise the bonds would undoubtedly suf- fer a severe drop in market price. But if the investor has confidence in the future of Cudahy, why should he not buy the debenture issue and obtain an enormously greater return on his money? The only answer can be that the investor wants the superior protection of the first mortgage in the event his judgment proves incorrect and the company falls into difficul- ties. In that case he would probably lose less as the owner of the first- mortgage bonds than through holding the junior issue. Even on this score it should be pointed out that if by any chance Cudahy Packing Company were to suffer the reverses that befell Fisk Rubber Company, the loss in market value of the first-mortgage bonds would be fully as great as those suffered by the debentures; for in April 1932 Fisk Rubber Company First 8s were selling as low as 17 against a price of 12 for the unsecured 51/2% Notes. It is clear, at any rate, that the investor who favors the Cudahy first- lien 5s is paying a premium of about 15% per annum (the differen

d be pointed out that if by any chance Cudahy Packing Company were to suffer the reverses that befell Fisk Rubber Company, the loss in market value of the first-mortgage bonds would be fully as great as those suffered by the debentures; for in April 1932 Fisk Rubber Company First 8s were selling as low as 17 against a price of 12 for the unsecured 51/2% Notes. It is clear, at any rate, that the investor who favors the Cudahy first- lien 5s is paying a premium of about 15% per annum (the difference in yield) for only a partial insurance against loss. On this basis he is undoubtedly giving up too much for what he gets in return. The conclu- sion appears inescapable either that he should make no investment in Cudahy bonds or that he should buy the junior issue at its enormously higher yield.12 This rule may be laid down as applying to the general case where a first-mortgage bond sells at a fixed-value price (e.g., close to par) and junior issues of the same company can be bought to yield a much higher return.13 3. Senior Liens Are to Be Favored, Unless Junior Obligations Offer a Substantial Advantage. Obviously a junior lien should be preferred only if the advantage in income return is substantial. Where the first-mort- gage bond yields only slightly less, it is undoubtedly wise to pay the small insurance premium for protection against unexpected trouble. Example: This point is illustrated by the relative market prices of Atchison Topeka and Santa Fe Railway Company General (first) 4s and Adjustment (second mortgage) 4s, both of which mature in 1995. 12 Both of the Cudahy issues were retired at 1021/2 in 1935. 13 Exceptions to this rule may be justified in rare cases where the senior security has an unusually preferred status—e.g., a very strongly entrenched underlying railroad bond. But see infra pp. 152–153. PRICE OF ATCHISON GENERAL 4S AND ADJUSTMENT 4S AT VARIOUS DATES Date Price of General 4s Price of Adjustment 4s Spread Jan. 2, 1913 971/2 88 91/2 Jan. 5, 191

st) 4s and Adjustment (second mortgage) 4s, both of which mature in 1995. 12 Both of the Cudahy issues were retired at 1021/2 in 1935. 13 Exceptions to this rule may be justified in rare cases where the senior security has an unusually preferred status—e.g., a very strongly entrenched underlying railroad bond. But see infra pp. 152–153. PRICE OF ATCHISON GENERAL 4S AND ADJUSTMENT 4S AT VARIOUS DATES Date Price of General 4s Price of Adjustment 4s Spread Jan. 2, 1913 971/2 88 91/2 Jan. 5, 1917 951/2 863/4 83/4 May 21, 1920 701/4 62 81/4 Aug. 4, 1922 931/2 841/2 9 Dec. 4, 1925 891/4 851/4 4 Jan. 3, 1930 931/4 93 1/4 Jan. 7, 1931 981/2 97 11/2 June 2, 1932 81 661/2 141/2 June 19, 1933 93 88 5 Jan. 9, 1934 941/4 83 111/4 Mar. 6, 1936 1145/8 1131/2 11/8 Apr. 26, 1937 1031/2 1063/4 31/4 Apr. 14, 1938 991/4 751/4 24 Dec. 29, 1939 1053/4 851/4 201/2 Prior to 1924 the Atchison General 4s sold usually at about 7 to 10 points above the Adjustment 4s and yielded about 1/2% less. Since both issues were considered safe without question, it would have been more logical to purchase the junior issue at its 10% lower cost. After 1923 this point of view asserted itself, and the price difference steadily narrowed. During 1930 and part of 1931 the junior issue sold on numerous occa- sions at practically the same price as the General 4s. This relationship was even more illogical than the unduly wide spread in 1922–1923, since the advantage of the Adjustment 4s in price and yield was too negligible to warrant accepting a junior position, even assuming unquestioned safety for both liens. Within a very short time this rather obvious truth was brought home strikingly by the widening of the spread to over 14 points during the demoralized bond-market conditions of June 1932. As the record appeared in 1934, it could be inferred that a reasonable differential between the two issues would be about 5 points and that either a substan- tial widening or a virtual disappearance of the spread wou

igible to warrant accepting a junior position, even assuming unquestioned safety for both liens. Within a very short time this rather obvious truth was brought home strikingly by the widening of the spread to over 14 points during the demoralized bond-market conditions of June 1932. As the record appeared in 1934, it could be inferred that a reasonable differential between the two issues would be about 5 points and that either a substan- tial widening or a virtual disappearance of the spread would present an opportunity for a desirable exchange of one issue for another. Two such opportunities did in fact appear in 1934 and 1936, as shown in our table. But this example is of further utility in illustrating the all-pervasive factor of change and the necessity of taking it into account in bond analy- sis. By 1937 the failure of Atchison’s earnings to recover within striking distance of its former normal, and the actual inadequacy of the margin above interest requirements as judged by conservative standards, should have warned the investor that the “adjustment” (i.e., contingent) element in the junior issue could not safely be ignored. Thus a price relationship that was logical at a time when safety of interest was never in question could not be relied upon under the new conditions. In 1938 the poor earnings actually compelled the road to defer the May 1 interest payment on the adjustment bonds, as a result of which their price fell to 751/8 and the spread widened to 24 points. Although the interest was later paid in full and the price recovered to 96 in 1939, it would seem quite unwise for the investor to apply pre-1932 standards to this bond issue. A junior lien of Company X may be selected in preference to a first- mortgage bond of Company Y, on one of two bases: 1. The protection for the total debt of Company X is adequate and the yield of the junior lien is substantially higher than that of the Company Y issue; or 2. If there is no substantial advantage in yield,

Although the interest was later paid in full and the price recovered to 96 in 1939, it would seem quite unwise for the investor to apply pre-1932 standards to this bond issue. A junior lien of Company X may be selected in preference to a first- mortgage bond of Company Y, on one of two bases: 1. The protection for the total debt of Company X is adequate and the yield of the junior lien is substantially higher than that of the Company Y issue; or 2. If there is no substantial advantage in yield, then the indicated protection for the total debt of Company X must be considerably better than that of Company Y. Example of 2: Issue Price in 1930 Fixed charges earned, 1929* Pacific Power and Light Co. First 5s, due 1955 101 1.53 times American Gas and Electric Co. Debenture 5s, due 2028 101 2.52 times * Average results approximately the same. The appreciably higher coverage of total charges by American Gas and Electric would have justified preferring its junior bonds to the first-mort- gage issue of Pacific Power and Light, when both were selling at about the same price.14 14 In 1937 the low price of Pacific Power and Light 5s was 51, against a low of 104 for the American Gas and Electric Debentures. Special Status of “Underlying Bonds.” In the railroad field an espe- cial investment character is generally supposed to attach to what are known as “underlying bonds.” These represent issues of relatively small size secured by a lien on especially important parts of the obligor system, and often followed by a series of “blanket mortgages.” The underlying bond usually enjoys a first lien, but it may be a second- or even a third- mortgage issue, provided the senior issues are also of comparatively small magnitude. Example: New York and Erie Railroad Third Mortgage Extended 41/2s, due 1938, are junior to two small prior liens covering an important part of the Erie Railroad’s main line. They are followed by four successive blan- ket mortgages on the system, and they have re

ystem, and often followed by a series of “blanket mortgages.” The underlying bond usually enjoys a first lien, but it may be a second- or even a third- mortgage issue, provided the senior issues are also of comparatively small magnitude. Example: New York and Erie Railroad Third Mortgage Extended 41/2s, due 1938, are junior to two small prior liens covering an important part of the Erie Railroad’s main line. They are followed by four successive blan- ket mortgages on the system, and they have regularly enjoyed the favored status of an underlying bond. Bonds of this description have been thought to be entirely safe, regard- less of what happens to the system as a whole. They have almost always come through reorganization unscathed; and even during a receivership interest payments are usually continued as a matter of course, largely because the sum involved is proportionately so small. They are not exempt, however, from fairly sharp declines in market value if insolvency overtakes the system. Examples: In the case of New York and Erie Third 41/2s (which had been voluntarily extended on maturity in 1923 and again in 1933), prin- cipal and interest were defaulted in March 1938, following the bankruptcy of the Erie two months earlier. The bid price declined to as low as 61. However, the various reorganization plans filed to the end of 1939 all provided for the payment of principal and interest in full on this issue. Chicago and Eastern Illinois Consolidated 6s, due 1934, were finally paid off in full in 1940, with further interest at 4%—but not until their price had fallen as low as 32 in 1933. Pacific Railway of Missouri First 4s and Second 5s and Missouri Pacific Railway Third 4s, all extended from their original maturities to 1938, are underlying bonds of the Missouri Pacific system. They contin- ued to receive interest and were left undisturbed in the receivership of 1915. Following the second bankruptcy in 1933, they continued to receive interest until their maturit

lly paid off in full in 1940, with further interest at 4%—but not until their price had fallen as low as 32 in 1933. Pacific Railway of Missouri First 4s and Second 5s and Missouri Pacific Railway Third 4s, all extended from their original maturities to 1938, are underlying bonds of the Missouri Pacific system. They contin- ued to receive interest and were left undisturbed in the receivership of 1915. Following the second bankruptcy in 1933, they continued to receive interest until their maturity date. At that time payment of principal was defaulted, but interest payments were continued through 1939. The var- ious reorganization plans virtually provided for these bonds in full, by offering them prior-lien, fixed-interest obligations of the new company. But since 1931, the price of these three issues has been as low as 65, 60, and 53, respectively. Other bonds, however, once regarded as underlying issues, have not fared so well following insolvency. Example: Milwaukee, Sparta and Northwestern First 4s, due 1947, ranked as an underlying bond of the Chicago and North Western Railway, and for many years their price was not far below that of the premier Union Pacific First 4s, due the same year. Yet the receivership of the Chicago and North Western was followed by default of interest on this issue in 1935 and collapse of its price to the abysmal low of 81/8 as late as 1939. From the foregoing it would appear that in some cases underlying bonds may be viewed as exceptions to our rule that a bond is not sound unless the company is sound. For the most part such bonds are owned by institutions or large investors. (The same observations may apply to certain first-mortgage bonds of operating subsidiaries of public-utility holding-company systems.) In railroad bonds of this type, the location and strategic value of the mileage covered are of prime importance. First-mortgage bonds on nonessential and unprofitable parts of the system, referred to sometimes as “divisional liens,

rule that a bond is not sound unless the company is sound. For the most part such bonds are owned by institutions or large investors. (The same observations may apply to certain first-mortgage bonds of operating subsidiaries of public-utility holding-company systems.) In railroad bonds of this type, the location and strategic value of the mileage covered are of prime importance. First-mortgage bonds on nonessential and unprofitable parts of the system, referred to sometimes as “divisional liens,” are not true underlying bonds in the sense that we have just used the term. Divisional first liens on poorly located mileage may receive much less favorable treatment in a reorganization than blanket mortgage bonds ostensibly junior to them. Example: Central Branch Union Pacific Railway First 4s, due 1938, were said to “underly” the Missouri Pacific First and Refunding mort- gage, which provided for their retirement. Yet the reorganization plans presented to the end of 1939 all offered better treatment for the Missouri Pacific First and Refunding 5s than for the ostensibly senior Central Branch bonds. As a practical matter it is not so easy to distinguish in advance between the underlying bonds that come through reorganization unscathed and those which suffer drastic treatment. Hence the ordinary investor may be well advised to leave such issues out of his calculations and stick to the rule that only strong companies have strong bonds. Chapter 7 THE SELECTION OF FIXED-VALUE INVESTMENTS: SECOND AND THIRD PRINCIPLES II. BONDS SHOULD BE BOUGHT ON A DEPRESSION BASIS The rule that a sound investment must be able to withstand adversity seems self-evident enough to be termed a truism. Any bond can do well when conditions are favorable; it is only under the acid test of depression that the advantages of strong over weak issues become manifest and vitally important. For this reason prudent investors have always favored the obligations of old-established enterprises which hav

ENTS: SECOND AND THIRD PRINCIPLES II. BONDS SHOULD BE BOUGHT ON A DEPRESSION BASIS The rule that a sound investment must be able to withstand adversity seems self-evident enough to be termed a truism. Any bond can do well when conditions are favorable; it is only under the acid test of depression that the advantages of strong over weak issues become manifest and vitally important. For this reason prudent investors have always favored the obligations of old-established enterprises which have demonstrated their ability to come through bad times as well as good. Presumption of Safety Based upon Either the Character of the Industry or the Amount of Protection. Confidence in the ability of a bond issue to weather depression may be based on either of two dif- ferent reasons. The investor may believe that the particular business will be immune from a drastic shrinkage in earning power, or else that the margin of safety is so large that it can undergo such a shrinkage without resultant danger. The bonds of light and power companies have been favored principally for the first reason, the bonds of United States Steel Corporation subsidiaries for the second. In the former case it is the char- acter of the industry, in the latter it is the amount of protection, which justifies the purchase. Of the two viewpoints, the one which tries to avoid the perils of depression appeals most to the average bond buyer. It seems much simpler to invest in a depression-proof enterprise than to have to rely on the company’s financial strength to pull its bonds through a period of poor results. [154] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. No Industry Entirely Depression-proof. The objection to this the- ory of investment is, of course, that there is no such thing as a depres- sion-proof industry, meaning thereby one that is immune from the danger of any decline in earning power. It is true that the Edison compa- nies

to rely on the company’s financial strength to pull its bonds through a period of poor results. [154] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. No Industry Entirely Depression-proof. The objection to this the- ory of investment is, of course, that there is no such thing as a depres- sion-proof industry, meaning thereby one that is immune from the danger of any decline in earning power. It is true that the Edison compa- nies have shown themselves subject to only minor shrinkage in profits, as compared, say, with the steel producers. But even a small decline may prove fatal if the business is bonded to the limit of prosperity earnings. Once it is admitted—as it always must be—that the industry can suffer some reduction in profits, then the investor is compelled to estimate the possible extent of the shrinkage and compare it with the surplus above the interest requirements. He thus finds himself in the same position as the holder of any other kind of bond, vitally concerned with the ability of the company to meet the vicissitudes of the future.1 The distinction to be made, therefore, is not between industries which are exempt from and those which are affected by depression, but rather between those which are more and those which are less subject to fluctuation. The more stable the type of enterprise, the better suited it is to bond financing and the larger the portion of the supposed nor- mal earning power which may be consumed by interest charges. As the degree of instability increases, it must be offset by a greater margin of safety to make sure that interest charges will be met; in other words, a smaller portion of total capital may be represented by bonds. If there is such a lack of inherent stability as to make survival of the enterprise doubtful under continued unfavorable conditions (a question arising frequently in the case of industrial companies of secondary size), then the bond issue ca

which may be consumed by interest charges. As the degree of instability increases, it must be offset by a greater margin of safety to make sure that interest charges will be met; in other words, a smaller portion of total capital may be represented by bonds. If there is such a lack of inherent stability as to make survival of the enterprise doubtful under continued unfavorable conditions (a question arising frequently in the case of industrial companies of secondary size), then the bond issue cannot meet the requirements of fixed-value investment, even though the margin of safety—measured by past performance— may be exceedingly large. Such a bond will meet the quantitative but not the qualitative test, but both are essential to our concept of investment.2 1 Note that a large number of utility holding-company issues (and even some overbonded operating companies) defaulted in 1931–1932, whereas the subsidiary bonds of the United States Steel Corporation maintained a high investment rating despite the exceedingly bad operating results. 2 For examples of this important point, see our discussion of Studebaker Preferred stock on p. 87 and of Willys-Overland Company First 61/2s on p. 767 of accompanying CD. Investment Practice Recognizes Importance of Character of the Industry. This conception of diverse margins of safety has been solidly grounded in investment practice for many years. The threefold classification of enterprises—as railroads, public utilities, or industrials— was intended to reflect inherent differences in relative stability and consequently in the coverage to be required above bond interest require- ments. Investors thought well, for example, of any railroad which earned its bond interest twice over, but the same margin in the case of an indus- trial bond was ordinarily regarded as inadequate. In the decade between 1920 and 1930, the status of the public-utility division underwent some radical changes. A sharp separation was introduced between light, h

intended to reflect inherent differences in relative stability and consequently in the coverage to be required above bond interest require- ments. Investors thought well, for example, of any railroad which earned its bond interest twice over, but the same margin in the case of an indus- trial bond was ordinarily regarded as inadequate. In the decade between 1920 and 1930, the status of the public-utility division underwent some radical changes. A sharp separation was introduced between light, heat, and power services on the one hand, and street-railway lines on the other, although previously the two had been closely allied. The trolley compa- nies, because of their poor showing, were tacitly excluded from the purview of the term “public utility,” as used in financial circles, and in the popular mind the name was restricted to electric, gas, water, and tele- phone companies. (Later on, promoters endeavored to exploit the popu- larity of the public utilities by applying this title to companies engaged in all sorts of businesses, including natural gas, ice, coal, and even storage.) The steady progress of the utility group, even in the face of the minor industrial setbacks of 1924 and 1927, led to an impressive advance in its standing among investors, so that by 1929 it enjoyed a credit rating fully on a par with the railroads. In the ensuing depression, it registered a much smaller shrinkage in gross and net earnings than did the transportation industry, and its seems logical to expect that bonds of soundly capitalized light and power companies will replace high-grade railroad bonds as the premier type of corporate investment. (This seems true to the authors despite the distinct recession in the popularity of utility bonds and stocks since 1933, due to a combination of rate reductions, governmental com- petition and threatened dangers from inflation.) Depression Performance as a Test of Merit. Let us turn our atten- tion now to the behavior of these three investment g

o expect that bonds of soundly capitalized light and power companies will replace high-grade railroad bonds as the premier type of corporate investment. (This seems true to the authors despite the distinct recession in the popularity of utility bonds and stocks since 1933, due to a combination of rate reductions, governmental com- petition and threatened dangers from inflation.) Depression Performance as a Test of Merit. Let us turn our atten- tion now to the behavior of these three investment groups in the two recent depression tests—that of 1931–1933 and that of 1937–1938. Of these, the former was of such unexampled severity that it may seem unfair and impractical to ask that any investment now under consideration should be measured by its performance in those disastrous times. We have felt, however, that the experiences of 1931–1933 may be profitably COMPARISON OF RAILROAD AND PUBLIC-UTILITY GROSS AND NET WITH THE AVERAGE YIELD ON HIGH-GRADE RAILROAD AND UTILITY BONDS, 1926–1938 (UNIT $1,000,000) Railroads Public utilities Year Gross1 Net railway operating income2 Yield on railroad bonds, %3 Gross4 Net5 (index %) Yield on public-utility bonds, %3 1926 $6,383 $1,213 5.13 $1,520 100.0 5.11 1927 6,136 1,068 4.83 1,661 106.8 4.96 1928 6,112 1,173 4.85 1,784 124.0 4.87 1929 6,280 1,252 5.18 1,939 142.5 5.14 1930 5,281 869 4.96 1,991 127.7 5.05 1931 4,188 526 6.09 1,976 123.5 5.27 1932 3,127 326 7.61 1,814 96.6 6.30 1933 3,095 474 6.09 1,755 98.2 6.25 1934 3,272 463 4.96 1,832 88.1 5.40 1935 3,452 500 4.95 1,912 92.9 4.43 1936 4,053 667 4.24 2,045 120.7 3.88 1937 4,166 590 4.34 2,181 125.8 3.93 1938 3,565 373 5.21 2,195 106.0 3.87 1 Railway operating revenues for all Class I railroads in the United States (I.C.C.). 2 Net railway operating income for the same roads (I.C.C.). 3 Average yields on 40 rail and 40 utility bonds, respectively, as compiled by Moody’s. 4 Revenues from the sale of electric power to ultimate consumers, compiled by Edison Electric Insti

.96 1,832 88.1 5.40 1935 3,452 500 4.95 1,912 92.9 4.43 1936 4,053 667 4.24 2,045 120.7 3.88 1937 4,166 590 4.34 2,181 125.8 3.93 1938 3,565 373 5.21 2,195 106.0 3.87 1 Railway operating revenues for all Class I railroads in the United States (I.C.C.). 2 Net railway operating income for the same roads (I.C.C.). 3 Average yields on 40 rail and 40 utility bonds, respectively, as compiled by Moody’s. 4 Revenues from the sale of electric power to ultimate consumers, compiled by Edison Electric Institute. Data from 90% of the industry are adjusted to cover 100% of the industry (Survey of Current Business). 5 Index of corporate profits of 15 public utilities, compiled by Standard Statistics Company, Inc. Figures are annual averages of quarterly relatives in which 1926 is the base year. viewed as a “laboratory test” of investment standards, involving degrees of stress not to be expected in the ordinary vicissitudes of the future. Even though the conditions prevalent in those years may not be duplicated, the behavior of various types of securities at the time should throw a useful light on investment problems. Various Causes of Bond Collapses. 1. Excessive Funded Debt of Util- ities. If we study the bond issues which suffered collapse in the post-bub- ble period, we shall observe that different causes underlay the troubles of each group. The public-utility defaults were caused not by a disappear- ance of earnings but by the inability of overextended debt structures to withstand a relatively moderate setback. Enterprises capitalized on a reasonably sound basis, as judged by former standards, had little diffi- culty in meeting bond interest. This did not hold true in the case of many holding companies with pyramided capital structures which had absorbed nearly every dollar of peak-year earnings for fixed charges and so had scarcely any margin available to meet a shrinkage in profits. The widespread difficulties of the utilities were due not to any weakness in the light and

latively moderate setback. Enterprises capitalized on a reasonably sound basis, as judged by former standards, had little diffi- culty in meeting bond interest. This did not hold true in the case of many holding companies with pyramided capital structures which had absorbed nearly every dollar of peak-year earnings for fixed charges and so had scarcely any margin available to meet a shrinkage in profits. The widespread difficulties of the utilities were due not to any weakness in the light and power business, but to the reckless extravagance of its financing methods. The losses of investors in public-utility bonds could for the most part have been avoided by the exercise of ordinary prudence in bond selection. Conversely, the unsound financing methods employed must eventually have resulted in individual collapses, even in the ordi- nary course of the business cycle. In consequence, the theory of invest- ment in sound public-utility bonds appears in no sense to have been undermined by 1931–1933 experience. 2. Stability of Railroad Earnings Overrated. Turning to the railroads, we find a somewhat different situation. Here the fault appears to be that the stability of the transportation industry was overrated, so that investors were satisfied with a margin of protection which proved insufficient. It was not a matter of imprudently disregarding old established standards of safety, as in the case of the weaker utilities, but rather of being content with old standards when conditions called for more stringent require- ments. Looking back, we can see that the failure of the carriers generally to increase their earnings with the great growth of the country since pre- war days was a sign of a weakened relative position, which called for a more cautious and exacting attitude by the investor. If he had required his railroad bonds to meet the same tests that he applied to industrial issues, he would have been compelled to confine his selection to a rela- tively few of the stro

ons called for more stringent require- ments. Looking back, we can see that the failure of the carriers generally to increase their earnings with the great growth of the country since pre- war days was a sign of a weakened relative position, which called for a more cautious and exacting attitude by the investor. If he had required his railroad bonds to meet the same tests that he applied to industrial issues, he would have been compelled to confine his selection to a rela- tively few of the strongly situated lines.3 As it turned out, nearly all of these have been able to withstand the tremendous loss of traffic since 1929 without danger to their fixed charges. Whether or not this is a case 3 If, for example, the investor had restricted his attention to bonds of roads which in the prosperous year 1928 covered their fixed charges 21/2 times or better, he would have con- fined his selections to bonds of: Atchison; Canadian Pacific; Chesapeake and Ohio; Chicago, Burlington and Quincy; Norfolk and Western; Pere Marquette; Reading; and Union Pacific. (With the exception of Pere Marquette, the bonds of these roads fared comparatively well in the depression. Note, however, that the foregoing test may be more stringent than the one we propose later on: average earnings = twice fixed charges.) of wisdom after the event is irrelevant to our discussion. Viewing past experience as a lesson for the future, we can see that selecting railroad bonds on a depression basis would mean requiring a larger margin of safety in normal times than was heretofore considered necessary. The 1937–1938 Experience. These conclusions with respect to rail- road and utility bonds are supported by the behavior of the two groups in the 1937–1938 recession. Nearly all issues which met reasonably strin- gent quantitative tests at the beginning of 1937 came through the ensu- ing slump with a relatively small market decline and no impairment of inherent position. On the other hand, bonds of both groups s

ng a larger margin of safety in normal times than was heretofore considered necessary. The 1937–1938 Experience. These conclusions with respect to rail- road and utility bonds are supported by the behavior of the two groups in the 1937–1938 recession. Nearly all issues which met reasonably strin- gent quantitative tests at the beginning of 1937 came through the ensu- ing slump with a relatively small market decline and no impairment of inherent position. On the other hand, bonds of both groups showing a substandard earnings coverage for 1936 suffered in most cases a really serious loss of quoted value, which in some instances proved the precur- sor of financial difficulties for the issuer.4 3. Depression Performance of Industrial Bonds. In the case of indus- trial obligations, the 1937–1938 pattern and the 1931–1933 pattern are appreciably different, so that the investor’s attitude toward this type of security may depend somewhat on whether he feels it necessary to guard against the more or the less serious degree of depression. Studying the 1931–1933 record, we note that price collapses were not due primarily to unsound financial structures, as in the case of utility bonds, nor to a mis- calculation by investors as to the margin of safety needed, as in the case of railroad bonds. We are confronted in many cases by a sudden disap- pearance of earning power, and a disconcerting question as to whether the business can survive. A company such as Gulf States Steel, for exam- ple, earned its 1929 interest charges at least 31/2 times in every year from 1922 to 1929. Yet in 1930 and 1931 operating losses were so large as to threaten its solvency.5 Many basic industries, such as the Cuban sugar producers and our own coal mines, were depressed prior to the 1929 debacle. In the past, such eclipses had always proven to be temporary, and investors felt justified in holding the bonds of these companies in the expectation of a speedy recovery. But in this instance the continuance

earned its 1929 interest charges at least 31/2 times in every year from 1922 to 1929. Yet in 1930 and 1931 operating losses were so large as to threaten its solvency.5 Many basic industries, such as the Cuban sugar producers and our own coal mines, were depressed prior to the 1929 debacle. In the past, such eclipses had always proven to be temporary, and investors felt justified in holding the bonds of these companies in the expectation of a speedy recovery. But in this instance the continuance of adverse conditions beyond all previous experience defeated their calcu- lations and destroyed the values behind their investment. 4 See Appendix Note 11, p. 740 on accompanying CD, for a summary of the performance of representative railroad and utility bonds in 1937–1938, as related to earnings coverage for 1936. 5 See Appendix Note 12, p. 741 on accompanying CD, for supporting data and other examples. From these cases we must conclude that even a high margin of safety in good times may prove ineffective against a succession of operating losses caused by prolonged adversity. The difficulties that befell indus- trial bonds, therefore, cannot be avoided in the future merely by more stringent requirements as to bond-interest coverage in normal years. If we examine more closely the behavior of the industrial bond list in 1932–1933 (taking all issues listed on the New York Stock Exchange), we shall note that the fraction that maintained a price reflecting reasonable confidence in the safety of the issue was limited to only 18 out of some 200 companies.6 The majority of these companies were of outstanding importance in their respective industries. This point suggests that large size is a trait of considerable advantage in dealing with exceptionally unfavorable devel- opments in the industrial world, which may mean in turn that industrial investments should be restricted to major companies. The evidence, however, may be objected to on the ground of having been founded on an a

safety of the issue was limited to only 18 out of some 200 companies.6 The majority of these companies were of outstanding importance in their respective industries. This point suggests that large size is a trait of considerable advantage in dealing with exceptionally unfavorable devel- opments in the industrial world, which may mean in turn that industrial investments should be restricted to major companies. The evidence, however, may be objected to on the ground of having been founded on an admittedly abnormal experience. The less drastic test of 1937–1938 points rather towards the conventional conclusion that issues strongly buttressed by past earnings can be relied on to withstand depressions.7 If, however, we go back over a longer period—say, since 1915—we shall find perennial evidence of the instability of industrial earning power. Even in the supposedly prosperous period between 1922 and 1929, the bonds of smaller industrial enterprises did not prove a dependable medium of investment. There were many instances wherein an appar- ently well-established earning power suffered a sudden disappearance.8 In fact these unpredictable variations were sufficiently numerous to sug- gest the conclusion that there is an inherent lack of stability in the small 6 These companies were: American Machine and Foundry, American Sugar Refining Com- pany, Associated Oil Company, Corn Products Refining Company, General Baking Com- pany, General Electric Company, General Motors Acceptance Corporation, Humble Oil and Refining Company, International Business Machine Corporation, Liggett and Myers Tobacco Company, P. Lorillard Company, National Sugar Refining Company, Pillsbury Flour Mills Company, Smith (A.O.) Corporation, Socony-Vacuum Corporation, Standard Oil Company of Indiana, Standard Oil Company of New Jersey and United States Steel Corporation. 7 Appendix Note 13, p. 742 on accompanying CD, summarizes the performance of industrial bonds in 1937–1938, as related to earnings fo

rporation, Humble Oil and Refining Company, International Business Machine Corporation, Liggett and Myers Tobacco Company, P. Lorillard Company, National Sugar Refining Company, Pillsbury Flour Mills Company, Smith (A.O.) Corporation, Socony-Vacuum Corporation, Standard Oil Company of Indiana, Standard Oil Company of New Jersey and United States Steel Corporation. 7 Appendix Note 13, p. 742 on accompanying CD, summarizes the performance of industrial bonds in 1937–1938, as related to earnings for a period ended in 1936. 8 See Appendix Note 14, p. 743 on accompanying CD, for examples. or medium-sized industrial enterprise, which makes them ill-suited to bond financing. A tacit recognition of this weakness has been responsi- ble in part for the growing adoption of conversion and subscription-war- rant privileges in connection with industrial-bond financing.9 To what extent such embellishments can compensate for insufficient safety will be discussed in our chapters on Senior Securities with Speculative Features. But in any event the widespread resort to these profit-sharing artifices seems to confirm our view that bonds of smaller industrial companies are not well qualified for consideration as fixed-value investments. Unavailability of Sound Bonds No Excuse for Buying Poor Ones. However, if we recommend that straight bond investment in the industrial field be confined to companies of dominant size, we face the difficulty that such companies are few in number and many of them have no bonds outstanding. It may be objected further that such an attitude would severely handicap the financing of legitimate businesses of second- ary size and would have a blighting effect on investment-banking activ- ities. The answer to these remonstrances must be that no consideration can justify the purchase of unsound bonds at an investment price. The fact that no good bonds are available is hardly an excuse for either issu- ing or accepting poor ones. Needless to say, the investor is n

have no bonds outstanding. It may be objected further that such an attitude would severely handicap the financing of legitimate businesses of second- ary size and would have a blighting effect on investment-banking activ- ities. The answer to these remonstrances must be that no consideration can justify the purchase of unsound bonds at an investment price. The fact that no good bonds are available is hardly an excuse for either issu- ing or accepting poor ones. Needless to say, the investor is never forced to buy a security of inferior grade. At some sacrifice in yield he can always find issues that meet his requirements, however stringent; and, as we shall point out later, attempts to increase yield at the expense of safety are likely to prove unprofitable. From the standpoint of the corporations and their investment bankers, the conclusion must follow that if their securities cannot properly qualify as straight investments, they must be given profit- making possibilities sufficient to compensate the purchaser for the risk he runs. Conflicting Views on Bond Financing. In this connection, obser- vations are in order regarding two generally accepted ideas on the sub- ject of bond financing. The first is that bond issues are an element of weakness in a company’s financial position, so that the elimination of funded debt is always a desirable object. The second is that when com- panies are unable to finance through the sale of stock it is proper to raise 9 See footnote 3, p. 290. money by means of bond issues. In the writers’ view both of these wide- spread notions are quite incorrect. Otherwise there would be no really sound basis for any bond financing. For they imply that only weak com- panies should be willing to sell bonds—which, if true, would mean that investors should not be willing to buy them. Proper Theory of Bond Financing. The proper theory of bond financing, however, is of quite different import. A reasonable amount of funded debt is of advantage to a

0. money by means of bond issues. In the writers’ view both of these wide- spread notions are quite incorrect. Otherwise there would be no really sound basis for any bond financing. For they imply that only weak com- panies should be willing to sell bonds—which, if true, would mean that investors should not be willing to buy them. Proper Theory of Bond Financing. The proper theory of bond financing, however, is of quite different import. A reasonable amount of funded debt is of advantage to a prosperous business, because the stock- holders can earn a profit above interest charges through the use of the bondholders’ capital. It is desirable for both the corporation and the investor that the borrowing be limited to an amount which can safely be taken care of under all conditions. Hence, from the standpoint of sound finance, there is no basic conflict of interest between the strong corpora- tion which floats bonds and the public which buys them. On the other hand, whenever an element of unwillingness or compulsion enters into the creation of a bond issue by an enterprise, these bonds are ipso facto of secondary quality and it is unwise to purchase them on a straight investment basis. Unsound Policies Followed in Practice. Financial policies followed by corporations and accepted by the public have for many years run counter to these logical principles. The railroads, for example, have financed the bulk of their needs through bond sales, resulting in an over- balancing of funded debt as against stock capital. This tendency has been repeatedly deplored by all authorities, but accepted as inevitable because poor earnings made stock sales impracticable. But if the latter were true, they also made bond purchases inadvisable. It is now quite clear that investors were imprudent in lending money to carriers which themselves complained of the necessity of having to borrow it. While investors were thus illogically lending money to weak borrow- ers, many strong enterprises were

debt as against stock capital. This tendency has been repeatedly deplored by all authorities, but accepted as inevitable because poor earnings made stock sales impracticable. But if the latter were true, they also made bond purchases inadvisable. It is now quite clear that investors were imprudent in lending money to carriers which themselves complained of the necessity of having to borrow it. While investors were thus illogically lending money to weak borrow- ers, many strong enterprises were paying off their debts through the sale of additional stock. But if there is any thoroughly sound basis for corpo- rate borrowing, then this procedure must also be regarded as unwise. If a reasonable amount of borrowed capital, obtained at low interest rates, is advantageous to the stockholder, then the replacement of this debt by added stock capital means the surrender of such advantage. The elimina- tion of debt will naturally simplify the problems of the management, but surely there must be some point at which the return to the stockholders must also be considered. Were this not so, corporations would be con- stantly raising money from their owners and they would never pay any part of it back in dividends. It should be pointed out that the mania for debt retirement in 1927–1929 has had a disturbing effect upon our bank- ing situation, since it eliminated most of the good commercial borrow- ers and replaced them by second-grade business risks and by loans on stock collateral, which were replete with possibilities of harm. Significance of the Foregoing to the Investor. The above analysis of the course of industrial bond borrowing in the last 15 years is not irrel- evant to the theme of this chapter, viz., the application of depression stan- dards to the selection of fixed-value investments. Recognizing the necessity of ultra-stringent criteria of choice in the industrial field, the bond buyer is faced by a further narrowing of eligible issues due to the elimination of fund

were replete with possibilities of harm. Significance of the Foregoing to the Investor. The above analysis of the course of industrial bond borrowing in the last 15 years is not irrel- evant to the theme of this chapter, viz., the application of depression stan- dards to the selection of fixed-value investments. Recognizing the necessity of ultra-stringent criteria of choice in the industrial field, the bond buyer is faced by a further narrowing of eligible issues due to the elimination of funded debt by many of the strongest companies. Clearly his reaction must not be to accept the issues of less desirable enterprises, in the absence of better ones, but rather to refrain from any purchases on an investment basis if the suitable ones are not available. It appears to be a financial axiom that whenever there is money to invest, it is invested; and if the owner cannot find a good security yielding a fair return, he will invariably buy a poor one. But a prudent and intelligent investor should be able to avoid this temptation, and reconcile himself to accepting an unattractive yield from the best bonds, in preference to risking his prin- cipal in second-grade issues for the sake of a large coupon return. Summary. The rule that bonds should be bought on the basis of their ability to withstand depression has been part of an old investment tradi- tion. It was nearly lost sight of in the prosperous period culminating in 1929, but its importance was made painfully manifest during the follow- ing collapse and demonstrated again in the 1937–1938 recession. The bonds of reasonably capitalized electric and gas companies have given a satisfactory account of themselves during this decade and the same is true—to a lesser degree—of the relatively few railroads which showed a large margin above interest charges prior to 1930. In the industrial list, however, even an excellent past record has in many cases proved unde- pendable, especially where the company is of small or moderate siz

follow- ing collapse and demonstrated again in the 1937–1938 recession. The bonds of reasonably capitalized electric and gas companies have given a satisfactory account of themselves during this decade and the same is true—to a lesser degree—of the relatively few railroads which showed a large margin above interest charges prior to 1930. In the industrial list, however, even an excellent past record has in many cases proved unde- pendable, especially where the company is of small or moderate size. For this reason, the investor would seem to gain better protection against adverse developments by confining his industrial selections to companies which meet the two requirements of (1) dominant size and (2) substan- tial margin of earnings over bond interest. III. THIRD PRINCIPLE: UNSOUND TO SACRIFICE SAFETY FOR YIELD In the traditional theory of bond investment a mathematical relationship is supposed to exist between the interest rate and the degree of risk incurred. The interest return is divided into two components, the first constituting “pure interest”—i.e., the rate obtainable with no risk of loss— and the second representing the premium obtained to compensate for the risk assumed. If, for example, the “pure interest rate” is assumed to be 2%, then a 3% investment is supposed to involve one chance in a hundred of loss, while the risk incurred in an 7% investment would be five times as great, or 1 in 20. (Presumably the risk should be somewhat less than that indicated, to allow for an “insurance profit.”) This theory implies that bond-interest rates are closely similar to insurance rates, and that they measure the degree of risk on some rea- sonably precise actuarial basis. It would follow that, by and large, the return from high-and low-yielding investments should tend to equalize, since what the former gain in income would be offset by their greater per- centage of principal losses, and vice versa. No Mathematical Relationship between Yield and Risk. This view

allow for an “insurance profit.”) This theory implies that bond-interest rates are closely similar to insurance rates, and that they measure the degree of risk on some rea- sonably precise actuarial basis. It would follow that, by and large, the return from high-and low-yielding investments should tend to equalize, since what the former gain in income would be offset by their greater per- centage of principal losses, and vice versa. No Mathematical Relationship between Yield and Risk. This view, however, seems to us to bear little relation to the realities of bond investment. Security prices and yields are not determined by any exact mathematical calculation of the expected risk, but they depend rather upon the popularity of the issue. This popularity reflects in a general way the investors’ view as to the risk involved, but it is also influenced largely by other factors, such as the degree of familiarity of the public with the company and the issue (seasoning) and the ease with which the bond can be sold (marketability). It may be pointed out further that the supposed actuarial computa- tion of investment risks is out of the question theoretically as well as in practice. There are no experience tables available by which the expected “mortality” of various types of issues can be determined. Even if such tables were prepared, based on long and exhaustive studies of past records, it is doubtful whether they would have any real utility for the future. In life insurance the relation between age and mortality rate is well defined and changes only gradually. The same is true, to a much lesser extent, of the relation between the various types of structures and the fire hazard attaching to them. But the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation. This is particularly true because investment losses are not distributed fairly evenly i

lation between age and mortality rate is well defined and changes only gradually. The same is true, to a much lesser extent, of the relation between the various types of structures and the fire hazard attaching to them. But the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation. This is particularly true because investment losses are not distributed fairly evenly in point of time, but tend to be concentrated at intervals, i.e., during periods of general depression. Hence the typical investment haz- ard is roughly similar to the conflagration or epidemic hazard, which is the exceptional and incalculable factor in fire or life insurance. Self-insurance Generally Not Possible in Investment. If we were to assume that a precise mathematical relationship does exist between yield and risk, then the result of this premise should be inevitably to rec- ommend the lowest yielding—and therefore the safest—bonds to all investors. For the individual is not qualified to be an insurance under- writer. It is not his function to be paid for incurring risks; on the contrary it is to his interest to pay others for insurance against loss. Let us assume a bond buyer has his choice of investing $1,000 for $20 per annum with- out risk, or for $70 per annum with 1 chance out of 20 each year that his principal would be lost. The $50 additional income on the second invest- ment is mathematically equivalent to the risk involved. But in terms of personal requirements, an investor cannot afford to take even a small chance of losing $1,000 of principal in return for an extra $50 of income. Such a procedure would be the direct opposite of the standard procedure of paying small annual sums to protect property values against loss by fire and theft. The Factor of Cyclical Risks. The investor cannot prudently turn himself into an insurance company and incur risks of losi

- ment is mathematically equivalent to the risk involved. But in terms of personal requirements, an investor cannot afford to take even a small chance of losing $1,000 of principal in return for an extra $50 of income. Such a procedure would be the direct opposite of the standard procedure of paying small annual sums to protect property values against loss by fire and theft. The Factor of Cyclical Risks. The investor cannot prudently turn himself into an insurance company and incur risks of losing his princi- pal in exchange for annual premiums in the form of extra-large interest coupons. One objection to such a policy is that sound insurance prac- tice requires a very wide distribution of risk, in order to minimize the influence of luck and to allow maximum play to the law of probability. The investor may endeavor to attain this end by diversifying his hold- ings, but as a practical matter he cannot approach the division of risk attained by an insurance company. More important still is the danger that many risky investments may collapse together in a depression period, so that the investor in high-yielding issues will find a period of large income (which he will probably spend) followed suddenly by a deluge of losses of principal. It may be contended that the higher yielding securities on the whole return a larger premium above “pure interest” than the degree of risk requires; in other words, that in return for taking the risk, investors will in the long run obtain a profit over and above the losses in principal suf- fered. It is difficult to say definitely whether or not this is true. But even assuming that the high coupon rates will, in the great aggregate, more than compensate on an actuarial basis for the risks accepted, such bonds are still undesirable investments from the personal standpoint of the aver- age investor. Our arguments against the investor turning himself into an insurance company remain valid even if the insurance operations all told may prove

t over and above the losses in principal suf- fered. It is difficult to say definitely whether or not this is true. But even assuming that the high coupon rates will, in the great aggregate, more than compensate on an actuarial basis for the risks accepted, such bonds are still undesirable investments from the personal standpoint of the aver- age investor. Our arguments against the investor turning himself into an insurance company remain valid even if the insurance operations all told may prove profitable. The bond buyer is neither financially nor psycho- logically equipped to carry on extensive transactions involving the set- ting up of reserves out of regular income to absorb losses in substantial amounts suffered at irregular intervals. Risk and Yield Are Incommensurable. The foregoing discussion leads us to suggest the principle that income return and risk of principal should be regarded as incommensurable. Practically speaking, this means that acknowledged risks of losing principal should not be offset merely by a high coupon rate, but can be accepted only in return for a correspon- ding opportunity for enhancement of principal, e.g., through the purchase of bonds at a substantial discount from par, or possibly by obtaining an unusually attractive conversion privilege. While there may be no real mathematical difference between offsetting risks of loss by a higher income or by a chance for profit, the psychological difference is very important. The purchaser of low-priced bonds is fully aware of the risk he is running; he is more likely to make a thorough investigation of the issue and to appraise carefully the chances of loss and of profit; finally— most important of all—he is prepared for whatever losses he may sustain, and his profits are in a form available to meet his losses. Actual invest- ment experience, therefore, will not favor the purchase of the typical high-coupon bond offered at about par, wherein, for example, a 7% interest return is imagined t

d bonds is fully aware of the risk he is running; he is more likely to make a thorough investigation of the issue and to appraise carefully the chances of loss and of profit; finally— most important of all—he is prepared for whatever losses he may sustain, and his profits are in a form available to meet his losses. Actual invest- ment experience, therefore, will not favor the purchase of the typical high-coupon bond offered at about par, wherein, for example, a 7% interest return is imagined to compensate for a distinctly inferior grade of security.10 Fallacy of the “Business Man’s Investment.” An issue of this type is commonly referred to in the financial world as a “business man’s invest- ment” and is supposedly suited to those who can afford to take some degree of risk. Most of the foreign bonds floated between 1923 and 1929 belonged in that category. The same is true of the great bulk of straight preferred stock issues. According to our view, such “business man’s invest- ments” are an illogical type of commitment. The security buyer who can afford to take some risk should seek a commensurate opportunity of enhancement in price and pay only secondary attention to the income obtained. Reversal of Customary Procedure Recommended. Viewing the matter more broadly, it would be well if investors reversed their custom- ary attitude toward income return. In selecting the grade of bonds suit- able to their situation, they are prone to start at the top of the list, where maximum safety is combined with lowest yield, and then to calculate how great a concession from ideal security they are willing to make for the sake of a more attractive income rate. From this point of view, the ordi- nary investor becomes accustomed to the idea that the type of issue suited to his needs must rank somewhere below the very best, a frame of mind which is likely to lead to the acceptance of definitely unsound bonds, either because of their high income return or by surrender to the bland- is

afety is combined with lowest yield, and then to calculate how great a concession from ideal security they are willing to make for the sake of a more attractive income rate. From this point of view, the ordi- nary investor becomes accustomed to the idea that the type of issue suited to his needs must rank somewhere below the very best, a frame of mind which is likely to lead to the acceptance of definitely unsound bonds, either because of their high income return or by surrender to the bland- ishments of the bond salesman. It would be sounder procedure to start with minimum standards of safety, which all bonds must be required to meet in order to be eligible for further consideration. Issues failing to meet these minimum require- ments should be automatically disqualified as straight investments, regardless of high yield, attractive prospects, or other grounds for partial- ity. Having thus delimited the field of eligible investments, the buyer may then apply such further selective processes as he deems appropriate. He may desire elements of safety far beyond the accepted minima, in which case he must ordinarily make some sacrifice of yield. He may also indulge 10 In an exceptional year such as 1921 strongly entrenched bonds were offered bearing a 7% coupon, due to the prevailing high money rates. his preferences as to the nature of the business and the character of the management. But, essentially, bond selection should consist of working upward from definite minimum standards rather than working down- ward in haphazard fashion from some ideal but unacceptable level of maximum security. Chapter 8 SPECIFIC STANDARDS FOR BOND INVESTMENT IV. FOURTH PRINCIPLE: DEFINITE STANDARDS OF SAFETY MUST BE APPLIED Since the selection of high-grade bonds has been shown to be in good part a process of exclusion, it lends itself reasonably well to the applica- tion of definite rules and standards designed to disqualify unsuitable issues. Such regulations have in fact been

ards rather than working down- ward in haphazard fashion from some ideal but unacceptable level of maximum security. Chapter 8 SPECIFIC STANDARDS FOR BOND INVESTMENT IV. FOURTH PRINCIPLE: DEFINITE STANDARDS OF SAFETY MUST BE APPLIED Since the selection of high-grade bonds has been shown to be in good part a process of exclusion, it lends itself reasonably well to the applica- tion of definite rules and standards designed to disqualify unsuitable issues. Such regulations have in fact been set up in many states by legisla- tive enactment to govern the investments made by savings banks and by trust funds. In most such states, the banking department prepares each year a list of securities which appear to conform to these regulations and are therefore considered “legal,” i.e., eligible for purchase under the statute. It is our view that the underlying idea of fixed standards and minima should be extended to the entire field of straight investment, i.e., invest- ment for income only. These legislative restrictions are intended to pro- mote a high average level of investment quality and to protect depositors and beneficiaries against losses from unsafe securities. If such regulations are desirable in the case of institutions, it should be logical for individu- als to follow them also. We have previously challenged the prevalent idea that the ordinary investor can afford to take greater investment risks than a savings bank, and need not therefore be as exacting with respect to the soundness of his fixed-value securities. The experience since 1928 undoubtedly emphasizes the need for a general tightening of investment standards, and a simple method of attaining this end might be to con- fine all straight-bond selections to those which meet the legal tests of eligibility for savings banks or trust funds. Such a procedure would appear directly consonant with our fundamental principle that straight [169] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill

o the soundness of his fixed-value securities. The experience since 1928 undoubtedly emphasizes the need for a general tightening of investment standards, and a simple method of attaining this end might be to con- fine all straight-bond selections to those which meet the legal tests of eligibility for savings banks or trust funds. Such a procedure would appear directly consonant with our fundamental principle that straight [169] Copyright © 2009, 1988, 1962, 1951, 1940, 1934 by The McGraw-Hill Companies, Inc. Click here for terms of use. investments should be made only in issues of unimpeachable soundness, and that securities of inferior grade must be bought only on an admit- tedly speculative basis. New York Savings-bank Law as a Point of Departure. As a mat- ter of practical policy, an individual bond buyer is likely to obtain fairly satisfactory results by subjecting himself to the restrictions which govern the investment of savings banks’ funds. But this procedure cannot be seri- ously suggested as a general principle of investment, because the legislative provisions are themselves far too imperfect to warrant their acceptance as the best available theoretical standards. The acts of the various states are widely divergent; most of them are antiquated in important respects; none is entirely logical or scientific. The legislators did not approach their task from the viewpoint of establishing criteria of sound investments for uni- versal use; consequently they felt free to impose arbitrary restrictions on savings-bank and trust funds, which they would have hesitated to pre- scribe for investors generally. The New York statute, generally regarded as the best of its class, is nevertheless marred by a number of evident defects. In the formulation of comprehensive investment standards, the New York legislation may best be used, therefore, as a guide or point of departure, rather than as a final authority. The ensuing discussion will follow fairly closely the pattern

o impose arbitrary restrictions on savings-bank and trust funds, which they would have hesitated to pre- scribe for investors generally. The New York statute, generally regarded as the best of its class, is nevertheless marred by a number of evident defects. In the formulation of comprehensive investment standards, the New York legislation may best be used, therefore, as a guide or point of departure, rather than as a final authority. The ensuing discussion will follow fairly closely the pattern set forth in the statutory provisions (as they existed in 1939); but these will be criticized, rejected, or amplified, whenever such emendation appears desirable. GENERAL CRITERIA PRESCRIBED BY THE NEW YORK STATUTE The specific requirements imposed by the statute upon bond investments may be classified under seven heads, which we shall proceed to enumer- ate and discuss: 1. The nature and location of the business or government. 2. The size of the enterprise, or the issue. 3. The terms of the issue. 4. The record of solvency and dividend payments. 5. The relation of earnings to interest requirements. 6. The relation of the value of the property to the funded debt. 7. The relation of stock capitalization to the funded debt. NATURE AND LOCATION The most striking features of the laws governing savings-bank invest- ments is the complete exclusion of bonds in certain broad categories. The New York provisions relative to permitted and prohibited classes may be summarized as follows (subject to a 1938 amendment soon to be discussed): Admitted Excluded United States government, state and municipal Foreign government and foreign corporation bonds. bonds. Railroad bonds and electric, gas and telephone Street railway and water bonds. Debentures mortgage bonds. of public utilities. Bonds secured by first mortgages on All industrial bonds. real estate. Bonds of financial companies (investment trusts, credit concerns, etc.). The Fallacy of Blanket Prohibitions. The legislature was

bject to a 1938 amendment soon to be discussed): Admitted Excluded United States government, state and municipal Foreign government and foreign corporation bonds. bonds. Railroad bonds and electric, gas and telephone Street railway and water bonds. Debentures mortgage bonds. of public utilities. Bonds secured by first mortgages on All industrial bonds. real estate. Bonds of financial companies (investment trusts, credit concerns, etc.). The Fallacy of Blanket Prohibitions. The legislature was evidently of the view that bonds belonging to the excluded categories are essentially too unstable to be suited to savings-bank investment. If this view is entirely sound, it would follow from our previous reasoning that all issues in these groups are unsuited to conservative investment generally. Such a conclusion would involve revolutionary changes in the field of finance, since a large part of the capital now regularly raised in the investment market would have to be sought on an admittedly speculative basis. In our opinion, a considerable narrowing of the investment category is in fact demanded by the unsatisfactory experience of bond investors over a fairly long period. Nevertheless, there are strong objections to the application of blanket prohibitions of the kind now under discussion. Investment theory should be chary of easy generalizations. Even if full recognition is given, for example, to the unstable tendencies of industrial bonds, as discussed in Chap. 7, the elimination of this entire major group from investment consideration would seem neither practicable nor desir- able. The existence of a fair number of industrial issues (even though a small percentage of the total) which have maintained an undoubted investment status through the severest tests, would preclude investors generally from adopting so drastic a policy. Moreover, the confining of investment demand to a few eligible types of enterprise is likely to make for scarcity, and hence for the acceptance o

f this entire major group from investment consideration would seem neither practicable nor desir- able. The existence of a fair number of industrial issues (even though a small percentage of the total) which have maintained an undoubted investment status through the severest tests, would preclude investors generally from adopting so drastic a policy. Moreover, the confining of investment demand to a few eligible types of enterprise is likely to make for scarcity, and hence for the acceptance of inferior issues merely because they fall within these groups. This has in fact been one of the unfortunate results of the present legislative restrictions. Individual Strength May Compensate for Inherent Weakness of a Class. It would seem a sounder principle, therefore, to require a stronger exhibit by the individual bond to compensate for any weakness supposedly inherent in its class, rather than to seek to admit all bonds of certain favored groups and to exclude all bonds of others. An industrial bond may properly be required to show a larger margin of earnings over interest charges and a smaller proportion of debt to going-concern value than would be required of an obligation of a gas or electric enterprise. The same would apply in the case of traction bonds. In connection with the exclusion of water-company bonds by the New York statute, it should be noted that this group is considered by most other states to be on a par with gas, electric, and telephone obligations. There seems to be no good reason for subjecting them to more stringent requirements than in the case of other types of public-service issues. The 1938 Amendment to the Banking Law. In 1938 the New York legislature, recognizing the validity of these objections to categorical exclusions, proceeded to relieve the situation in a rather peculiar man- ner. It decreed that the Banking Board could authorize savings banks to invest in interest-bearing obligations not otherwise eligible for invest- ment, provided app

to be no good reason for subjecting them to more stringent requirements than in the case of other types of public-service issues. The 1938 Amendment to the Banking Law. In 1938 the New York legislature, recognizing the validity of these objections to categorical exclusions, proceeded to relieve the situation in a rather peculiar man- ner. It decreed that the Banking Board could authorize savings banks to invest in interest-bearing obligations not otherwise eligible for invest- ment, provided application for such authorization shall have been made by not less than 20 savings banks, or by a trust company, all of the capi- tal stock of which is owned by not less than 20 savings banks. (This meant the Savings Bank Trust Company of New York.) Clearly this amendment goes much farther than a mere widening of the categories of savings-bank investment. What it does, in fact, is to supersede—potentially, at least—all the specific requirements of the law (other than the primary insistence on interest-paying bonds) by the com- bined judgment of the savings banks themselves and the Banking Board. This means that, in theory, all seven of the criteria imposed by the law may be set aside by agreement of the parties. Obviously there is no practical danger that the legislative wisdom of the statute will be completely flouted. In fact, investments authorized by virtue of this new provision up to the end of 1939 are all unexceptionable in character. They include previously ineligible debenture issues of very strong telephone and industrial companies. (Curiously enough, no industrial mortgage bond has as yet been approved, but this may serve to confirm our previ- ous statement that good industrial bonds are likely to be debentures.) The action to date under the 1938 amendment has represented a praiseworthy departure from the unduly narrow restrictions of the statute itself, which we have criticized above. We are by no means convinced, however, that the legislation as it now stands is

issues of very strong telephone and industrial companies. (Curiously enough, no industrial mortgage bond has as yet been approved, but this may serve to confirm our previ- ous statement that good industrial bonds are likely to be debentures.) The action to date under the 1938 amendment has represented a praiseworthy departure from the unduly narrow restrictions of the statute itself, which we have criticized above. We are by no means convinced, however, that the legislation as it now stands is in really satisfactory form. There seems to be something puerile about enacting a long list of rules and then permitting an administrative body to waive as many of them as it sees fit. Would it not be better to prescribe a few really important cri- teria, which must be followed in every instance, and then give the Bank- ing Board discretionary power to exclude issues that meet these minimum requirements but still are not sound enough in its conservative judgment? Obligations of Foreign Governments. We have argued against any broad exclusions of entire categories of bonds. But in dealing with for- eign-government debts, a different type of reasoning may conceivably be justified. Such issues respond in but small degree to financial analysis, and investment therein is ordinarily based on general considerations, such as confidence in the country’s economic and political stability and the belief that it will faithfully endeavor to discharge its obligations. To a much greater extent, therefore, than in the case of other bonds, an opin- ion may be justified or even necessitated as to the general desirability of foreign-government bonds for fixed-value investment. The Factor of Political Expediency. Viewing objectively the history of foreign-bond investment in this country since it first assumed impor- tance during the World War, it is difficult to escape an unfavorable con- clusion on this point. In the final analysis, a foreign-government debt is an unenforceable contract. If payme

re, than in the case of other bonds, an opin- ion may be justified or even necessitated as to the general desirability of foreign-government bonds for fixed-value investment. The Factor of Political Expediency. Viewing objectively the history of foreign-bond investment in this country since it first assumed impor- tance during the World War, it is difficult to escape an unfavorable con- clusion on this point. In the final analysis, a foreign-government debt is an unenforceable contract. If payment is withheld, the bondholder has no direct remedy. Even if specific revenues or assets are pledged as secu- rity, he is practically helpless in the event that these pledges are broken.1 1 Among the numerous examples of this unhappy fact we may mention the pledge of specific revenues behind the Dawes Loan (German government) 7s, due 1949, and the Sao Paulo Secured 7s, due 1956. Following default of service of these two loans in 1934 and 1932, respectively, nothing whatever was done, or could have been done, to enforce the claim against the pledged revenues. It follows that while a foreign-government obligation is in theory a claim against the entire resources of the nation, the extent to which these resources are actually drawn upon to meet the external debt burden is found to depend in good part on political expediency. The grave inter- national dislocations of the postwar period made some defaults inevitable, and supplied the pretext for others. In any event, because non- payment has become a familiar phenomenon, its very frequency has removed much of the resultant obloquy. Hence the investor has, seem- ingly less reason than of old to rely upon herculean efforts being made by a foreign government to live up to its obligations during difficult times. The Foreign-trade Argument. It is generally argued that a renewal of large-scale international lending is necessary to restore world equilib- rium. More concretely, such lending appears to be an indispensable adjunct to the

has become a familiar phenomenon, its very frequency has removed much of the resultant obloquy. Hence the investor has, seem- ingly less reason than of old to rely upon herculean efforts being made by a foreign government to live up to its obligations during difficult times. The Foreign-trade Argument. It is generally argued that a renewal of large-scale international lending is necessary to restore world equilib- rium. More concretely, such lending appears to be an indispensable adjunct to the restoration and development of our export trade. But the investor should not be expected to make unsound commitments for ide- alistic reasons or to benefit American exporters. As a speculative opera- tion, the purchase of foreign obligations at low prices, such as prevailed in 1932, might prove well justified by the attendant possibilities of profit; but these tremendously depreciated quotations are in themselves a potent argument against later purchases of new foreign issues at a price close to 100% of face value, no matter how high the coupon rate may be set. The Individual-record Argument. It may be contended, however, that investment in foreign obligations is essentially similar to any other form of investment in that it requires discrimination and judgment. Some nations deserve a high credit rating based on their past performance, and these are entitled to investment preference to the same degree as are domestic corporations with satisfactory records. The legislatures of sev- eral states have recognized the superior standing of Canada by authoriz- ing savings banks to purchase its obligations, and Vermont has accepted also the dollar bonds of Belgium, Denmark, Great Britain, Holland, and Switzerland. A strong argument in the contrary direction is supplied by the appended list of the various countries having debts payable in dollars, classified according to the credit rating indicated by the market action of their bonds during the severe test of 1932. 1. Countries whose

l states have recognized the superior standing of Canada by authoriz- ing savings banks to purchase its obligations, and Vermont has accepted also the dollar bonds of Belgium, Denmark, Great Britain, Holland, and Switzerland. A strong argument in the contrary direction is supplied by the appended list of the various countries having debts payable in dollars, classified according to the credit rating indicated by the market action of their bonds during the severe test of 1932. 1. Countries whose bonds sold on an investment basis: Canada, France, Great Britain, Netherlands, Switzerland. 2. Countries whose bonds sold on a speculative basis: Argentina, Australia, Austria, Bolivia, Brazil, Bulgaria, Chile, China, Colombia, Costa Rica, Cuba, Czecho-Slovakia, Denmark, Dominican Republic, Esthonia, Finland, Germany, Guatemala, Greece, Haiti, Hungary, Japan, Jugoslavia, Mexico, Nicaragua, Panama, Peru, Poland, Rumania, Russia, Salvador, Uruguay. 3. Borderline countries: Belgium, Ireland, Italy, Norway, Sweden. Of the five countries in the first or investment group, the credit of two, viz., France and Great Britain, was considered speculative in the preced- ing depression of 1921–1922. Out of 42 countries represented, therefore, only three (Canada, Holland, and Switzerland) enjoyed an unquestioned investment rating during the twelve years ending in 1932. Twofold Objection to Purchase of Foreign-government Bonds. This evi- dence suggests that the purchase of foreign-government bonds is subject to a twofold objection of generic character: theoretically, in that the basis for credit is fundamentally intangible; and practically, in that experience with the foreign group has been preponderantly unsatisfactory. Apparently it will require a considerable betterment of world conditions, demonstrated by a fairly long period of punctual discharge of international obligations, to war- rant a revision of this unfavorable attitude toward foreign bonds as a class. Canadian issues may undo

s subject to a twofold objection of generic character: theoretically, in that the basis for credit is fundamentally intangible; and practically, in that experience with the foreign group has been preponderantly unsatisfactory. Apparently it will require a considerable betterment of world conditions, demonstrated by a fairly long period of punctual discharge of international obligations, to war- rant a revision of this unfavorable attitude toward foreign bonds as a class. Canadian issues may undoubtedly be exempted from this blanket condemnation, both on their record and because of the closeness of the relationship between Canada and the United States. Individual investors, for either personal or statistical reasons, may be equally convinced of the high credit standing of various other countries, and will therefore be ready to purchase their obligations as high-grade investments. Such commitments may prove to be fully justified by the facts; but for some years, at least, it would be well if the investor approached them in the light of exceptions to a general rule of avoiding foreign bonds, and required them accordingly to present exceptionally strong evidence of stability and safety.2 2 The foregoing section relating to foreign-government bonds is reproduced without change from the 1934 edition of this work. War conditions existing in 1940 add emphasis to our conclusions. Note that at the end of 1939 the dollar bonds of only Argentina, Canada, and Cuba were selling on better than a 6% basis in our markets. (Certain Cuban bonds were sell- ing to yield over 6%. Note also that Great Britain, Netherlands, Sweden, and Switzerland had no dollar bonds outstanding.) For data concerning foreign-bond defaults see various news releases and reports of Foreign Bondholders’ Protective Council, Inc. Bonds of Foreign Corporations. In theory, bonds of a corporation, however prosperous, cannot enjoy better security than the obligations of the country in which the corporation is loc

than a 6% basis in our markets. (Certain Cuban bonds were sell- ing to yield over 6%. Note also that Great Britain, Netherlands, Sweden, and Switzerland had no dollar bonds outstanding.) For data concerning foreign-bond defaults see various news releases and reports of Foreign Bondholders’ Protective Council, Inc. Bonds of Foreign Corporations. In theory, bonds of a corporation, however prosperous, cannot enjoy better security than the obligations of the country in which the corporation is located. The government, through its taxing power, has an unlimited prior claim upon the assets and earnings of the business; in other words, it can take the property away from the private bondholder and utilize it to discharge the national debt. But in actuality, distinct limits are imposed by political expediency upon the exercise of the taxing power. Accordingly we find instances of corpo- rations meeting their dollar obligations even when their government is in default.3 Foreign-corporation bonds have an advantage over governmental bonds in that the holder enjoys specific legal remedies in the event of nonpayment, such as the right of foreclosure. Consequently it is proba- bly true that a foreign company is under greater compulsion to meet its debt than is a sovereign nation. But it must be recognized that the con- ditions resulting in the default of government obligations are certain to affect adversely the position of the corporate bondholder. Restrictions on the transfer of funds may prevent the payment of interest in dollars even though the company may remain amply solvent.4 Furthermore, the distance separating the creditor from the property, and the obstacles interposed by governmental decree, are likely to destroy the practical value of his mortgage security. For these reasons the unfavorable con- clusions reached with respect to foreign-government obligations as fixed-value investments must be considered as applicable also to foreign- corporation bonds. SIZE The bon

ay prevent the payment of interest in dollars even though the company may remain amply solvent.4 Furthermore, the distance separating the creditor from the property, and the obstacles interposed by governmental decree, are likely to destroy the practical value of his mortgage security. For these reasons the unfavorable con- clusions reached with respect to foreign-government obligations as fixed-value investments must be considered as applicable also to foreign- corporation bonds. SIZE The bonds of very small enterprises are subject to objections which disqualify them as media for conservative investment. A company of relatively minor size is more vulnerable than others to unexpected hap- penings, and it is likely to be handicapped by the lack of strong banking connections or of technical resources. Very small businesses, therefore, have never been able to obtain public financing and have depended on pri- vate capital, those supplying the funds being given the double inducement 3 See Appendix Note 15, p. 743 on accompanying CD, for examples. 4 See Appendix Note 16, p. 744 on accompanying CD, for examples. of a share in the profits and a direct voice in the management. The objec- tions to bonds of undersized corporations apply also to tiny villages or microscopic townships, and the careful investor in municipal obligations will ordinarily avoid those below a certain population level. The establishment of such minimum requirements as to size neces- sarily involves the drawing of arbitrary lines of demarcation. There is no mathematical means of determining exactly at what point a company or a municipality becomes large enough to warrant the investor’s attention. The same difficulty will attach to setting up any other quantitative stan- dards, as for example the margin of earnings above interest charges, or the relation of stock or property values to bonded debt. It must be borne in mind, therefore, that all these “critical points” are necessarily rule-of- thumb de

ing of arbitrary lines of demarcation. There is no mathematical means of determining exactly at what point a company or a municipality becomes large enough to warrant the investor’s attention. The same difficulty will attach to setting up any other quantitative stan- dards, as for example the margin of earnings above interest charges, or the relation of stock or property values to bonded debt. It must be borne in mind, therefore, that all these “critical points” are necessarily rule-of- thumb decisions, and the investor is free to use other amounts if they appeal to him more. But however arbitrary the standards selected may be, they are undoubtedly of great practical utility in safeguarding the bond buyer from inadequately protected issues. Provisions of New York Statute. The New York statute has prescribed various standards as to minimum size in defining investments eligible for savings banks. As regards municipal bonds, a population of not less than 10,000 is required for states adjacent to New York, and of 30,000 for other states. Railroads must either own 500 miles of standard-gauge line or else have operating revenues of not less than $10,000,000 per annum. Unse- cured and income bonds of railroad companies are admitted only if (among other special requirements) the net income available for dividends amounts to $10,000,000. For gas and electric companies, gross revenues must have averaged $1,000,000 per year during the preceding five years; but in the case of telephone bonds, this figure must be $5,000,000. There are further provisions to the effect that the size of the bond issue itself must be not less than $1,000,000 for gas and electric companies, and not less than $5,000,000 in the case of telephone obligations. Some Criticisms of These Requirements. The figures of minimum gross receipts do not appear well chosen from the standpoint of bond invest- ment in general. The distinctions as to population requirements would scarcely appeal to investors throughout