&! % A.'S’Jp . Wut V. ^ Knowledge of Investment By Charles Lee Scovil Representing Spencer Trask & Co. Spencer Trask & Co. 43 Exchange Place, New York Albany, N. Y., State and James Streets Boston, Mass., 50 Congress Street Chicago, 111., 115 Adams Street THE TROW PRESS NEW YORK U^evce Contents ./ Chapter I page Saving and Investing 1 Security of Principal 3 Excessive Rates of Interest 5 Misleading Statements 7 Distribution of Securities 9 Mortgage and Deed of Trust 11 Chapter II Coupon and Registered Bonds 15 When Bonds are Lost 19 Redeemable Bonds 21 Sinking Fund 22 Forms of Bonds 24 “And Interest” Prices 28 Payment and Delivery of Bonds 30 Chapter III Management of Corporations 32 Rights of Common Stockholders 34 Surplus Reserve 35 Chapter IV Preferred Stocks 39 Diversification of Investments 40 Best Issues of Preferred Stocks 40 (? 49371 CHAPTER I SAVING AND INVESTING MONEY The selection of sound investments is largely a matter of education. It is a sub- ject deserving of careful study by every- one, but especially by those whose habit it may be to save some part of their earn- ings, by people dependent upon income, or by business concerns appreciating the wisdom of creating a surplus reserve fund. No man can foretell at what time or under what circumstances he may cease to be a factor in the activities of this world. It is therefore wise for him to familiarize the immediate members of his family with the subject of investment. Otherwise, as frequently happens, they may be per- suaded to invest in hazardous schemes the money accumulated solely for their future benefit. If the judicious investment of 1 Spencer Trask & Co. money were a topic of discussion in the home, people would be slow to employ their funds in unsafe, untried or highly specu- lative investments. Then again, there are men who are large earners of money, and who, appar- ently without any uneasiness of mind, ab- solutely ignore the necessity of saving and investing any part of their income. It is also a fact that men often believe them- selves to be investing money, when they are simply turning it over to irresponsible people, who may employ little, if any, of the cash in a legitimate enterprise. Those who do not save and invest money in times of prosperity fail to for- tify themselves against the day of adver- sity. Thus, everyone should be careful not only to save, but also to acquire the greatest possible knowledge of investment ; its affiliation with progress and prosper- ity, and its direct bearing upon the wel- fare of all people. Our railroads, our public utility and industrial corporations — in fact, the bone and sinew of every 2 Spencer Trask & Co. successful industry — is the result of in- vestment. The Government itself rests largely upon this foundation. It takes money, the money of individuals collec- tively, to finance and maintain all of these interests, and while it will always be true that some investments are more specula- tive than others, there are comparatively simple ways by which people with savings or surplus may avoid the pitfalls. Security of Principal It is generally recognized that in times of great prosperity large sums of money are employed in the purchase of undesir- able investments. The two chief reasons are as follows: First: The high cost of living causes many investors to give too much thought to the amount of their income, thus neg- lecting one of the fundamentals of sound investment, which is security of principal. Second: The high prices commanded by raw materials and manufactured prod- Spencer Trask & Co. ucts lead men to believe that larger profits could be made if sufficient capital were available to permit of business expansion. In many instances, these profits are based largely upon estimated results and dreams of the future. As time goes on, and the inevitable decline in the volume of general business takes place, with lower range of prices all along the line, the uninformed investor, who may have placed a part of his money in such enterprises, finds him- self to be the owner of securities from which little or no income is to be derived, and for which there is practically no mar- ket. In other words, the investments can- not be converted into cash without an unreasonably large loss of principal. It is only after experiences of this kind that many investors learn this basic principle of safeguarding money: Look -first to the intrinsic value of the security. This does not mean that it is difficult to make desirable investments in times of great prosperity. On the contrary, dur- ing such periods many long established 4 Spencer Trask & Co. and sound corporations, with whose se- curities well-informed investors are fa- miliar, find it expedient to become heavy borrowers. This may be due to the neces- sity for enlarged facilities to meet the in- creasing demands of a business. If in- terest rates are high, which is usually the case at such times, the corporations have to sell their securities at prices which will attract capital. It is then that the well-informed investor, guided by the ad- vice of his investment banker, is in a posi- tion to take advantage of the opportunity to obtain, with safety, a liberal return on his money. Naturally, when interest rates again become normal, the investments may be expected to appreciate in market value. Excessive Rates of Interest I have no intention of dignifying by comparison with judicious investment, cer- tain classes of speculative real estate, min- ing stocks and numerous other similar propositions, all of which are to be con- 5 Spencer Trask & Co. sidered as entirely apart from the field of legitimate investment. At the same time, in view of the large sums of money lost in such ventures, it is difficult to conceive how any explanation of investment can ignore some brief reference to this deplor- able condition. I therefore caution the reader against having anything to do with such propositions. If the vast amount of securities which it is claimed will yield anywhere from eight to fifty per cent annual income, were investments of sound and progressive value, the promoters would experience no difficulty in securing capital from respon- sible bankers. Therefore, when you are offered securities with the promise of an excessive return on your money, remember that the reputable investment banker, with his knowledge and special facilities for investigating property values, is unable to get for his clients sound investments yield- ing more than, approximately, four to six per cent. This, of course, applies more es- pecially to high-grade or good investment 6 Spencer Trask & Co. bonds. On the other hand, responsible investment banking firms are sometimes able to offer their clients well secured 1 preferred stocks yielding a return of, approximately, seven per cent. Investors should bear in mind, however, that bonds usually represent fixed property ; pre- ferred stocks, quick assets ; common stocks, surplus earnings and good-will. When preferred stocks have no mortgage or bonded debt ahead of them and none can be created without the consent of at least a majority of the preferred stock outstanding, and when they are preferred both as to assets and dividends over com- mon stock, they partake of many of the characteristics ordinarily found in bonds. Misleading Statements Investors are sometimes misled by the statement that subscriptions for securities will be received through the medium of 1 Preferred Stocks of this type are discussed on pages 39-42. 7 Spencer Trask & Co. certain banks or trust companies. Too often, it is the object of promoters to take this means of inspiring the confidence of prospective investors. Therefore, it is well to bear in mind that so long as a com- pany offering its securities direct to the public, is without bad reputation, a bank or trust company with which it carried a reasonably large deposit account might feel justified in permitting the use of its name in this way, without in any sense as- suming a sponsorship for the investment. Another thing to remember is this: a company selling its securities direct to the public is really conducting two branches of business, entirely separate and distinct from each other. It is enough of a prob- lem in itself in these days to successfully and profitably transact a mercantile busi- ness, without attempting to combine with it the sale of stocks or bonds. A company trying to do both of these things might be successful in either one of them, but it is frequently true that the profit derived by insiders from the sale of the securities 8 Spencer Trask & Co. at exorbitant prices results in the neglect of the regular business of the company. Then again, in the distribution of securi- ties, it should not be merely a question of selling. On the contrary, one of the most important considerations should be the per- manent protection of investors who may employ their money in the purchase of them. Distribution of Securities This will explain why investment bank- ing firms of the highest type, specializing in the business of investment, are the nat- ural medium through which well-managed corporations sell their securities to the public. The facilities which these firms have for the wide distribution of securi- ties, not only popularize the issues, but broaden the market for them. While this is a most desirable condition from the standpoint of investors, it is of great benefit to the corporations, because the market position of the securities would 9 Spencer Trask & Co. warrant the sale of subsequent issues at higher prices than would be otherwise pos- sible. Usually, the investment firms are rep- resented on the board of directors of the corporations, although many houses rec- ommending and dealing in the securities of large railroads and corporations, whose issues are known the world over and ac- tively traded in on the New York Stock Exchange, do not have this representa- tion. In fact, as the affairs of such cor- porations are more or less a matter of public knowledge, the responsibilities of those firms having representation in the directorate are not ordinarily so great as in the case of smaller public utility and industrial corporations, whose securities are not always listed, or, if listed, are closely held by investors, and rarely traded in on the New York Stock Exchange. These issues are commonly known as the “ specialties 99 of the investment firms un- derwriting them, and it is essential that the bankers recommending the securities 10 Spencer Trask & Co. be identified with the management of the properties. Therefore, it is the custom for a member of the firms to become a di- rector in the corporations, with the result that investors have a direct representative constantly watchful of their interests. No responsible investment firm would agree to purchase an issue of bonds until the physical and financial condition of the corporation had been thoroughly investi- gated, not only as to past and existing conditions, but also as to future possibili- ties. The examinations are made by well- known engineers, expert accountants, and men trained in the actual operation of the business itself. If the investigations are favorable, and the legality of the issue approved by competent attorneys, the banking firm will then, and only then, un- derwrite the issue. Mortgage and Deed of Trust Furthermore, a “ Mortgage and Deed of Trust ” is framed between the issuing 11 Spencer Trask & Co. company and a trustee — the latter usu- ally a well-known trust company, having a reasonably large capital and surplus. Under the terms of the indenture, which are reviewed in detail by the bankers and their attorneys, the issuing company conveys and assigns unto the trustee all of the property, rights, franchises, etc., upon which the bonds are to be a mort- gage. It also specifies, among other things, the amount of bonds, and the con- ditions under which they may be issued, a description of the property mortgaged, the keeping of the same insured and in repair, and numerous other important stipulations designed to protect the bond- holders. In addition, it is usually speci- fied that if default shall be made in the performance of any agreement contained in the indenture, or in the payment of in- terest upon any of the outstanding bonds, and shall so continue for the term speci- fied (usually from three to six months), the whole amount of bonds outstanding then becomes due and payable, in accord- 12 Spencer Trask & Co. ance with the terms of the deed of trust. In order that all of the holders of out- standing bonds may receive the same fair and impartial treatment, united action upon their part is essential. It is there- fore usually customary to specify in the deed of trust that while the trustee may enforce the rights of all bondholders at the written request of holders of only from twenty-five per cent to thirty per cent of the bonds outstanding, at the same time, it takes a majority of the bondhold- ers (from sixty to ninety per cent as the case may be) to direct and control the action of the trustee in the sale of the property, or in the appointment of a re- ceiver to operate it for their benefit. This would prevent the sale of the property at a price which might be considered a sac- rifice. On the other hand, if the form of se- curity to be issued were stock, it is ob- vious that the corporation would have to be controlled by the clients and friends of the investment banker, because no re- 13 Spencer Trask & Co. liable firm would finance a corporation unless the positive assurance were given that it would be in a position to protect the interests of its clients, no matter through what future exigencies the cor- poration might pass. These facts should serve to explain why responsible investment firms are recog- nized as being the only proper channel through which to buy or sell security issues. The service rendered, which is largely professional in its scope, is the governing factor with the reputable banker, and is so recognized by all well- managed corporations. It is a service which is essential to the individual invest- or, aiding him, so far as the experienced mind can determine, in selecting safe and profitable investments. 14 CHAPTER II COUPON AND REGISTERED BONDS Generally speaking, bonds represent a mortgage divided into several parts, and in most cases the interest is payable semi- annually. The denominations are usually $1,000, although sometimes they are is- sued in smaller or larger amounts. There are three distinct forms of bonds, as fol- lows: Coupon bonds , Coupon bonds registered as to principal only , Bonds registered as to both principal and interest . It is very important for investors to know just what these different forms sig- nify, notwithstanding that in all cases the issuing companies are responsible for the 15 Spencer Trask & Co. punctual payment of the principal and interest. Coupon bonds “ pass by delivery,” as is usually specified in mortgages. In other words, as the principal and interest become due, both are payable to bearer. The bond itself recites upon its face the obligation of the issuing company, etc., and has attached thereto small interest certificates, commonly known as “ coupons.” Assuming that a $1,000 coupon bond is one of an issue hav- ing twenty years to run before the prin- cipal becomes payable, and that it bears interest at the rate of five per cent per annum, payable semi-annually, January 1 and July 1, there would be attached to the bond forty coupons of $25 each. With every January 1 and July 1 the owner detaches from the bond one of these cou- pons, and, upon presenting the same at the fiscal agency of the issuing company, receives $25 in cash, representing the in- terest on the $1,000 bond for six months. If the holder of the coupon preferred, he could deposit the same at his bank for col- 16 a. v £ irtion of the bond reserved for Spencer Trask & Co. lection; or a bank or trust company, to whom he were known, might arrange to cash it for him. It frequently happens that investors leave bonds in trust with investment bankers. In this case, if the investor so directs, the banker will detach the coupons upon the interest dates, collect the same, and make such disposition of the proceeds as the client may direct. When the final coupon attached to a bond be- comes due, the bond itself should also be presented for payment. Based upon a coupon bond of $1,000 denomination, the holder would receive $1,000 in cash, rep- resenting his principal, in addition to the $25 in cash for the last coupon. Some- times the final coupon is not attached to the bond, in which case, when the bond is presented for payment at maturity, the holder receives also the interest for the last six months. Usually coupon bonds may be registered as to principal, and, in some cases, they may be exchanged for bonds registered as to both principal and interest. 17 Spencer Trask & Co. Coupon bonds registered as to princi- pal only are a direct obligation of the issuing company to the registered owners. Such bonds are not negotiable, except by the written assignments of the registered owners, whose names appear upon the bonds. The coupons attached to such bonds, however, are payable to bearer, in the same manner as those attached to cou- pon bonds. Bonds registered as to prin- cipal only, may be released to bearer by the issuing company, or its agents, when accompanied by the written assignments of the registered owners. When so re- leased, they become coupon bonds, and may be sold and delivered as such. Bonds registered as to both principal and interest are a direct obligation of the issuing company to the registered owners. They are usually issued in certificate form, assignable in writing, and have no cou- pons attached, checks for the interest being mailed directly to the registered owners. Practically all of the modern mortgages provide for the conversion of 18 Spencer Trask & Co. such bonds into coupon bonds. When mortgages do not so provide, such bonds usually sell at slightly lower prices than coupon bonds of the same issuing com- pany, owing to the limited demand, and, in the event of sale, it is necessary to as- sign them in blank, disposing of them spe- cifically as registered bonds. Investors should be very particular not to write their names, nor make notations, upon bonds. When this is done, it is nec- essary to sell them as “ endorsed bonds,” which, of course, affects their market value. When Bonds Are Lost It is obvious that coupon bonds should be placed in a safe-deposit vault, or lodged in some secure quarter. It is a matter of record that a stolen coupon bond, when purchased by an innocent third party, cannot be recovered by the original own- er. Further than this, the issuing com- pany, or its fiscal agents, would ha\e to pay the coupons as they became due, and 19 Spencer Trask & Co. also the par value of the bond at its ma- turity. This will explain why many inves- tors prefer to leave bonds in trust with their investment bankers. It is also one of the reasons why responsible investment bankers will not buy or sell securities for a stranger, until satisfied that he is all he represents himself to be. When a coupon bond is lost, the fiscal agents of the issu- ing company should be notified promptly, and, if possible, the number of the bond furnished. A communication should also be addressed to the investment banker, who will render the client every possible assistance in the effort to recover the bond. In the case of a lost bond, the issu- ing company might, in its discretion, ar- range to issue a new bond, but only upon the filing of a satisfactory bond of in- demnity. In view of these facts, it is advisable for persons of moderate means, buying bonds solely for investment, to have them registered as to principal, notwithstand- ing that the coupons attached to the 20 Spencer Trask & Co. bonds are payable to bearer, the same as in the case of coupon bonds. The regis- tration of bonds as to principal is, how- ever, a safeguard to the owners, so far as the principal is concerned, and such bonds when released to bearer, in the manner as heretofore stated, become readily nego- • tiable. Redeemable bonds: In some mortgages the right is reserved by the issuing com- pany to buy all or any part of the out- standing bonds before maturity, usually upon prior notice to holders of from one to six months, by advertisement. This naturally has an effect upon the market for such bonds, and explains why they often sell at lower prices than bonds which are not redeemable, although the redeem- able bonds may bear the same rate of in- terest and possess even greater intrinsic value. To illustrate: If a $1,000 bond were redeemable at the option of the issuing company at, say, 105 ($1,050), it would be exceptional for a buyer to be willing to pay in excess of this figure Spencer Trask & Co. for the same. When such bonds are re- deemed, coupon bonds are payable to the bearer at the office of the issuing com- pany, or its agents ; and registered bonds, when accompanied by written assignments, are redeemable in the same manner. All bonds cease to bear interest after the date of redemption, or maturity. Sinking Fund Some mortgages provide that a certain amount of cash, or a percentage of gross earnings, or so many cents for each ton of coal mined, etc., shall be paid by the issu- ing company to the trustee at stated periods, and applied as a sinking fund for the purchase of outstanding bonds, at not exceeding a specified price. It is custom- ary to provide in such mortgages, that the issuing company shall advertise, semi- annually, or annually, as the case may be, the amount of money in the hands of the trustee available for the purchase of bonds for the sinking fund. The holders of the 22 Spencer Trask & Co. outstanding bonds who may so elect, offer them to the trustee at a price at which they would be willing to sell, not exceed- ing, however, the figure specified in the mortgage. When the bids are opened, the bonds offered at the lowest prices are, of course, accepted. If no offerings are re- ceived, the mortgage usually specifies that the trustees may draw by lot a sufficient amount of the outstanding bonds to ab- sorb the sinking-fund money, paying the holders the sinking-fund price, no more and no less. The issuing company then advertises the numbers of the bonds so drawn, and, as far as the holders are con- cerned, the principal and interest of such bonds have matured. The holders of the drawn bonds, upon presenting them at the office of the trustee, receive in payment therefor the price specified in the mort- gage. In some cases, in lieu of draw- ing bonds by lot, the trustee may invest and accumulate the sinking-fund money. Bonds purchased for the account of the sinking fund must be either cancelled and 23 Spencer Trask & Co. destroyed, on the one hand ; or they must be kept alive and held by the trustee. In the latter case, the bonds continue to draw interest, the same as other outstanding bonds, the interest being applied by the trustee toward the future purchase of bonds for the sinking fund. Generally speaking, the mortgages of coal compa- nies, or those exhausting a product which cannot be replaced, should provide for a sinking fund, making it certain that as the amount of coal, or whatever product it may be, is diminished, the bonded debt of the company will be proportionately de- creased. Forms of Bonds Investors should always ascertain the position occupied by an issue of bonds with respect to its lien on the properties. For example, among the many different forms of bonds may be mentioned the following: First Mortgage Bonds, First and Refunding Mortgage Bonds, Consolidated Mortgage Bonds, 24 Spencer Trask & Co. General Mortgage Bonds, Improvement Mortgage Bonds, Collateral Trust Bonds, Convertible Bonds, Debenture Bonds, Income Bonds, Short Term Notes, Equipment Bonds. First Mortgage Bonds are almost always a first claim against properties. Sometimes, however, but only in rare cases, bonds bearing the title of “ first mortgage 99 are a first lien on only a part of the property, being subject on the re- maining property to underlying or prior bonds, for the retirement of which a suffi- cient amount of the first mortgage bonds may be reserved. First and Refunding Mortgage Bonds, Consolidated Mortgage Bonds, and Gen- eral Mortgage Bonds, are ordinarily a first mortgage on some part of the prop- erties, and may become ultimately a first mortgage on all of the properties covered 85 Spencer Trask & Co. by the deed of trust, as the underlying bonds become due and payable. Improvement Mortgage Bonds, as their title implies, are issued for special im- provements, and are usually a direct mort- gage on the properties, subject to the underlying bonds. Collateral Trust Bonds may be secured by pledge of stock with the Trustee, or by pledge of both stock and bonds. Some- times, they are additionally secured by a direct lien upon the properties. Convertible bonds are usually a direct obligation of the issuing corporation, at a fixed rate of interest, although, in some cases, they are also a lien upon the prop- erties. The holders have the right to con- vert the bonds into stock within a specified time and on stated terms. Debenture Bonds are usually simply an obligation of the issuing corporation, but it is sometimes provided that they shall rank equally as to lien on the properties with any future mortgage that the cor- poration may authorize. 26 Spencer Trask & Co. Income bonds, as their title implies, only receive interest when the earnings have been sufficient to justify the payment of the same. Many holders of real estate debenture bonds or income bonds do not perhaps ap- preciate that they are simply an obliga- tion issued against equities, and their safety dependent almost wholly upon the success of the company. This is why bonds of this type are to be regarded as semi- speculative. Short Term Notes are issued by cor- porations either during periods of high interest rates or at other times when long-term bonds cannot be sold at reason- able prices. They represent a temporary method of financing, and are a direct obligation of the issuing corporation. Sometimes, they are secured by pledge of collateral with the Trustee, and in a few cases are guaranteed as to principal, or as to both principal and interest. Car Trusts, Equipment Bonds and Equipment Notes are issued to pay for rt Spencer Trask & Co. equipment, and are ordinarily paid off serially, or by installments. Usually, all of the equipment is pledged as collateral until the last installment is paid. Thus, the security for the remaining bonds or notes enhances with the reduction of the amount outstanding. “ And Interest 99 Prices All interest-bearing bonds listed upon the New York Stock Exchange are dealt in “and interest.” The commission charge is -J of one per cent of the par value, or $1.25 for each $1,000 bond. Buyers of unlisted bonds are not usu- ally charged a commission, although there are exceptions to this rule. Such bonds, however, usually sell at a given price “ and interest ” in the same manner as listed bonds. This means that the buyer pays the accrued interest from the date of the last paid coupon up to, but not in- cluding, the date of payment for the bond. To illustrate: Assume that on April 1 an 28 Spencer Trask & Co. investor paid for a $1,000 five per cent bond at cost of, say, 98^ and interest , the coupons attached to the bond being pay- able January 1 and July 1. A statement would be rendered, as follows: $1,000 5 per cent, bond at 98^, $985.00 Accrued interest from Jan. 1 to Apr. 1, at the coupon rate, 12.50 Cost of unlisted bond, $997.50 If the order had been executed on the New York Stock Ex- change, add ^ of one per cent, commission, 1.25 Cost of listed bond, $998.75 On July 1 the owner of the $1,000 bond would cash the $25 coupon, and thus be reimbursed the $12.50 paid as accrued interest from January 1 to April 1. The remaining $12.50 would represent interest at the coupon rate from April 1 to June 30, inclusive, during which period the bond was actually owned by the buyer. 29 Spencer Trask & Co. Payment and Delivery of Bonds When purchasing investment securities, so far as the initial transaction is con- cerned, it is customary for buyers to fur- nish satisfactory references, preferably a bank reference. It is also the custom, when bonds are purchased by persons re- siding in other sections of the country, for the investment bankers to receive pay- ment therefor, and make delivery thereof, by one of the three following methods: 1. The bonds may be forwarded to the buyer, either by registered mail or ex- press, after the investment house has re- ceived payment therefor. This is the prevailing method when executing orders for the purchase of bonds through New York Stock Exchange firms. In such cases, the buyer should make remittance in funds payable in New York City, the day following the purchase, excepting on Fri- days, when payment should be made the following Monday. The reason for this is, that the broker, who acts merely as an 30 Spencer Trask & Co. agent in the transaction, is required to make payments in this same way and man- ner, and the buyer should, therefore, be governed accordingly. 2. The bonds may be forwarded to the buyer, accompanied by a draft for the amount of their cost, delivery being made upon payment of the draft. 3. The bonds may be forwarded to any bank designated by the buyer, deliv- ery being made upon payment of the amount due. In all three cases, it is customary for investment bankers to receive remittances at some bank in the city where they trans- act their business ; otherwise, it is the cus- tom for the buyer to pay the collection charges. 31 CHAPTER III MANAGEMENT OF CORPORATIONS Broadly speaking, the management of corporations may be divided into two parts : First — the duties of the directors, who are responsible to the stockholders, by whom they are elected to office, and whose best interests they should always aim to safeguard. Second — the duties of the operating officials, who are accountable to the direc- tors for the conduct of the business. However, as many of the directors, while keeping in close touch with the progress of the business, are not always familiar with all of the details, it is cus- tomary for some of the operating officials to be included in the directorate. The directors, as a body, must see to 32 Spencer Trask & Co. it that the business be properly conducted ; the credit and financial standing of the company well safeguarded; the physical condition of the property amply main- tained; in fact, that every precaution be taken to protect the invested capital. The operating officials, on the other hand, have more to do with the actual con- duct of the business ; the details of manu- facturing, the creation of an effective distributing organization, which, to be successful, must not only secure new cus- tomers, but retain the good-will of the old. Summed up, this means an expanding and profitable business. From this it becomes evident that no matter how great may be the true value of a property, the development of its earn- ing power is really dependent upon good management. The gross earnings must be sufficient to defray the cost of opera- tion, as also to pay interest, taxes, in- surance and other fixed charges. A cor- poration failing to do all these things is on the road to serious trouble. The in- 33 Spencer Trask & Co. terest on bonds must be paid. If not, a receivership is almost inevitable. There- fore, a competent management will aim to keep fixed charges reduced to a minimum. Moreover, in years of prosperity, some part of surplus earnings should be set aside as a reserve fund, thus fortifying the business against adverse conditions. Rights of Common Stockholders It should be borne in mind, however, that the common stockholders, whose claim against assets or earnings, is subject to that of the bondholders, and in most cases to that of the preferred stockholders, are entitled to a fair proportion of the surplus earnings. This will be more readily ap- preciated when it is remembered that com- mon stockholders, especially those of large corporations, often furnish additional capital for the expansion of the business, or the enlargement of plant facilities. For example, when corporations need money, it is not an unusual custom to 34 Spencer Trask & Co. offer stockholders the opportunity of pur- chasing an additional amount of common stock on a pro-rata basis, and at a lower figure than the price for which it sells in the open market. While this is ordinarily regarded as a valuable privilege, the fact remains that the additional money in- vested is entitled to a fair dividend return. Its expenditure enhances the value of the properties, and affords a larger equity for the protection of the holders of the bonds, preferred stock, or other securities having priority over the common stock as to as- sets and dividends. Surplus Reserve One of the most perplexing problems that directors have to solve is just what proportion of surplus earnings should go back into the property, or be set aside as a surplus reserve. In many cases, opera- ting officials want practically all of the surplus earnings put back into the prop- erty, and are opposed to any distribution 35 Spencer Trask & Co. to the common stockholders. But the di- rectors, who, as already explained, are elected by the stockholders, are in duty bound to see that an equitable disburse- ment is made, and if no dividends are paid in any year when a good surplus has been earned, some explanation is due the stock- holders. Ordinarily, it is wise to distribute to common stockholders, approximately, fifty per cent, of annual surplus earnings, but this is not always feasible or practi- cable. Sometimes, stockholders are most un- reasonable in their demands, and if dis- satisfied with dividend disbursements, will sell their holdings and reinvest in the shares of other corporations. This con- dition is likely to have a temporarily bad effect on the market price of the stock. If additional capital were needed in the business when securities were declining in market value, the corporation would, in all probability, have to sell its bonds or stocks at lower prices than those war- ranted by their true value. Thus, every- 36 Spencer Trask & Co. thing within reason must be done to main- tain credit and financial standing. This will explain why directors are sometimes influenced to be too liberal in the dis- bursement of dividends during times of good prosperity, with the result that pay- ments are likely to be reduced, or per- haps suspended, when a general business reaction takes place. When the period of depression comes, however, as it always does, the conservatively managed corpora- tion, whose directors have accumulated a good surplus reserve, is in a position to continue regular dividend disbursements, and has the complete confidence of its stockholders. All these things go to prove how im- portant and complex are the duties of directors. There is practically no limit to their legitimate powers. They are re- sponsible for the entire business and finan- cial policy of a corporation, and may either carry it to the height of prosperity, or hamper and retard its progress. When we stop to consider the magnitude of the 37 Spencer Trask & Co. corporate interests of this country, and the difficulties to be overcome in the growth and development of properties, it must be apparent to fair-minded people that directors, as a whole, measure up to the standard of their responsibilities. / 38 CHAPTER IV PREFERRED STOCKS There is a growing tendency on the part of those responsible for the manage- ment of industrial corporations to obtain capital requirements through the issue and sale of preferred stock. When securi- ties of this type are issued against estab- lished and skillfully managed businesses, and underwritten by large and responsible investment firms, they are regarded as thoroughly sound investments, well adapt- ed to the needs of people who feel that they must secure the highest rate of interest on their money compatible with safety, or a return approaching seven per cent. On the other hand, they are more or less at- tractive to investors of large means, who may be for the most part buyers of bonds, but who adopt the plan of placing some 39 Spencer Trask & Co. part of their money in preferred stocks of high standard, thereby increasing their average income. Diversification of Investments This is in line with judicious invest- ment, as a result of which investors come to appreciate the wisdom of diversifying their holdings, both as to type of security and geographical location of the prop- erties. By this method, investors increase the average return on their money, and also fortify themselves against adverse conditions, which might otherwise affect only the one type of investment, or the particular section of the country, in which all of their money were employed. Thus, it becomes obvious that diversification is essential to judicious investment. Best Issues of Preferred Stocks While it is impossible to lay down any fixed rule for the guidance of people in- vesting in preferred stocks of this type, 40 Spencer Trask & Co. it is ordinarily true that the best issues are surrounded by the following safeguards: First: Preferred both as to assets and dividends over common stock. Second: No dividends to be paid on the common in any year until all accumulated dividends have been paid on the preferred. Third: No mortgage or bonded indebt- edness, and none to be created in the fu- ture except with the consent of at least a majority of the preferred stock out- standing. Fourth: Net quick assets, [comprising only cash, accounts and bills receivable, and fair inventory value of raw material and manufactured products] equal to at least the amount of the preferred stock outstanding. Fifth: Ownership by the management of practically all of the common stock, which insures its personal interest in the successful and profitable expansion of the business. Sixth: After the common has received reasonably liberal dividends in any one 41 Spencer Trask & Co. year, some portion of surplus earnings should be set aside as a reserve fund, either for betterments and additions, or, at the discretion of the directors, for the retirement of a part of the preferred stock outstanding. The record of earnings is, of course, of vital importance. Generally speaking, the net earnings should average for a period of years from two to three times the an- nual dividend requirements on the pre- ferred stock outstanding, including the stock immediately to be issued and offered investors. Moreover, it is essential that the value of the plants and properties be appraised by independent experts, the books and accounts audited by certified public accountants, and the legality of the issue of the preferred stock passed upon by well-known attorneys. It can be stated as a fact that no responsible investment firm would offer an issue of preferred stock to its clients until all of these matters had been thoroughly and satisfactorily inves- tigated. 42 Spencer Trask & Co. This explanation of investment should make it clear that the selection of sound and profitable securities is not in any sense a difficult problem, provided your knowl- edge of the subject is sufficient to enable you to take advantage of the suggestions, or advice, of a responsible investment firm. The more study you give the subject, the greater will become your conviction that the success of well-informed investors is due, for the most part, to the efficiency of the organization of their investment bankers.