Penny stock investing principles.

HOW TO INVEST MONEY


I

GENERAL PRINCIPLES OF INVESTMENT

With the immense increase in wealth in the United States during the last decade and its more general distribution, the problem of investment has assumed correspondingly greater importance. As long as the average business man was an habitual borrower of money and possesed no private fortune outside of his interest in his business, he was not greatly concerned with investment problems.

The surplus wealth of the country for a long time was in the hands of financial institutions and a few wealthy capitalists. These men, the officers and directors of banks, savings-banks, and insurance companies, and the possessors of hereditary wealth, were thoroughly equipped[8] by training and experience for the solving of investment problems and needed no help in the disposition of the funds under their control.

During the last ten years, however, these conditions have been greatly altered.

The number of business men to-day in possession of funds in excess of their private wants and business requirements is far greater than it was ten years ago, and is constantly increasing. These men are confronted with a real investment problem.

While they have not always recognized it, the problem which they are called upon to solve is really twofold - it concerns the safeguarding of their private fortune and the wise disposition of their business surplus. They have usually seen the first part of this problem, but not all have succeeded in clearly understanding the second. When the treatment of a man's business surplus is spoken of as an investment problem, it is meant, of course, not his working capital, which should be kept in liquid form for immediate needs, but that portion of his surplus which is set aside for emergencies. It is coming to be a recognized principle that every business enterprise of[9] whatever kind or size should establish a reserve fund.

It is felt that the possession of a reserve fund puts the business upon a secure foundation, adds to its financial strength and reputation, and greatly increases its credit and borrowing capacity. The recognition of this fact, combined with the ability to set aside a reserve fund, has brought many men to a consideration of the best way in which to dispose of it. It is obviously a waste of income to have the surplus in bank-accounts; more than that, there would be a constant temptation to use it and to confuse it with working capital. Its best disposition is plainly in some safe interest-bearing security, which can be readily sold, so that it will be available for use if necessity demands.

Confronted with the double problem thus outlined, what measure of success has attended the average business man in its solution?

It is safe to say that the average man has found it easier to make money than to take care of it. Money-making, for him, is the result of successful activity in his own line of business, with which he is thoroughly familiar; while the investment of money is a thing apart from his business, with which he is not familiar,[10] and of which he may have had little practical experience. His failure to invest money wisely is not due to any want of intelligence or of proper care and foresight on his part, as he sometimes seems to believe, but simply because he is ignorant of the principles of a business which differs radically from his own.

The investment of money is a banker's business. When the average man has funds to invest, whether he be a business man or a pure investor, he should consult some experienced and reliable investment banker just as he would consult a doctor or a lawyer if he were in need of medical or legal advice. This book is not intended to take the place of consultation with a banker, but to supplement it.

The advantage of such consultation is shown by the fact that if a man attempts to rely on his own judgment, he is almost certain not to do the best thing, even if his business instinct leads him to avoid those enterprises which are more plainly unpromising or fraudulent. It should be remembered, however, that widows and orphans are not the only ones ensnared by attractive advertisements and the promise of brilliant returns. In most cases, widows' and[11] orphans' funds are protected by conscientious and conservative trustees, and it is the average business man who furnishes the money which is ultimately lost in all propositions which violate the fundamental laws of investment.

The average man is led into these unwise investments through a very natural error of judgment. Accustomed to take reasonable chances and to make large returns in his own business, he fails to detect anything fundamentally wrong in a proposition simply because it promises to pay well. He forgets that the rate of interest on invested money, or pure interest, is very small, and that anything above that can only come as payment for management, as he makes in his own business, or at the sacrifice of some essential factor of safety which will usually lead to disaster.

For the successful investment of money, however, a good deal more is required than the mere ability to select a safe security. That is only one phase of the problem. Scientific investment demands a clear understanding of the fundamental distinctions between different classes of securities and strict adherence to the two cardinal principles, distribution of risk and[12] selection of securities in accordance with real requirements.

One of the most important distinctions is that between promises to pay and equities. Bonds, real-estate mortgages, and loans on collateral represent somebody's promise to pay a certain sum of money at a future date; and if the promise be good and the security ample, the holder of the promise will be paid the money at the time due. On the other hand, equities, such as the capital stocks of banking, railway, and industrial corporations, represent only a certain residuary share in the assets and profits of a working concern, after payment of its obligations and fixt charges. The value of this residuary share may be large or small, may increase or diminish, but in no case can the holder of such a share require any one, least of all the company itself, to redeem the certificate representing his interest at the price he paid for it, nor indeed at any price. If a man buys a $1,000 railroad bond, he knows that the railroad, if solvent, will pay him $1,000 in cash when the bond is due. But if he buys a share of railroad stock, his only chance of getting his money back, if he should wish it, is that some[13] one else will want to buy his share for what he paid for it, or more. In one case he has bought a promise to pay, and in the other an equity.

It is not the intention, from the foregoing, to draw the conclusion that equities under no circumstances are to be regarded as investments, because many of our bank and railroad stocks, and even some of our public-utility and industrial stocks, have attained a stability and permanence of value and possess sufficiently long dividend records to justify their consideration when investments are contemplated; but it is essential that the investor should have a thorough understanding of the distinction involved.

The principle of distribution of risk is a simple one. It involves no more than obedience to the old rule which forbids putting all one's eggs in the same basket. The number of men who carry out this principle with any thoroughness, however, is very small. Proper distribution means not only the division of property among the various forms of investment, as railroad bonds, municipals, mortgages, public-utility bonds, etc., but also the preservation of proper geographical proportions within each[14] form. Adherence to this principle is perhaps not so important for private investors as for institutions. A striking instance of the need for insistence upon its observance in the institutional field was furnished by one of the fire-insurance companies of San Francisco after the earthquake. It appeared that the company's assets were largely invested in San Francisco real estate and in local enterprises generally, where the bulk of its fire risks were concentrated. As a result, the very catastrophe which converted its risks into actual liabilities deprived its assets of all immediate value. This instance serves to show the importance of the principle and the necessity for its observance.

The principle of selection in accordance with real requirements is more complex. It involves a thorough understanding of the chief points which must be considered in the selection of all investments. These are five in number: (1) Safety of principal and interest, or the assurance of receiving the principal and interest on the dates due; (2) rate of income, or the net return which is realized on the actual amount of money invested; (3) convertibility into cash, or the readiness with which it is possible to[15] realize on the investment; (4) prospect of appreciation in value, or that growth in intrinsic value which tends to advance market price; and (5) stability of market price, or the likelihood of maintaining the integrity of the principal invested.

The five qualities above enumerated are present in different degrees in every investment, and the scientific investor naturally selects those securities which possess in a high degree the qualities upon which he wishes to place emphasis. A large part of the problem of investment lies in the careful selection of securities to meet one's actual requirements. The average investor does not thoroughly understand this point. He does not realize that a high degree of one quality involves a lower degree of other qualities. He may have a general impression that a high rate of income is apt to indicate less assurance of safety, but he rarely applies the same reasoning to other qualities. When he buys securities, he is quite likely to pay for qualities which he does not need. It is very common, for example, when he wishes to make a permanent investment and has no thought of reselling, to find him purchasing[16] securities which possess in a high degree the quality of convertibility. From his point of view, this is pure waste. A high degree of convertibility is only obtained at the sacrifice of some other quality—usually rate of income. If he were to use more care in his selections, he could probably find some other security possessing equal safety, equal stability, and equal promise of appreciation in value, which would yield considerably greater revenue, lacking only ready convertibility. Thus he would satisfy his real requirements and obtain a greater income, at the expense only of a quality which he does not need.

The quality of convertibility divides investors into classes more sharply than any other quality. For some investors convertibility is a matter of small importance; for others it is the paramount consideration. Generally speaking, the private investor does not need to place much emphasis upon the quality of convertibility, at least for the larger part of his estate. On the other hand, for a business surplus, ready convertibility is an absolute necessity, and in order to secure it, something in the way of income must usually be sacrificed.[17]

Again, some investors are so situated that they can insist strongly upon promise of appreciation in value, while others can not afford to do so. Rich men whose income is in excess of their wants, can afford to forego something in the way of yearly return for the sake of a strong prospect of appreciation in value. Such men naturally buy bank and trust-company stocks, whose general characteristic is a small return upon the money invested, but a strong likelihood of appreciation in value. This is owing to the general practise of well-regulated banks to distribute only about half their earnings in dividends and to credit the rest to surplus, thus insuring a steady rise in the book value of the stock. Rich men, again, can afford to take chances with the quality of safety, for the sake of greater income, in a way which poor men should never do. In practise, however, if the writer's observation can be depended upon, it is usually the poor men who take the chances—and lose their money.

In the quality of safety, there is a marked difference between safety of principal and safety of interest. With some investments the principal is much safer than the interest, and[18] vice versa. This can best be illustrated by examples. The bonds of terminal companies, which are guaranteed as to interest, under the terms of a lease, by the railroads which use the terminal, are usually far safer as to interest than as to principal. While the lease lasts, the interest is probably perfectly secure, but when the lease expires and the bonds mature, the railroads may see fit to abandon the terminal and build one elsewhere, if the city has grown in another direction, and the terminal may cease to have any value except as real estate. On the other hand, a new railroad, built in a thinly settled but rapidly growing part of the country, may have difficulty in bad years in meeting its interest charges, and may even go into temporary default, but if the bonds are issued at a low rate per mile and the management of the road is honest and capable, the safety of the principal can scarcely be questioned.

Stability of market price is frequently a consideration of great importance. This quality should never be confused with the quality of safety. Safety means the assurance that the maker of the obligation will pay principal and[19] interest when due; stability of market price means that the investment shall not shrink in quoted value. These are very different things, tho frequently identified in people's minds. An investment may possess assured safety of principal and interest and yet suffer a violent decline in quoted price, owing to a change in general business and financial conditions. In times of continued business prosperity very high rates are demanded for the use of money, because the liquid capital of the country, to a large extent, has been converted into fixt forms, in the development of new mines, the building of new factories and railroads, and in the improvement and extension of existing properties. These high rates have the effect of reducing the price level of investment securities because people having such securities are apt to sell them in order to lend the money so released, thus maintaining the parity between the yields upon free and invested capital.

As an illustration of this tendency, within the last few years New York City 3½-per-cent bonds have declined from 110 to 90, without the slightest suspicion of their safety. Their inherent qualities have changed in no respect[20] except that their prospect of appreciation in quoted price has become decidedly brighter. Their fall in price has been due to two factors, one general and the other special—first, the absorption of liquid capital and consequent rise in interest rates, occasioned by the unprecedented business activity of the country, and, second, to the unfavorable technical position of the bonds, due to an increased supply in the face of a decreased demand.

It will be seen that the question of maintaining the integrity of the money invested is a matter of great importance and deserves to rank as a fifth factor in determining the selection of investments, altho it is not an inherent quality of each investment, but is dependent for its effect upon general conditions. If it is essential to the investor that his security should not shrink in quoted price, his best investment is a real-estate mortgage, which is not quoted and consequently does not fluctate. For the investment of a business surplus, however, where a high degree of convertibility is required, real-estate mortgages will not answer, and the best way to guard against shrinkage is to purchase a short-term security, whose[21] approach to maturity will maintain the price close to par.

The foregoing comments, in a brief and imperfect way, serve to indicate the main points which should be considered in the selection of securities for investment. The considerations advanced will be amplified as occasion demands in the following pages. For the present, the main lesson which it is sought to draw is the necessity that a man should have a thorough understanding of his real requirements before he attempts to make investments. For a private investor to go to a banker and ask him to suggest a security to him without telling him the exact nature of his wants is about as foolish as it would be for a patient to go to a physician and ask him to give him some medicine without telling him the symptoms of the trouble which he wished cured. In neither case can the adviser act intelligently unless he knows what end he is seeking to accomplish.

It is plainly impossible within the limits of a small volume to consider the needs of all classes of investors. Special attention will be paid to the requirements of a business surplus and of the private investor. In the field of private[22] investment two distinct classes can be recognized—those who are dependent upon income from investments and those who are not. Both classes will be considered. For the investment of a business surplus, safety, convertibility, and stability of price are the qualities to be emphasized; for investors dependent upon income, safety and a high return; and for those not dependent upon income, a high return and prospect of appreciation in value. In the following chapters railroad bonds, real-estate mortgages, industrial, public-utility, and municipal bonds and stocks will be considered in turn; their advantages and disadvantages will be analyzed in accordance with the determining qualities above enumerated, and their adaptability to the requirements of a business surplus and of private investment will be discust.



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