Common Stocks As Long Term Investments

Edgar Lawrence Smith

• Publisher: Golden Springs Publishing
• Year: 2015
• eBook ISBN: 9781786256294
• Topic: Economia
• Subtopic: Investimenti e titoli

Edgar Lawrence Smith, (1882-1971) was an economist, investment manager and author of the influential book "Common Stocks as Long Term Investments", which promoted the then-surprising idea that stocks excel bonds in long-term yield.. He worked in banking and other financial endeavors in the years after college, then signed on in 1922 as an adviser to the brokerage firm Low, Dixon & Company. While there, he later recounted in his Harvard class's 50th reunion yearbook, "I tried to write a pamphlet on why bonds were the best form of long term investment. But supporting evidence for this thesis could not be found." This discovery led to the 1924 publication of "Common Stocks as Long Term Investments." The book was widely reviewed and praised, and became a key intellectual support for the 1920s stock market boom. Its success enabled Smith to launch a mutual fund firm, "Investment Managers Company." It also garnered him an invitation from the economist John Maynard Keynes, who had favorably reviewed the book in "The Nation", to join the Royal Economic Society. The Wall Street Crash of 1929 brought a turn in Smith's fortunes.—Print Ed.

CHAPTER I—BONDS AND THE DOLLAR

WHEN the topic of conservative investment is under discussion, high grade bonds hold an unassailable position in the minds of most people, and the discussion usually resolves itself into weighing the relative merits of different issues of such bonds or how far it is safe to stray away from the most highly secured bonds in an effort to obtain a higher income return. Those who venture to suggest preferred stocks sometimes feel that they have gone as far as conservative opinion will support them. Common stocks are ordinarily left out of the discussion altogether.

Common Stocks are, in general, regarded as a medium for Speculation—not for Long Term Investment.

Bonds, on the other hand, are generally held to be the best medium for Long Term Investment—free from the hazards of Speculation.

Is this view sound? What are the facts?

A venerable tradition of conservatism has attached to first mortgages whether upon real estate or upon corporate property as the basis for an issue of bonds. This tradition was supported by experience up to 1897, when the purchasing power of the dollar reached its highest point. But the experience of investors in real estate mortgages and in mortgage bonds, with respect to a depreciating currency since 1897 and with respect to a rising interest rate since 1902, raises grave doubt as to the justification of this tradition with particular reference to personal as opposed to institutional investments.

Because common stocks are regarded as speculative, they are frequently omitted entirely from the lists of a great many investors. Is this omission based on a thorough study of the relative merits of bonds and stocks or is it based in part on prejudice? It is true that stocks fluctuate in price in response to many factors, some related to the industry they represent, some to general business conditions, some to the temporary market position of avowed speculators.

Is it not possible that the association of speculation with common stocks has somewhat influenced a majority of investors against them, and has exaggerated in their minds the danger of possible loss to those who buy them for long term investment?

Is it not possible that the definite weakness of otherwise perfectly safe bonds is overlooked—namely, that they cannot in any way participate in the growth and increasing activity of the country—that they are defenceless against a depreciating currency?

The fundamental difference between stocks and bonds is that—

Stocks represent ownership of property and processes; their value and income return fluctuating with the earning power of the property.

Bonds represent a promise to pay a certain number of dollars at a future date with a fixed rate of interest each year during the life of the loan.

The value of stocks, expressed in dollars, increases with the growth and prosperity of the country and of the industry represented. It also increases in proportion as dollars themselves decrease in purchasing power as expressed in a higher cost of living. Stocks are subject to temporary hazards of hard times, and may be destroyed in value by a radical change in the arts or by poor management.

The value of high grade bonds, expressed in dollars, changes far less because their value represents dollars and nothing but dollars.

The only commodity whose price in terms of dollars does not vary at all (except under most extraordinary conditions) is gold. That is because a dollar is, by definition, a certain weight of gold of a certain fineness. The price is legally fixed. The price at which bonds sell participates with gold in this legal, but to a certain degree fictitious, stabilization.

Such fluctuations as do occur in the dollar price of bonds result from—

1. Changes in the credit position of the issuing company—the prospects of its being able to pay interest and principal when due. This is largely influenced by its earning power in excess of current interest requirements.

2. Changes in the current demand and supply of liquid capital, in relation to the length of the unexpired term and the fixed interest rate of the bonds in question.{1}

As the question of including well selected common stocks in a long term investment fund, as against confining such a fund to bonds alone, is to some extent related to the nature of the dollar, some space will be devoted to a discussion of the dollar as a measure of real value. If we seem to treat it with a certain amount of disrespect, it is only to emphasize its weakness. The dollar stands to-day as the soundest currency unit in the world, for which those who have shared in defending it against the assaults of free silver and have fortified it through the creation of the Federal Reserve Banking System deserve our gratitude. Nevertheless, it shares, with all currencies yet devised, certain definite weaknesses. It is vulnerable to unwise governmental action, and those governmental authorities whose duty it is to maintain its value are ever on the defensive. Labor seeking higher wages is, in part, attacking the value of the dollar; farmers seeking higher prices for their products and eager to pay off the mortgage on the farm are, in part, assailing the value of the dollar; tariff protected industries join in reducing the purchasing power of the dollar. All debtors favor a depreciating dollar. An increasing value to the dollar is accompanied by distress on the part of large portions of the community, a lessening of its value is accompanied by an appearance of great prosperity and a general feeling of well-being. As a result, there is a constant struggle between those who would maintain the full purchasing power of the dollar and those whose interests lie in the other direction. As the latter are in the majority, and as they become increasingly well organized, there is no certainty that the dollar will recover the ground it has steadily lost since 1897, or that it will not again suffer such radical depreciation as occurred between 1915 and 1920.

In addition to its tendency to lose ground from the point of view of the actual commodities or services it will buy, we find the income dollar losing the power to maintain its recipient in the same relative social position due to the increasing number of commodities required to satisfy the same social standards.

The ordinary commodity index of the purchasing power of the dollar does not include this factor, which is represented, let us say, by better heating, lighting and plumbing, by automobiles instead of buggies, by telephones, radio and so on down the list of the things we have to-day that were unknown to our fathers, offset in part, only, by lower manufacturing costs due to improved machinery and quantity production. All these things call for more dollars of income. At the same time they add a corresponding value to those industries which supply them. In other words they all contribute to a more rapid circulation of money which is reflected in the dollar value of common stocks representing industries that participate in this circulation.

Among the current factors which tend to retard the recovery of value by the dollar are state and municipal expenditures. The following editorial from the New York World of October 8, 1923, illuminates this point:

“The Budget in its current issue publishes an analysis of Federal census returns from fourteen typical States of the Union showing the costs of their Governments in 1922. These costs are exclusive of the costs of county, city and town Governments and amount to $438,690,000, or $13.21 per capita. Applied to the whole population of the United States, the figures indicate a State Government cost of $1,443,161,272 for 1922, which is more than double the cost for as recent a year as 1919 and four times the cost for 1913.”

Building State roads is found to figure largely in this startling expansion of State expenditure. It is the newest thing in State activity and comparable with the railroad-building furor of seventy years ago. States are bonding themselves right and left for these improved highways and the interest cost is yet to figure in the fast-mounting construction and maintenance costs of the taxpayers. Cities, towns and counties are chipping in additional sums. The Federal Government is there as well with an actual and prospective expenditure fairly staggering. It is the day of the automobile, whose private extravagances are forcing a public extravagance in due proportion.

States as sovereign bodies have been noticeable in recent years chiefly for their shrinking place in the American scheme of government. But as free and independent debt-contractors and road-builders and tax-burdeners they are glowing with a new life.

THE DOLLAR

If it were conceivable that the length of a yard stick were influenced by changing conditions, growing longer during certain periods and shorter during other periods; if at the same time all other measures used to reduce the dimension of length to numerals adapted to computation were equally changeable; if, let us say, the meter fluctuated; if, let us further suppose, the influences which worked upon the current length of the yard stick differed from those which worked upon the current length of the meter so that the yard might be gaining in length while the meter was becoming shorter; if all these things were true, and there were no fixed standard of measurement or word to describe length that meant the same thing in one year as it did in another, it would certainly prove a great embarrassment to the engineering profession, to say nothing of the rest of us. It is hard for us to conceive how any business could be transacted, how any buildings could be erected, how any clothes could be made, and yet undoubtedly they would be.

OTHER MEASURES ARE FIXED

Fortunately this is not the case. The measure of length is a fixed thing, and from this fact, the measurement of cubical content becomes a fixed thing, derived mathematically from the measure of the length of three dimensions. The establishment of weights as fixed units becomes possible through the fact that cubic contents may be accurately measured in materials which do not vary in specific gravity. Thus even weight units are fixed only because they can be derived mathematically from the fixed unit of measure—length.

Measures of value, on the contrary, are not fixed. The Dollar to-day is a different measure from the Dollar of yesterday. The Mark of to-day—well, let us say of an hour ago—is a different measure of value from the Mark of the moment. And so it is with the Pound Sterling, the Franc, the Ruble, the Yen, and to add to the confusion, the only simple way we can describe the varying value of one fluctuating measure of value is in terms of other fluctuating measures of value. Logically this cannot be done. But it is done. It is done solely because something has to be done, and no more satisfactory method has been devised for defining value. The best that can be said is that some measures of value are more stable than others. During one period of years it may be the Pound Sterling with which all other measures are compared; during another it may be the Dollar. But over any considerable period of time, it can be safely stated, the actual measure of true wealth or true value will change. It has never remained the same and the chances are that unless some entirely new method is found for measuring value, it never will remain the same.

IMPORTANT TO INVESTORS

This fact is of greater moment to individual investors, whose investments are made with the happiness and comfort of their children in mind, than is usually supposed. “Safety of principal,” yes—that is the first essential. But what is “principal”—is it merely the obligation of some sound organization to repay a certain number of fluctuating measures of value at a future date? What if, at the date of repayment, the measure has shrunk to one-half of its present size? Has the principal been safeguarded? To show that this is not a thought that should be dismissed as pure theory, it seems worthwhile to refer to an editorial which appeared in the New York World, July 12, 1923, apropos “Dollar Wheat.”

“Time was when ‘dollar wheat’ was the familiar slogan and maximum demand of the American farmer. But that was when the dollar would buy something over and above the cost of producing a bushel of wheat. Now the dollar will buy little more than half as much, and for a bushel of wheat falls short of the cost of production.”

There is no doubt that the wheat farmer’s dollar had shrunk. If it had been a yard stick in the days when dollar wheat sounded like a high price, it would have been only a trifle over 18 inches long at the time this editorial appeared.

If it is true, then, that the dollar may shrink in value, and that an investment in bonds is defenceless against such shrinkage, how does it come about that the most conservative of our great financial institutions invest so great a proportion of their total assets in bonds repayable in dollars?

There is a vast difference between the investment needs and purposes of such institutions from those of the individual investor, or the family estate. Take an insurance company for example. It is by the nature of its business perfectly safeguarded against any possible loss through the depreciation of the dollar. It deals in nothing but dollars. Its contracts call for the payment of future dollars. It therefore requires to know only that it will receive from its investments more future dollars than it will have to pay out. The purchasing power of those future dollars is of no concern to it. If dollars have shrunk in value, the beneficiary under its policies absorbs the shrinkage, the company does not.

BANKS AND INSURANCE COMPANIES

The same is true of savings banks, commercial banks and trust companies. Their investments are all made to protect dollar obligations. Their sole concern is so to conduct their affairs that they will always have available more dollars than they will be called upon, ...

Table of contents

• Title page
• TABLE OF CONTENTS
• INTRODUCTION
• ACKNOWLEDGEMENTS
• CHAPTER I-BONDS AND THE DOLLAR
• CHAPTER II-BONDS AND COMMON STOCKS
• CHAPTER III-COMPARISON BETWEEN COMMON STOCKS AND BONDS, 1901-1922
• CHAPTER IV-COMPARISON BETWEEN COMMON STOCKS AND BONDS, 1866-1899
• CHAPTER V-FINANCIAL CONDITIONS, 1866-1885
• CHAPTER VI-ADDITIONAL COMPARISONS BETWEEN COMMON STOCKS AND BONDS
• CHAPTER VII-RAILROAD STOCKS, 1901-1922
• CHAPTER VIII-A NEW STOCK MARKET CHART, 1837-1923
• CHAPTER IX-LAW OF INCREASING COMMON STOCK VALUES AND INCOME RETURN
• CHAPTER X-TIME HAZARD IN THE PURCHASE OF COMMON STOCKS
• CHAPTER XI-A FEW GENERALITIES
• CHAPTER XII-FLUCTUATIONS IN BOND VALUES
• CHAPTER XIII-SUPPLEMENTARY TESTS OF COMMON STOCKS
• CHAPTER XIV-INVESTMENT MANAGEMENT
• APPENDIX I-RETURN FROM BONDS, 1866-1885
• APPENDIX II-RETURN FROM BONDS, 1866-1885 (SECOND GROUP)
• APPENDIX III-RETURN FROM BONDS, 1880-1899