What Should One Look for in Appraising an Investment?
A . W BLUEJuly151927
What Should One Look for in Appraising an Investment?
BUSINESS & INVESTMENTS
11 undr.*ls ot ihousands of dollars arc lost annually in Canada through careless investment. Fraudulent aid worthless securities are being constantly poured on to the market to entrap the unwary. A general observance of this simple maxim will assist in the reduction and elimination of this economic waste—
"BEFORE YOU IN VEST—CONSULT YOUR BANKER.”
A . W BLUE
WHEN an investor is seeking a suitable medium by which he may profitably employ some idle funds be will, if he is prudent and conservative, consult an authority on investment matters before making a commitment. He will be told that this or that security is a safe investment; that another group is speculative and that still another is highly speculative. He hears much of assets, earning power, interest and dividends, yields, working capital and other technical terms, which may mean much or little to him, according to his knowledge of investment matters.
If he is a member of the order of small or ‘average’ investors, the chances are there is much in the inforn ation received that is perplexing and highly confusing He takes the expert’s opinion at its face value. He is in no position to sift the matter for himself, and if he continues to display the conservatism and forethought which brought him to the expert in the first instance, he will disregard those securities categoried as speculative, foregoing the uncertainty of rewards in the dim future, for the certainties of the ‘sure’ thing of the present. The wisely selected investment issue will ensure safety of principal, as well as a substantial and fixed return on his investment. But, in his negotiations to date he has been compelled to rely entirely for guidance upon the so-called authority. He is incapable of passing judgment of his own accord, and therefore he is denied that sense of perfect satisfaction that comes with the absolute knowledge that one has chosen wisely and well.
The ‘Average’ Investor
r_P HE average investor—and it is to this individual that this articleis addressed—may have a rudimentary, or, at best a very general knowledge of investment science, but he is possessed of a keen desire for money making. He wants to become rich, and he is prepared to take any short cut that promises a quick approach to the avenue of wealth. Ignorance of investment matters in his case is a very dangerous thing. He becomes the prey of fraudulent schemers who appeal to his credulity and avarice. He has not the training or experience to enable him to appraise the worth of the proffered security.
The investor cannot be reminded too often of the elaborate investment chain that has been forged from coast to coast, with a link in the form of the branch bank manager ensconced in every town, village and hamlet of the Dominion. There is no need to invest blindly and in ignorance. The bank manager is the willing servant of the public in investment matters.
But the average investor may not be satisfied to rely solely upon the judgment of others. He is ambitious, and wants to be in a position to appraise an investment proposition to his own satisfaction. And here he is to be commended, for a
broader knowledge of the fundamentals of investment would correct faulty investment habits, and reduce or eliminate entirely the huge annual economic wastage arising out of purchase of worthless securities.
What makes a Good Security?
7"HAT factors determine the value of W a security? What should the investor look for; what information should he have on which to base his judgment? How may this information be secured and, once in the possession of the investor, what is its significance, and how may it be applied to the security in question? These suggestions open up a broad field for investigation, reaching down to the foundation rock of investment science. It will be possible here to touch upon a few high spots only, but it is hoped that a little light may be thrown upon this highly important subject.
In the first place, the investor should be familiar with the ranking of the several grades of securities. It may be here pointed out that the larger enterprises of the country are financed, not as a rule by the capital of a small group of individuals who direct operations, but generally through small advances from a great many people throughout the country, who are in no sense associated with the company in any capacity, except through a community of interest. These numerous individuals, mainly investors, advance their money and in return receive certificates for bonds or stock. They receive interest periodically on their ‘Investment’ if they hold bonds and dividends if they purchase stock or shares. Investment machinery has been set up to facilitate financing of this character, but the process in essence is as outlined.
A bond is a promise to pay. The company issues its bond in return for a certain sum of money which has been loaned to it. It agrees to return this money on a definite date, and in the meantime will pay the investor (the individual who loaned the money) interest for the use of his funds. The bondholder has no voice in the company, but retains a strong personal interest in its affairs, as improved earnings not only ensure regular interest payments, but enable the company to set up a reserve for the retirement of the debt at maturity, and, furthermore, increase the security back of the bond, thus adding to its potential value. The bond is a first charge, a first mortgage upon the company. Bond interest has first call on earnings after operating charges. The assets which form the security for the bond comprise real estate, plant and equipment, inventory, working capital, and earning power. The bondholder is a dormant, but still a potential force in the company’s affairs. So long as all goes well he is an obscure figure, but let mischance overtake the firm, and it is no longer possible to continue payments of bond interest,
then the bondholder becomes a dominating factor. He may, in the event of default of interest payments, and if he considers the outlook so gloomy as to warrant drastic action in order that he protect his interest in the concern, press for foreclosure proceedings, which involves the winding up of the company, its sale, and the distribution of the cash residue to bond holders to the full extent of their equity in the company. The balance, if any, may be appropriated for the discharge of obligations to the junior creditors and security holders.
Preferred and Common Stocks
CTOCKS are divided into two major C classes, preferred and common. The stockholder is a partner in the company—one of a great many it is true, but a partner nevertheless—with a very active interest in the company and its operations. He is privileged to raise his voice at the annual meeting or at such special general meetings as may be called. The preferred shares have first claim on assets in the event of liquidation, after the bondholders have been satisfied. The preferred also has first call for dividends after bond interest, and dividends are usually fixed at a certain definite rate. The preferred stockholder, receiving dividends on this fixed basis, has no prospect, except in certain defined instances, of receiving anything more. He is potentially protected against loss of dividend by a provision that in the event of earnings declining to a point where it is impossible to pay dividends, these unpaid dividends accumulate and must be discharged when the earnings are restored to a basis warranting such action.
The common shareholder has no such protection. He receives dividends only after the bonds and preferred stock have been provided for. The junior security holder is subject to the moods of business and of directors. His stock usually possesses voting power, and where there is flagrant miscarriage of justice on his behalf, he may rise up in his might and wrath and upset the powers that be. In actual practice this is a rare occurrence, for, as a rule, directors are fair minded, upright members of society, bent on doing the best for all so far as it is within their power.
It is obvious, therefore, that bonds and preferred stock rank at the head of the security list. There are many gradations within the respective ranks, it is true, but as a general rule the element of risk in the two senior groups is reduced to the point where they assume investment status. The common stock subject to the fluxing whims of fickle fortune, may more properly be classed as a speculative security, especially when a member of the non-dividend paying class, and it is only under special circumstances that this issue vaults into the investment column.
What Constitutes Security?
VW"HAT constitutes the security
back of an investment issue, and what determines market valuation? The investor interested in the issues of any particular company should secure a copy of the balance sheet, in which is presented a condensed, yet comprehensive, picture of its financial structure. The balance sheet is divided into two columns, left and right, assets and liabilities. The assets embrace such items as plant, equipment, inventories, goodwill, current assets, the latter including cash, accounts receivable, inventories, etc. The company’s capitalization is presented in the ‘liabilities’ column, together with accounts payable, bank loans, 'if any, and reserves. The ratio of tangible assets, plus reserves, to the ‘funded debt’—that is the bonded indebtedness of the company—affords a fairly accurate index of the scale of protection back of the bonds
outstanding. If the ratio is three or four to one, the bondholder may rest assured that he is will protected, no matter what may happen. The preferred stockholder has a legitimate claim upon the balance of assets, after the face of the funded debt is deducted, and this residue constitutes the ‘book value’.of the stock.
But earning power is an asset of primary importance. It is earning which in the final analysis, provides the basis and incentive for speculative investment. The securities of a company which earns little beyond its operating expenses, possess little attraction as investments. A company whose earnings are now small, but are likely to increase very substantially over a term of years, offers more inducement to the investor, but the securities of a company, which has a record of years of successful experience, earning all requirements with a substantial margin to spare, stand at the head of the investment list.
Earnings establish a factor of fundamental importance to the holder of preferred or common stocks. If profits are insufficient to cover dividends, the customary disbursements to shareholders may be cut off, a case of revenue deferred for the preferred shareholder, but the common has no such comfort. Where a preferred dividend is earned two or three times over, and this performance repeated over a number of years, and the industry is engaged in a highly essential business, the investor has little cause for worry, and his security rides on the crest of the market. The common shares are particularly sensitive to earnings, for in many cases earnings constitute the only asset back of the junior issue. Earnings per share of common are computed after all charges have been met, and the market takes due cognizance of earnings in its appraisal of a security’s value. It is a commonly quoted rule that a share of common stock is entitled to sell at ten times its earnings. If earnings are equivalent to $4 per share, the stock should sell, at approximately 40; if $10 per share, the stock may sell at 100. The market does not follow such an arbitrary course, however, and the rule has very definite limitations.
Character of Industry
rT'HE investor should study assets and earning power, two vital factors contributing to the value of the security. He should give consideration to the character of the industry, and the conditions currently obtaining or likely to rule in the succeeding months and years. This is a point for special consideration in a new industry, one whose securities lack the seasoning that only comes with years of operation and experience. Is the product one that will command a ready market? Will it be influenced by changes in public appetites and styles? Is the concern well managed? This is a point of primary importance, for success or failure are largely predestined by the character of the executives at the head of the organization. Is the industry likely to attract competition or may it continue to hold a virtual monopoly of its field? What is the nature of raw product requirements? Are supplies abundant and accessible, and how are production costs likely to run? These and other points are open for consideration. This may seem a large order, but careful attention to the major details will amply repay the investor.
Of course the individual who confines his operation to government or municipal obligations, to the so-called gilt-edged bonds, may forego these considerations. Government bonds are the highest form of security available, and may be purchased with impunity. In all other cases where the element of risk cannot be wholly suppressed the investor should not rest content with his own judgment. The most skilled sometimes err, and why
not he? The well considered opinion of a banker or others well versed in financial affairs, will create an added safeguard, and curtail the investment hazard.
(Other points in a series of articles on what an Investor should know, will be dealt with by Mr. Blue in succeeding issues.--The Editor.)
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