r How to Analyze Industrial Securities How to Analyze Industrial Securities By CLINTON COLLVER, M. C. S. Manager Investment Department New York Stock Exchange firm, Author "Industrial Securities" pre- pared for the Investment Bankers' Association of America THIRD EDITION Published by MOODY'S INVESTORS SERVICE JOHN MOODY, President 35 Nassau Street, New York City 1921 Copyright, 1921, by MOODY'S INVESTORS SERVICE NEW YORK All Right* Reserred PREFACE Since the second edition the industrial boom was dis- placed by the trying business drouth of 1920. Those cor- porations which conserved cash will come through. How- ever, some companies which declared earnings out in divi- dends are in better shape than those which converted cash into idle plant extensions. Such foolish action exchanged the very choicest of assets into virtual liabilities ! Part of our industries had been keyed up to supplying the demands of super-prosperity here, plus unusually large foreign requirements. Yet many industrial mana- gers planned inventories and capacity as though demand would be multiplied indefinitely. By now, however, calm vision has displaced mirage. "Book value" measurement has been displaced by the yard stick of earnings. The inherent weakness of "net current assets," composed all or mostly of goods, has received practical demonstration. Several warnings given in this and previous editions look mild enough in the light of recent developments. Yet in spite of troubles contemporary, there is no doubt but that well financed and managed industrials will con- tinue to deserve and receive high investment regard. This book has been written for those who have taken care of the pennies, but who have found their dollars under constant siege by deceptive "opportunity." Taking the positive angle, this book is particularly intended to be helpful in pointing the way to profit- able investment and speculation. Analysis is profit- able because so many will not avail themselves of 524002 it, because so many are willing to labour years in accumulating funds which they take minutes to place. So in times good or bad the markets are full of anomalies, securities which are selling entirely out of line with the general run. If all investors and speculators based their commit- ments upon cool analysis, the security markets would be dull localities. However, human nature does not change. In the days of the Mississippi Bubble and today the same tendencies have prevailed. Cupidity still holds sway, but creates opportunities available to those who will determine their purchases and sales upon analysis instead of hopes. Effort has been made to bring out method of analysis by the use of concrete illustrations taken from well-known corporations, rather than by theo- retical dissertation. I have not attempted to bring all figures in this edition strictly to date. Many figures for 1919 and 1920 seem anything but indicative of the less erratic conditions which most of us now expect. Acknowledgment is gladly made for help received at New York University, and especially to Dr. A. M. Sakolski, and to Melbourne S. Moyer, C. P. A., sometime lecturers in that institution. CLINTON COLLVER 34 Pine Street, New York. Table of Content* INTRODUCTION: I. Preliminary Statement 1 II. Policy of Publicity 5 III. Industrials Compared with Railroads 9 IV. Magnitude and Varieties of Industrials 13 V. Advantages of Large Scale Enterprise 17 BUSINESS FACTORS: VI. Fluctuations in Demand 21 VII. Diversification 25 VIII. Integration Source of Supplies 31 IX. Standardization and Location 37 X. Competition 41 MANAGEMENT: XI. The Personal Equation 47 XII. Co-operation and Loyalty 55 XIII. Financial Control Alliances 57 XIV. Financial Policy 61 BALANCE SHEET DEBIT: XV. Lack of Uniformity 69 XVI. Certificates of Public Accountants 71 XVII. Complete Balance Sheet 75 XVIII. Fixed or Capital Assets 81 XIX. Permanent Investments 93 XX. Treasury Stocks and Bonds 97 XXI. Goodwill and Organization 9* XXII. Patents, Trademarks, Brands, Rights 103 XXIII. Working and Trading Assets 109 XXIV. Current Assets 115 XXV. SinkingFunds 119 XXVI. Deferred Assets 123 BALANCE SHEET CREDIT: XXVII. Bond Limitation 127 XXVIII. Preferred and Common Stocks 137 XXIX. Changing Capitalization Form 143 XXX. Current Liabilities 147 XXXI. Working Capital 153 XXXII. Reserves 157 XXXIII. Surplus 159 XXXIV. Book Value .... .161 Table of Contents continue PAGES INCOME FACTORS : XXXV. The Income Account 165 XXXVI. Consistent Form Necessary 167 XXXVII. Gross Sales 171 XXXVIII. Gross and Net Profits 175 XXXIX. Other Income 179 XL. Total or Gross Income 179 XLI. Interest 183 XLII. Profit and Loss Surplus 185 XLIII. Margin of Safety Average Profits 187 New Promotions 189 Federal Trade Commission Query , 205 Index . . 209 INTRODUCTION Preliminary Statement IN order to analyze securities of any kind it is essen- tial that complete and frequent reports of earnings and reliable figures as to financial condition be avail- able. Without light we are in the dark and darkness in the financial world is the moral breach of trust of the use of "inside information" possessed by the few and the hopeless gambling of uninformed outsiders. It is true that some industrial corporations do not report their earnings or their true financial affairs with the promptness and fidelity to truth which characterizes such companies as the Pennsylvania Railroad. Yet there are railroads whose statements have been found in gross error, and now many Pennsylvanias exist among the industrials. Investment is the placement of funds for safety of principal and surety of interest return; speculation is defined as the intelligent attempt to discount the future; gambling as the staking of money on blind chance. It is therefore clear that investment and speculation are not possible unless full and frequent reports of earnings and reliable statements of financial condition are given. If certain industrial corporation directors have not yet dis- covered that the dishonor of breach of trust is outgrown, the public can assist in the awakening and incidentally preserve its hard-earned dollars by directing its attention (i) 2 How to Analyze Industrial Securities to companies issuing more reliable and more frequent in- formation arid which are managed for the benefit of the stockholders as a whole. A new doctrine, a new standard of publicity and con- scientious responsibility has arrived and with it a more friendly attitude of the public mind toward industrial corporations. The increased demands for publicity on the part of stockholders, more nearly approaching the close responsibility demanded by English stockholders, the de- mands of Government officials for more uniform reports and the well-defined increase in moral responsibility of directors of industrial corporations results in information admitting intelligent analysis of industrial corporation securities. Also, through the years have come the results of ex- perience of good and bad experience ; better methods in promotion and capitalization. Mistakes and weaknesses of the older corporations have been either largely out- grown or pruned in drastic reorganization. Latter day reorganizations, forced by weak methods or gross errors in management, have been accomplished to meet the conditions of poor times, so that the approach of pros- perity brings almost certain and large profits. In the light of innumerable previous reorganizations errors and weaknesses have been eliminated which in former years would have existed even after reorganization. It has been said that a brick could not be thrown away in the Carnegie Steel Company's plants without its principal owner being forthwith apprised of the fact through its accounting department. Mr. Carnegie was Preliminary Statement one of the first business men in control of large industry to realize the importance of properly kept books of ac- count and to use them in formulating plans of action. To the advance in accounting work a generous part of the advance in corporation management must be cred- ited. Officials now know facts that their predecessors blindly guessed at; they have day by day related facts, figures and graphs essential to the conduct of modern busi- ness that managers of only yesterday knew nothing about. Accurate knowledge of costs of production is only one of the results of modern accounting methods that were not available when large industrial enterprise originated. Managers generally now take a long range view of corporation finance. Strength of treasury, upkeep of property, improvements of methods and expansion of activities and of markets appear more important than exhibitions of inflated income accounts and balance sheets, brightly colored in order to declare unearned dividends and thereby to cultivate artificially the growth of security prices. More intelligent and advanced methods in competition prevail at the present time than formerly. Instead of relentless competition, usually destructive to all con- cerned, a spirit of helpful co-operation now generally exists among industrial enterprises of any size. In the suits of the Government against the United States Steel Corporation and the International Harvester Company no competitor could be found who was not their friend. Associations of active competitors have eliminated in- numerable trade abuses and testify to the new doctrine 4 How to Analyze Industrial Securities that in the unlimited trade possibilities of the world the prosperity of one depends upon the prosperity of all. In the Railway Business Association, for example, are over four thousand firms and corporations manufacturing rail- way supplies and equipment. The Wool Association ties together great and small factors in the wool trade. Almost immediately upon its birth the association erad- icated flagrant trade practices which had persisted for generations. One of the most striking economic developments re- sulting from the world war has been the improved position of labor and the tendency of capital and labor to regard each other as partners. It has been well put recently by a well-known capitalist that "Labor and Capi- tal should both have a fair wage. The surplus should be divided." It is not surprising that there is less opposition to big business to-day than at any time since the possible evils of trust operation were first recognized. II Policy of Publicity THE contention against publicity most frequently offered by corporations is that it would injure them to publish reports which would inform their competitors of the progress of their business and profits. But if all corporations should agree to issue such reports any drawback from this source would cease. The ad- vantage to be gained from the knowledge would be gen- eral. At its best, this policy of concealment is a narrow one, abandoned by progressive corporations in every line, and it is doubtful if many of those who put the argu- ment forward believe in it. That policies of publicity adopted by various large cor- porations are varied is not surprising, since any policy of adequate publicity is not yet universal; the old and obsolescent "information for insiders only" still prevails in certain corporations. However, many important cor- porations make sincere attempts at publicity. Representa- tive examples are as follows: Sears, Roebuck & Company and the F. W. Woolworth Company give their total monthly sales each month. This is good, as far as the information goes; it leaves much to be imagined as to net profits. The American Hide & Leather Company gives net 6 How to Analyze Industrial Securities earnings each quarter in cumulative form, i. e., three, six, nine, twelve months, together with a statement show- ing current assets. The American Steel Foundries Company gives quar- terly reports. The Lackawanna Steel Company gives quarterly in- come each quarter, also earnings in cumulative form and record of unfilled tonnage orders. The General Chemical and Corn Products companies give earning statements each quarter in cumulative form. The United States Steel Corporation's quarterly re- ports show earnings by months. Since 1911 the gross sales to customers have been separated from sales be- tween subsidiary companies. On the tenth of each month a report of unfilled orders on hand is issued, which, taken in connection with the activity of plants and the prices of steel and iron, give a reasonable line on current earn- ings monthly. The United States Rubber Company gives semi-an- nual reports of earnings. Quarterly reports were given out at one time but were abandoned, the company assert- ing that rubber earnings were so variable because of seasonal influences that quarterly reports were mislead- ing. Policy of Publicity All companies whose stocks are now listed on the New York Stock Exchange must publish at least once a year and submit to stockholders at least fifteen days in ad- vance of the annual meeting a statement of their phys- ical and financial condition, consisting of a consolidated income account concerning the previous fiscal year and a consolidated balance sheet showing assets and liabilities at the end of the year. The exchange authorities are making efforts to insure publication of these reports in- side of the fifteen days' limit, also to secure the volun- tary publication of quarterly or semi-annual reports in addition to the compulsory annual reports. It is now widely recognized that quarterly if not monthly reports, at least of earnings, can be prepared by corporations in most lines of business, and necessary for the protection of the public. Certainly the management of few companies remains in the dark to developments until the annual statements are made up. Why should the management (and directorate) have the enormous ad- vantage of information months fresher than that given to the ordinary partner-stockholder? Ill Industrials Compared With Railroads METHODS of analysis of railway securities have been well publicized. In the search for methods of analyzing and judging industrial securities the essential differences between railroad and industrial se- curities are worth considering. 1. As to stability of earnings: The advantage is surely on the side of the railroads, although certain chain store corporations and packing companies exhibit earnings of a consistency to make the best railroad organization en- vious. The margin of earnings over interest charges is usually much smaller, especially in times of prosperity, for the railroads which cannot raise rates as the demand for their service increases. Industrials not only enjoy better busi- ness in prosperity but greater business at greater margins of profit. In depression, railroads cannot store their ser- vice as can industrials their products, nor can they dump their service abroad as can the industrials their output. In prosperous times railroads have to spend more for materials, wages, etc., and net earnings may actually de- crease as business becomes too great to handle with econ- omy. In times of depression, materials and wages are lower in cost. In but few railroad systems can such ex- penditures be cut to offset the decrease in traffic. Yet (9) 10 How to Analyze Industrial Securities depression in rail earnings does not as a rule compare in depth with the depression experienced in specific in- dustrial corporations. 2. Elasticity. Industrial corporations can more easily increase the capacity of their plants or buy other plants to supplement their output. The railroad is fixed. In- crease in capacity beyond the normal is most difficult. 3. Possible failure in demand for products of indus- trial corporations. The services of railroads are always necessary. A bankrupt railroad is almost never torn up. It is reorganized and operation does not cease. The country is dotted with empty industrial plants whose products are no longer marketable. 4. Lack of standardization of activities and methods. Railroad operation is a science. Methods are practically identical from one end of the country to the other, so that employes and officials are almost interchangeable. In- dustrial operations are as many as the variations of all industry variations almost infinite in number, from building of battleships to producing a moving picture film. Even so, the advantage of accounting and cost keeping, methods of sales and of advertising generally, are bringing the principles of operation of the various classes of industrial corporations into closer relationship. 5. Large possibility of expansion of industrial earnings through diversification of products and expansion of mar- kets. Railroad business is more limited to the shipments of agricultural products or industries in the territory adjacent to it. New and profitable traffic arrangements can be made, but usually the field for such action is lim- Industrials Compared With Railroads 11 ited. The possibilities of expansion of industrial organi- zation are almost without limit. 6. Difference in business and financial structure and financial method. Fixed property such as rail and right of way, equipment, stations, etc., usually form from 95 per cent, up of railroad assets. Business being more stable and dependable, railroads finance themselves more generally with borrowed funds and, since their business is practically on a cash basis, need little actual bank bal- ance. From 50 per cent, upward of the property of in- dustrial corporations is, or should be, in trading and current assets as a rule. Industrials usually have the more simple corporate organization. Many railroads control subsidiaries through lease or guarantees, condi- tions not usual among industrials. Securities of rail- roads are issued in divers forms from debentures to terminal mortgages. Industrial capitalization is usually very simple. IV Magnitude and Varieties of Industrials CENSUS figures show an increase in the value of manufactured products from $5,369,579,000 in 1879 to $24,246,434,724 for 1914, with an advance . in capital invested from $2,790,273,000 to $22,790,979,- 937. This growth naturally reflects in increased interest in industrial securities. The amount of business done by the largest industrials compares favorably with the receipts of the greatest railroad systems. The census statement below, the last available, shows statistics for manufacturing, excluding building trades and hand trades, as compared with figures for 1909. FINAL FIGURES Number Establishments Number Persons En- gaged, Average Dur- ing Year 1914 275,791 8 263 153 1909 268,491 7 678 578 % In- crease 2.7 7 6 Primary Horsep'r Used Capital Owned and Bor- rowed . 22,547,574 $22 790 979 937 18,675,376 $18 428 269 706 20.7 23 7 Salaries 1287916951 938 574 967 37 2 Wages 4,078 332 433 3 427 037 884 19 Services (total) 5 366 249 384 4 365 612 851 22 9 Materials 14,368 088 831 12 142 790 878 18 3 Value of Products Value added by Manu- facturing value of products less cost of Material .. 24,246,434,724 9.878.345.893 20,672,051,870 8.529.260.992 17.3 15.8 (13) 14 How to Analyze Industrial Securities As 1909 was a year of general prosperity and 1914 one of unusual depression, the later figures do not show the marked increase that more normal years would have indicated. The kind of industrial corporations may be roughly given as follows : Manufacturing. (a) Iron and steel and finished products, such as au- tomobiles, farming machinery, pumps, elevators, radia- tors, boats, ships, tin and detinning processes, bridges, factory and office machinery, household appliances. (b) Electrical apparatus. (c) Railway equipment manufacture. (d) Rubber tires, shoes, clothing, hose. (e) Smelting and refining, cement, brick. (f) Agricultural and miscellaneous products, flour, brewery and distillery products, meat, biscuit, sugar, fruit, cotton oil, tobacco, paper, match, shoes, leather, gum, drugs, chemicals, fertilizers, moving pictures, phonographs, powder and ammunition. (g) Publishing and educational. Distributing and trading: (a) Department stores, cigar stores, 5 and 10-cent stores, mail order houses, profit sharing. (b) Cotton and woolen goods. Clothing. Construction. It will be noticed that mining companies are not in- cluded, because the principles of mining are entirely at variance with the principles of other business and Magnitude and Varieties of Industrials 15 analysis of their securities must be made by materially different methods. Corporations, e. g., steel companies, whose mining op- erations are only a part of their business, are included. v Advantages of Large Scale Enterprises THE story of large scale enterprise is that of business dependent on rapid mails, railroads, steamships, telephone and telegraph. Without these agencies amalgamations of manufacture and dis- tribution would not be feasible. The control and operation of widely separated plants or distributing agencies de- pends directly upon these better transportation and com- munication facilities. Had modern transportation and communication facilities existed earlier, large scale enter- prise would have started earlier. Under the present sys- tem of specialized economic life large scale enterprise is a necessity. Its advantages have proved as follows : 1. Ease of financing. Large corporations have access to the capital reservoirs of the entire country and in normal times to capital from the whole world at low rates. Small corporations are limited to capital from the few directly concerned and from local banks whose rates are high and whose financial strength may not al- ways be sufficient for normal needs, not to consider expansion. Smaller corporations do not pay, from a standpoint of financiers, who will handle small issues of securities, if at all, only for exorbitant charges. 2. Location. Small businesses many times seem to (17) 18 How to Analyze Industrial Securities happen as far as locality is concerned. Large business enterprise is able, because of its financial strength, to choose locations nearer the market for its products or the source of raw material, as seems best, gradually closing those plants or distributing agencies not well situated from the economic standpoint. The closing of plants of the Steel Corporation and of the Corn Products Company are examples. Especially well located smaller corporations may not suffer in this comparison as do isolated plants not well located, but even the best of small corporations suffer in competition with a corpora- tion which has plants and distributing agencies in all parts of the country. This is especially important when freight is a large item, as, for example, in iron, steel and cement. Corporations whose activities are wide- spread, for instance, chain stores, have the advantage of operating in communities with varied interests. General business may be poor in some of the cities operated in, but good in others, excellent in still others. A corporation operating in only one community finds business more or less influenced by the condition of business in that one community. 3. Advantages in advertising. Large corporations are best able to conduct national advertising campaigns. 4. Large scale plants are possible, using improved and economical methods of production. 5. Large scale production and distribution admit of purchasing in large quantities at consequent lower cost. With stronger financial resources larger corporations are able to buy at favorable times to supply future re- Advantages of Large Scale Enterprises 19 quirements. In some industries corporations control the production of the raw materials and every stage of manufacture to delivery of the most finished products, as, for example, the United States Rubber Company. 6. Large corporations are able to avail themselves of the highest priced brains of the country in manufactur- ing and distribution, and yet are less dependent on the life or ability of any one man. Standards of produc- tion rate and of costs are possible. Comparative state- ments furnished at frequent intervals by the various plants or branches furnish a constant incentive to super- intendents and managers. Such results are difficult of attainment in small corporations because the practices and costs of each corporation are usually guarded. In larger corporations each part is given the advantages of the best practices of the others. Large corporations are best able to carry on expensive but ultimately profitable experimental and development work. 7. Large corporations have the capital with which to develop foreign trade. Small enterprises could not develop the foreign field as the Singer Sewing Machine Company, the International Harvester Corporation and the United States Steel Corporation have done. 8. Corporations producing large quantities are able to make the best use of waste or by-products. The con- ventional example is that of fertilizer, horn, gelatine, glue and other products of the large meat packing plants; various waste manufactures of tobacco com- panies are even more profitable. 9. A corporation having several plants is not likely 20 How to Analyze Industrial Securities to be crippled by fire or flood or strikes. The large corporation is less apt to be embarrassed by losses from personal accident suits. 10. In many industrial lines a large corporation, for example a rubber manufacturing concern, is able to pro- duce a great variety of articles, so that the average de- mand is usually more dependable than in the case of a company having only one or a limited number of articles. PART II BUSINESS FACTORS VI Fluctuations in Demand GOOD business will hide many sins. Sins of pro- motion, of organization, capitalization, manipu- lation and management are well concealed behind the skirts of constantly increasing sales. As with Rufus Wallingford's colored carpet tack industry, good busi- ness may even reform the sinner. Business may be so good that decency is obviously the best policy to the most morally blunted. Consider the treatment of a certain railroad and of a certain tinplate product com- pany, both controlled by the same hand. Business has been good with the industrial corporation. Will the sales keep up not only keep up, but con- sistently expand? should be the security holders' first mental inquiry. Is the business a necessity like meat, bread, biscuit, oil, or cheap automobiles? Is its prod- uct in daily use satisfying a great, broad, growing de- mand? Does it, like the five and ten-cent stores, "sell to all classes of people small things which go to make up everyday life, and does it sell a large volume of these goods with the small margin of profit?" If it does, thrift- preserving and fortune-making possibilities are plainly indicated. Take, for example, the business of the F. W. Wool worth and the S. S. Kresge Companies. Sales (21) 22 How to Analyze Industrial Securities have constantly increased year after year. Even during the panic years 1907-1908 the sales of the F. W. Wool- worth Company maintained a satisfactory increase. Is the business one which fluctuates by season? Is it like the ice and chewing gum business, blessed by a sweltering summer and cursed by seasonable temper- atures? Does it, like the rubber shoe business, depend upon thick slush and thick slush only for cheering sales reports? Is it a business like railway equipment or building construction, whose activities are intensified business barometers? Is it like the upper leather in- dustry ? In good times people buy shoes to throw away ; in poor they have their old shoes patched. Is it like steel, that best recognized prince or pauper industry? Some time ago a sand and gravel company issued securities capitalizing its business on a basis of cur- rent profits. It happens that the city in which this corporation operates had not only been largely rebuilt within the past few years because of a fire, but a large sewer system demanding immense quantities of sand and gravel had just been completed. Is not close consideration of future possibilities in such a case essential? Consider carefully changes in demand. Remember the fate of the original American-La France Fire En- gine Company, manufacturing horse-drawn equipment when the world demanded the strongest gasoline-pro- pelled apparatus. Consider the Michigan Buggy Com- pany, offering a splendid automobile about five years too late. Fluctuations in Demand 23 Do style or fad control the gross receipts? If so, style or fad is the thing, and a gamble. During the bit- terest times the wool industry has known in genera- tions the manufacturers of pony fabrics for women's coats worked twenty- four hours a day and longed for more hours. Now how many pony coats do you see? No manufacturer of any article depending on style or fad can expect to have a dependable business. Remem- ber bicycling. Two well-attested remedies exist to counteract the usual tendency of an industrial organiza- tion to suffer first from starvation and next from over- eating: Diversification of product and careful conserva- tion of earnings. Prominent examples of the efficacy of these remedies, if taken simultaneously, are the Gen- eral Electric Company and the Western Electric Com- VII Diversification EDK at the activities of the American Can Com- pany. It makes more than 43,000 different kinds of cans or containers. Besides the ordinary tin cans for food products, talcum powder, tobacco, soap, soup, meats, etc., the company makes the following arti- cles: Adding machines, banks, bread-boxes, coffee-mill hoppers, confectioners' novelties, corrugated ware, cotton tags, first-aid kits, fiber boxes, paper boxes, fumigators, ice-cream freezers, insect-powder guns, japanned tinware, lead kegs, orchard heaters, display signs, paint strainers, peanut roasters, turpentine cups, fly traps, tin or sheet- metal stoves, signs, tinware, ash and garbage cans, oil cans, shipping cases of fiber, auto tanks, oil tanks, etc. One large factory at Joliet, 111., runs exclusively on fiber and other shipping cases and boxes. Two factories run exclusively on tinware and all kinds of tin and sheet- metal products not to be sealed. Suppose the American Can Company depended for its sales on the salmon packing industry, one of its largest customers. Salmon run in four-year cycles. After the big year there is a sharp drop for two succeed- ing years, then a large increase and then a phenomenal run. This is due to the habits of the fish, for which no adequate explanation has been advanced. (25) 26 How to Analyze Industrial Securities Suppose the corn packing industry formed the sole demand for the products of the American Can Com- pany. Green corn was only half a pack in 1913. How- ever, in 1914 the green corn pack was large, counter- acting a small salmon pack. With its many thousands of products, so many of them of widely diversified use, it is easy to understand that the business of the American Can Company is de- pendable. It is not surprising that after the year 1911 the president was able to report to the stockholders that, although the year had been an unfortunate one in many lines of industry, the business of the American Can Com- pany had been entirely satisfactory. The rapid strides of the Republic Iron & Steel Com- pany are largely traceable to a careful diversification of product. This company seven or eight years ago was essentially an iron company. Under the chairmanship of J. A. Topping the mills have been transformed into plants making many forms of steel, and this has been done without fatally disturbing its original business. Moreover, the company manufactures profitable by- products, such as benzol and toluol. This careful di- versification has made the Republic Steel Company one of the strongest in the industry. The Lackawanna Steel Company was essentially a rail and rail-fittings corporation, although it did pro- duce plates, structural steel and bars, and billets, blooms and pig iron. The demand for rails, like that of all other supplies for railroads, greatly fluctuates, and as a result the Lackawanna Company has been Diversification 27 violently injured in times of depression. For example, in 1911, with a capacity of 600,000 tons a year, its rail production was less than 226,000 tons. In that year the profits per ton of steel sold were 11 cents a ton. While not yet manufacturing light finished prod- ucts, commanding high prices, the company has con- stantly increased its lines, as well as extended the shapes, sizes and uses of the old. Contractors' supplies, such as a branded sheet piling; reinforcing bars and general structural fabricating are now manufactured. From every angle the company is better prepared than ever before for any period of general depression. The Prest-O-Lite Company is one of the many com- panies whose existence has been maintained by wise diversification of the use of its products. Its gas tanks were almost universally used before the advent of elec- tric lighting systems for automobiles. The demand for the tanks would have dropped perpendicularly had the company not adapted its system and product to com- mercial fields, for the use of contractors, railroads and manufacturers in cutting and welding metals. As a result of its diversification the earnings have improved in spite of the change in automobile practice. The United States Rubber Company's earnings have been maintained by taking up new lines. The tire busi- ness has at different times made up in profits for de- clines in sales of its older staple production. In the company's showrooms in New York are exhibited such varying products as toys, bathroom supplies, floor tile, mbber clothing, belting, packing, electrical insulating 28 How to Analyze Industrial Securities material, football bladders, boots, shoes, arctics, "rub- bers," rubber heels, a new composition sole for shoes, surgical supplies, gloves, rubber office bands, horse- shoes, fire hose, tires. Almost daily, new uses for rubber are discovered. Even fly swatters are now made from this essential, accommodating material. The American Cotton Oil Company, through its sub- sidiary the N. K. Fairbanks Company, manufactures "Cottolene," "Gold Dust" and "Fairy Soap." The American Linseed Oil Company has taken up the manufacture of cocoanut oil and produces the cook- ing shortening "Sawtay" which is successfully invading the grocery and delicatessen field. Even the Gillette Safety Razor Company, probably looking ahead to the time when its patent will expire, has evolved a second product an aluminum hot-water bottle and it would not be surprising if other articles were soon made by this company. The International Harvester Company is a well known example of a company having diversified products. It makes all kinds of implements for agricultural purposes. The patents of the Crown Cork and Seal Company on bottle cap machines and supplies have been expir- ing. The company has aggressively pushed a milk bottle seal, and a seal for food containers. The com- pany has also worked up a large business in litho- graphed metal signs. The Diamond Match Company, besides manufactur- ing matches, is engaged in manufacturing match-making machinery and in all sorts of lumber products. It has Diversification 29 a paper-board mill, block and shook factories, planing mills, box, sash, door, blind and veneer factories, and even conducts retail lumber yards. A combination of the ice and coal business has long been recognized as a profitable one, not only to keep a reliable working force together at all times, trucks and working capital busy at different seasons, but also to equalize earnings. Abnormalities of seasons tend to equalize over a series of years, and a combination of ice and coal business will tend to have much more depend- able earnings than either business alone. The United Cigar Stores Company has sucessfully introduced soda fountains in many of its stores, par- ticularly in the South. In competition with nearby stores it sells stationery and periodicals in some sections. Its necessity for renting has developed a real estate de- partment specializing on subleases. VIII Integration Source of Supplies ONLY secondary in importance to the demand for the products of a corporation is its control over permanently adequate sources of raw material. This is a serious question in many industries, such as iron and steel, paper, matches and rubber. Companies controlling raw materials in all stages of manufacture have a tremendous advantage in times when raw materials are exceedingly high in cost. To be sure, in times of depression the advantages of integra- tion are not so marked, but even then raw materials, such as rubber, pulpwood and iron ore, are seldom sold at a loss. As is well known, many of the larger steel corpora- tions are thoroughly integrated. The United States Steel Corporation and others own or control immense bodies of iron ore, coke and limestone. The Steel Corporation owns railroad and steamship lines, controlling the prod- uct from the red earthy ore to the finest of wire. The International Harvester Company, besides own- ing ore and coal, a steamer, blast furnaces, a Bessemer mill, a blooming mill and merchant mills through the Wisconsin Steel Company, controls large holdings of timber in Missouri and Mississippi. (31) 32 H'ow to Analyze Industrial Securities The United States Rubber Company, through a sub- sidiary, has developed immense plantations of rubber trees in Sumatra. It now controls about 75,000 acres of land, of which approximately 45,000 acres are cleared and planted with some 5,200,000 trees. About 3,600,- 000 were in bearing at the end of 1918. The company employs approximately 18,000 natives and incidentally great care is given to their welfare. The investment so far, has been something over $9,000,000, and the rub- ber plantation is by far the largest under one ownership in the world. The United Fruit Company owns banana plantations and railroads in Central America and the West Indies, as well as its well known steamship lines. In its sugar di- vision it owns plantations, mills and a refinery at Boston, making it the "only complete sugar process operated by a single combination of capital in the world." Difficulty in securing dependable supplies of its prod- uct has led the American Ice Company to build artifi- cial plants in principal markets and within a short time it will probably gather or buy little natural ice. There is a limit, however, to the capital which should be tied up in raw material. A corporation may be raw material poor. For example, if a corporation has too much capital tied up in iron ore deposits or coal mines, it may not be able to take out and profitably use enough of the raw material to pay good interest on the money invested. In some industries for example, wool, leather, cotton goods, and cotton oil it is not usually practical to own or operate the sources of raw materials. Integration Source of Supplies 33 The American Cotton Oil Company could not well operate the immense cotton acreage necessary for the production of the cottonseed used. This ofttimes proves a source of weakness to the corporation because it finds difficulty in advancing the price of its finished product with the advance in the price of the raw material. Its products compete with those of decidedly dissimilar bases, e. g., lard and olive oil. In some years the source of materials becomes a problem of gravity for the com- pany. Its president in a report for a recent year said the large cotton crop did not yield to the oil mills a proportionately large quantity of cottonseed, because in some sections considerable quantities became damaged, and a larger quantity than usual was used for fertilizer and cattle-feeding purposes, being relatively cheaper than commercial fertilizers or other available foodstuffs. Another corporation has necessarily had constant trouble in securing a supply of raw materials. The Vulcan Detinning Company buys scrap tin, separates the tin from its base material by electro-chemical process and sells the two resulting products to steel manufac- turers. The demand for the products is unlimited, but the company cannot buy up sufficient tin cans and other scrap tin to utilize its capacity. A surprising development in relation to raw material took place in the American Chicle Company. The re- bellions and revolutions in Mexico resulting in destruc- tion to the company's plantations helped drive the stock from over 200 to a low of 34 and the dividend of one and one-half per cent, a month was entirely cut off. 34 How to Analyze Industrial Securities With all the advantages which integration usually brings, it is not indispensable where favorable arrange- ments can be made for raw materials, semi-finished or finished parts. The automobile industry presents an ex- ample. Few if any companies make all the parts of an automobile. Some 150 manufacturers buy motors from a corporation which makes nothing else, and several of the most prosperous automobile manufacturers are simply assemblers of parts. One company has recently devoted much advertising space to an attempt to prove that it can offer best value because it manufactures practically the entire machine. Figures are given show- ing the profits saved on each part ordinarily purchased outside. These figures may be perfectly correct and yet other manufacturers might offer at least equal value and buy a large part of their units. It might pay to make the units. It might pay better to buy part of them, using capital in expansion of assembling plants, adver- tising or in purchases of raw material and units at favorable times, rather than tying up the money in shops requiring complicated processes. It would not be practical for most automobile manu- facturers to manufacture the iron and steel of which their product is mostly composed. Strange as it may seem, it would be much more feasible for them to enter the aluminum industry. An increase of two or three cents a pound in steel is a big advance, but is a small factor in the cost of a car. An advance of thirty to forty cents a pound in aluminum is a serious matter, Integration Source of Supplies 35 especially so because more and more aluminum is being used in each car. Integration has often been profitably accomplished by amalgamation of interests for example, a yarn com- pany with an underwear mill. At the present time the amalgamation of the complementary American Linseed Company and the National Lead Company is widely advised. A merger of the Tennessee Copper Company, a producer of sulphuric acid, and The International Agricultural Chemical Company is suggested as a wise move to insure integration as well as to reconcile exist- ing conflicting interests in regard to contracts. IX Standardization and Location IN certain industries, of which perhaps shipbuilding and automobile making are as prominent as any, standardization is more necessary than integration. Until war conditions enforced standardization Ameri- can shipyards could not compete with English yards. One English yard made only a standard 5,000 ton steam vessel, another a 10,000 ton and so on, while each American yard built to order many types and sizes. England learned long ago to turn out ships as we turn out automobiles, with which English makers could not compete, even with American cars selling higher in England than in America. American shoes outsell others in the world markets because in this country factories specialize year after year on one type, men's high grade or women's medium grade for example, while abroad a small factory will make many styles in several grades for men, women arid children. The plants of many corporations, like Topsy, "simply growed." An inventor or local capitalist is apt to pro- ceed to work out his idea in marketable form with little regard to expense of bringing raw material or con- venience to market. In some industries, such as watch- (37) 38 How to Analyze Industrial Securities making, where freight is of minor importance, the geo- graphic location of the plant is of little or no importance. On the other hand, with the Portland cement industry, for instance, location is of first importance. Another example is that of fertilizers. The Government estimates that not less than 2,500,000,000 tons of phosphate rock exist in Wyoming, Utah, Idaho and Montana, a supply so enor- mous as to be practically inexhaustible. Much of it is of higher grade than the Florida rock, yet this Western rock does not compete at all with the Southern product. It is not yet widely needed in the West and the freight from the Western States to the East is three times the worth of the rock on the Atlantic seaboard. It is evi- dent, therefore, that as long as the Eastern rock holds out, companies owning Western rock may find little market for their wares. In the glucose, steel and auto- mobile industries many plants have had to be closed be- cause of unfavorable location. The United States Steel Corporation has plants so situated with relation to raw materials and to markets that it successfully competes in all parts of this country except the extreme West and New York City. The Bethlehem Steel Company, because of its more favorable location in reference to this particular market, controls structural steel sales in New York City. Yet the possession of several plants may prove a dis- advantage. The International Steam Pump Company found that economy was impossible in the small scat- tered plants it acquired. Standardization and Location 39 The American Locomotive Company found that it could build equipment most economically by centralizing manufacturing and erecting. Therefore, the company not long ago disposed of long-established plants in Rhode Island, New Jersey, and New Hampshire. However, it is evident that companies having a country- wide market for their wares whether they be paints or watches, have an advantage over corporations operating in restricted sections, because business conditions are seldom uniform. The mail order houses and manu- facturers of automobiles, as a class for example, prosper as does the whole country, and are not embarrassed by unfortunate conditions in any one part of the country. Competition TT F conditions of extreme competition forced the I inception of early combinations," says Dr. Arthur -* S. Dewing in his 'Corporate Promotions and Reorganizations/ "it is equally true that the attractive- ness of each one resulted from the promise of the oppo- site extreme, that of monopoly. Expectations were high of materially increased prices and profits because of the elimination of competition. This was true even in indus- tries where monopoly was impossible for example, in leather and in corn products. In fact, certain corporations which were expected to monopolize their fields found that every movement made simply encouraged competition competition at the hands of men whose plants newly constructed were in a better condition to compete than those of the larger corporations. The companies con- trolling the largest percentage of the business in their line were the quickest to go into the hands of receivers." Dr. Dewing further states that the glucose corporation controlled 85 per cent, of the business and the asphalt corporation 80 per cent, of the business. Both were stifled by competition within two years. Dr. Selwyn-Brown states that the International Steam Pump Company controlled over 90 per cent, of the steam pump business. The corporation was obliged to undergo (41) i2 How to Analyze Industrial Securities drastic reorganization. Yet practical, profitable monopoly is possible only through unusual business ability; the control of a raw product such as some local brick companies, patents such as those of the Mergenthaler Linotype Company and the Gillette Razor Company or the possession of a trade mark. For years the Eastman Kodak Company retained a practical monoply in its field because of the trade name it controls. Large profits certainly invite competition. Striking examples are the phonograph and the motion picture fields. As this country becomes more and more devoted to manufacture, it is reasonable to expect that competition will become more keen and profits per dollar of gross sales smaller, except, perhaps, in certain instances during times of abnormal prosperity. Take, for example, the field of electric apparatus and supplies. Contrast the cost of a most improved six-pound flatiron three dollars with that obtaining a few years ago. The General Elec- tric Company reports a constant narrowing of profits in all lines. In the past few years the profits on standard tin cans have steadily declined, even allowing for fluctuation in the price of tinplate base. The American Company sells cans at such prices that no company without facilities for cheap manufacture and an excellent selling organiza- ton can compete with it. The United States Rubber Company has constantly reported a lowering margin of profit, offset, of course, as with manv others, bv increased sales. Competition 43 In the meat packing trade, profits per pound are so small that "our coinage does not include a coin as small as the profit on each pound of goods."* Before abnormal war conditions, the profits of Swift & Company were of- ficially stated to be less than one quarter of one cent per pound. Later profits rose, but at 2.04 per cent, of the turnover, were not over one-half cent per pound. In some ways the packing business has hopelessly retro- graded. Fifty-five years ago Gustavus F. Swift, the founder of Swift & Company, began business by selling a $20 heifer at a profit of $10. It staggers the imagina- tion to think of what the present colossal organization could earn at this rate of profit. Henry Ford has dominated the low-priced automobile field by maintaining quality and lowering prices, each revision of price downward nipping dozens of potential competitors. Profits in sugar refining are small, and until recently were steadily declining, usually being less than one cent per pound for the refiner. Quoting the chairman of the board of directors of the American Company : "The Na- tional, Arbuckle, Warner, Federal, Revere and other in- dependents compete with the American and with them- selves for trade, and sometimes the small refiner is the one who makes the price fall. He can put the market down, but can never put it up. No refiner can maintain *Boston News Bureau. 44 How to Analyze Industrial Securities quotations in the face of price cutting. No one refiner can fix the price, and besides the competition among them- selves, the refiners have to contend with the severe com- petition of beet sugar. Beet sugar from Colorado and California comes into the Eastern markets and is sold right in this state (New York) as far down as Albany." Normally, beet sugar makers offer strong competition. They contract for their beets with the grower before they are planted and so have an advantage in being able to sell in advance of production, since cost can be approxi- mated closely. The cane refiner knows only what a cer- tain consignment of raw sugar has cost him. The Corn Products Company has been continuously beset with the strongest competition. Since the organi- zation of the Corn Products Company several large com- panies have begun manufacturing glucose, starch, etc., keeping down the prices and preventing the Corn Prod- ucts Company from making satisfactory headway until war and post-war conditions created unusual demand. The downfall of the original Allis-Chalmers Company can be traced to severe competition, beginning in 1904, in heavy reciprocating steam engines, its principal prod- uct at that time. One of the largest electrical compa- nies began to manufacture these engines and, being much stronger financially, it hurt the Western company. In return the Allis-Chalmers Company began to manufacture electrical apparatus, but the larger electrical companies were better able to survive. Following the drastic reor- ganization and prosperous war business, the Allis-Chal- mers Co. is now in position to compete more favorably. Competition 45 The experience of the Jamestown Art Metal Com- pany is illuminating as to the effects of competition. This company originally manufactured a line of stamped ceilings and other sheet-metal work. Competition be- came so severe as to cause reorganization. The original field was considered hopeless and the company simply changed its line, now making steel furniture, apparently with great success. Take the leather industry. Here, size is of little ad- vantage. Little equipment is necessary for economical production, and new tanneries can start up at any time and compete to fair advantage with those longer estab- lished. This is equally true of the malting industry. As stated before, competition is no longer as ruthless as it used to be. Besides the force of government control, business men have come to recognize the superior logic of co-operation over more destructive methods. Yet the race is certainly to the strong, and plentiful resources and an unusual amount of brains are necessary for com- petition in conditions of the most ideal co-operation. PART III MANAGEMENT XI The Personal Equation A MOST any meaty saying may be safely cred- ited either to Lincoln or Emerson. I believe it was Emerson who wrote something to the effect that "an institution is but the lengthened shadow of a single man." Surely this has been true of most large corpora- tions. Were not the Westinghouse companies at least until shortly before the founder died the lengthened shadow of George Westinghouse? Is not the management of the United States Steel Corporation an expression of the personality of Judge Gary? Can we not see in the de- velopment of the chain store organizations the dominant influence of two personalities, F. W. Woolworth and George Whelan? The importance of the personal equation is much greater in industrial than in railway management. There are over 250,000 miles of railway in this country and management has become so standardized that it is not difficult to shift men from one system to another without great loss or trouble to the railroads affected. Few in- dustrial corporations are so standardized. The activities and problems of operation are so diverse that the per- sonnel of management is of first importance and should be one of first consideration to the investor or speculator. (47) 48 How to Analyze Industrial Securities The ability of the managers to increase sales, to lower costs, to improve the quality of the product, to direct the policy, and to master the financial problems consti- tutes an important element in maintaining the standing of industrial securities. Consider the problems of the United States Cast Iron Pipe and Foundry Company. Because of careful and skilful management it is operating one-half the plant fa- cilities it needed a few years ago and is producing more pipe than was possible in the earlier years. Because of superior business ability the Standard Oil Company, even without questionable competitive tactics, would have reached an enormous size. The head of an independent can company recently said: "The rise in Can strikes me as the most natural thing in the whole market. There is not another indus- trial company in America as well managed as that. We are constantly receiving reminders of its efficiency. Its managers lead and we follow; and we find we have to hustle to keep up with them. Because of the pace which they have set, the can-making industry of the United States is 50 per cent, more efficient than it was a few years ago." Whenever the success of a corporation depends largely upon the managerial ability of one or two or any few men the stockholders should be protected against the death of these men by life insurance. This truth is becoming more and more widely recognized, for in no other way can the loss of the managers of many corpora- tions be compensated even in part. The Personal Equation 49 However, even in industrials there is plainly a ten- dency toward standardization of personnel. Corpora- tions such as the Western Electric Company have ar- ranged that each important employee has an "under- study," so that the loss of any one man would not be dis- astrous. In the Woolworth stores the position of the store manager is by no means as dominant as it was in years past. The work has been so standardized that the management of even the far removed stores is done largely from the main office, this being made possible through comprehensive analytical daily reports sent in by the store managers. Yet the limits of standardization must be recognized. For example: that the Riker-Hegeman chain of drug stores were not as great a success as anticipated was an open secret. Mr. Whelan's United Cigar Stores methods were introduced into the drug stores, but with- out corresponding result. Mr. Whelan could not dele- gate his personality to indifferent, mediocre, ill-paid and dissatisfied clerks in the responsible, specialized drug business. Control and management afterwards went to drug store men. *"The theoretical economies of large-scale operation may easily be overbalanced by the purely human ele- ment of inefficient ability." Referring to one particular corporation the Cotton Duck consolidation Dr. Dewing says : "Its long continued failure attests to the extreme difficulty of obtaining a man with skill of management sufficient to handle a large and scattered group of mills *Dewing: "Corporate Promotions and Reorganizations." 50 How to Analyze Industrial Securities as economically as the man of ordinary ability can man- age a single mill." In times of prosperity flourishing firms and corpora- tions do not need to seek additional capital. They are besieged by offers from promoters and underwriters to recapitalize on a greatly extended scale. Naturally, own- ers are interested because recapitalization not only in- volves the creation of a ready market for shares so that part of it can easily be sold, but capital added to the business capital which can be used in carrying out ex- tensions and in taking up new lines. It often happens that a business is entirely ruined by the addition of new capital. The owners of a business may be extremely successful in a small way, but prove helpless when the business is called upon to earn divi- dends on a large amount of newly injected capital. Funds so easily secured may be used less cautiously than profits saved out of earnings. The McCrum-Howell Company furnishes a good ex- ample. Successful in its original lines of heating appara- tus, upon recapitalization it plunged desperately into the vacuum cleaner business. This new line was not success- ful and the corporation went through a drastic reorgani- zation. The Rumely Company was another example. Upon being financed by New York security houses its former vice-president and general manager acquired inventories totalling $16,500,000, besides contracts for materials ag- gregating $4,500,000. Normal inventories should have been about one- fourth as large. Practically all the com- The Personal Equation pany funds were tied up in inventories. Yet it is widely known that the implement business requires large work- ing capital and must extend long credits. The company lost $6,000,000 in round figures in one year before going into the hands of receivers, the loss amounting to 43.4 cents for every dollar of gross sales. That managers of large business enterprise should thoroughly understand the peculiar problems of their business will seem but natural. Hard experience proves that the prospective investor or speculator in industrials should find out whether the management has any intelli- gent idea as to its duties. Perhaps the most ludicrous failure of recent years was that of a corporation formed to take care of other corporations in difficulty. The managers of the Assets Realization Company had so lit- tle conception of its limitations that it assumed liability in lost hope enterprises and itself went through realiza- tion and liquidation. The American Locomotive Company presents another example of a corporation which did not know the first essentials of a business in which it engaged the manu- facture of automobiles. Leaving aside controversial mat- ter and quoting from the best recognized automobile manufacturers' trade paper The Automobile: "The company lost money on every car put out from 1906 (when it began the manufacture of automobiles) to 1913 (when it gave up the business). The company put out 57 models in seven years, an average of over eight different models from the same factory each year. 52 How to Analyze Industrial Securities To make matters worse, some of these were taxicabs, some passenger cars, and the majority trucks. Added to this impossible multiplicity of models was that of fail- ure to standardize among these different ones. For ex- ample, the company built its own steering columns and parts, and built a different one for each model, excluding two truck types. "The company built rear axles, a combination of sta- tionary and live type of most excellent design, but of enormous cost. The special machine for making the sta- tionary part cost $58,000, yet it was needed for producing only 250 parts annually. Had the company built axles for other concerns, which it would not do, this expensive equipment might have been converted from a loss to a profitable investment. The annual meeting of the stock- holders of the company is held near the first of August. The automobile organization did not usually know until this meeting even whether the manufacture of automobiles would be continued for the coming season. The en- gineering, selling and advertising departments did not know before this meeting what policy and program they could carry out for the following year, whereas at this late date rival companies had their models for the fol- lowing year on the market, well advertised. Advertising appropriations that were asked for June were not forth- coming until the end of October or early November. When the engineering, sales and advertising departments would recommend an output of 800 cars, the purchasing department would buy for 1,600. In the factory, ma- chines were found manufacturing parts for two week? The Personal Equation . 53 after such parts had been altered in design or discon- tinued. "Being impossibly late in getting out its products, the annual output would rarely ever be sold. The car pro- gram would be inflexibly fixed no matter how late the policy for the year was decided upon. The result was that the following July and August a large number of passenger cars would remain unsold at a time when other companies were marketing their models for the succeed- ing year. "The policy of working over carried-over cars and carrying them along as new types for the following year was often followed. They were dismantled and changes in chassis and body made, changes which added enor- mously to the cost, so that when finally disposed of they were marketed at a great loss." Comment upon such pretended management is un- necessary. Able management is not crippled by changes of price in its supply of raw materials. Either the materials are bought ahead on exchanges such as the cotton and grain exchanges this "hedging" as it is called adequately protecting against fluctuation of the price or else they secure large quantities of raw material when it is cheap. Clever managers are experts on business and banking conditions. They follow cycles and buy raw materials at times of depression and when, fortunately, money is always easy. The old New England Cotton Yarn Company is an example of one whose managers neither protected themselves on the exchanges nor were clever 54 Hbw to Analyze Industrial Securities in buying at times when raw cotton was cheap. Immense losses were the result. The M. Rumely Company was weakened by unfor- tunately planned and excessive increases in inventory. On the other hand, some of the cotton mill people, for example, of the Pepperell mill, have conserved their cash and taken advantage of abnormal cotton markets in a way that has reflected in many years of unusually satisfactory dividends. Find out whether the managers of a corporation are optimistic only at times of great prosperity which unex- pectedly burst upon them, or whether they are pre- pared for prosperity in times of depression and, con- versely, whether in times of prosperity they are prepared for depression. It is not by accident that in the pros- perity of 1906 the United States Steel Corporation had some $75,000,000 in its treasury, the largest amount up to that time, nor that it now has a very much greater fund in its treasury. The Steel Corporation was ready for the panic of 1907 and is ready for anything now. If a corporation has been recently recapitalized it is of prime importance to find out whether the manage- ment will remain with the men responsible for success in the past, if they are large caliber men. The consistent success of the well known 5 and lOc. store companies is largely due to the continued interest of most of the original interests. The failure of many earlier enter- prises resulted from the retirement of the founders. XII Co-operation and Loyalty IT is essential, in judging the securities of a corpora- tion, to find whether it has the enthusiastic loyalty oi directors, officers and employees. Find out whether the corporation shares its profits with its employees, or offers its securities to them on attractive terms so that the employees become partners in the business. Freedom from labor troubles is one of the most important con- siderations with industrials. There is little likelihood of serious labor troubles in plants such as those of Proctor & Gamble (Ivory Soap) and General Chemical. The men are partners in the profits. Naturally, such condi- tions create a spirit of loyalty and dissipate the natural distrust of labor against capital. The labor situation is a source of weakness to cor- porations such as the United States Realty and Im- provement Company and the General Electric Com- pany. "Welfare work" and profit sharing are not only creditable but are business necessities, paying for themselves time and time again. Find out whether the corporation is generous with its producers of business. Take the Bethlehem Steel Corpora- tion. No salary in Bethlehem exceeds $10,000 per annum, yet some of Mr. Schwab's associates have received as (55) 56 How to Analyze Industrial Securities high as $500,000 a year, but they must earn it. Mr. Schwab determines a unit cost in every department and then sets the premiums for increases in business ef- ficiency and economics by such a ratio as to derive the largest profit from every department. The general staff shares in a general division, but the men who make the profits in their departments have their percentages for their wage gain. Where Mr. Schwab has set the unit standard at $1 for cost, and a manager or superintendent gets 1 per cent, for reduction down to 95, he not only gets 2 per cent, for the next 5 per cent, reduction and 3 per cent, for the next 5 per cent, reduction, but the highest rate applies on the total reduction, so that there is every incentive for a man to strive for the last dollar of ef- ficiency. A sales agent for the Bethlehem Corporation is not a scrambler for gross business, for he gets no commis- sion on his sales. He gets a percentage of the profits made from the goods he sells. He is therefore a hustler for profits, and not for total sales. He is not a mere sales agent. He must become a merchant seek- ing profit in his sales, studying markets, finance, plant capacity and fundamentals of business. Many companies now ticket a generous amount of their shares for the managers, providing an attractive incentive for unusual efforts. XIII Financial Control Alliances WHO controls the corporation ? Not only are they successful, but are they trusted in the banking world ? Many a man is successful whose credit is not good and whose corporation will stand little rough weather on that account. On the other hand, the right management, whether or not strong financially by itself, will command financial backing. In many instances strong financial support will carry through a corporation which would otherwise succumb. Take the American Linseed Company for example. It is largely controlled by Mr. Rockefeller, Sr., who has provided such funds as are required for a loan, with- out collateral, an open book account, subject to draft as needed and to payment as the company has funds, at the rate of 5 per cent, per annum, interest paid on average daily balances only. The Colorado Fuel and Iron Company is also under the same strong financial control and support. Both companies remained economic failures for years, not earning interest return on the capital risks involved. Yet both companies are coming to have good credit from their own strength. Strong control has been their only means of salvation. (57) 58 How to Analyze Industrial Securities A corporation's business alliances and contracts may require scrutiny. What are its relations with those who furnish its raw products? It is not long since that one of the largest leather companies, although excep- tionally strong financially, was crippled in earnings be- cause of serious differences between the company and the producers of the hides. On the other hand, the American Can Company has obtained its principal raw material, tinplate, at rates cheaper than those quoted to its competitors. The General Electric Company and the Westing- house Electric & Manufacturing Company had, from 1896 to 1911, a working agreement whereby they ex- changed patents and avoided cutthroat competition which exists in some other lines. Important patents hav- ing expired by 1911 a renewal of the contract was not considered necessary. The General Electric Company has a working alliance with the American Locomotive Company in the manufacture of electrical locomotives and with the Entz Motor Patents Corporation in the manufacture of gasoline-electric propelled motor cars. The Electric Company has a large stock interest in the Entz Corporation. The Westinghouse Company has a working agreement with the Baltimore Locomotive Com- pany for the manufacture of electric locomotives. Contracts between corporations sometimes result sur- prisingly. The International Agricultural Chemical Cor- poration had a contract with the Tennessee Copper Com- pany to take that company's production of sulphuric acid at $4.81 a ton up to 225,000 tons a year. The price Financial Control Alliances 59 proved intolerable to the International and the amount was reduced to 180,000 tons, the purchaser retaining, however, an option on production above this minimum. Upon the beginning of the European war, sulphuric acid prices went to record figures, and a compromise was made this time in order to placate the Tennessee Com- pany. At one interesting stage the Tennessee Company sold a large amount of acid to Russia, counting on a surplus production which the International firmly claimed under its contract. Under pleas of necessary repairs the Tennessee shut down its plant entirely, later, however, rushing to catch up with arrears of its de- liveries. Any long term contracts for materials should contain clauses permitting modification of terms in event of abnormal market prices for materials, labor, or capital requirements, or in event of radical legal developments or changes in taxation. XIV Financial Policy THAT a corporation is an artificial personality cre- ated by law is a truism. Why make or feel a mystery in regard to corporation financial and busi- ness policy? Why not think of a corporation as an in- dividual and judge it as you would an individual? Consider the S. S. Kresge business before it became an artificial personality. The first Kresge store was opened in Detroit in 1897 with a capital of $6,700. In 1911, by diligent attention to business and reinvest- ment of surplus earnings, the stores did a business of $7,923,040 and earned $470,866 from sixty-four stores. This was before the incorporation of the business in 1912. Wasn't the progress of the business analogous to that of any clever private individual whether he be a merchant, doctor, lawyer, or mechanic? Doesn't the careful man in any line save as he is able and carefully invest, gradually becoming independent and wealthy? The Kresge business is but an example of an independ- ent effort. The Crown Cork & Seal Company of Baltimore is a good example of an artificial personality, a corpora- tion which was prudent. Surplus earnings some years exceeded the total issue of stock. Yet it conserved (61) G2 How to Analyze Industrial Securities its earnings, paying but 8 per cent, for several years, then gradually increasing to 20 per cent. Recently it has been entirely justified in declaring extra cash dividends. But it saved until it could well afford to spend. It was through careful saving that the Republic Iron & Steel Company built up its important diversified steel plants. The original Standard Oil Company carefully con- served its cash and was always prepared to take advan- tage of the ever changing conditions in the oil fields and the oil markets. It always had saved up huge amounts for exploring, experimenting, and purchasing. The wisdom of this farsighted policy is still evident in the security markets. From its organization to 1919 the United States Steel Corporation has paid common-stock holders an average of only about 4 per cent, in dividends. Had it been reckless it could have paid 5, 6, 7, or even 8 per cent, and not spent all its earnings, but it never would have had the strength it has to-day. In times of depression it would have had to defer the preferred stock dividend and have been brought close to bankruptcy. As it is, the cor- poration has enormously increased its steel capacity since 1901. It has spent, out of earnings, much more than par for each share of common stock in new construction and acquisition of property. To-day the corporation is a bulwark of physical and financial strength. It has been prudent; even so, it could have been more careful in regard to the spending of its surplus earnings. Financial Policy 63 By all means it is a better long range financial policy to conserve earnings until stable dividends can be paid. Had United States Steel paid on the common, before 1916, 1, 1, 1, 2, 2, 2, 2, 3, 3, 3, 3, 4, 4, 5, 5 per cent, which averages practically the same as paying 2, 4, 3J^, 0, 0, 0, 2, 2, 2^4, Sy 2 , 5, 5, 5, 4*/ 4 , per cent, the stock would have, on the whole, ranked much higher than it did. If the corporation afterwards formed to take over the Kresge business had become reckless, and had spent not only the cash it earned and saved, but more than that, would it not have been in the same position as a spend- thrift individual? Is not the corporation which earns $10 a share and spends $10 a share or more in dividends as reckless as the man who earns $10 and spends that much or more? Is the result of reckless corporation action any more uncertain than reckless individual action ? The best known examples of common stocks now valuable but years ago almost worthless are the United States Steel Corporation and the Bethlehem Steel Cor- poration. The common stock of the Bethlehem Steel Corporation was considered of little value for many years. Dividends on the preferred stock were withheld and every available dollar carefully used in enlarging the scope of operation and in extending its sources of raw materials. The results, though spectacular at pres- ent because of war orders, would have been just as cer- tain had no war begun. The history of the United States Steel Corporation is somewhat different because 64 How to Analyze Industrial Securities of its payment of the preferred dividend. However, dividends on the common stock were kept down with some evidence of conservatism and the assets were built up from surplus so that now well over $200 per share of common stock is represented by actual assets. Some managers seem to believe in the declaration of unearned dividends as a means of keeping up the credit of a corporation. Nothing could be more disastrous to credit, but this false doctrine persists. Unwarranted dividends plainly impair financial resources. Then when a general depression or any other untoward circum- stances appear the invited end occurs. Dividends, whether or not warranted, certainly do give the appear- ance of prosperity to the unsophisticated, but only to such. It is the old story of eating the cake and having it too. Comparatively few people have breadth of vision ; com- paratively few are willing to postpone immediate pleas- ure for the sake of greater future pleasure. "Every evidence shows that had the earlier interests been willing to forego immediate profits and conserve the funds of the corporation the enterprises could have been placed on a sound footing and the men (most interested in the price of the securities) would themselves have secured vastly greater returns. The failures of the Glucose Sugar Re- fining, the American Malting, the United States Realty and the New England Cotton Yarn companies were the result of payment of dividends on stock which in each of these cases were unwarranted. They represented, ex- Financial Policy 65 cept for the subterfuges of accounting, an actual impair- ment of capital. "The haste with which these early dividends were declared was at variance with the simplest principles of sound finance. In the majority of cases dividends were begun almost immediately after the organization of the corporation, before an opportunity had been given for the new enterprise to manifest its independent earn- ing power. In very few cases did the directors have un- questionable evidence from a careful audit of the books to prove that the dividends had been earned, and the basis of their judgment was seldom more than a mere estimate, which failed to make adequate provision for depreciation. "In the instance of the American Malting Company, subsequent revelations showed that the directors could not have known what the earnings actually were at the time the first dividend on the stock was declared, be- cause in the court testimony it appears that the gen- eral books had not then been balanced from the books of the branches. Similar conditions probably existed in other corporations where the methods of accounting have not been subject to as rigorous a scrutiny."* Another example of reckless dividend payment is that of the old Union Bag & Paper Company. In its first year, after payment of the 7 per cent, preferred dividend, there was left a surplus of $724,169, but after that time the company was not justified in paying the full rate *Dewing, 549, 551. 66 How to Analyze Industrial Securities in any year, although it was paid for nearly eight years before any reduction was made. During those eight years very little was charged off for depreciation, and through that period property and equipment expendi- tures were skimped. Following a bond issue authorized in order to provide for extensions and to provide an ade- quate supply of raw material the rate was reduced in 1906 to 5^2 per cent, and to 4 per cent, for each suc- ceeding year to 1912. In 1913 3 per cent, was paid and none at all since until 1916. In 1912 two machines, costing $250,000, reduced the cost of paper $4 a ton. Had the corporation been more conservative in dividends many other such improvements could have been provided. Unusual general prosperity has brought better prospects to this hitherto weak, competition-ridden corporation. It has been reorganized, the new corpora- tion having but one class of stock: common. The pre- ferred stock, with unpaid dividends and the old common, were primed in the exchange. The American Ice Company, after a somewhat dis- astrous early career, reformed and is now on its way to security. The corporation has retired a large note issue out of earnings, has worked up a respectable working capital, and has built artificial ice plants out of earn- ings. In 1887 the Midvale Steel Company was in trouble largely because of excessive dividends. Outside interests obtained control, and for ten years no returns were made to stockholders and all the earnings were conserved. Profits increased until they far outmeasured the capitali- Financial Policy 67 zation of $750,000. In 1897 dividends were again de- clared. This is the corporation which added subsidiaries to itself and reported profits of around $30,000,000 in a single year after the original stock was turned in for $230 a share cash. It is interesting to figure this price on a basis of the stock as before February, 1910, when a dividend in stock of 1,200% was declared. PART IV BALANCE SHEETS DEBIT XV Lack of Uniformity SKILL and analysis are apt to be unavailing if ex- pended upon information which is, in fact, misin- formation. Nearly all large corporations publish an- nual reports, available upon request to the secretary. With the increase of publicity these annual reports are increasingly valuable. In periods of prosperity they are usually conservative. The managers take care that the depreciation is well taken care of, that machinery is well maintained and that bad debts are eliminated. It is not at all unusual that actual conditions are much better than as shown by the published reports. Hidden assets in the form of unwarranted reserves for depreciation are created, property is acquired out of surplus earnings which does not appear in the balance sheets, a store of fat is secretly laid up against the lean years which fol- low those of plenty. In times of adversity corporation reports must often be viewed with skepticism. With earnings impaired managers are inclined to skimp depreciation, mainte- nance and reserves in order to make a creditable show- ing. It follows, then, that with our customary sequence of prosperity and depression the interpretation of ac- counts submitted must usually be made with considera- tion as to general conditions. (69) 70 How to Analyze Industrial Securities It must be remembered that as yet no uniform sys- tems of industrial accounting are required. Many in- come accounts are noteworthy for what they omit or conceal rather than for what they convey. The securities of corporations which do not publish adequate reports must often be considered pure speculations. The re- quirements of the Federal Income Tax have done much toward showing the possibilities of adequate accounting. The Federal Trade Commission has power to require reports from corporations as it sees fit. The Federal Reserve Board, Washington, has published a bulletin, "Approved Methods for the Preparation of Balance Sheet Statements." This bulletin is a reprint of infor- mation and data acquired by the Federal Trade Com- mission from the American Institute of Accounts. The bulletin gives a proposed "Profit and Loss Account" called in this book (page 167) Income Account, as well as a proposed balance sheet. The accompanying remarks are well worth attention. It is reasonable to expect that uniform forms of accounting will eventually be provided for the different industrial lines as they have for railways. Owing to the various kinds of industrial activity, from say commission merchandising or publishing, to ship- building, various standard forms will eventually be re- quired. XVI Certificates of Public Accountants TOO much reliance has been placed upon the in- dorsement of public accountants of income accounts andbalance sheets. Of course an uncertified financial report is like an unsearched real estate title. But as there are various grades of skill and reliability in the field of title searching, just so are there various grades of skill and responsibility in public accounting work. Nor does it necessarily avail that the financial report be certified by a public accounting firm of large size and many offices. Two of the largest firms, whose certificates are found on many large corporations' reports, do not enjoy a good reputation among accountants. On the other hand the writer has been employed by two of the largest firms in the country, whose standing is above suspicion. Firms do exist which will, for a small fee, certify to balance sheets which are entirely if not criminally misleading. It is unfortunate that the public accounting firm is not chosen by the stockholders as is the case abroad. In this country the officers of a corporation choose the auditors and naturally they will find such as will certify to the accounts as the officials present them. One especial abuse in accounting work is the bidding system. Many corporations do not realize the impor- tance of thorough work, and actually solicit bids for the (71) 72 How to Analyze Industrial Securities work. Fancy submitting questions of a law involving mil- lions of dollars to the lawyer making the lowest bid for the case ! Another source of abuse is the "partial audit," the accountants being employed to audit only part of the accounts or part of the books, while the financial reports, as submitted to the public, appear to the un- suspecting to be founded on books of account entirely vouched for. The first step to be taken by the prospective investor or speculator is to find that the records are certified by a firm of public accountants, the second is to ascertain the reputation of the public accountants, the third to examine the nature of the certificate. Sometimes it means little that books of account are O. K.'d by a firm of public accountants. It may simply mean that according to the contract made by the company with the accountants the certificate proclaims that the books are in balance, with no responsibility whatever as to the reliability or truth- fulness of the accounts themselves. Many contracts specify that the accountants are not paid to go back of the books themselves, the entries in which may be entire- ly incorrect. Again, the accountants may not audit any- thing except the main books of a large corporation, the books of subsidiary corporations remaining untouched. Early in his business experience the writer had charge of the books of a subsidiary of a corporation whose stocks were listed on the New York Stock Exchange. The subsidiary corporation erected a very large office building. The shell was completed and charged, as it should be, against capital, The building was completed, Certificates of Public Accountants 73 partitions and fixtures were installed, and this large amount was treated as an expense under the blind of "Fixtures for Tenants." One of the largest firms of public accountants certified to the financial records of the parent corporation, never even touching the subsidi- ary books, which would have disclosed concealed assets running up into six figures. To be dependable an accountant's report must accept full responsibility for all books of record, including all subsidiary books and all sources of entries made thereon as well as the valuation of all property listed. If this be found over the signature of a firm of public ac- countants having a proper reputation the books of ac- count may be accepted with assurance. It must be re- membered that accountants take upon themselves no responsibility for which they do not show obligation in their certificate. The smash in the McCrum-Howell Company is one of many examples of companies ending in a most spec- tacular failure soon after the publication of a wonderful financial report signed by a firm of public accountants. It transpired that a large part of the assets appeared on the books but no place else. In certain flotations, for example, Pugh Stores, securi- ties have been sold on the standing of the public account- ants which, according to the prospectus "audited the books and accounts." Later it would be found that while the books and accounts were duly audited, the certified figures were not those given out. The reliability of the distributor of all information should be beyond ques- tion and the accountants' report should be available, XVII Complete Balance Sheet THE balance sheet first demands our attention in the analysis of accounts. This is simply a statement showing, or purporting to show, the financial condi- tion of a company as of a given date, usually the last day of the company's business or fiscal year. It is a state- ment of what the company owns and what it owes. An annual report usually contains both a balance sheet and an income account. Both are entirely necessary. Years ago the American Sugar Refining and the Stand- ard Oil Company published balance sheets but no in- come accounts. Those interested in the securities would then attempt to figure the earnings by comparison of the latest with prior balance sheets, taking into consid- eration the dividends paid during the past year. These calculations proved an interesting pastime but did not appreciably lessen the advantage of the few insiders who knew the actual status of the company and its earnings. A company may have splendid earnings, yet if, like the old Westinghouse Electric & Manufacturing Com- pany, it has large maturing debts it cannot take care of, or if it lacks cash much needed for other purposes, it is not safe. The balance sheet only will disclose the true state of affairs. (75) 76 How to Analyze Industrial Securities Some corporations, equipment companies for ex- ample, are engaged in a business showing violent fluctu- ations. Some of them, particularly the American Car & Foundry Company, are well prepared in financial strength for depressions and an income account for a poor year without a balance sheet would not give a fair impression. For convenience in following these articles a com- monly accepted form of balance sheet is given. Several of the items are supported by schedules of the accounts making up the major items. Amounts in figures are pur- posely omitted. As industrial enterprises differ so materially in nature of business, it cannot be expected that all corporations will present balance sheets in forms even approximately approaching the one given. It is hoped, however, that the balance sheet and schedules will suggest to stock- holders of some corporations where the financial state- ments they receive should give more explicit and detailed information. Complete Balance Sheet 77 THE MONTVILLE MANUFACTURING COMPANY. Balance Sheet December 31, 1918. Assets. Fixed or Capital Assets. Plant and Property. Sched- ule 1. Investments. Schedule 2. Treasury Stock at Par. Treasury Bonds at Par. Patents. Trademarks. Goodwill. Working and Trading Assets. Inventories, Schedule 3. Current Assets: Cash. Scheduled Securities. Schedule 5. Accounts Receivable. Accrued Interest on Bonds Owned. Dividends Declared on Stocks Owned. Drafts and Notes Receivable. Interest Accrued on Drafts and Notes Receivable. Due from Subscribers to Capital Stock. Total Current Assets. Sinking Fund for Bonds. Schedule 6. Insurance Fund. Pension Fund. Deferred Assets. Schedule 7. Capital, Liabilities and Surplus. Capital Stock. Preferred : Authorized. Less Unissued. Issued and Outstanding... Common : Authorized Less Unissued. Issued and Outstanding... Capital Stock Subscribed.. First Mort. 5% Bonds. Authorized. Less Unissued. Issued and Outstanding. . . Five year 6% Notes Issued and Outstanding Current Liabilities: Taxes Accrued Payroll Accrued Accounts Payable. Notes and Drafts Payable. Expenses Accrued. Interest Accrued on Notes and Drafts Payable. Dividends Payable. Interest Accrued on First Mort. Bonds. Interest Accrued on Five Year Notes Total Current Liabilities . . . Reserves. Schedule 7. Profit and Loss Surplus. Capital Surplus Total Total Contingent Liabilities with particulars. 78 How to Analyze Industrial Securities On the left, debit or asset side of the balance sheet are usually found three classes of accounts : fixed, capital, or permanent assets; current or quick assets, and de- ferred assets. On the right hand, credit or liability side of the balance sheet, are normally found capital liabilities, i. e., stocks and bonds; current liabilities; reserves and surplus. The classes of accounts on both assets and liability sides of the balance sheet will be considered in detail. SCHEDULES SUPPORTING BALANCE SHEET. 1. Plant and property: Land and buildings. Additions to buildings. Plant equipment. Horses, wagons and motors. Furniture and fixtures. 2. Investments : Securities owned: Names and amounts of stocks and bonds with dividend and interest yield, price paid and present market price. 3. Inventories : Raw Materials. Manufacturing department. Finished good, manufacturing. Finished goods, trading. Shipping department. Coal, oil and waste. Stable and garage supplies. Postage, stationery, &c. 4. Cash in hand and on deposit: Cash in bank. Impressed cash, and Expense fund. Freight deposit. 5. Securities : See Schedule No. 2. 6. Sinking Fund: See Schedule No. 2. Complete Balance Sheet 79 7. Deferred charges to expense: Discount on bonds. Legal expense deferred. Organization expense. Insurance prepaid. Rent paid in advance. Taxes paid in advance. Advertising. Advances for subsidiaries: 8. Reserves for: Depreciation, Buildings, Equipment, etc. Outside investments. Subsidiary securities. Treasury stock. Treasury bonds. Raw materials. Current asset securities. Accounts and notes receivable. Sinking and other fund securities. Extinguishment of assets. Dividends. XVIII Fixed or Capital Assets FIXED, capital or permanent property assets consist of land and buildings, machinery, tools, equipment patents, trademarks, goodwill, horses, wagons, mo- tors, furniture and fixtures and investments. All the fixed assets, excluding investments, are often combined in one item : Plant and Equipment. When set down sep- arately the amount is presumed to represent the actual value of the property. If the amount given is explained as "Plant and Equipment," inquiry is open as to the date and basis of valuation as well as to the experi- ence and reputation of those whose valuation has been taken. Not infrequently are the valuations of fixed assets, however stated, largely fictitious; in fact, simply an arbitrary amount to offset the amount of stocks and bonds on the other side of the balance sheet. Such assets are usually largely water, whether listed as partly goodwill, which is usually water, or not. The combination of tangible asset accounts with in- tangible assets such as goodwill, patents and so forth, not only baffles successful analysis of the real value of the assets and the amount of water, but also prevents determination as to whether the proper amount of de- preciation is being charged from earnings by the cor- poration. (81) 82 Hbw to Analyze Industrial Securities Reliable public accountants who assume responsibility for the valuation of assets verify them by their own count and appraisal; secondly, by the co-operation of technical engineers and professional appraisers. Many certificates of accountants do not make clear whether the plant account is simply a bookkeeping figure. Too often a company's own count and valuation of inventory is accepted without check. In bond and stock circulars this statement is often found: "The following figures show the value of the plants as appraised by conservative independent author- ities." Appraisals as well as certificates of financial state- ments in general must be considered with decided skepti- cism. Nothing can be taken for granted simply because it is on paper, even on paper from the offices of the best security dealers in the country. They make mistakes. It is for the investor or speculator to avoid assuming the loss arising from such errors. Many an appalling industrial wreck has been caused, many a promising business has been blighted, because of overvaluation of obsolete fixed assets or the failure to preserve the original value of the fixed assets, plant, machinery and equipment. A recent example of overvaluation of plant assets was in the General Motors Company. It was incorporated in 1908 to take over some 26 automobile and accessory companies. As was the case with the Rumely, its man- agement bought raw materials and equipment with a lavish hand and with little regard for the effect on the Fixed or Capital Assets 83 company's finances. By 1910 General Motors was in bad condition. A large banking house took charge and charged off about $10,000,000 representing scrap ma- terial and useless machinery formerly booked as assets. With improved management the company made steady progress after this drastic procedure. The collapse of the New England Cotton Yarn Com- pany, previously mentioned, was due to taking over and issuing securities against plants woefully overvalued and largely obsolete, as well as to poor management. The same was true of the National Starch Manufac- turing Company and the Glucose Sugar Refining Com- pany. Even after the starch and glucose companies were merged and the resultant corporation placed under the control of E. T. Bedford it was authoritatively stated in the Government trust suit against the corporation that "when the present organization took over the properties, they were in a dilapidated condition, the machinery was antiquated, buildings unsuitable for the manufacture of the company's products, and costs at a level that would not permit of a return on the investment." In fact after reorganization of the present Corn Products Company its president stated : "During the past fifteen years three successive reorganizations of the industry have been rendered necessary because of the pay- ment of greater amounts in dividends than was consistent with the proper up-keep of the plants." This should emphasize the importance of ascertaining the condition of the plant and equipment of corporations before in- vesting in their securities. 84 Hbw to Analyze Industrial Securities Naturally, unmaintained plants, or plants obsolete be- cause of changes in process, cannot compete to advan- tage with those properly maintained and with the latest equipment. The American Malting Company for many years was tremendously handicapped because of owning plants which were entirely out of date and suited only for the production of malt by the hopelessly expensive and slow "floor process." Likewise the Pennsylvania Steel Company, which was taken over by the Bethlehem Steel Corporation, was unable to compete in ordinary times with more modern and economical plants. Only the un- usual market conditions of the war boom enabled the plants to reopen to advantage. Since the acquisition of these properties upwards of $50,000,000 have been ex- pended for improvements and extensions and the plants thoroughly modernized. Although a large part of the funds were used on the shipyard department the status of the iron and steel making plant has entirely changed. Some corporations claim to offset depreciation by repairs, renewals and improvements, without making the conventional depreciation charges. Such claims usually will not bear the strict investigation which they call for. Such substitute measures usually suggest a lack of method of providing for the depreciation of property. Even granting that plants may be "maintained" to original capacity, in these days of rapid strides in in- dustrial processes entire plants, not to say parts of equipment or certain processes, may become obsolete. Such was the case with the complete plants of the American Malting Company. It is necessary, therefore, Fixed or Capital Assets 85 that depreciation, including obsolescence, be provided for adequately. To be sure, part of the "Plant and Equipment" does not necessarily depreciate at all. For this reason land and buildings should be separately itemized. The land itself may increase in value and sometimes buildings de- preciate slowly. When accounts are not separately stated, analysis is to just that extent doubtful and the security of the investor or speculator compromised. Depreciation should in most instances bear close rela- tion to the business of a corporation. Of course a plant may rust out more quickly than it can wear out. But with companies owning large sources of raw materials depreciation on raw materials not rapidly depleted may be nil. This is true with the holdings of ore and coal lands of steel corporations, woodlands of paper and match manufacturers. It is obvious, therefore, that while it is essential that all fixed assets of a corporation must be preserved, the rate of depreciation of wear, tear and of the obsolescence of these assets varies in different industries and condi- tions. Referring again to ore land, one is reminded of Mr. Hill's remark that "iron ore does not go out of style." From five to ten per cent, is an average rate of de- preciation on manufacturing plants, not including sources of raw material. Theoretically a good steel plant, for example, depreciates at the rate of ten per cent, a year, provided ordinary repairs are made. 86 How to Analyze Industrial Securities * If a company has but one plant it is almost impos- sible to keep it at full value year after year, because it depreciates as a whole. It is possible for a company to keep its plants in as good condition as possible and to add new construction out of earnings and so counter- balance loss suffered elsewhere by depreciation. Usu- ally new construction out of earnings does not occur and unless a definite policy of depreciation charges is adhered to, an evil day will come when the plant which has been well "maintained" out of earnings will suddenly be found obsolete if not worn out. In actual practice two general methods of depreciation, aside from "maintenance," are commonly used. One is to keep the assets at the original or arbitrary value, set- ting up a "Reserve for Depreciation," on the liability or credit side of the balance sheet out of the earnings to compensate for depreciation and obsolescence. The other is to charge off earnings directly against the assets, showing depreciation and obsolescence allowance by ex- hibiting each year a declining value of original assets. Theoretically, at least, the first method seems prefer- able, because the original and additional assets are at all times visible, with the reserve on the other side of the balance sheet counterbalancing the loss through deprecia- tion and obsolescence. The Liggett & Myers Tobacco Company has kept its plants from dangerous depreciation and obsolescence in two ways. Quoting an interview of some little time *See Cole Accounts 96-106. Fixed or Capital Assets 87 ago: "The real estate, machinery and fixtures amount to $7,165,038, against which there is a reserve for de- preciation amounting to $2,021,379. As a matter of fact, the real estate has appreciated in value, and I may state that the physical condition of all property is in better condition than ever before. Modern machinery has been installed, and everything in connection with the various manufacturing plants is kept up to date." The United States Steel Corporation has kept its prop- erty account at relatively the same figure year after year, applying as a reduction, the balances in Depreciation and Sinking Funds, which at the end of 1918 amounted to $307,324,775. Mr. Herbert Knox Smith, of the United States Bureau of Corporations, reported that the United States Steel Corporation had from April 1, 1901, to December 31, 1911, charged off $43,077,687 more for depreciation than was necessary ; in other words, creating a hidden surplus to this extent by charging off this amount of property which retained its value. The technical depreciation charges of the corporation are but the beginning of what it has done to maintain its position out of earnings. As is the case with certain other steel manufacturers, large sums have been spent for renewals, improvements, and so forth, which have much more than offset the de- preciation and obsolescence. When it is considered that largely as a result of additional exploration work United States Steel seems to have as much iron ore in sight to-day as at any time since its organization, and is better 88 How to Analyze Industrial Securities fortified from the standpoint of fuel than it was on the day it began business, and this without material addition of capital, it is evident that the Steel Corporation has not only maintained its position but has greatly bet- tered it. To be sure, analysis of individual classes of assets is impossible because they are "lumped," yet the depreciation and other charges out of earnings have been so heavy as to leave no possibility of skimping. In fact, so much has been charged of! for depreciation, used in extraordinary replacement and in new construc- tion, including the Gary works, that the common stock, once entirely "water," is now represented by over par in tangible assets. The General Electric Company is another corporation whose assets have been maintained and greatly increased out of earnings. In the past fifteen years it has charged off annually for depreciation an average of about thirty- six per cent, of book valuation. From 1901 to 1908 de- preciation charges in percentage to book value were even greater than those over later years, up to the years of war conditions. The highest percentage was forty-six per cent, in 1902, the lowest ten per cent, in 1909. It is apparent, therefore, that no value would remain on the books at all were it not that new construction has continually been made. At the beginning of the year 1915 General Electric valued its plants at $31,063,332. During the year it added $4,485,069 in real estate, machinery, patterns and fixtures. It charged off for depreciation $5,985,069 from the same class of accounts, leaving the property accounts totaled at $29,563,331, smaller than at the beginning of the year. Fixed or Capital Assets 89 The company values its vast number of patterns at nothing whatever, and has kept the ratio of book value to each square foot of floor space at the ridiculously low value of about $2 for many years past. Of course, the plants of the General Electric Com- pany are worth several times the value on its books. Assets valued at less than their worth proclaim strength, which will ultimately benefit the security holder. Though unnecessary depreciation allowances on any property create hidden assets to just the extent of the excess de- preciation, yet the practice is conservative and harm- less because done openly and because it shows up in income accounts and in the balance sheets open to all. The security holder is not deceived into underrating his holdings and selling them at a loss as in cases where fic- titious expense accounts, such as "Alterations for Ten- ants," are charged for new capital assets of construc- tion. It seems scarcely possible that the General Electric Company could ever have suffered the pangs of ad- versity. Yet after beginning dividends and selling in 1893 at 114, the stock sold down to $20 a share and a reorganization ensued. The capitalization was cut down and the book value of plants and securities owned were marked down to agree with reasonable appraisal. Gen- eral Electric learned conservatism from actual experi- ence, and never has forgotten the lesson. Actual cash value is not an absolute assurance of corporate value, however. The old Allis-Chalmers Man- ufacturing Company had over $100 in assets for every 90 How to Analyze Industrial Securities dollar of its securities outstanding, yet these securities became practically worthless. Great plants with magnifi- cent machinery may be a liability if they must be pre- served at a large cost for- depreciation and out of bor- rowed capital without business existing to keep these assets employed. It is possible for a company to be found as was the Allis-Chalmers Company, land and plant, or assets, poor. This company could not pay in- terest on its debts because of the lack of business. An important consideration, usually overlooked in ana- lyzing corporation reports, is whether fire insurance is carried on the property. Not long ago the Bethlehem Steel Corporation lost about $1,500,000 in property be- cause of a fire at its works in South Bethlehem. This corporation could well stand the monetary loss con- cerned, but the loss might have greatly exceeded this amount. It was certainly a mistake in management that the corporation dropped its insurance policies September, 1915, even though it had accumulated a treasury surplus of over $30,000,000 by that time. A corporation such as the F. W. Woolworth Company may well carry its own insurance because, with hun- dreds of well separated properties, its risks are as well scattered as those of any insurance company and its fire losses will be at least as small as those of an or- dinary insurance company. It can therefore save the forty per cent, of insurance premiums which would be consumed by agents' commissions, taxes, expenses and profits of insurance companies. A corporation whose plants are not so widely scattered cannot afford to carry Fixed or Capital Assets 91 its own insurance. To do so is to take a long chance not consistent with conservative management. Is there enough insurance in force? A well known credit man is quoted in a booklet issued by the National Association of Credit Men : "Of the great mass of prop- erty statements coming under my observation not one in fifty shows sufficient insurance carried." Is the amount of insurance varied to cover changing inventories? A common practice is to strike an average between high and low seasonal inventories, inadequate when inventories are high, excessive during the dull season. Contrast with this blundering method those of such firms as Marshall Field & Co., which keep a perpetual inventory of all stocks, employ special insur- ance experts to cancel or add insurance daily to keep pace with fluctuations in insurable property. Armour & Co. have their insurance policies adjusted daily. In lines where stocks are not subject to such rapid changes monthly revisions of policies and amounts are found advisable. Can there be a more important consideration than adequate fire insurance? Do you know what would be the effect of a serious fire on the securities you propose to purchase? Industrial companies are usually particularly subject to severe loss by fire. A loss, of less importance if con- fined to one of several plants, may prove fatal if de- stroying the main building. The physical loss may be covered by fire insurance but the loss of business re- mains. 92 How to Analyze Industrial Securities It is not generally known that profits may be insured. The special form of insurance is called "Use and Occu- pancy" and compensates for loss of the use of buildings because of fire. Such insurance is available only to corporations of the highest reputation and stability. Sears, Roebuck & Company, for example, with an enor- mous distributing plant in Chicago, are insured both against the physical and business losses of fire. Such insurance should be considered a splendid bulwark of strength by a prospective security holder. XIX Permanent Investments FOLLOWING the plant and property accounts come the permanent investments of industrial cor- porations. These may be either investments made out of surplus earnings and carried as permanent anchors to windward, or represent securities of subsidiary or affiliated companies. Such securities, of course, are not to be considered as current assets, but are classed as permanent or capital assets. "They represent an excess of capital over and above that required by the business, and while they may be, in the majority of cases, easily convertible into cash, it is only in the event of some extraordinary circumstances or unusual demand that such proceeding takes place. They seem to be looked upon more in the nature of fixed capi- tal and not as something which is fluctuating constantly in conformity with the volume of business."* When the security holdings are large in proportion to the total assets, separate schedules of all the stocks and bonds owned with prices paid and dividend and in- terest yield should be shown. The securities must be analyzed item by item in order to determine whether or not they are worth the value as shown on the books. * Wildman. (93) 94 How to Analyze Industrial Securities Many corporations have been forced into financial dif- ficulties because of misadventures of securities shown on the books at high value. This is particularly true in the case of corporations issuing bonds to pay for stocks of another company. If the stocks fail to yield dividends the bonds issued in payment for the stocks must still pay interest; in other words, pay for a "dead horse." It is entirely proper to maintain securities held as permanent investments at the original cost price or par value, provided, however, that reserve is set up on the credit or liability side of the balance sheet to offset any depreciation which may occur. Maintenance of any as- set on the books at cost price with the reserve offsetting depreciation thereof has, as explained before, the ad- vantage of exhibiting conditions as they originally were together with necessary adjustments. It is not desirable that investments which have appre- ciated in value be marked at higher figures than cost price. Even such master minds as J. Ogden Armour, John D. Rockefeller and E. H. Harriman have made lamentable, almost ridiculous, errors in acquiring securi- ties. A present gain may be a loss to-morrow, and safety lies in listing assets at cost or less. Much caution must be exercised in regard to the securities of subsidiary and affiliated companies held by a parent corporation. It is not long since that the West- inghouse Electric and Manufacturing Company was obliged to write off or drastically mark down the book value of its investments in foreign electric holdings. Permanent Investments 95 That its foreign plant investments had not been profitable is indicated by the fact that in the year ending- March 31, 1914, over 78 per cent, of its gross income came from its domestic manufacturing business while 12 per cent, came from investments with a book value over $2,000,000 in excess of the value at which the domestic plants were carried. The possibilities of concealment and fraud between the books of a holding corporation and the books of a subsidiary are almost unlimited. The only satisfactory method of analysis lies in the examination of the reports of each of the subsidiary corporations, examining them as carefully as though their securities were the ones pri- marily under scrutiny, then analyzing with equal care the books of the parent corporation, then making an analysis of an absolute consolidation of the accounts of all the corporations, including those of the parent com- pany. The possibilities of misleading information are evident from the fact that the bills payable of one of the cor- porations included may be the bills receivable of another. It is easy to count a debt of a subsidiary corporation as a resource of the holding organization, but not to count it as a liability of the subsidiary because of the plausible reason that it is not a claim due outsiders. Again, the holding corporation may count as a resource the notes of the subsidiary payable to the holding corporation for merchandise and at the same time count as a resource such merchandise in the hands of the subsidiary. It is simple for the holding corporation to sell goods to its 96 H'ow to Analyze Industrial Securities subsidiary at such prices as to show a big profit for itself but at a decided loss to the subsidiary. If access then is not had to the books of the subsidiary the fallacy of the parent's prosperity may not be disclosed for several years. A great mercantile corporation collapsed. A large number of banks, which had considered its paper gilt edged, suddenly found that notes payable to the extent of several million dollars, not shown on the books of the holding corporation or on any statement of subsidiaries given to the banks, had been issued and discounted by its subsidiaries. Books audited as suggested before and signed by reputable public accountants would not only have disclosed such an unfortunate situation, but probably would have suggested in ample time a remedy for conditions which made such futile financing seem expedient. In 1901, before the advent of the present management and the more adequate reports now available, the United States Rubber Company owed per published figures but $1,648,694 in loans and accounts payable, an amount exceeded by quick assets. Very soon after, $12,000,000 of bonds were issued to provide payment for the press- ing obligations of subsidiary corporations. Comprehen- sive figures showing the relations between subsidiary and holding corporation, together with consolidated accounts, will be found in many listing statements of the New York Stock Exchange, e. g., statement of the Interna- tional Salt Company. XX Treasury Stocks and Bonds ONE important consideration in regard to treasury stock is to ascertain whether the amount so listed is in reality what it purports to be. Some companies include among their current assets stocks or bonds which have been authorized but never sold. This is highly im- proper. Treasury stocks or bonds are such in actuality only when they have been issued for value and repur- chased by the company or donated to its treasury. Of course the status of the corporation would remain un- changed if the treasury stocks and bonds were cancelled and burned, simply reducing the outstanding capitaliza- tion to this extent. However, in many instances this is not feasible. Stock issued is presumed to be disposed of at par and cannot be issued for less without a corresponding liability to its holder for the difference between what it is issued for and the par value. Treasury stock is presumed to have been issued once for par value and therefore may sub- sequently be sold at any price or given away if desired.* Treasury stocks or bonds would seem more logically to be carried as investments than as current assets. Is not the sale of these treasury securities practically the same as new financing? * Wildman. (97) 98 How to Analyze Industrial Securities Securities held in the treasury cannot properly be set at par without an offsetting account unless the market quotation for the securities of the same issues outstanding is par or above. A proper treatment would appear to be to carry securities at par, placing on the credit or liability of the balance sheet a reserve to offset any possible inflation of value. Treasury stocks or bonds are usually acquired through the action of a sinking fund invested each year to re- duce the amount of securities, more often bonds, out- standing. However "treasury stock" publicly offered by a cor- poration has not usually been bought in previously by a company except technically. The issuance is accom- plished by placing a surplus amount of the stock in the hands of the promoter or other interested person for a nominal consideration. Then as per prior agreement the stock is donated back to the company which can then legally market it to the public. However, as in the cases of the D & C Company (Food) and the old Marconi Company reams of stock were sold as treasury stock, while the proceeds went, not to the issuing companies, but to private individuals. Xo new moral is to be drawn from such practice. There simply seems to be no limit to the audacity of a certain fraternity of operators. XXI Goodwill and Organization PHILANDER C. KNOX said something like this : "Goodwill is property capable of being appraised, bought and sold. In many cases it is the main in- gredient of value. It represents all the strength, industry, tact and judgment that makes success in estimating the worth of a business. It is not infrequently reckoned more valuable than the buildings and the machinery that makes up the physical plant." Goodwill is simply the power of attraction whereby the proprietor causes the buyer to seek him or his place of business when in the market for the kind of goods which the proprietor has for sale. The Goodwill account is then logically a capitalization of the profit resulting from business secured. Yet there are few more baffling obstructions to clear analysis of corporation reports that the Goodwill account because of its inclusion with the Plant or Property account. The intangible asset of Goodwill may arbitrarily be placed at any figure what- ever. In fact such an account as "Plant, Goodwill, etc.," may be usually considered as consisting mostly if not almost entirely of the latter items. Generally a corpora- tion having Goodwill of actual value is not at all ashamed to set it up for what it actually is. The value of the Goodwill of the firms such as Marshall Field & (99) 100 How to Analyze Industrial Securities Co., Steinway & Co., Victor Talking Machine Company, the General Electric Company, is enormous, yet strange to say the companies having the largest amount of bona fide Goodwill value are most apt to place its value at $1 or to omit such an account entirely. The creation of the Goodwill account usually occurs in the recapitalization of prosperous corporations by bankers or promoters. This was especially true in the latter part of 1911 and the early part of 1912. One of the principal reasons for this was the demand for 7 per cent, industrial preferred stocks for investment pur- poses to which several banking houses catered. The preferred stocks represented the entire amount of assets, while the common stock represented Goodwill or present and expected earning power. For example, when the F. W. Woolworth Company was recapitalized the real assets were about $15,000,000. Against this was issued 7 per cent, preferred stock. The net earnings of the assets were sufficient to pay the 7 per cent, on the new $15,000,000 of preferred stock and leave nearly 8 per cent, on the $50,000,000 common stock which represented Goodwill. As commonly known, this Woolworth com- mon stock has continuously earned and paid dividends, proving that the Goodwill had actual value. More often Goodwill simply represents capitalization of earnings hoped for. Peculiar instances of the capitalization of Goodwill have occurred in mergers of corporations whose in- dividual net earnings have been almost if not absolutely nil, this unfortunate state of affairs having been due to Goodwill and Organization 101 slashing competition between these companies. Mer- gers effected by skillful and tactful promoters have sup- ported appreciable amounts of Goodwill, necessary be- cause the stockholders of the original companies would not release their holdings unless they received more than the physical value of the properties. Such Goodwill would have as its basis simply the value that harmony of previously opposed interests might give. Still another origin of the Goodwill account is expense of advertising which new firms are obliged to do in order to secure their share of business. It does not seem improper that this unusual expense be charged to a Goodwill account reflecting the extra cost of establish- ing the business. Of course this capitalized expense, in deference to conservatism, should be distributed over the future years which should receive the benefit, being annually reduced by charges against profits. Goodwill is usually considered an asset of diminish- ing value, and while examples may be given of corpora- tions whose Goodwill value is constantly increasing, yet these same corporations will probably be found to be most industrious in wiping the Goodwill account from their books. This may be done by setting aside surplus earnings to this end. For example, the Goodwill account of the United States Realty & Improvement Company amounted at the close of 1905 to $6,300,000. All this has been written off. The American Cotton Oil Com- pany carries in its assets $23,594,870 as the amount of Goodwill, Brands, etc. As a theoretical offset, the com- pany adds year by year to its profit and loss surplus, 102 How-to Analyze Industrial Securities thus reducing the difference in the amounts of Good- will and- of surplus. The surplus amounts to but about a half of the Goodwill account. XXII Patents, Trademarks, Brands, Rights THESE accounts have a familiar sound. Honestly expressed they are perfectly legitimate, but gener- ally they represent a euphonious attempt to con- ceal the absence of assets of real value. In other words, they represent arbitrary amounts of goodwill or "water." "Basic" patents are considered the most valuable, be- cause they cover a whole process or large idea and not simply a minor detail. Very few true basic patents are obtainable at this late date. It is related that one of the most profitable patents was issued for an improved building screw, the patent simply covering a screw with a gimlet point. Previous to this screws had been flat on the end and a hole had to be drilled before insertion. The gimlet screw could be driven. It is related that the company controlling the patent prospered so that it literally scarcely knew what to do with the money. Its wagons were gold laid, the harnesses emblazoned with gold and silver, and so on. Naturally when a patent, trademark, brand, or right is purchased by a corporation at a large but fair figure, the purchase price should be expressed in the balance sheet under its true name. No one will doubt the legitimacy while it still had years to run of a large patent account in the books of the Gil- lette Razor Company. The vast assets of the American (103) 104 Hbw to Analyze Industrial Securities Tobacco Company were founded on patents on cigarette machines. Who doubts the value of patents of the Mer- genthaler Linotype Company or the Vulcan Detinning Company? As is well known, the latter corporation succeeded in obtaining $677,352 from the American Can Com- pany because of infringement on the Vulcan Com- pany's patented processes. Even more recently the validity of the "Weed" tire chain was upheld and sev- eral prosperous competing companies were obliged to go out of business. When an arbitrary value is placed upon patents it is very apt to be found that the item consists chiefly of the most intangible goodwill. A more satisfactory method is to capitalize the income reasonably representing the special income for which the patents, trademarks, brands, rights, etc., can fairly be held responsible. Suppose a company capitalized at $1,000,000 earns as a fair average $140,000 a year. Suppose the typical firm in the line of business in which the company is engaged the "Representative Firm," as economists call it brings in 7 per cent, profits on an average. If the patents, trade- marks, brands, or rights are responsible for this excess earning it would not seem unreasonable to capitalize this excess at 7 per cent., or $1,000,000. It will be remem- bered that this is the method used in capitalizing the goodwill of the F. W. Woolworth Company. But patents are apt to be vain things for safety. Patents did not suffice to secure the rights to manu- Patents, Trademarks, Brands, Rights 105 facture moving picture machines to its inventor, Mr. Edison, and after being in the courts for 37 years the suit of Thomas A. "Edison against the Atlantic & Pacific Telegraph Company and the heirs of Jay Gould for the alleged infringement of telegraph patents was thrown out by the Supreme Court of the United States. Again it was only after 31 years of litigation that the American Telephone and Telegraph Company was forced to pay the Western Union Telegraph Company $5,279,000 for the infringement of a patent. The Eastman Kodak Com- pany waxed enormously wealthy, while the inventor of its principal product died in comparative poverty. The widow of the Reverend Hannibal Goodwin, who invented the photographic film, first received belated benefits of her husband's inventive genius at the age of 81. The litigation extended for eleven years. The patents cov- ering photographic films in all forms, including cartridge films, film packs and moving picture films, were appar- ently, and after eleven years of litigation proved, valid. Yet the corporation which used the patents made such enormous strides in the 17 years of its infringement that it was able to pay the damages secured by the bona fide holders of the patents without skipping a single extra dividend. A patent is supposed to confer on the patentee the exclusive right to make and sell the particular device described, but does not undertake to stop infringement. It is simply a permit for its owner to spend his own money in looking for people who may begin making devices similar to his and bring suit in one court after 106 How to Analyze Industrial Securities another to stop them. As is widely known, patents are made non-effective by such simple expedients as leaving out some unimportant part mentioned in the claims or putting in something different from a part described. Patents are usually of little value unless the holder is well able to defend them and to purchase other patents as they are issued so as to hold a controlling power in the field, thereby discouraging efforts to fight. In July, 1910, the Allis-Chalmers Manufacturing Com- pany won its suit on Patent No. 546,059 against the General Electric Company. Yet, while the suit was in progress, the business and credit of the smaller corpora- tion was torn to pieces and never recovered until after drastic reorganization. Simply because of its longer financial arm the Na- tional Cash Register Company was able to wear out weaker competitors by bringing suits against their en- tirely valid patents. Patents are issued for but seventeen years and are renewable only by a special act of Congress. They are therefore essentially a wasting asset and must be written off yearly to extinction at the end of the legal period. Obviously the patents of the Vulcan Detinning Company, for example, are small in value now as compared with their value when first issued. Yet not always do the benefits from a patent expire at the time as does its theoretical exclusive legal right. The patent right may create goodwill at least partially offsetting the expiration of the patent. Consider the goodwill created by the McCormick Harvester Company, Patents, Trademarks, Brands, Rights 107 resulting largely from patents so enormously valuable that Congress refused to renew them. The corporation into which the McCormick Harvester Company was merged was organized without any goodwill or other intangible assets, again giving an example of conserva- tism which would seem, at least in comparison with the action of other companies, to show an excess of prudence. Who can question the value of trademarks and brands such as "Royal" baking powder, "Gold Medal" flour, "Ford" automobiles? When purchased for cash such values may very properly be set up as assets. In the name of conservation careful managers will usually gradually wipe out such intangible assets by annual charges against earnings. XXIII Working and Trading Assets rr^HE items Plant and Property, Investments, Treas- ury Stock and Patents, Trademarks and Goodwill -- have already been taken up. In logical order the next account is that of Working and Trading Assets or Inventories. The Inventory items consist of such ac- counts as Materials and Supplies, Goods in Process, Finished Goods, Finished Parts Purchased for As- sembling, Packing Material, Coal, Oil and Waste, Sta- tionery, Advertising Matter, Postage and similar inven- tories. These Working and Trading Assets are those con- sumed in the manufacture of the goods or the conduct of the business. In the case of a purely manufacturing corporation the assets are Working Assets. Naturally, in the case of a mercantile corporation, corresponding assets would be Trading Assets. Quite generally, Working and Trading Assets are in- cluded among the Current Assets, which is the next item on the balance sheet. This practice does not appear to be entirely sound, because the Working and Trading Assets are not such as may be depended upon for reali- zation at short notice without ruinous concessions from book value. This the Rumely Company found at high cost. (109) 110 How to Analyze Industrial Securities It is highly important to ascertain whether these Working and Trading Assets have been inventoried by professional appraisers or reliable accountants, or whether the count and valuation of the company's own employees have been taken. When the valuation is made by a reliable appraisal corporation, or by a reliable firm of public accountants, the items may be taken at book value. As an example of the work done by reliable account- ing firms, an inventory in which the writer participated may be in place. At 6 P. M., and without warning, the force of one of the largest accounting firms of Chicago took possession of a condensed milk factory near Chi- cago. The cash was counted immediately, then the horses, wagons and harness. The milk was inspected and measured. The same was done to the vats of con- densed milk. The stock of canned goods was then counted. It was not taken for granted that the boxes in the stock department were filled with cans of con- densed milk. The boxes were opened and the contents counted, an occasional can being opened and the con- tents examined. If such procedure is considered necessary in the veri- fication of assets having such comparatively little bulk value as condensed milk, the importance of checking up inventories of corporations whose finished product is higher priced articles of copper, brass or steel is quite apparent. Not only must quantities and qualities be checked, but values of inventories must be considered. All ma- terials and supplies should be inventoried at cost. If Working and Trading Assets 111 the market price is lower at the time the balance sheet is made up, then a reserve to offset their decline in market value should be placed on the credit or liability side of the balance sheet. This procedure shows at once the actual cost of materials and supplies, and determines the loss if purchased at higher than present market value. A less preferable course is to place the inven- tories at the newer, lower market price, charging the necessary deduction as a loss to the business. The United States Rubber Company in a recent year charged off as a loss a decline in inventory value amounting to about $1,500,000. Inclusion in the price of inventories of material and supplies of the inward freight, cartage, etc., expended on the goods still on hand is entirely proper. Not many corporations exhibit a reserve for the depreciation of inventories in case of a decline but, in accepted practice, value inventories at cost or present market price, which- ever is lower. This is not open to criticism except that the balance sheet will not then show if undue losses have been sustained through depreciation in market value. By no means should inventories, purchased at lower than present market prices, be increased as the specula- tive prices advance. In 1906 copper was 26c a pound; within a few months it dropped to lie. Companies who inventoried their copper supplies bought at, say, 16c, at the maximum price of 26c, placed themselves in a dan- gerous position when the price abruptly fell. It would appear that at times of evident and exuberant prosperity and inflated prices, ample reserves might with 112 How to Analyze Industrial Securities propriety be set up on the liability side to offset the decline in materials and supplies which will most cer- tainly appear sooner or later, and at a time when stocks of raw matenals will probably be as large as they are now. Goods in Process valuation consists of raw material plus the labor so far expended and part of the overhead charges. Only expert appraisers are qualified to attest to such values, as they are special to each separate busi- ness. Finished Goods valuations consist of raw material plus labor, manufacturing overhead cost, and by some it is considered wise to include the overhead charges for ad- ministration, advertising, selling, etc. The inclusion of the latter items seems questionable. Not a few large corporations carry their Finished Goods not only as high as full selling cost, but at selling price, anticipating mar- kets and profits which may never materialize. Such pro- cedure is entirely indefensible. The more nearly some inventories are in the shape of raw materials, the more likely they are to liquidate at full value, because styles and fads are less apt to render raw materials unserviceable. Another consideration in regard to inventories is some- times of importance. Are the inventories, if booked at cost price, shown to include or exclude discounts? If the discounts are not taken off it would follow that the company poorly managed or financed would make a bet- ter showing of inventories than the one which showed them at the same cost price, with the discount eliminated. Working and Trading Assets 113 Complications sometimes arise in the inventories of holding companies, because of profits claimed on the books of subsidiaries, which have worked upon material. Only a consolidated balance sheet with inter-company profits eliminated would clearly demonstrate the true status. XXIV Current Assets CURRENT Assets, popularly called Quick Assets, are supposed to include only such as will soon become available in cash for the purpose of meet- ing debts which become due in equally short time. Every item of Current Assets is open to question until absolutely verified. Even the Cash may include "Cash Items"; in other words, I. O. U.'s of doubtful value. The Accounts and Notes Receivable may not be worth their face value by any means. In fact, nearly all cor- porations ought to set aside a reserve on the credit or liability side of the balance sheet as a "Reserve for Bad Debts." Of course the cash should be separated from the Notes and from the Accounts Receivable, though all three are lumped in more balance sheets than one. In most corporations the Accounts Receivable are more liquid and certain than are the Notes Receivable, because a debt usually becomes a Note Receivable only when it becomes overdue as an account. Naturally an overdue obligation is normally not as good as one of current standing. Here, as elsewhere, principles should not be laid with too much assumption. In the agricul- tural implement business, for instance, Notes Receivable are normally very large in amount because notes are taken from agents and from farmers in payment for im- (115) 116 How to Analyze Industrial Securities plements as a regular policy. In other lines, conducted on a cash basis, for example, the 5 and lOc stores, neither Accounts nor Notes Receivable are a factor. Drafts and Notes Receivable usually draw interest from date of making. As probably a large number of these drafts and notes have been running for some time, though the principal is not due at the time of making up the balance sheet, a considerable amount of interest has accrued to the benefit of the corporation. This is styled Accrued Interest on Drafts and Notes Receivable. Many corporations do not separate the interest, but combine principal and accrued interest as Drafts and Notes Re- ceivable and Interest. Bonds owned as Investments or in the Current As- sets may pay interest at different times. If any interest is accrued but not paid at Balance Sheet time, the ac- count is naturally labeled Accrued Interest on Bonds Owned. Dividends on stocks owned are not legally considered as an asset until they are declared by the board of directors. As soon as declared they are a legal liability of the corporation intending to pay them. As soon as dividends are declared on stocks owned they become Current Assets. In the case of a holding company only a consolidated balance sheet with inter-company Current Liabilities and Current Assets eliminated can make the actual truth known, as has been stated before. Suppose the parent company needs cash and a subsidiary gives a note which the parent discounts at the bank. This is not an un- Current Assets 117 questionable form of Quick Asset, yet it may appear very plausible on the books of the holding company. On the other hand, a subsidiary company may be in difficul- ties, and the parent advances the funds needed, taking in return the subsidiary's notes. The subsidiary may or may not be able to pay them back. An important account among the Current Assets of many corporations is Securities. Securities purchased for permanent investment should, as before stated, be placed among the Capital Assets. Only those should be considered as Current Assets which have been ac- quired with funds not needed in the regular conduct of business securities purchased to keep idle funds pro- ducing returns. Of course a schedule of these securities should be shown, and the basis of valuation given. They should be highly marketable, as their inclusion in Current As- sets would admit no slow market securities. The pre- ferred method of valuation would be at cost price, with a reserve on the credit or liability side of the ledger to provide for depreciation in value, if any, since purchase. This method would make possible easy analysis as to the profit or loss on the purchase. A large number of cor- porations which have recently been phenomenally suc- cessful because of "war orders" have placed part of their profits in securities, bought at present high prices, and listed among Current Assets. These securities will need scrutiny in the future, when the financial and business outlook may not be so bright as it is at present. XXV Sinking Funds SINKING Funds are accumulations of capital set aside in order to meet obligations maturing in the future. Such obligations often have indentures providing that certain amounts be set aside annually, which at compound interest will equal the maturing debt. These amounts may be set aside in cash and be placed in the company's treasury, or preferably, in the hands of the trustees of the bonds ; usually a trust company. The Sinking Fund may be invested in securities, selected by officials of the corporation, or by the trustee, if the inden- ture so provides. A Sinking Fund in cash accumulating in a corpora- tion's treasury for a number of years is ofttimes liable to prove a source of temptation to the officials. It is supposedly set aside in order to take care of one par- ticular debt. If kept at the disposal of the company dur- ing all the years intervening between the first payment into the Sinking Fund and the maturity of the debt, more than one time of stringency, more than one time of unusual apparent speculative possibility will appear, when the cash in the Sinking Fund may prove too great a temptation and its use changed from its intended pur- pose. This has been experienced in countless cases, tak- (119) 120 How to Analyze Industrial Securities ing a charitable view as to the disappearance of the Sink- ing Fund. A better method is that the indenture of the bond provide that the Sinking Fund payments be made to a trust company as trustee, which shall each year use the Sinking Fund cash paid in to purchase bonds in the open market, reducing by this much annually the amount of debt outstanding of the corporation. These bonds may then be destroyed. Sometimes the purchased bonds are "kept alive" in the company's treasury and interest paid on them. Nothing is gained by this procedure, unless the accruing 1 interest is added to the fund, and the danger of possible conversion is an argument against this practice. In any event the Sinking Fund should represent cash, or securities purchased with the cash. If in cash, its lo- cation and guardianship should be known. If repre- sented by securities, a schedule of the Sinking Fund as- sets should be presented, with purchase and present market price. The United States Steel Corporation and subsidiaries had retired through Sinking Fund operations at the end of 1918 some $117,913,000 of bonds, which bonds are held alive in the Sinking Fund and the interest applied to the redemption of additional bonds. In 1918 this accruing interest amounted to $5,620,211, as compared with the fixed annual Sinking Fund payments from earnings of $6,002,555. Thus a steadily increasing amount of bonds is redeemed each year. For instance, the annual Sinking Fund charge for the first collateral Sinking Funds 121 5s is $3,040,000, while $5,623,000 of those bonds were redeemed in 1918. It has become common practice for corporations to establish Insurance Funds for the protection of their property against fire and other dangers. The economies of dispensing with regular fire insurance has already been discussed. When established, the Insurance Fund should be in cash or in marketable securities. If in the latter a schedule of their content should be shown. Pension Funds are funds set aside to provide pen- sions for employees who have grown old in the ser- vice. Increasing numbers of corporations are taking up such action both from an altruistic and from a hard business point of view. As with all other funds, the amount should be in cash or in marketable securities. Insurance and Pension Funds are not to be con- sidered free assets of the business. They are counter- balanced, in fact, if not on the books, by a probable loss in the case of the Insurance Fund and by a certain future liability in the case of the Pension Fund. XXVI Deferred Assets DEFERRED Assets, sometimes called Deferred Charges to Expense, are neither quick nor capital assets. In fact, part of them are largely "assets by courtesy." Deferred Assets include prepaid expense charges. Insurance expenses, for example, are normally paid by the year. Suppose the annual premium, $5,000, is paid June 1 and the balance sheet is made up December 31. Obviously, insurance is paid for till the following June, and the entire $5,000 should by no means be charged to expense by December 31. The proper way would be to set up an account, which is considered an asset account, Insurance Paid in Advance. Then each month a twelfth part of this insurance premium payment is charged up to expense: Insurance. On December 31, half of the $5,000 would properly be charged to the ex- pense Insurance account and half be left to be charged off in the coming six months. The $2,500 remaining in the Insurance Paid in Advance account would be placed in the balance sheet as a Deferred Asset. Of course, in case of forced liquidation on December 31, not all of this $2,500 would be refunded by the insurance company, which would prune the amount, because the rate for six months is higher than for the full-year period. Yet the balance sheet as a w*hole is considered to represent "go- (123) 124 How to Analyze Industrial Securities ing concern" values, and Insurance Paid in Advance is surely to be valued at regular period rates. Rent Paid in Advance and Taxes Paid in Advance are other similar accounts which are assets to the extent that they are pre- paid at the time the balance sheet is made up, by the same reasoning as applies to Insurance Paid in Advance. The benefits of Organization Expense, at least theo- retically, extend over a number of years. This seems to be as logical as that the expense of building superintendence is rightfully included in cost and therefore in the asset Plant and Buildings after the plant of a corporation is constructed. Therefore it is common practice to cre- ate an account Organization Expense at the time of the beginning of the career of a new corporation. This is normally decreased each year by writing off part of the amount to Profit and Loss. At the end of ten years the account is usually entirely written off. Its convertibility as an asset may in instances be open to argument, but in case of large Organization Expense there seems to be no reason why this expense should be entirely charged to Profit and Loss the first year. Theoretically, moving a plant from one place to an- other more economically fitted to the corporation's pur- poses may constitute an expense of sufficient resulting benefit to the company to be called a Deferred Asset ac- count Moving Expenses, and to be written off from Profit and Loss only over a number of years. Usually this practice is frowned upon. It is well to know that such accounts are frequently found to be the founda- tion of the account in the balance sheet Deferred Charges Deferred Assets 125 to Expense, especially when no schedule is given to sup- port the balance sheet account. The 1914 annual report of the Loose-Wiles Biscuit Company exhibited an account "Deferred Charges to Future Operations" amounting to $391,292. The ac- count is explained to include "prepaid insurance, interest, etc., balance of special publicity expenses, and the net operating outlay incidental to the initial operation of the New York bakery." It is not orthodox to treat any operating expenses as assets. These "assets" may or may not have been a very large part of the $391,292. The accountants who certi- fied to the report sidestepped responsibility by stating that the Deferred Charges to Future Operations repre- sented outlays which, in the opinion of the directors, were reasonably and properly chargeable against future profits. By the end of 1918 the company had reduced the Deferred Charges to $118,635. In taking over properties legal expenses may be in- curred in large amount. The benefits of this expense may fairly apply over a series of years. Where so handled, a Legal Expense Deferred account is established, which is written off to Profit and Loss from year to year. The unusual expense of Advertising necessary to new firms in some lines of business is sometimes included in the Goodwill account. Other firms create a separate ac- count, as a Deferred Asset, charging off to Profit and Loss a goodly proportion of the amount each year. Advances to Subsidiaries as loans for expansion or for 126 How to Analyze Industrial Securities paying interest before earnings are developed is a com- mon account which should be placed among the De- ferred Assets, and not among the Current Assets. Whether the asset will be deferred permanently will depend upon the future of the subsidiary. If the amount is large, further investigation is indicated. Discount on Bonds is an account arising from the sale of a corporation's bonds at a discount from par. Suppose $1,000,000 twenty-year 5% bonds are sold at 92. Obviously the proceeds would be $920,000, while full $1,000,000 must be paid at maturity. If the entire $80,000 discount is charged to Profit and Loss the first year, the annual report will show a material loss, not en- tirely justified by facts, because probably the company could have sold twenty-year 6% bonds at par, involving no discount. It is quite proper, then, to set up the $80,000 Discount on Bonds as a Deferred Asset, writing off the account during the period the bonds run twenty years. Unfortunately many corporations have added the discount on bonds to the Plant or Land and Building account. The fact that this has been common practice is simply another short reason for skepticism regarding accounts that are not fully itemized and verified. Discount on Capital Stock, arising from the sale of stock at a discount from par. This discount is usually carried as Goodwill, though it would seem better prac- tice to set it up as a special account among the "assets by courtesy." PART V BALANCE SHEET CREDIT XXVII Bond Limitation THE conventional balance sheet, as exemplified by the form given on page 77 shows the capital stock at the head of the credit side of the balance sheet. For the present, capital stock will be ignored in favor of funded liabilities because of convenience in discussing the form of capitalization. Every one of the first large industrial corporations was forced by competitive conditions. Owners of many plants afterwards merged were overjoyed at an oppor- tunity to turn in their properties at inflated figures, se- cure cash and prior lien securities in a newly promoted corporation, and retire to quiet life. Those were the halcyon days of careless finance. Bonds were issued not only for property absorbed but even for promoters' profits, making a fixed charge of the expected economies of large scale productions and watered bonds. Un- wieldy financial structures such as the National Cordage Company, the National Asphalt Company and the United States Shipbuilding Company collapsed. The present generation of security purchasers may analyze the cause of the decline and fall of the great corporations which have gone before, and easily trace the path which leads away from safety. (127) 128 How to Analyze Industrial Securities In the first epidemic of consolidation, corporations were capitalized on the basis of expected earnings in the years of greatest prosperity. A corporation may exist indefinitely if its capitalization be represented in common stock, because returns are not obligatory, but ordinary bond charges are absolute. A deviation from expected returns of operation because of the depression period of the cycles in which general business labors and a collapse occurs. This seems so elementary as to need no proof, yet hundreds of millions of dollars have been sacrificed by investors because they had not learned this simple truth. The careful investor may learn it for himself, never to forget, if he will, and at the expense of other people's fortune breaking experience. Take for example the Allis-Chalmers Company. It struggled along for years under the burden of a fixed charge on $11,148,000 bonds which, besides interest, carried a sinking fund requirement and finally suc- cumbed. Having changed the form of its capitalization so that it is able to conserve its earnings, it is now on the path to prosperity. Most large corporations now doing business without direct court management are capitalized on more con- servative lines than most of those organized during the first period of consolidation. Some of them were created differently. Others, such as the Maxwell Motor Com- pany, have had their present form thrust upon them by voluntary or involuntary reorganization. To be sure, many of the best industrial corporations have issues of bonds. As a rule, however, a large bond Bond Limitation 129 issue is a caution sign. The United States Steel Cor- poration always has had large issues of bonds, and at present the corporation's financial strength seems as- sured but for many years the future was a grave ques- tion. If a business is one of comparatively steady income, bonds may be, as a medical practitioner says, "indicated.'* Normally a prior lien on the earnings and assets, they carry less risk to the security holder and consequently less income than other forms of capitalization. Bonds enable the common-stock holder to "trade on the equity" using at a profit borrowed funds. Suppose a business has $500,000 1st mortgage 5% bonds and $100,000 common stock. Now, suppose the earnings on the $600,000 invested are 8%. Paying $25,000 required for interest on the $500,000 bonds would leave $23,000, or 23% on the $100,000 capital stock, instead of the 8% which would have been shown without the more easily satisfied bonds. Yet the advantage may be more apparent than real. Bondholders, to be lightly dismissed in times of pros- perity, hold the fearsome "mortgage on the farm" when times of adversity come. Were the net income to drop from $48,000 to $25,000 the bondholders' requirements would be but barely met, and any decline from $25,000 would be a serious matter unless the corporation was well fortified with cash. Large bond issues have there- fore proved the undoing of more than one promising industrial. Perhaps the most obvious lesson of the past two decades of corporation finance and the one 130 How to Analyze Industrial Securities learned at the highest cost is that as far as solvency is concerned an industrial corporation depends upon the form of its capitalization and not its amount. Stock- holders, even cumulative preferred stockholders, may be pacified, or grimly told to wait until strength of treasury justifies capital return. Bondholders will not wait. They demand their pound of flesh and become the source of control in case of reorganization. An industrial corporation cannot soundly be financed like a railroad by enlisting new borrowed capital for a very large part of extensions. It must pay for its new plants and improvements largely out of earnings, and must supply itself with funds in the same way in order to place its securities upon a sound basis. This is true because a large part of its so-called permanent assets have little permanent value, whereas those of a railroad do have permanent value. The values in industrial plants are not permanent, partly because the plants themselves must so rapidly and continually be improved in order to cater to the changing demands, as iron and steel con- sumers for example; and partly because these plants, if the owning company ever becomes insolvent, are often but little more than junk. On the contrary, a piece of railroad property sold under the hammer will bring al- most all it actually cost. The business of a railroad may rise or fall with the times, but it can never wholly van- ish, whereas the business of an industrial concern can and often does vanish, as, for instance, a number of once flourishing automobile companies. It is because of these differences that thoroughly sound industrial companies should conserve their earnings and borrow sparingly. Bond Limitation 131 Times of prosperity such as 1915, 1916 and 1919, most promising in outlook, prove times of temptation to corporation managers. Now only the silver linings of the clouds are seen, and the future promises unlimited numbers of fat, juicy orders. New plants are planned, new equipment ordered, and all at prices which would seem exorbitant in ordinary times. Perfectly proper proceedings, these, if orders accepted on an abnormal price basis will assuredly prove so remunerative that the profits pay for the expansion. To plan extensions on borrowed money to accommodate business risen beyond the limits of reason, at exorbitant prices of labor and material, appears to be a questionable policy. Cycles, in business and finance, still run their course, and the depression certain to follow a "fool's paradise" may prove drastic and drawn out. The dollars should be kept in reserve, ready for service on the firing line, instead of being dissipated in large dividends or tied up in plant assets which are not only unused, but a financial burden in times less prosperous. In the public utility field, telephone and power corpora- tions are, as classes, particularly luminous examples of corporations luxuriating in even-keeled progress of earn- ings and profits. Telephone and power corporations may issue bonds drawing on earnings to a larger extent than can a corporation engaged, for example, in erecting office and hotel buildings. To be of any security to investors and to avoid a painful resemblance to the biblical action of a millstone, the bond issue of any cor- poration should be supported by sustained earnings, 132 How to Analyze Industrial Securities proving for several consecutive years a liberal amount over interest requirements. The customary business depression cuts off about 50 % of the average industrial corporation income available for return on bonds and stocks. Funded debt must therefore be carefully limited to the proved possibilities of earnings. Net earnings for the past five years, in- cluding the present, should be at least double the total interest charges. If, then, the net earnings have been $210,000, $201,000, $150,000, $215,000, $300,000, bond interest would amount to but $75,000, half the net earn- ings of the least prosperous year. At 5%, $75,000 would pay interest on $1,500,000, quite enough interest-bearing debt, it would seem, for an industrial with net earnings ranging from $150,000 to $300,000. Such limitation would add greatly to credit. Further capital require- ments could well be met from profits and increase in capital stock. That the obvious advantage of trading on the equity, i. e., benefiting through the use of capital borrowed at comparatively low rates, is not always essential is proven by the success of corporations such as most of the Standard Oil companies and the Ford Motor Company, which do not have even preferred stock. These have financed themselves out of earnings and have attained apparently unassailable financial strength. The Singer Sewing Machine Company also has a simple system of finance $60,000,000 in common stock. The Mergenthaler Linotype Company has $12,786,700 Bond Limitation 133 common stock, no preferred stock, no bonds. Such or- ganizations are of "safety first" character. The com- mon stock has as its equity the total valuation of the property, less floating dfcbt. Most of the corporations recently organized or re- capitalized have been promoted without bonds. Ex- amples are the Kresge and McCrory 5 and 10 cent stores. In fact, a large number of corporations have in recent years been organized on a basis of common stock only. A common form of capitalization is with one class stock of no par value. For example, the Lee Rubber and Tire Company has 150,000 such shares. Besides legal advantages in meeting taxation laws such stocks avoid even the appearance of coincidence of par with physical or book valuation and so help focus attention to the company's tangible and earning values. As illustrating the recognized necessity to curb un- wieldly industrial issues the bond provisions of Armour & Company and of the National Enameling & Stamp- ing Company are interesting. The strength of the Gen- eral Electric bonds is also notable. Armour & Company have outstanding $50,000,000 real estate first mortgage 4 l / 2 per cent, bonds. The mortgage provides that the unincumbered quick assets of the com- pany and its auxiliary companies shall at all times exceed the aggregate debt of the company and auxiliary com- panies, including the outstanding bonds of this issue. The National Enameling and Stamping Company had at last report outstanding $2,315,000 refunding first 134 How to Analyze Industrial Securities mortgage real estate sinking fund 5's which provide that the liquid assets of the company must equal the aggregate debts including outstanding bonds of this issue. The General Electric Company has authorized $75,- 000,000 of 5 and 6 per cent, debenture (unsecured) bonds. During the fourteen years to 1920, earnings for the stock were never less than $4,802,252, the figure for 1910. This year of lowest earnings showed over 1 and l /4 times the interest requirements of all these bonds authorized. Dur- ing the past eight years no year has shown total authorized bond interest earned less than three times. Moreover, only $25,000,000 of the bonds have been issued. The stock of the General Electric Company amounts to about $140,000,000, which at a fair average price of as low as $140 per share provides an equity back of its debts of about $196,000,000. The company has only $2,047,000 other bonds outstanding. As funded debt is usually considered all indebtedness maturing in more than a year, included therefore with bonds are short-term bonds or notes. Obligations com- ing due within five years are usually called notes, no matter whether secured or unsecured. Short-term ob- ligations are issued most often either to bridge a financial requirement considered only temporary, or to avoid the ruinous sacrifice in marketing long-term securities in an unwilling bond market. The corpora- tion issuing short-term notes, which command fair prices at nearly all times usually aims to secure any required permanent funds by refunding with longer-term Bond Limitation 135 maturities upon the appearance of favorable financial markets. Much acumen, or what is sometimes just as effective, much good fortune, must attend the refunding of short- term obligations. This is also true of long-term bonds presently maturing. Bonds issued in 1898, coming due in 1923, will require payment or refunding in 1923 just as truly as notes issued in 1919 and due four years hence. In fact, it is suggested that corporations place all funded maturities of less than five years in a separate category as now being short-term obligations, no matter when issued. If the short-term obligations are paid off at maturity, well and good. If they are refunded prior to or at this date to advantage in a rising, confident bond market, it is a transaction reflecting credit on the financial manage- ment. But not all short-term obligations are either paid at maturity or positively provided with refunding ar- rangements. Every little while parts of 1907 and 1908 and of 1914, for example credit in large quantities be- comes most difficult to secure, and refunding of obliga- tions almost impossible. The presence of a large amount of obligations maturing within a year or two may prove a millstone. This was true of the notes of the highly prosperous Westinghouse Electric and Manufacturing Company in 1907-1908. Financial stringency follows a plethora of loanable funds as surely as night follows the day, and stringency is nor- mally soon accompanied by decided declines in corpora- tion incomes conspiring against the refunding of obliga- tions. 136 How to Analyze Industrial Securities The United States Rubber Company had at the end of 1915 nearly $32,000,000 funded securities of long term and note issues maturing by the first day of December, 1918, besides $19,939,709 loans and notes payable, which included a large amount of borrowing which required reduction. This was officially recognized, in spite of large receivables on the other side of the balance sheet. The company is prospering, is in strong hands, and is conserving profits. Many stockholders will sleep easier now that a new financing plan has been safely under- written. A comparison of balance sheets before and after a bond or note issue is placed with investors usually shows how the funds have been used, though the information is usually indicated in the "remarks" of the annual re- ports. To take a simple example: suppose a company has a note issue of $10,000,000 maturing in 1915. Just before maturity the company sold a bond issue of $20,- 000,000. The annual report for the year 1915 would show no $10,000,000 note issue; instead there are $20,- 000,000 bonds among the liabilities, bills payable have decreased by $5,000,000 and cash increased $6,000,000. It would be evident that the new funds had been used to refund the note issue, to reduce the payables and to increase the cash. The $1,000,000 cash unaccounted for would probably prove to come from earnings saved from the year's business. XXVIII Preferred and Common Stocks AFTER a series of disasters to corporations having outstanding unwieldy funded indebtedness, promo- tions were made by the flotation of cumulative preferred stock and common stock, without bonds. In theory the preferred stock was issued to the value of the property. In certain cases cumulative preferred stock was issued for more than the value of the assets watered preferred stock. To issue cumulative preferred stock to the value of the property usually invited reck- less action. Few corporations can expect, until fortified by many years of economy and business expansion, to be able consistently to earn even 6 or 7 per cent, on the value of the property. Depressions in this country are sharp. Several of the largest corporations have gone into receivership because of paying unearned dividends on the cumulative preferred stock. To be sure, cumulative pre- ferred stock dividends are not arbitrary charges. They need not be paid. However, corporations are managed for the benefit of common-stock holders. One of the human failings has been, especially in past years, to value stocks by dividends rather than by earnings. At the time of organization promoters and underwriters usually receive common stock for their efforts. To make a mar- (137) 138 How to Analyze Industrial Securities ket to obtain the desideratum, cash, in exchange for com- mon stock, unwarranted dividends were declared on pre- ferred stock in order to give promise of dividends on the common. Cumulative preferred stocks are often, like most com- promises, necessary evils. Corporations not unusually prosperous issue cumulative preferred stock not only be- cause such stock may be sold to the public and the com- mon-stock holders can "trade on the equity," but because the investing public demands assurance that dividends on the preferred stock, shall not lapse indefinitely to the ultimate benefit of the common-stock holders. History shows that in far too many cases both preferred-stock holders and common-stock holders have suffered de- plorably. It would seem better to allow dividends on cumulative preferred stock to accumulate until the cor- poration could well afford to take care of them than to declare the dividend at the expense of all concerned. The directors of the Colorado Fuel & Iron Company declared dividends of 60% in 1916 on the $2,000,000 8% cumulative preferred stock, taking care of dividends previously omitted. Years before the company could have paid in full the comparatively small amount in- volved in squaring up the dividend requirement, but little criticism is levelled at the management for its con- servatism. Stock certificates should be as carefully examined as deeds. Every word may be essential. The preferred stock should be preferred as to earnings and in case of dissolution as to distribution of assets. If the dividends Preferred and Common Stocks 139 are not cumulative, i. e., payable in full from date of issuance to present date at the rate specified before any dividend may be declared on the common, the holder should know it. If any of the preferred dividends due in the past have not been paid, the possibility of payment is, perhaps, the most important consideration in regard to the purchase of the stock. A large number of preferred stocks are redeemable at a certain price, say 105 or 115, and some preferred stocks hang around the redeemable figure. The limita- tions of possibilities for a long, profitable investment in such stocks are evident. On the other hand, substantial profits have come to purchasers at a lower figure through redemption at the callable price. Some preferred stocks participate in all profits with the common by the terms of the certificate, and unless the re- turn on the preferred is specifically limited the preferred stock shares equally with the common after the pre- ferred dividend is paid in full. Many of the corporations having preferred stock are retiring it either as a matter of expediency or because of a provision entered into. The Woolworth, Kresge and McCrory Corporations have pledged themselves to issue no bonds nor to increase the preferred stock with- out consent of 2/3 of both common and preferred stock. Moreover, a certain amount is set aside by each of these corporations for the redemption of preferred stock up to a certain stipulated market price. The Woolworth Com- pany has retired $2,500,000 of preferred and has a large amount in the treasury to be retired. 140 How to Analyze Industrial Securities The Bethlehem Steel Corporation has authorized and outstanding $30,000,000 of 8% non-voting cumulative convertible preferred stock. It is preferred as to divi- dends over $14,908,000 7% preferred and shares equally with the 7% as to assets. The 8% issue is convertible at any time at the holder's option into the "B" class common stock at 115. That is, 1150 par value of 8% preferred is exchangeable for 1000 of "B" common. The convertible preferred however is redeemable on 90 days' notice at 115 and accrued dividends from Jan. 1, 1917. A large automobile company has recently issued 8